Module 33 Oligopoly in Practice

What You Will Learn The legal constraints of antitrust policy The factors that limit tacit collusion The cause and effect of price wars, product differentiation, price leadership, and nonprice competition The importance of oligopoly in the real world 1 2 3 4

Oligopoly in Practice Oligopolies operate under legal restrictions in the form of antitrust policy. Antitrust policies are efforts undertaken by the government to prevent oligopolies from becoming or behaving like monopolies. But many achieve tacit collusion.

Oligopoly in Practice Tacit collusion is limited by a number of factors: Large numbers of firms Complex products and pricing schemes Bargaining power of buyers Conflicts of interest among firms

Tacit Collusion and Price Wars Real industries often realize it is in their best interest to keep their prices above the noncooperative level.

Tacit Collusion and Price Wars A variety of factors make it hard for an industry to coordinate on high prices: The more firms, the less incentive to behave cooperatively. Complex pricing schemes and complex products make monitoring other firms difficult. Firms often differ in their perceptions of what is fair or in their best interests. Large buyers can bargain for lower prices.

Tacit Collusion and Price Wars Because tacit collusion is often hard to achieve, most oligopolists charge prices that are far below what they would charge if they could collude explicitly. Sometimes tacit collusion breaks down and aggressive price competition amounts to a price war.

Economics in Action The Price Wars of Christmas During the last several seasons, toy retailers have engaged in cutthroat competition, driving some retailers to bankruptcy. The causes include preferences that have changed from toys to video games and the Internet. New entrants, such as Walmart and Target, reduce the future payoff from collusion. Retailers depend on holiday sales for nearly half of their annual sales. In an effort to expand sales and undercut rivals, retailers have begun slashing prices earlier in the season.

Product Differentiation and Price Leadership To limit competition, oligopolists often engage in product differentiation. Product differentiation can be an attempt by a firm to convince buyers that its product is different from the products of other firms in the industry.

Product Differentiation and Price Leadership When products are differentiated, it is sometimes possible for an industry to achieve tacit collusion through price leadership. Oligopolists often avoid competing directly on price by engaging in nonprice competition through advertising and through other means.

Product Differentiation and Price Leadership In price leadership, one firm sets its price first, and other firms follow. Firms that have a tacit understanding not to compete on price often engage in intense nonprice competition, using advertising and other means to try to increase their sales.

How Important Is Oligopoly? Oligopoly is far more common than either perfect competition or monopoly. Predictions from the supply and demand model are often valid for oligopoly.

How Important Is Oligopoly? Is the model of perfect competition still useful? Yes. Important parts of the economy are fairly well explained by the perfect competition model. The analysis of oligopoly is far more difficult than that of perfect competition. Economists like to use the assumption of perfect competition.

Summary To limit the ability of oligopolists to collude and act like monopolists, most governments pursue an antitrust policy designed to make collusion difficult. In practice, however, tacit collusion is widespread. A variety of factors make tacit collusion difficult: large numbers of firms, complex products and pricing, differences in interests, and bargaining power of buyers. When tacit collusion breaks down, there is a price war. Oligopolists try to avoid price wars in various ways, such as through product differentiation and price leadership, in which one firm sets prices for the industry. Another is through nonprice competition, such as advertising.