Feb 25 2015

Ways firms may collude in Oligopolistic markets

Published by at 3:29 pm under Cartels,collusion,Oligopoly

Oligopolistic markets are unique among the four market structures we have studied. Unlike perfect and monopolistic competition and pure monopoly,the individual firms in an oligopoly are heavily interdependent of one another with regards to business decisions relating to price, service, location, advertising, product differentiation, and so on. The actions of one firm will impact heavily the profitability of its major competitors.

This sometimes gives oligopolies an incentive to collude with one another. Collusion, as defined by Investopedia is A non-competitive agreement between rivals that attempts to disrupt the market’s equilibrium. By collaborating with each other, rival firms look to alter the price of a good to their advantage.”

Collusion can take many forms, and is not always overt in nature (in other words, it may be going on without any actual discussions between the firms colluding). Below are three ways firms may collude:

Overt, formal collusion – the cartel model: A cartel, as defined by Investopedia, is “An organization created from a formal agreement between a group of producers of a good or service, to regulate supply in an effort to regulate or manipulate prices.” An example of a cartel is California’s Raisin Administrative Committee. Listen to this story to learn more.

  • California’s raisin producers meet annually to determine the quantity of raisins that should be released to the market
  • In years where the crop is very good, they will “divert” raisins to the “reserve” and reduce the supply
  • This keeps the price high.
  • By colluding through the cartel, the raisin growers get to sell their output for a higher price and the total quantity released to the market is less than would be released without the cartel. The cartel makes the raisin market look more like a monopoly (higher price, lower quantity, less consumer surplus).

Tacit, informal collusion – the price leadership model: Not all collusion is formal and overt. In fact, because of the negative impact collusion has on consumers (higher price, lower quantity), it is actually illegal in many countries and government will investigate and possibly prosecute firms that attempt to collude to raise prices (see this story about the US Justice Department investigating the a proposed merger between two food wholesale companies). In order to avoid investigation by the government, firms often engage in tacit collusion, when firms agree to keep prices high without explicitly saying so.

Beer market in the US: The story about the US beer market indicates that a form of tacit collusion may be taking place between the two largest beer producers.

  • When Anheuser Busch/InBev raises the prices for its beers, its main competitor (Miller/Coors), tends to do so too.
  • The two firms control 65% of America’s beer market. When both raise their prices, demand tends to be relatively inelastic, allowing both firms to enjoy higher revenues.
  • If the two firms were acting competitively, the smaller firm (Miller/Coors), would most likely ignore price increases by Anheuser Busch/Inbev, and enjoy the greater demand resulting from the larger firm’s consumers switching beers.
  • The “price leadership” model of tacit collusion is when one firm (typically the largest in the market) raises prices and competitors willingly follow suit, leading to a smaller decrease in quantity demanded for the larger firm and increased revenues for all firms in the market.

Grocery stores in the United Kingdom: Another example of tacit collusion can be seen in the UK grocery market. The big grocery chains offer “price-match guarantees” that promise their consumers that they will never pay less for their groceries at another supermarket.

  • Sellers have no incentive to lower their prices because they will be less likely to steal the competition’s customers when the competition has a price-match guarantee.
  • Through such a scheme, all grocery chains are likely to keep their prices HIGH and “price-wars” (which benefit consumers), are much less likely to occur.
  • The price-match guarantee (which on the surface appears to be good for consumers) acts as a form of tacit collusion and results in consistently higher prices for groceries in the UK.

Graphing collusive oligopolies: Under competition, oligopolists that lower their prices may initiation a “price war” due to the strong incentive any price cut creates for competitors to also cut prices. Likewise, price increases are less likely under competition because price increases tend to be ignored as the competition gains market share when the first firm raises its price. These assumptions of competitive oligopolies are reflected in the “kinked demand curve” model.

noncollusive

Under a collusive oligopoly, price increases is greater and the chance of price wars is much smaller. Demand for an individual firm’s output when it is colluding with its competitors looks more like the demand for a monopolist’s output; it is relatively inelastic, even when the firm raises its prices (since price increases are more likely to be matched rather than ignored). The collusive oligopolists demand curve looks like this.

collusion


About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

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