Collusive Oligopoly

Topics: Petroleum, OPEC, Cartel Pages: 11 (3386 words) Published: September 4, 2008
In a perfectly competitive market it is assumed that owing to presence of manybuyers and many sellers selling homogeneous products,the actions of any singlebuyer or seller has a negligible impact on the market price of product. However in reality this situation is seldom realized. Most of the time individual sellershave some degree of control over the price of their outputs. This condition is referredas imperfect competition.

Barriers to entry are the factors that make it difficult for new firms to enter an industry, which lead to imperfect competition. Mostly commonly known barriers of entry areeconomies of scale, legal restrictions, high cost of entry and advertising and productdifferentiation.

Imperfect competitive markets can be classified into three categories 1. Monopoly where single seller has control over the industry and no other firmexists producing a close substitute. True monopolies are rare in the present situation.

2. Monopolistic competition where a large number of sellers exist sellingdifferentiated products

3. Oligopoly is an intermediate form of imperfect competition in which only afew sellers exist in the market with each offering a product similar or identicalto the others.

Oligopoly usually exhibits the following features:

1. Entry barriers: Significant entry barriers prevail in the markets that thwart thedilution of competition in the long run.This helps dominant firms to maintainsupernormal profits. Though many smaller firms can operate on the periphery of anoligopolistic market, but none of them is large enough to have any considerable effecton market prices and output.

2. Interdependent decision-making: Interdependence implies that firms must take into account probable reactions of their rivals to any change in price, output or forms of non-price competition.

3. Non-price competition: Non-price competition is a consistent feature of thecompetitive strategies of oligopolistic firms. Examples of non-price competition suchas free deliveries and installation, longer opening hours (e.g. supermarkets and petrolstations),branding of products and heavy spending on advertising and marketing.

If firms operate in cooperative mode to minimize the competitions betweenthemselves this behavior is called as Collusion. When two or more firms agree to settheir outputs or prices to divide the market among themselves, it is called as collusive oligopoly. 2.0 Collusive oligopoly:

There are two types of collusive oligopoly

A. Price leadership – tacit collusion
This occurs when one firm has a clear dominant position in the market and thefirms with lower market shares follow the pricing changes driven by the dominant firm.

B. Overt collusion:This occurs when firms openly agree on price, output, and other decisions aimed at achieving high profits. Firms who coordinate their activities throughovert collusion and by forming collusive coordinating mechanisms, such a group ofindependent firms working in unison is called as cartel.

When this happens the existing firms decide to engage in price fixing greements orcartels. The aim of this is to maximize joint profits and act as if the market was apure monopoly.

2.1 Price fixing in collusive oligopoly

Collusion is often explained as a product of motive to achieve joint-profitmaximization within a market or circumvent price and revenue instability in anindustry. Price fixing can be deemed as an attempt by suppliers to control supply andfix price at a level close to the level expected from a monopoly.However in order to fix prices, the producers in the market must be able to exertcontrol over market supply.

The figure 1 below depicts a producer cartel fixes the cartel price at output Qm andprice Pm decided by the fact where marginal revenue of the cartel MR is equal tomarginal cost MC of the cartel. The distribution of the cartel output among the cartelmembers could be decided on the basis of an output quota...
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