Under what conditions will the oligopolists agree to co-operate in their decisions
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Oligopoly is a market structure under which only a few
suppliers dominate the market and the entrance of new suppliers is either
constrained or impossible. Usually,
the oligopoly market is dominated by 2-10 firms, who have a joint share of the
market of 50% or more. Automobile, steel, air transport are common examples of
oligopolies. Or, in a global sense, we could call oil producer countries
oligopolies and OPEC – a cartel. At least some firms may influence price due to
their important contribution to the total output. Every firm in the situation
of oligopoly knows that if it, or its competitors either change prices or
output, the revenues of all the participants on the market will change. That
means that firms are interdependent. For example, if General Morors Corporation
decides to raise prices on its cars, it should consider retaliative moves by
Ford, Chrysler, and other competitors in order to calculate the ultimate
changes in sales.
It is generally assumed that every firm on the market
realizes that its changes in prices or output will cause other firms to
retaliate. The kind of retaliation any supplier expects from its competitors as
a reaction to his changes in prices, output, or change of marketing strategy is
the main factor that influences its decisions.
That expected reaction also influences the balance of oligopoly markets.
Oligopolies may interact in two main ways:
Price wars, when a firm tries to increase it sales by
reducing prices, expecting that other firms will not be able to respond by
doing the same. This stops when no firm can low its prices anymore, which
occurs when P=AC and profit equals 0. Unfortunately for consumers, price wars
do not usually last long. Firms have temptations to co-operate with each other
in order to set up higher prices and to share markets in such a way, as to
avoid new price wars and their bad impact on revenues.
From the above factor results co-operation. Its closest form
is a cartel, when a union of oligopolies acts as a monopoly. Cartels are
illegal in many countries of the World.
Another reason for co-operation is to increase the entrance
barriers to prevent other firms (especially the so-called hit and run firms) to
join the market and drop prices. In that situation firms try to coordinate
To answer this question, I first need to describe the way
agreement between oligopolies form. Let us suppose that there are 15 suppliers
in the area A who want to co-operate with each other. These firms set their
prices equal to their average costs. Each of the firms is afraid to raise
prices for the reason its competitors might not follow that move and its
profits will become negative. Let us suppose that the production is at the
competitive level Qc (pic. A), that corresponds to the production quantity
under which the demand curve crosses MC, which is a horizontal sum of the
marginal cost curves of each supplier. MC would coincide with the demand curve
if the market were perfectly competitive. Each firm produces 1/15 of the total
The original balance exists at the point E.; the
competitive price is Pc. At that price each of the producers gets normal
revenue. At the price Pm, resulting from the co-operation agreement, each firm
could maximize its profits by setting Pm=MC. If each of the firms does that,
than there will be an over supply on the market, equal to QmQ units per month.
The price would fall to Pc. In order to maintain cartel price, each of the
firms should produce no more than the quota qm.
When the firms decide to co-operate, they should
implement the following policies to be able to maximize their profits.
They should make sure that there exists an entrance barrier
to the market in which they operate in order to prevent other firms from
selling a good at an old price after they increase prices for their output. If
the barriers do not exist, then the increase in prices would attract other
producers. The supply would then increase and prices would fall below the
monopoly level, co-operating firms aim to maintain.
They should decide on the general pattern of production.
This could be done by estimating market demand and by calculating marginal
profit for all levels of production. Firms need to produce so that their MC=MR
(we assume that all firms have similar production costs). The monopoly
production level would maximize revenues of each of the firms (see Pic. A). The
demand curve for the output is in the region of D. The marginal revenue that
corresponds to that curve is MR. The monopoly production level equals to Qm,
which corresponds to the point where MR crosses MC. The monopoly price equals
Pm. The current price equals Pc and the current output – Qc. That means that
the current balance is the same as it would be under competition.
Each participant in co-operation agreement should have
production quotas. The monopoly production Qm should be divided between all
members of the treaty. For example, each firm could produce a 1/15 share of Qm
per month. If all the firms had identical cost functions it would be equivalent
to recommending them to balance their production till their marginal costs
become equal to the market marginal revenue (MR’). Until the sum of the monthly
outputs of all producers equals Qm, it is possible to maintain the monopoly
Firms under co-operation agreement usually encounter
problems when they try to make a decision about monopoly prices and the level
of output. These problems are especially serious if the firms cannot agree on
the estimate of the market demand, its price elasticity; or, if they have
different production costs. Firms
with higher production costs try to insist on higher prices.
Every firm has incentives to increase its production at
cartel prices. At the same time, if everyone will increase production then the
agreement will fail because prices will decrease to their initial level. Pic. B
shows marginal and average costs of a typical producer. Before the conclusion of
co-operation agreement the firm behaves as if the demand for its output at the
price Pc was perfectly elastic. It does not increase prices because it fears to
lose all its sales to its competitors. It produces the quantity qc. As all
firms behave in the same way, the industrial output equals Qc, which is the
value that would exist under perfect competition. Under the newly established
agreed prices the firm is allowed to produce qm units of output, corresponding
to the point at which MR equals MC of each of the firms.
Let us suppose that the owners of any one of the firms think
that the market price will not fall if they start selling more than that
quantity. If they take Pm as price lying beyond their influence, then their
profit maximizing output will be q’, under which Pm=MC. If the market price
does not decrease, the firm can increase its profits from PmABC to PmFGH by
producing above the quota.
Just one firm could be able to increase its output without
causing any significant decrease in market prices. Let us suppose, however,
that all producers start producing above their quotas in order to maximize
their profits under “cartel” prices
Pm. The industrial output would then increase to Q’, under which Pm=MC, which
will result in excess supply as at that price the demand would be lower than
the supply. Consequently, prices will fall until the market clears, i.e. till
they become equal to Pc and the producers will come back where they have
Cartels usually try to penalize those who cheat with quotas.
The main problem however occurs when the cartel price gets set up, some firms,
aiming to maximize their profits, could earn more by cheating. If everyone is
cheating the co-operation agreement breaks down as profits fall to 0.
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