The Legal Framework

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.

Contrasting Approaches to Antitrust Regulation

In the European Union, a competition commission enforces competition and antitrust regulation for the 28 member nations. The commission has the authority to block mergers, force companies to sell subsidiaries, and impose heavy fines if it determines that companies have acted unfairly to inhibit competition.

Although companies are able to dispute charges at a hearing once a complaint has been issued, if the commission feels that its own case is convincing, it rules against the firm and levies a penalty. Companies that believe they have been unfairly treated have only limited recourse. Critics complain that the commission acts as prosecutor, judge, and jury.

In contrast, charges of unfair competition in the United States must be made in court, where lawyers for the Federal Trade Commission have to present their evidence to independent judges. Companies employ legions of highly trained and highly paid lawyers to counter the government’s case. For U.S. regulators, there is no guarantee of success. In fact, judges in many cases have found in favor of companies and against the regulators. Moreover, companies can appeal unfavorable decisions, so reaching a final verdict can take several years.

Companies, not surprisingly, prefer the American system. The accompanying figure further shows why. In recent years, on average, fines for unfair competition have been higher in the European Union than in the United States.

Observers, however, criticize both systems for their inadequacies. In the slow-moving, litigious, and expensive American system, consumers and rival companies may wait a very long time to secure protection. And companies often prevail, raising questions about how well consumers are protected. But some charge that the EU system gives inadequate protection to companies that are accused. This is a particular concern in high-tech industries, where network externalities are strong and rivals can use complaints of unfair competition to hobble their competitors.

Sources: European Commission, Department of Justice Workload Statistics; PACIFIC Exchange Rate Service at University of British Columbia.

Sidney Harris/Cartoonstock.com

Antitrust policy consists of efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies.

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?