OLIGOPOLY - 2

OLIGOPOLY – 2

Introduction:

Usually there exists some form of tacit or formal understanding among firms of a particular industry in an oligopoly market. Firms choose to follow a uniform price-output policy among them to avoid the uncertainty arising out of interdependence and to avoid price wars as well as cut throat competition. When firms enter into such collusive agreements either formally or tacitly (secretly), collusive oligopoly comes into existence.

Market collusions:

There are two types of market collusions among firms in oligopoly. They are cartels and price leadership. In a cartel, firms jointly fix a price and output policy through agreements. In the case of price leadership one firm sets the price called as ‘price leader’ and others follow it called as ‘followers’. Follower firms follow the price leader even it means deviating from its own profit maximizing objective because it is believed to be in one’s advantage not to compete with the price leader.

Cartels:

It basically refers to a common sales agency that undertakes selling operations for all the firms that are party to the agreement. Now-a-days it takes on various formal or tacit agreements. Due to its competition restraining character their formation is treated as illegal in many countries.

Formal collusion agreements maybe of various forms. One of it is called “Perfect Cartel”. In this case members firms completely surrender their rights of price and output determination to a central administrative agency. The goal of this authority is to achieve maximum joint profits for the member firms. On account of its competition restraining character cartels have been treated as illegal in several countries.

In a perfect cartel, the output quota of each member is decided by the central administrative agency. The goal is to keep total cost of total ouput by the industry minimum. This objective can be achieved when various firms in the cartel produce their outputs at equal marginal costs.

Illustration and explanation:

It is already understood that the objective of the cartel is to maximize joint profits of its members. Given this the process of price output determination maybe analyzed in the following paragraphs by assuming the cartel to consists of two firms.

First the cartel will estimate the aggregate demand curve for the industry. As an aggregation of the industry consumers’ demand it will be a downward sloping curve. The Marginal Revenue curve showing the cartel’s additional revenue of its additional output and sale will be below the demand curve DD. The Cartel’s Marginal Cost curve MCC is the horizontal addition of marginal cost of the two firms i.e. MCA + MCB = MCC.

The cartel maximizes joint profits at industry output level where MR = MCC i.e. OQ output at price level QL (or) OP. (See figure 37.1, page – 750, Advanced Economic Theory: Microeconomic Analysis, H L Ahuja). Given this total output OQ fixed by the cartel, it will now allot this output to firms A and B in such a way that both the firms have the same (equal) Marginal Cost. This is done by extending point R horizontally to the two firms. Also the two firms take the cartel’s decided price as given and manages its marginal cost as well as its average cost in a such a manner that MC is same for both firms and th respective average cost will indicate the profit or loss faced by the firms. In the figure it is:

OQ1 = equilibrium output of firm A.
OQ2 = equilibrium output of firm B.
PFTK = supernormal profits of firm A.
PEGH = supernormal profits of firm B.

However in a perfect cartel arrangement division of profits among the firms depends on ‘relative bargaining strengths’ of firms within the cartel. It is not necessarily proportionate to the individual output of each firm. In fact output quota allocation is on the basis of minimizing costs and not on the basis of determining profit distribution.

Market sharing cartels:

Perfect cartels are quite rare in the real world. The more prevalent one is loose cartels in which there is market sharing by firms. There are two methods of market sharing: (a) Non – price Competition and (b) Quotas.

Market sharing by non-price competition: In this arrangement a uniform price is agreed upon by the cartel. Usually it will be a price that will ensure some profits even to high cost firms. With each firm in the industry taking the uniform cartel price as given, they are free to produce their won profit maximizing output and also engage in non-rice competitive market strategies like advertising to promote their sales. However these cartels are quite unstable because low cost firms are heavily tempted to try price cutting strategies. They engage in it tacitly by providing secret price concessions to their buyers. But eventually this gets exposed, price war follows and the cartel breaks down.

Market sharing quota: Here firms agree to an output quota arrangement that each firm would produce and sell at an agreed price. In case of homogenous products and equality of costs among firms, a monopoly solution emerges. If there are cost differences, output shares agreed upon are also different between the firms. Although ratio of output sharing should be fixed according to each firm’s past sales and productive capacity it ultimately depends on each firm’s bargaining power and skill, because the two criteria can be manipulated by firms. Region wise market division arrangement is also present in cartels. Whatever the arrangement followed in a cartel, cost difference between firm’s and free entry of new players into the oligopolistic industry create instability in the carte.