Oligopoly in Practice Module KRUGMAN'S MICROECONOMICS for AP* 30 66 Margaret Ray and David Anderson

What you will learn in this Module: The legal constraints of antitrust policy. The factors that limit tacit collusion. The causes and effects of price wars, product differentiation, price leadership, and nonprice competition. The importance of oligopoly in the real world. The purpose of this module is to explore the legal framework designed to prevent collusive behavior. The module also discusses the characteristics of oligopolies that make tacit collusion less likely in practice.

Antitrust Legislation Laws including the Sherman Act and the Clayton Act make cartels, collusion, and certain anti-competitive business practices illegal 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 made it difficult to form monopolies or for oligopolies to act like monopolies.

Factors Limiting Tacit Collusion There are some industry characteristics that make such tacit collusion less likely in the real world. 1) 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. A large number of firms also means that it is easier for firms to enter the industry. In other words, it’s not a very concentrated oligopoly to begin with. 2) The tacit agreement just can’t keep up when there are a variety of products and related services. 3) 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? If firms have quite diverse characteristics and interests, it will be more difficult to establish and maintain tacit agreements. 4) 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, it is unlikely to succeed Large numbers The more firms in the industry, the less likely tacit collusion will be successful Complex products and pricing schemes It is easier to tacitly agree to keep a price high if the product is simple and there are few ways price can be set. Differences in interests If firms have diverse characteristics and interests, it will be more difficult to establish and maintain tacit agreements. Bargaining powers of buyers If the buyers of a product have bargaining power, or they operate in a competitive retail environment, tacit agreements to keep prices high are unlikely to succeed. Sca

Product Differentiation and Tacit Collusion Price leadership Non-price competition Product differentiation is the attempt by firms to convince buyers that their products are different from those of other firms in the industry (either by making them different or just convincing buyers that they are). If firms can convince buyers, they can charge a higher price. 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. Non-Price competition occurs when firms compete without lowering prices; non-price competition. For example:   Offer a warranty or better service than their rivals, offer longer hours, a charge card with rewards program, personal shoppers, or amenities like a café in the store.

How Important is Oligopoly? Prevalence in the “real world” Difficulty of modeling oligopoly firm behavior Oligopoly is more common in the real world than perfect competition and monopoly and it is also more difficult to study. After all, the oil industry behaves differently than the breakfast cereal industry.   But, 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.