MODULE 5: OLIGOPOLY

If a few firms face identical orIf a few firms face identical orhighly similar demand and costs...highly similar demand and costs...

Collusion is the act of firms working together or Collusion is the act of firms working together or cooperating to establish the price and output levels cooperating to establish the price and output levels in a particular market.in a particular market.

They will seek joint profitThey will seek joint profitmaximization...maximization...

Collusive OligopolyCollusive Oligopoly

Cartels CartelCartel

– Group of firms that have explicitly and openly agreed to Group of firms that have explicitly and openly agreed to work together to set the price that will be charged in a work together to set the price that will be charged in a particular market or the production quotas for all the particular market or the production quotas for all the firms.firms.

Centralized CartelCentralized Cartel– Formal agreement among member firms to set a Formal agreement among member firms to set a

monopoly price and restrict outputmonopoly price and restrict output– Incentive to cheatIncentive to cheat

Market-Sharing CartelMarket-Sharing Cartel– Collusion to divide up marketsCollusion to divide up markets

Collusive Pricing Model The Centralized Cartel Model:The Centralized Cartel Model: The Oligopolists Get Together (Since The Oligopolists Get Together (Since

There are So Few of Them) and There are So Few of Them) and Act Act As If They Were One MonopolistAs If They Were One Monopolist. .

Collectively Produce the Monopolistic Collectively Produce the Monopolistic Quantity (establish quotas) - Thus Quantity (establish quotas) - Thus Maximizing Profit as a groupMaximizing Profit as a group..

Example: OPECExample: OPEC

a) Decrease competition, achieve monopoly-like behavior

b) Decrease uncertainty

c) Decrease ease of entry

Motivations for Collusion

Problems With Cartels Generally, They Are Generally, They Are Not LegalNot Legal

(Price Fixing)(Price Fixing) They Are They Are Difficult to OrganizeDifficult to Organize

and Monitorand Monitor Can’t Force New Firms to JoinCan’t Force New Firms to Join Usually there is CheatingUsually there is Cheating

The Incentive to Cheat On A Cartel If the Cartel Maintains the Monopoly Price, If the Cartel Maintains the Monopoly Price,

The The Individual Member of the Cartel Can Individual Member of the Cartel Can Act Like a Price TakerAct Like a Price Taker (They Can Sell the (They Can Sell the Quota amount at the Market Price)Quota amount at the Market Price)

As a Price Taker, They Maximize Profit As a Price Taker, They Maximize Profit Where MC = MR.Where MC = MR.

This Quantity is Greater Than the Cartel This Quantity is Greater Than the Cartel Wants the Individual Firm to Produce.Wants the Individual Firm to Produce.

All Firms in the Cartel Do This and the All Firms in the Cartel Do This and the Cartel Falls ApartCartel Falls Apart

Obstacles to CollusionObstacles to Collusion• Demand & Cost DifferencesDemand & Cost Differences• Number of FirmsNumber of Firms• CheatingCheating• RecessionRecession• Potential Entry (or new)EntryPotential Entry (or new)Entry• Legal Obstacles: AntitrustLegal Obstacles: Antitrust

Dominant Firm Price Leadership One dominant firm One dominant firm (largest or lowest (largest or lowest

cost)cost) and several other rival firms and several other rival firms Dominant firm determines price to Dominant firm determines price to

maximize profitmaximize profit Other firms take price and sell what they Other firms take price and sell what they

can at that price.can at that price. All firms watch output to All firms watch output to prevent excess prevent excess

supply and the need to reduce price.supply and the need to reduce price.

Dominant Firm Oligopoly

A dominant firm oligopoly may exist if A dominant firm oligopoly may exist if one firm:one firm:– Has a big cost advantage over the other Has a big cost advantage over the other

firms.firms.

– Sells a large part of the industry output.Sells a large part of the industry output.

– Sets the market price.Sets the market price.• Other firms are price takers.Other firms are price takers.

Dominant Firm Oligopoly

Let’s use Big-G as an example.Let’s use Big-G as an example.

Big-G is the dominant Big-G is the dominant

gas station in a city.gas station in a city.

MR

XD

S10

D

Dominant Firm Oligopoly

Quantity (thous. of gal./week)

Pric

e (d

olla

rs p

er g

allo

n)

Quantity (thous. of gal./week)0

0.50

1.00

1.50

0 20

0.50

1.00

1.50

1020

b

10

a

MC

a b

Ten small firms and market demand Big-G’s price and output decision