In an earlier Economics in Action, we described how the four leading chocolate companies in Canada were allegedly colluding to raise prices for many years. Collusion is not, fortunately, the norm. But how do oligopolies usually work in practice? The answer depends both on the legal framework that limits what firms can do and on the underlying ability of firms in a given industry to cooperate without formal agreements.

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, they 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: there is always a temptation for each firm in a cartel to produce more than it is supposed to.

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, 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 of 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-f ixing, and some had even supported the creation of cartels, believing that it would help their own firms against foreign rivals. But the situation has changed radically over the past 30 years, as the European Union (EU)—a supranational body tasked with enforcing antitrust policy for its member countries—has moved 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 informs on its co-conspirators. In addition, Congress increased the maximum fines levied upon conviction. These two new policies clearly made informing on your cartel partners a dominant strategy, and it has paid off as 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?

If a real industry were as simple as our lysine example, it probably wouldn’t be necessary for the company presidents to meet or do anything that could land them in jail. Both firms would realize that it was in their mutual interest to restrict output to 30 million pounds each and that any short-term gains to either firm from producing more would be much less than the later losses as the other firm retaliated. So even without any explicit agreement, the firms would probably achieve the tacit collusion needed to maximize their combined profits.

Real industries are nowhere near that simple. Nonetheless, in most oligopolistic industries, most of the time, the sellers do appear to succeed in keeping prices above their noncooperative level. Tacit collusion, in other words, is the normal state of oligopoly.

Although tacit collusion is common, it rarely allows an industry to push prices all the way up to their monopoly level; collusion is usually far from perfect. As we discuss next, there are four factors that make it hard for an industry to coordinate on high prices.

Less Concentration In a less concentrated industry, the typical firm will have a smaller market share than in a more concentrated industry. This tilts firms toward noncooperative behavior because when a smaller firm cheats and increases its output, it gains for itself all of the profit from the higher output. And if its rivals retaliate by increasing their output, the firm’s losses are limited because of its relatively modest market share. A less concentrated industry is often an indication that there are low barriers to entry.

Complex Products and Pricing Schemes In our lysine example the two firms produce only one product. In reality, however, oligopolists often sell thousands or even tens of thousands of different products. Under these circumstances, keeping track of what other firms are producing and the prices they are charging is difficult. This makes it hard to determine whether a firm is cheating on the tacit agreement.

Differences in Interests In the lysine example, a tacit agreement for the firms to split the market equally is a natural outcome, probably acceptable to both firms. In real industries, however, firms often differ both in their perceptions about what is fair and in their real interests.

For example, suppose that Ajinomoto was a long-established lysine producer and ADM a more recent entrant to the industry. Ajinomoto might feel that it deserved to continue producing more than ADM, but ADM might feel that it was entitled to 50% of the business. (A disagreement along these lines was one of the contentious issues in those meetings the FBI was filming.)

Alternatively, suppose that ADM’s marginal costs were lower than Ajinomoto’s. Even if they could agree on market shares, they would then disagree about the profit-maximizing level of output.

Bargaining Power of Buyers Often oligopolists sell not to individual consumers but to large buyers—other industrial enterprises, nationwide chains of stores, and so on. These large buyers are in a position to bargain for lower prices from the oligopolists: they can ask for a discount from an oligopolist and warn that they will go to a competitor if they don’t get it. An important reason large retailers like Walmart are able to offer lower prices to customers than small retailers is precisely their ability to use their size to extract lower prices from their suppliers.

These difficulties in enforcing tacit collusion have sometimes led companies to defy the law and create illegal cartels. We’ve already examined the cases of the lysine industry and the chocolate industry. An older, classic example was the U.S. electrical equipment conspiracy of the 1950s, which led to the prosecution of and jail sentences for some executives. The industry was one in which tacit collusion was especially difficult because of the reasons just mentioned.

Tacit collusion just didn’t seem practical—so executives met secretly and illegally to decide who would bid what price for which contract.

Because tacit collusion is often hard to achieve, most oligopolies charge prices that are well below what the same industry would charge if it were controlled by a monopolist—or what they would charge if they were able to collude explicitly. In addition, sometimes collusion breaks down and there is a price war. A price war sometimes involves simply a collapse of prices to their noncooperative level. Sometimes they even go below that level, as sellers try to put each other out of business or at least punish what they regard as cheating.

Lysine is lysine: there was no question in anyone’s mind that ADM and Ajinomoto were producing the same good and that consumers would make their decision about which company’s lysine to buy based on the price.

In many oligopolies, however, firms produce products that consumers regard as similar but not identical. A $10 difference in the price won’t make many customers switch from a Ford to a Chrysler, or vice versa. Sometimes the differences between products are real, like differences between Froot Loops and Wheaties; sometimes, like differences between brands of vodka (which is supposed to be tasteless), they exist mainly in the minds of consumers. Either way, the effect is to reduce the intensity of competition among the firms: consumers will not all rush to buy whichever product is cheapest.

As you might imagine, oligopolists welcome the extra market power that comes when consumers think that their product is different from that of competitors. So in many oligopolistic industries, firms make considerable efforts to create the perception that their product is different—that is, they engage in product differentiation.

A firm that tries to differentiate its product may do so by altering what it actually produces, adding “extras,” or choosing a different design. It may also use advertising and marketing campaigns to create a differentiation in the minds of consumers, even though its product is more or less identical to the products of rivals.

A classic case of how products may be perceived as different even when they are really pretty much the same is over-the-counter medication. For many years there were only three widely sold pain relievers—aspirin, ibuprofen, and acetaminophen. Yet these generic pain relievers were marketed under a number of brand names, each brand using a marketing campaign implying some special superiority (one classic slogan was “contains the pain reliever doctors recommend most”—that is, aspirin).

Whatever the nature of product differentiation, oligopolists producing differentiated products often reach a tacit understanding not to compete on price. For example, during the years when the great majority of cars sold in the United States were produced by the Big Three auto companies (General Motors, Ford, and Chrysler), there was an unwritten rule that none of the three companies would try to gain market share by making its cars noticeably cheaper than those of the other two.

But then who would decide on the overall price of cars? The answer was normally General Motors: as the biggest of the three, it would announce its prices for the year first, and the other companies would match it. This pattern of behavior, in which one company tacitly sets prices for the industry as a whole, is known as price leadership.

Interestingly, firms that have a tacit agreement not to compete on price often engage in vigorous nonprice competition—adding new features to their products, spending large sums on ads that proclaim the inferiority of their rivals’ offerings, and so on.

Perhaps the best way to understand the mix of cooperation and competition in such industries is with a political analogy. During the long Cold War between the United States and the Soviet Union, the two countries engaged in intense rivalry for global influence. They not only provided financial and military aid to their allies; they sometimes supported forces trying to overthrow governments allied with their rival (as the Soviet Union did in Vietnam in the 1960s and early 1970s, and as the United States did in Afghanistan from 1979 until the collapse of the Soviet Union in 1991). They even sent their own soldiers to support allied governments against rebels (as the United States did in Vietnam and the Soviet Union did in Afghanistan). But they did not get into direct military confrontations with each other; open warfare between the two superpowers was regarded by both as too dangerous—and tacitly avoided.

Price wars aren’t as serious as shooting wars, but the principle is the same.

We have seen that, across industries, oligopoly is far more common than either perfect competition or monopoly. When we try to analyze oligopoly, the economist’s usual way of thinking—asking how self-interested individuals would behave, then analyzing their interaction—does not work as well as we might hope because we do not know whether rival firms will engage in noncooperative behavior or manage to engage in some kind of collusion.

Given the prevalence of oligopoly, then, is the analysis we developed in earlier chapters, which was based on perfect competition, still useful?

The conclusion of the great majority of economists is yes. For one thing, important parts of the economy are fairly well described by perfect competition. And even though many industries are oligopolistic, in many cases the limits to collusion keep prices relatively close to marginal costs—in other words, the industry behaves “almost” as if it were perfectly competitive.

It is also true that predictions from supply and demand analysis are often valid for oligopolies. For example, in Chapter 5 we saw that price controls will produce shortages. Strictly speaking, this conclusion is certain only for perfectly competitive industries. But in the 1970s, when the U.S. government imposed price controls on the definitely oligopolistic oil industry, the result was indeed to produce shortages and lines at the gas pumps.

So how important is it to take account of oligopoly? Most economists adopt a pragmatic approach. As we have seen in this chapter, the analysis of oligopoly is far more difficult and messy than that of perfect competition; so in situations where they do not expect the complications associated with oligopoly to be crucial, economists prefer to adopt the working assumption of perfectly competitive markets. They always keep in mind the possibility that oligopoly might be important; they recognize that there are important issues, from antitrust policies to price wars, where trying to understand oligopolistic behavior is crucial.

We will follow the same approach in the chapters that follow.