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.[1]
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[2].
That expected reaction also influences the balance of oligopoly markets.
Oligopolies may interact in two main ways:
1)
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.
2)
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 their activities.
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 output Qc.
Pic. А
Pm
Pc E
MR`
MC D
MR
Qm Qc Q`
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.
1)
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.
2)
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.
3)
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 price.
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.[3]
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.
Pic. В
AC MC
Pm A F
C B
H
G
MR`
qm qc q`
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”[4]
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
initially started.
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.
1.
Grebenschikov P.I.,
Leusskiy A.I., Tarasevitch L.S, Microeconomics, St. Petersburg 1996., pp. 213- 216
2.
Livshits A.Y. Introduction
to the Market Economy, Moscow 1991, pp.158-161
3.
McConnell C.P., et al.,
Economics, Moscow 1993, pp. 125-7
4.
Begg D., Fisher S.,
Dornbusch R., Economics, 5th ed., McGraw-Hill
1997, pp. 151-51, 176, 146, 148
5.
Lancaster K., Introduction
to Modern Microeconomics, 2nd ed., N-Y 1974, p. 200-1
6.
Nicholson W., Microeconomic
Theory, 7th ed., The Dryden Press 1998, pp. 580-4
[1]
Grebenschikov P.I., Leusskiy A.I., Tarasevitch L.S, Microeconomics,
St. Petersburg 1996., p. 213
[2]
Livshits A.Y. Introduction to the Market Economy,
Moscow 1991, p.159
[3]
Livshits A.Y. Introduction to the Market Economy,
Moscow 1991, p. 161
[4]
I am using the expression “cartel price” for the purpose of
simplification. What I mean by it is the high price that resulted from the
co-operation agreement between oligopolies.
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