To understand oligopoly pricing in practice, we must be familiar with the legal constraints under which oligopolistic firms operate. In the United States, oligopoly first became an issue during the second half of the nineteenth century, when the growth of railroads—themselves an oligopolistic industry—created a national market for many goods. Large firms producing oil, steel, and many other products soon emerged. The industrialists quickly realized that profits would be higher if they could limit price competition. So many industries formed cartels—that is, they signed formal agreements to limit production and raise prices. Until 1890, when the first federal legislation against such cartels was passed, this was perfectly legal.

However, although these cartels were legal, their agreements weren’t legally enforceable—members of a cartel couldn’t ask the courts to force a firm that was violating its agreement to reduce its production. And firms often did violate their agreements, for the reason already suggested by our duopoly example in Module 64: there is always a temptation for each firm in a cartel to produce more than it is supposed to.

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In 1881, clever lawyers at John D. Rockefeller’s Standard Oil Company came up with a solution—the so-called trust. In a trust, shareholders of all the major companies in an industry placed their shares in the hands of a board of trustees who controlled the companies. This, in effect, merged the companies into a single firm that could then engage in monopoly pricing. In this way, the Standard Oil Trust established what was essentially a monopoly of the oil industry, and it was soon followed by trusts in sugar, whiskey, lead, cottonseed oil, and linseed oil.

Eventually, there was a public backlash, driven partly by concern about the economic effects of the trust movement and partly by fear that the owners of the trusts were simply becoming too powerful. The result was the Sherman Antitrust Act of 1890, which was intended both to prevent the creation of more monopolies and to break up existing ones. At first this law went largely unenforced. But over the decades that followed, the federal government became increasingly committed to making it difficult for oligopolistic industries either to become monopolies or to behave like them. Such efforts are known to this day as antitrust policy.

One of the most striking early actions of antitrust policy was the breakup of Standard Oil in 1911. Its components formed the nuclei of many of today’s large oil companies—Standard Oil of New Jersey became Exxon, Standard Oil of New York became Mobil, and so on. In the 1980s a long-running case led to the breakup of Bell Telephone, which once had a monopoly on both local and long-distance phone service in the United States. As we mentioned earlier, the Justice Department reviews proposed mergers between companies in the same industry and will bar mergers that it believes will reduce competition.

Among advanced countries, the United States is unique in its long tradition of antitrust policy. Until recently, other advanced countries did not have policies against price-fixing, and some even supported the creation of cartels, believing that it would help their own firms compete against foreign rivals. But the situation has changed radically over the past 25 years, as the European Union (EU)—an international body with the duty of enforcing antitrust policy for its member countries—has converged toward U.S. practices. Today, EU and U.S. regulators often target the same firms because price-fixing has “gone global” as international trade has expanded. During the early 1990s, the United States instituted an amnesty program in which a price-fixer receives a much-reduced penalty if it provides information on its co-conspirators. (Remember that the Great Vitamin Conspiracy was busted when a French company, Rhone-Poulenc, revealed the cartel in order to get favorable treatment from U.S. regulators.) In addition, Congress substantially increased maximum fines levied upon conviction. These two new policies clearly made informing on cartel partners a dominant strategy, and it has paid off: in recent years, executives from Belgium, Britain, Canada, France, Germany, Italy, Mexico, the Netherlands, South Korea, and Switzerland, as well as from the United States, have been convicted in U.S. courts of cartel crimes. As one lawyer commented, “You get a race to the courthouse” as each conspirator seeks to be the first to come clean.

Life has gotten much tougher over the past few years if you want to operate a cartel. So what’s an oligopolist to do?