The competitive spectrum

No single general model of oligopoly behavior exists. The reason is that an oligopolist can decide on pricing and output strategy in many possible ways, and there are no compelling grounds to characterize any of them as the oligopoly strategy. Although there are five or six formal models, we'll focus on two informal models of oligopoly behavior that give you insight into real-world problems rather than exercise your reasoning and modeling abilities as my earlier discussion did.

1) Cartel.

An extreme case of oligopoly is a cartel, where the firms behave as a monopoly in a manner similar to that of the Organization of Petroleum Exporting Countries (OPEC) in the world oil market.

Forming a cartel: directions and difficulties

Let's examine some of the problems faced by a cartel in its quest for increased profits. Suppose several brick producers want to form a cartel. Here are the four steps necessary to form the cartel.

Step 1. Make sure there is a barrier to entry to prevent other firms from selling bricks after the price is increased.

Step 2. Organize a meeting of all brick producers to establish a target level of output.

Step 3. Set up quotas for each member of the cartel. Divide up the agreed-upon cartel output among the firms.

Step 4. Make sure no firm exceeds its quota. This step is crucial to make the cartel work. It's also difficult to enforce. The reason is that each firm has incentives to sell more than its assigned quota as the cartel price.

2) Implicit Price Collusion.

In other cases the various firms meet, sometimes only by happenstance, at the golf course or at a trade association gathering, and arrive at a collective decision. In yet other cases the firms engage in implicit collusion—multiple firms make the same pricing decisions even though they have not explicitly consulted with one another.

3) Price war.

A price war is a bout of continual price cutting by rival firms in a market. It's one of many possible consequences of oligopolistic rivalry. Price wars are great for consumers but bad for the profits of sellers.

4) The Contestable Market Model.

The contestable market model is a model of oligopoly in which barriers to entry and barriers to exit, not the structure of the industry, determine a firm's price and output decisions.

5) Price leadership.

In some oligopolistic markets, one dominant firm in the industry sets its price to maximize its own profits; other firms simply follow its lead by setting exactly the same price. The dominant firm is called the price leader.

6) Price rigidity: the kinked demand curve model.

In very competitive markets, such as those for wheat and other agricultural commodities, prices are very sensitive to changes, in demand and supply. In such markets prices change almost by the minute.

7) Entry-limit pricing.

Firms in an oligopolistic market may set prices in order to make it unprofitable for potential new entrants into the market to actually begin selling. To accomplish this objective, firms in the market do not necessarily set a price that maximizes their current profits. Instead, they are forward looking enough to forgo current profits in order to keep new entrants from entering the market and putting downward pressure on future profits.

Summarizing of the high points of the four types of competition is represented in table 9.1.

Table 9.1