Price discrimination, collusion and cartels, the theory of contestable markets, and game theory and oligopoly behaviour.

What this dot point is asking

WJEC wants you to explain how firms with market power behave: price discrimination and its conditions, collusion and cartels, the theory of contestable markets, and game theory in oligopoly.

The answer

Price discrimination

Three conditions must hold. The firm must have price-setting (monopoly) power; it must be able to separate consumers into groups with different price elasticities of demand; and it must be able to prevent resale (arbitrage) between groups, or the cheap buyers would resell to the dear ones. The firm then charges a higher price to the group with more inelastic demand and a lower price to the more elastic group, capturing more consumer surplus and raising total revenue and profit. The effects are mixed: it raises profit and can fund investment or allow some consumers to be served who otherwise would not be, but it transfers surplus from consumers to the firm and can be seen as unfair.

Collusion and contestable markets

Collusion may be overt (a formal cartel agreement) or tacit (an unspoken understanding, such as price leadership where firms follow a dominant firm). It is attractive because it avoids destructive price wars, but it harms consumers through higher prices and is therefore prohibited. The theory of contestable markets is important because it shifts the focus from the number of firms to the freedom of entry and exit: if hit-and-run entry is easy (low sunk costs), even a single incumbent must price competitively to deter entrants, so a market can behave competitively without many firms. This insight underpins policies that lower barriers to entry rather than break up firms.

Game theory and oligopoly

In an oligopoly, interdependence means each firm must anticipate rivals' reactions, which game theory captures. In the classic prisoner's dilemma, if both firms keep prices high they share high profits, but each is tempted to undercut to win market share; since both reason this way, both end up cutting prices and earning lower profits, a worse joint outcome (a Nash equilibrium in which neither can do better given the other's choice). This explains both the pull towards collusion (to escape the dilemma and reach the high-profit outcome) and why collusion is unstable (each partner is tempted to cheat). It also explains price rigidity and the preference for non-price competition in oligopoly.

Examples in context

Example 1. Price discrimination in travel. Airlines and rail companies are textbook price discriminators: the same seat costs different amounts depending on when it is booked, time of travel and flexibility, separating leisure travellers (elastic, price-sensitive) from business travellers (inelastic). The conditions hold, the firms have market power, the groups have different elasticities, and a ticket cannot easily be resold, so the strategy raises revenue. It illustrates all three conditions for price discrimination in a familiar market.

Example 2. Cartels and competition enforcement. Competition authorities regularly uncover and fine cartels, firms secretly agreeing prices or carving up markets, in industries from construction to consumer goods. These cases show collusion in action (acting like a monopoly to raise joint profit) and its instability (cartels are often exposed when a member defects and applies for leniency). They explain why collusion is illegal and why authorities offer leniency to whistle-blowing members, exploiting the prisoner's dilemma to break cartels.

Try this

Q1. State the three conditions necessary for price discrimination. [3 marks]

• Cue. Market (price-setting) power; the ability to separate consumers into groups with different price elasticities of demand; and the ability to prevent resale (no arbitrage) between groups.

Q2. Explain what is meant by a contestable market. [3 marks]

• Cue. A market where the threat of entry is strong because barriers to entry and sunk costs are low, so incumbents are disciplined to keep prices and profits down even if there are few firms.