Module 66: Oligopoly in Practice
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Key Economic Concepts
Legislation, notably the Sherman Antitrust Act, prohibits most forms of explicit cartel and monopoly behavior.
Oligopolists may tacitly collude if there are few firms, simple products, similar interests and buyers who have little bargaining power.
Firms in oligopolies often compete by differentiating their products so they can raise price above competitive levels.
If one firm emerges as a price leader, tacit collusion will result as other firms set prices based on the prices set by the leader.
Even if firms do not compete on the basis of price, they may compete in other areas.
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Module Layout
II. The Legal Framework
II.Tacit Collusion and Price Wars
A. Large Numbers
B. Complex Products and Pricing
Schemes
C. Differences in Interests
D. Bargaining Power of Buyers
III. Product Differentiation and Price Leadership
IV.How Important is Oligopoly?
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I. The Legal Framework
Explicit cartel collusion on a large scale is uncommon today because of legislation such as the Sherman Antitrust Act of 1890.
Modern economies such as the United States and the European Union have, with a series of antitrust laws, made it difficult to form monopolies or for oligopolies to act like monopolies.
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II. Tacit Collusion & Price Wars
Because explicit collusion is illegal, firms in oligopolies might escape the Prisoners’ Dilemma if they eventually find tacit collusion, with prices above competitive levels, to be productive.
There are some industry characteristics that make such tacit collusion less likely in the real world.
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II. Tacit Collusion & Price Wars
Tacit collusion requires that the participants “get it”. They understand that if everyone keeps the price high, all firms benefit. But if there are many firms, someone might not understand this mechanism for
higher profits.
And more firms means it’s easier to cheat on the tacit agreement without being detected.
BOTTOM LINE: The more firms in the industry, the less likely tacit collusion will be successful.
A. Large Numbers
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II. Tacit Collusion & Price Wars
Imagine that two cell phone providers, Verizon and AT&T, might consider tacit agreements on the price of phone service. How many different products do they offer? Quite a few! How many different pricing plans do they offer?
Maybe Verizon keeps the price of text message plans high, but slashes the price of internet service.
AT&T sees this as reneging on a tacit agreement to keep all prices high, so cuts prices on all services offered to their customers.
BOTTOM LINE: It is much easier to tacitly agree to keep a price high if the product is quite simple and if there are very few ways in which price can be set.
B. Complex Products and Pricing Schemes
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II. Tacit Collusion & Price Wars
Do the firms share common interests and agree upon how the market should be shared?
Do they operate in the same regions of the country or world?
Do they have similar agreements with their labor unions and suppliers?
Is one firm more established, while the other is a relatively new entrant?
BOTTOM LINE: If firms have quite diverse characteristics and interests, it will be more difficult to establish and maintain tacit agreements.
C. Differences in Interests
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II. Tacit Collusion & Price Wars
Producers usually sell their products to a retailer, who in turn sells the product to the consumer. For example, the breakfast cereal industry, an oligopoly of just a few firms (General Mills, General Foods) sells to large grocery chains like Kroger, Safeway, and Wal-Mart. These huge retailers (the grocery stores) compete in a very competitive environment for shoppers, and they have a lot of buying power due to their size.
Because of these two factors, if General Mills and General Foods tried to tacitly agree to keep cereal prices high, they are unlikely to succeed.
BOTTOM LINE: If the buyers of a product have significant bargaining power, or if they operate in a highly competitive retail environment, tacit agreements by producers to keep the price high are unlikely to succeed.
D. Bargaining Power of Buyers
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III. Product Differentiation & �Price Leadership
The market for athletic footwear (Nike, Reebok,Adidas) has a product like a pair of running shoes, but each firm spends a lot of money developing characteristics that cause their shoes to stand out as different, and better, than rival shoes. If consumers agree, the firm can increase the price and consumers will be willing to pay it.
But if all firms agree that this strategy works, how will a tacit agreement on price develop?
A price leader is a firm that sets a price and the rival firms follow it. By following the leader, a tacit agreement is created.
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III. Product Differentiation & �Price Leadership
Firms can also compete without lowering prices; non-price competition. How can firms use non-price competition?
• Offer a warranty or better service than their rivals.
• Retailers can offer longer hours, a charge card with rewards program, personal shoppers, or amenities like a café in the store.
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IV. How Important is Oligopoly?
Oligopoly is more common in the real world than perfect competition and monopoly and it is also more
difficult to study.
Economists use the benchmarks of perfect competition and monopoly to gauge the behavior of oligopolists and the outcomes.
Are firms able to tacitly raise prices? If so, the market will share more characteristics with monopoly (high profits, deadweight loss) than with perfect competition.
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Practice Question #1
1. Having which of the following makes it easier for oligopolies to coordinate on raising prices?�
a. a large number of firms�
b. differentiated products�
c. buyers with bargaining power�
d. identical perceptions of fairness�
e. complex pricing schemes
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Practice Question #2
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Practice Question #3
3. When was the first federal legislation against cartels passed?�
a. 1776�
b. 1800�
c. 1890�
d. 1980�
e. 2011
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Practice Question #4
4. Organized crime groups act as_____.
a. Perfect competitors
b. Monopolisitic competitors
c. Cartels
d. Government agencies
e. Non-colluding oligopolies
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Practice Question #5
5. Oligopolists engage in tacit collusion in order to�
a. raise prices.�
b. increase output.�
c. share profits.�
d. increase market share.�
e. all of the above.
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