(Price Leadership) Why might a price–leadership model of oligopoly not be an effective means of collusion in an oligopoly?
The Correct Answer and Explanation is:
Correct Answer:
A price-leadership model of oligopoly might not be an effective means of collusion because it is informal and lacks enforceability, making it unstable and prone to breakdown due to cheating or changes in market conditions.
Explanation:
In an oligopoly, a few dominant firms control the market, and their decisions are highly interdependent. One common model used to explain pricing behavior in such markets is price leadership, where one firm, usually the largest or most efficient, sets the price, and other firms follow. Although this can result in similar outcomes to collusion—such as higher prices and reduced competition—it is not a formal or legally binding agreement, making it inherently unstable.
One major reason price leadership may fail as a collusion method is the lack of enforceability. Since there is no formal contract, firms are free to deviate at any time. A follower firm might undercut the leader’s price to increase market share, triggering price wars and destabilizing the market. The leader also cannot force compliance, making long-term coordination difficult.
Additionally, asymmetric costs and objectives among firms can cause problems. Not all firms may find the leader’s price profitable or sustainable, especially if smaller firms face higher production costs or have different market strategies. This divergence increases the temptation to deviate from the leader’s pricing.
Market changes such as shifts in demand, new entrants, or regulatory scrutiny can also disrupt price leadership. For example, if consumer preferences change or antitrust authorities intervene, firms might abandon the informal agreement to avoid penalties or losses.
Lastly, communication barriers can lead to misunderstandings or misinterpretations of price changes. If a price leader changes its price due to internal factors like cost fluctuations, followers might not react as expected, leading to uncoordinated pricing.
Therefore, while price leadership may appear to be a form of tacit collusion, its informality, instability, and lack of enforceability make it an unreliable mechanism for sustaining collusion in an oligopoly.
