Businesses engage in many pricing (and non-price-related) competitions in order to increase their profits. The pricing behaviors they choose are related to the type of market they’re in, whether an oligopoly or a monopoly.
Interdependence leads oligopolists to behave strategically. The strategic pricing behaviors that occur in oligopoly include price leadership and price wars. In addition to these pricing behaviors, oligopolies also engage in non-price competition. The purpose of these price and non-price behaviors is the same, however, and that is to maximize oligopolistic firms’ profits.
Price leadership takes place when a dominant firm makes the pricing decision for the rest of the market. These decisions are often made public long before the new price goes into effect, and represent a form of tacit collusion. Smaller firms in the industry will usually follow suit and match the price leader’s price. Price leadership offers firms an opportunity to capture a price that is higher than would occur if the firms directly competed on price. Consumers usually fare better under price leadership than they would if the firms formed a cartel but worse than if they were highly competitive.
Price wars occur when firms break out of the price leadership model and begin undercutting one another’s prices. Although it sounds bad, price wars are often advantageous to consumers because of the competitive prices created in the process. Some firms have been accused of financing price wars by raising prices in one part of their market in order to cut their price in another part of their market. A price war continues until the firms once again reach tacit collusion and return to the price leadership model.
While in the price leadership operating mode, firms compete on the basis of product differentiation as opposed to price. By emphasizing their product’s differences and uniqueness, firms attempt to wrest market share from one another. As in the monopolistically competitive market, oligopolists engaging in non-price competition will spend large sums on advertising. For example, the major American beer brands do not compete on price, but instead rely on non-price competition in the form of advertising in order to gain market share from one another.
On the opposite end of the spectrum from perfect competition lies monopoly. As the name suggests, monopoly is a market dominated by a single seller. In the United States, monopolies are generally not allowed to exist, and every effort is made by government regulators at the FTC to prevent their creation. The reason for this prohibition is that monopolies create a serious problem for both consumers and likely competitors in the marketplace. Despite the fact that monopolies are undesirable, there are several good reasons for some to exist. The following are the primary reasons for the existence of most monopolies in the United States:
Monopoly occurs when a competitive firm eliminates all competition. Through control of key resources, mergers, and even a little help from government, once-competitive firms may find themselves in the enviable position of being a monopolist. A typical pricing behavior for a monopoly is to increase prices as much as possible.
John D. Rockefeller’s Standard Oil Trust is probably the most notable American monopoly. By controlling the resource, purchasing the competition, and having political influence, Standard Oil at its height of power virtually controlled all oil production in the United States. This was good for Mr. Rockefeller as it made him the world’s wealthiest man, but for consumers and possible competitors, the results of the Standard Oil Trust were high prices, inefficient production, and significant barriers to entry. Eventually, the Sherman Antitrust Act was used to break up Standard Oil, and ever since the government has taken an active role in preventing further monopolies.
Because they lack competition, monopolies can engage in price discrimination to make it difficult for other firms to do business. Price discrimination is the ability to charge different customers different prices for the same good or service. For example, a railroad monopolist could charge different rates to different customers for carrying the same amount of freight. Today, thanks to the Clayton Antitrust Act, price discrimination for the most part is illegal.
Some forms of price discrimination still exist because they are seen as acceptable.
You might have benefited from price discrimination the last time you went to a movie theater or flew on an airplane. Senior citizen, student, and military discounts are usually offered at theaters. Business travelers and vacationers often pay very different prices for tickets on the same flight even though they might both fly coach. How do the airlines get away with it? It is defensible because vacationers and business travelers have different elasticities of demand for airline tickets. Vacationers have elastic demand for tickets because they are able to book travel months in advance and are often willing to purchase nonrefundable fares. Business travelers’ demand is much more inelastic, and thus they are willing to pay the higher price for the convenience of refundable fares and the privilege of booking tickets at short notice. By being allowed to charge different prices for basically the same ticket, the airline is able to better ration tickets between those who need a ticket and those who want a ticket.