Comparison of the Contestable Market Model and the Cartel Model

Because of the importance of the invisible handshake in determining strategies of oligopolies, no one "oligopolistic model" exists. The stronger the ability of oligopolies to collude (i.e., the more the invisible handshake can prevent entry), the closer to a monopolist solution the oligopoly can reach. The weaker the invisible handshake and the harder it is to prevent new entry, the closer is the oligopoly solution to the competitive solution. That's as explicit as one can be.

An oligopoly model can take two extremes:

(1) cartel model in which an oligopoly sets a monopoly price,

(2) contestable market model in which an oligopoly with no barriers to entry sets a competitive price.

Thus, we can say that an oligopoly's price will be somewhere between competitive price and monopolistic price. Other models of oligopolies give results in between these two.

Much of what happens in oligopoly pricing is highly dependent on the specific legal structure within which firms interact. In Japan, where large firms are specifically allowed to collude, we see Japanese goods selling for a much higher price than those same Japanese goods sell for in the United States. For example, you may well pay twice as much for a Japanese television in Japan as you would in the United States From the behavior of Japanese firms; we get a sense of what pricing strategy U.S. oligopolists would follow in the absence of the restrictions placed on them by law.

Notice that both the cartel model and the contestable market model use strategic pricing decisions—firms set their price based upon the expected reactions of other firms. Strategic pricing is a central characteristic of oligopoly.

One can see the results of strategic decision making all the time. For example, consider a firm that announces that it will not be undersold—that it will match any competitor's lower price and will even go under it. Is that a pro-competitive strategy leading to a low price? Or is it a strategy to increase collusive information and thereby prevent other firms from breaking implicit pricing agreements? Recent work in economics suggests that it is the latter.

Let's now see how a specific consideration of strategic pricing decisions shows that the cartel model and the contestable market model are related.

Other Oligopoly Models

Behavior in oligopolistic markets is very difficult to analyze. The difficulty seems from the fact that the way firms behave depends crucially on how they think their rivals will respond to their pricing policies. The way firms compete in a market also depends on how they think their rivals will react to changes in advertising policies or to the introduction of new products.

In the preceding analysis of oligopoly we considered only the possibility of price wars and the tendency of firms to collude to maximize group profits. There are many other possible outcomes in oligopolistic markets. Each outcome depends on how firms regard their rivals, on their willingness to collude with their rivals, and on the penalties they may pay for illegal collusion. Each oligopolistic market must be examined by itself to determine what is going on.