Price wars and sustaining collusion

Overview

Price war, market sharing and whistle-blowing or leniency arrangement.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a price war?

   Model answer

   A price war is a period in which rival firms repeatedly undercut one another, each cut being matched or beaten, so that prices fall well below their previous level and often below the level at which the firms earn supernormal profit. It is the breakdown of coordination into open price competition.

2. 2

   What can trigger a price war in an oligopoly?

   Model answer

   Common triggers are the entry of an aggressive new competitor, a cartel member being caught cheating, a slump in demand that leaves the industry with excess capacity, a firm launching a share-grabbing strategy after new ownership or management, or a technological change that cuts one firm's costs and lets it profitably undercut the rest.

3. 3

   A firm's total fixed cost is £60 and its total variable cost at outputs of 1 to 6 units is £40, £64, £78, £96, £130 and £186. A price war drives price down to £30 per unit. Should the firm keep producing in the short run?

   Model answer

   Average variable cost is £40, £32, £26, £24, £26 and £31 at outputs of 1 to 6, so the lowest average variable cost is £24 at 4 units. A price of £30 exceeds £24, so the firm should continue. Producing 4 units gives revenue of £120 against total cost of £156, a loss of £36, whereas shutting down would leave it paying the full £60 of fixed cost. Staying open is £24 better.

4. 4

   Using the same firm, with total fixed cost £60 and total variable cost of £40, £64, £78, £96, £130 and £186 at outputs of 1 to 6 units, at what price should it shut down in the short run?

   Model answer

   It should shut down once price falls below the minimum average variable cost of £24, which occurs at 4 units. At a price of £20, for instance, the best output would still be 4 units, giving revenue of £80 against total cost of £156 and a loss of £76, which is worse than the £60 loss from closing. Below £24 the firm cannot even cover the cost of the resources it uses up by producing.

5. 5

   Why is pricing below average variable cost treated as evidence of predatory intent rather than ordinary competition?

   Model answer

   A firm maximising short-run profit will never price below average variable cost, because doing so loses more money than shutting down. A price set deliberately below that level therefore cannot be explained by any short-run commercial motive, and the natural explanation is that the firm is accepting present losses to drive a rival out and recover the money later through higher prices.

6. 6

   Why can a price war be good for consumers in the short run but harmful in the long run?

   Model answer

   In the short run prices fall, consumer surplus rises and output expands towards the allocatively efficient level. In the long run the losses may force smaller competitors out, leaving a more concentrated market in which the survivor can raise prices above their original level, and the depressed profits during the war can also cut the investment and innovation that would have benefited consumers later.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.