Thanalatchemy Karuppiah, KYUEM
CHAPTER 7: THE PRICE SYSTEM AND THE MICRO ECONOMY
• Oligopolists are pulled in two different directions:
The interdependence of firms may make them wish to collude with each other. If
they could club together and act as if they were a monopoly, they could jointly
maximise industry profits.
On the other hand, they will be tempted to compete with their rivals to gain a
bigger share of industry profits for themselves.
• These two policies are incompatible. The more fiercely firms compete to gain a bigger
share of industry profits, the smaller these industry profits will become.
For example, price competition will drive down the average industry price, while
competition through advertising will raise industry costs. Either way, industry
profits will fall.
• Sometimes firms collude, sometimes not. The following sections examine first collusive
oligopoly (both open and tacit) and then non-collusive oligopoly.
Collusive oligopoly
•
When firms under oligopoly engage in collusion, they may agree on output, prices,
market share, advertising expenditure, etc.
•
Such collusion reduces the uncertainty they face. It reduces the fear of engaging in
competitive price cutting or retaliatory advertising, both of which could reduce
total industry profits.
a) A formal collusive agreement is called a cartel.
The cartel will maximise profits if it acts like a monopoly: if the members
behave as if they were a single firm. This is illustrated in Figure 7.3.
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Thanalatchemy Karuppiah, KYUEM
•
The total market demand curve is shown with the corresponding market MR curve.
•
The cartel’s MC curve is the horizontal sum of the MC curves of its members (since
we are adding the output of each of the cartel members at each level of marginal
cost).
•
Profits are maximised at Q1 where MC = MR. The cartel must therefore set a price
of P1 (at which Q1 will be demanded).
•
Problem with Cartel:
i.
higher prices and less output for consumers
ii.
overall profit is maximised at this price, individual firms have different cost
structures and so not all firms will be maximising their own profits, and this
can cause constant tension within the cartel.
•
So, collusion is generally banned by governments and is against the law in most
countries.
•
If a country’s anti- trust authority finds that firms have engaged in anticompetitive
behaviour such as price fixing agreements, then the firms will be penalized with fines
or other punishments.
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Thanalatchemy Karuppiah, KYUEM
•
Formal collusion between governments may be permitted. The prime example is
OPEC (the Organisation for Petroleum Exporting Countries), which sets production
quotas and prices for the world oil markets.
OPEC is probably the best known of all cartels. It was set up in 1960 by the five major oilexporting countries: Saudi Arabia, Iran, Iraq, Kuwait and Venezuela. It has 12 members,
including Nigeria, Angola, Libya and Ecuador. Its stated objectives were as follows:
•
The co-ordination and unification of the petroleum policies of member countries.
•
The organisation of means to ensure the stabilisation of prices, eliminating harmful
and unnecessary fluctuations.
•
There are a number of conditions necessary for a cartel to operate successfully.
These include:
•
i.
a limited number of firms in the industry, all of whom are members similar
cost structures for all firms
ii.
high barriers to entry to prevent new firms entering the industry
iii.
all firms obey the rules of the cartel
iv.
a stable market
v.
the firms produce very similar or identical products which will make
agreements on price easier to establish.
Is there any problem here for the cartel in fixing the price?
Alternatively, the cartel members may somehow agree to divide the market
between them.
Each member would be given a quota.
The sum of all the quotas must add up to Q1.
If the quotas exceeded Q1, either there would be output unsold if price
remained fixed at P1, or the price would fall.
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Thanalatchemy Karuppiah, KYUEM
• But if quotas are to be set by the cartel, how will it decide the level of each
individual member’s quota?
The most likely method is for the cartel to divide the market between the
members according to their current market share. This is the solution most
likely to be accepted as ‘fair’.
• Where open collusion is illegal, however, firms may simply break the law, or get
round it.
• Alternatively, firms may stay within the law, but still tacitly collude by watching
each other’s prices and keeping theirs similar.
• Firms may tacitly ‘agree’ to avoid price wars or aggressive advertising campaigns.
b) Tacit collusion: price leadership (Informal collusion)
•
Where oligopolists take care not to engage in price cutting, excessive
advertising or other forms of competition. There may be unwritten ‘rules’ of
collusive behaviour such as price leadership.
One form of tacit collusion is where firms keep to the price set by an
established leader.
•
There are three common models.
Models
Explanation
Dominant firm
models
• This normally involves firms following the lead of a firm which
has a dominant position in the market in terms of its output
and market share.
• Other firms will be likely to keep to the agreement for fear
that if they do not their existence could be threatened by an
aggressive pricing strategy by the dominant firm. Saudi
Arabia, for example, is a dominant player in OPEC.
Barometric firm
price leadership
•
This involves leadership by a firm that has consistently
been seen to judge market conditions accurately over
time and is, therefore, seen as a good "barometer” of
market trends.
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Thanalatchemy Karuppiah, KYUEM
•
The barometric firm is the firm that is either
trend setter for the product
The innovator of a new technological production
technique
• The barometric firm need not be the largest firm and it
could change from time to time.
Parallel pricing
This involves firms in the industry making the same price
changes at any given time.
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