Most real markets are neither perfectly competitive nor monopolies. They are oligopolies — dominated by a small number of firms whose decisions are interdependent. Understanding oligopoly requires game theory, the study of strategic interaction.
Monopolistic competition sits between perfect competition and oligopoly. Many firms sell differentiated products (think restaurants or clothing brands). Each has a tiny bit of market power, but free entry ensures zero economic profit in the long run. The key insight: product differentiation creates downward-sloping demand curves even with many competitors.
In an oligopoly, the key challenge is that each firm's best strategy depends on what the other firms do. If your competitor cuts prices, should you match? If they increase advertising, should you respond? These strategic interactions are modeled using game theory.
Game theory basics introduce the essential framework: players, strategies, payoffs, and the Nash equilibrium — a situation where no player can improve their payoff by changing their strategy alone. The prisoner's dilemma shows why rational firms may end up in outcomes that are bad for everyone: each firm has an incentive to cheat on a cooperative agreement, even though mutual cooperation would be more profitable.
The Cournot model assumes firms compete on quantity — each chooses how much to produce, taking the other's output as given. The Bertrand model assumes firms compete on price — and reaches the striking conclusion that just two competitors can drive prices down to marginal cost, the same as perfect competition.
These models explain real-world phenomena: why airlines match each other's prices, why OPEC struggles to maintain production quotas, and why tech companies engage in fierce price wars.