2.1.2.

Oligopoly:
Collusive Models


 Collusion
• Collusion is a non-competitive legal or illegal
agreement between rivals which attempts to disrupt
the market's competitive equilibrium.
• It is where competing firms conspire to work together
to gain an unfair market advantage.
• It is common among duopolies.
• Why firms collude?
– To charge higher price
– To decrease uncertainty (what the other may do)
– To minimize competition
• Collusive agreements are highly unstable because
firms may cheat each other
• Collusion can be of two forms
Implicit (Tacit) Collusion
• Is collusive outcome that requires no formal
agreement and no direct communication between
firms
• It may develop through personal contacts, a group
ethos (attitudes), or live-and-let-live attitudes
• Example: Price leadership
Explicit Collusion
• Include verbal and written agreements to collude
• Example: Cartel
 Models of Price Leadership
• In models of price leadership or parallel pricing the
firms tacitly recognize their interdependence.
• One firm announces a price change, and the other
firms rapidly follow.
• There are three price types of price leadership
– Low cost price leadership
– Dominant firm price leadership
– Barometric price leadership

05/26/2024 4
a) Low Cost Price leadership
• The low cost firm become leader and set price
• The other firms follow taking the price
• If the follower refused to take the price the low cost
firm eliminates it through price competition
• But the follower firm can influence the price set by
the leader through supplying more or less than the
expected amount
• So the leader has to make market share agreement
formally or informally
• Thus, the leader set equilibrium price taking the
market demand curve as its own and make agreement
with the follower how much to produce
05/26/2024 5
Example:
• Assume there are two firms producing cane
sugar that share the market equally (q A=qB). If
the market demand is
P  7000  2Q and if their costs are
TC A  1000q A and TCB  3000qB

Then answer the following questions

05/26/2024 6
 A) Which firm is the low cost firm to lead the market?
Since TCA<TCB, firm A is the leader
B) What is the profit function of firm A?
 A  Pq A  TC A
 A   7000  2Q  q A  1000q A where Q  q A  qB
 A  7000  2  q A  qB  q A  1000q A where q A  qB
 A  7000  2  q A  q A  q A  1000q A
 A  6000q A  4q A2
C) What is the leader firm profit maximizing q A?

05/26/2024 7
  A  6000q A  4q A2
d A
 6000  8q A  0
qA
q A  750

D) What is the supply of the follower firm?

Since they share the market equally qA=qB=750
E) What is the equilibrium (profit maximizing)
price? P  7000  2Q
P  7000  2(q A  qB )
P  7000  2(750  750)
P  4000
05/26/2024 8
F) What are the profits of the leader and follower
firms?
 A  Pq A  TC A
 A  4000(750)  1000(750)
 A  2, 250, 000

 B  PqB  TCB
 B  4000(750)  3000(750)
 B  750, 000

05/26/2024 9
b) Dominant Firm Price Leadership
• Leader: the industry is dominated by one firm, owing
to its superior efficiency (lower costs), or perhaps its
aggressive behaviour. It set price
• Follower (Competitive fringe): many small firms.
They passively follow the price set due to
convenience, ignorance or fear. They act like
competitive firms (price takers)
• The leader assumed to have known its demand, its
cost and the costs of the fringes

05/26/2024 10
• The leader deduct the supply of all small firms from total
demand and get the residual demand
• Then maximize its profit
(Demand LEADER = Demand TOTAL – Supply FRINGE)
Example
• Assume in a market where there is one big firm and other
small firms, the market demand is P  7000  Q
and the small firms total supply is P  1000  qs
if the total cost of the dominant firm is TC  1000qd

05/26/2024 11
A) Derive the residual demand function that is not
supplied by the small firms
• First change the market demand and supply of small
firms into quantity form
• Then deduct small firms supply from market demand
P  7000  Q  Q  7000  P
P  1000  qs  qs  1000  P
• Thus, the residual demand is
Q  7000  P

qs  1000  P
1
qd  8000  2 P  P  4000  qd
2
 B) What is the profit function of the dominant
firm?  d  Pqd  TCd
 1 
 d   4000  qd  qd  1000qd
 2 
1 2
 d  3000qd  qd
2
C) What is the dominant firm profit maximizing
quantity?
1 2 d d
 d  3000qd  qd  3000  qd  0 qd  3000
2 dqd
05/26/2024 13
D) What is the price set by the dominant firm?
1
P  4000  qd
2
P  4000  0.5 x3000
P  2500
E) What is the profit of the dominant firm?
 d  Pqd  TCd
 d  2500 x3000  1000 x3000
 d  4,500, 000

05/26/2024 14
F) What is the small firms supply at the price
set?
qs  1000  P
qs  1000  2500
qs  1500

c) Barometric price leadership

• The firm with up-to-date information set price
• Based on the past price information, it sets current
price.
• The price leader acts as a barometer of prevailing
market conditions for other firms in the industry.
05/26/2024 15
 Cartel
• A cartel is an organization created by agreement
between a group of producers to regulate supply in
order to regulate or manipulate prices and share the
market between them selves
• It is a collection of independent firms that act
together as if they were a single producer and thus
can fix output and prices without competition
• Cartel has a central agency that make decisions
• Many cartels seek to enhance the market power of a
group of producers.
• Cartel restrain competition and restrict output
• In USA cartel is illegal
A) Profit Maximization Cartel
• Joint profit maximization refers to a situation where
members of a cartel, duopoly, oligopoly or similar
market condition engage in pricing- output decisions
designed to maximize the groups' profits as a whole.
• In essence, the member firms seek to act as a
monopoly (as if they are one firm)
• The central agent is assumed to have all information
about market demand and costs of all firms
• Profit maximizing quantities are set by the central
agent and price is determined by the market
• Example: Let there are two firms (firm A&B)
who form a cartel
• The firms produce identical product (cane sugar)
• The firms’ cost functions need not necessarily be
identical
• The central agent has full information about the
firms demand and cost
P  6000  50Q where Q  q A  qB
TC A  500q A2 and TCB  1000qB2

• No entry - entry is successfully deterred

A) Formulate the joint profit function
  PQ  TC
  P(q A  qB )  TC A  TCB
  (6000  50Q)(q A  qB )  50q A2  100qB2
  6000  50(q A  qB )  (q A  qB )  50q  100q
2
A
2
B

  6000q A  6000qB  100q A2  100q A qB  150qB2

B) What is the profit maximizing quantities?
  6000q A  6000qB  100q A2  100q A qB  150qB2

 6000  200q A  100qB  0
q A

 6000  100q A  300qB  0
qB
6000  200q A  100qB

6000  100q A  300qB
Solving simultaneously
q A  24 and qB  12
 C) What is the profit maximizing price?
P  6000  50Q where Q  q A  qB
P  6000  50(24  12)
P  4200
D) What is the maximum joint profit?

  6000q A  6000qB  100q A2  100q AqB  150qB2

  6000(24)  6000(12)  100(24)  100(24)(12)  150(12)
2 2

  108, 000
 Or
  PQ  TC A  TCB
  4200(24  12)  50(24) 2  100(12) 2
108, 000
E) What are the profits of each firm?
 1  Pq A  TC A  2  PqB  TCB
 1  4200(24)  50(24)  2  4200(12)  100(120)
2 2

 1  72, 000  2  36, 000

   1   2  72, 000  36, 000  108, 000
 B) Market Sharing Cartel
• In such cartel firms make agreement on how to share
the market
• Market can be shared through
– Non-price competition
– Quota market sharing
– Geographical market sharing
 Non-price Competition Market sharing
• Firms set average price by bargaining that makes all
of them profitable
• They compete by differentiating product like by
varying the color, design, shape packing
advertisement etc.
• The low cost firm usually cheat by charging lower
price
 Quota Market Sharing
• Firms set and agree on how much each firm supply
• Quota depends on cost of a firm and other factors
• If all firms have equal cost, they supply equally
• If their cost is different quota depends on their
bargaining power
• During bargaining process past levels sales and or
the basis for productive capacity of the firms are
considered for decision.
• Firms may cheat by supplying more that makes it
unstable cartel
 Regional Market Sharing Cartel
• Firms share the market by defining markets
(geographical boundary) where each firm supply
• Such cartel is not stable because of
The firm with low cost encroach to the area of the
other
Firms reach other firms’ market through
advertisement
 Other motives for collusion
• What are the motives of collusion?
• As we have seen above near- monopoly profit
maximization is one motive
• The other motives are the following
– Risk management and the enhancement of
security
– Exchange of information
– Unsatisfactory Performance
 Risk management and
the enhancement of security
• The reduction of risk may be the principal motive for
collusion
• Risk comes from the following
1) Consumer taste may change
2) The firm and competing firms may increase supply
that decreases price
– Mass-production technology raises the risk
3) Firm’s reliance on large orders that are placed
infrequently
• Undercutting is more likely if orders are large and
irregular than if they are small and regular.
4) Firms that operate with short time horizons are
likely to accept the immediate gain from a price
reduction and be unconcerned bout future
retaliation.
5) Firms with large overheads or excess capacity may
also be tempted to violate tacit price agreement and
decrease price
• Overhead refers to the ongoing business expenses not
directly attributed to creating a product or service.
• Overheads are business costs that are related to the
day-to-day running of the business.
• A firm might attempt to escape from these risks by
developing market power independently through
– product differentiation,
– product innovation or
– Vertical integration
• However, all such strategies are costly and uncertain.
• Collusion represents an alternative method for
reducing risk.
• High risk may bring about collusion
 Exchange of information
• Many of the factors that motivate collusion are
associated with uncertainty.
• Accordingly, such concerns might be reduced by the
provision of useful market information, which may
itself be a powerful motive for collusion.
• All firms require information on which to base their
decisions.
• The importance of information depends on the degree
of interdependence, or on the extent to which firms
are vulnerable to damage by the actions of rivals.
• The firms get good information if they collude
• Sharing information may drive firms towards more
cooperative forms of behaviour.
Unsatisfactory Performance
• Years of poor profitability, perhaps caused by intense
competition and frequent price-cutting, may
eventually prompt firms to collude
• A firm’s growth record can also reflect its
profitability and collusion
• Firms in a declining industry are perhaps more likely
to collude in an attempt to restore profitability to
some historical level.
 Factors Conducive to Cartel Formation

• The main factors conducive to cartel formation are

– Seller concentration and the number of firms
– Similar cost functions
– Similar market shares
– Similar products
– No vertical integration
– Low transaction costs
Seller concentration and the number of firms
• Firms find it easier to collude in industries with
– high levels of concentration, or
– small numbers of firms.
• Coordination becomes more difficult as number of
firms increases.
• As number of firms increases, the unanimity of goals
diminishes.
• With a dilution of unanimity, the group incurs heavier
bargaining, monitoring and enforcement (or
transaction) costs.
• As the number of firms increases, the contribution of
each firm to total output decreases, and the firms
become more likely to ignore their interdependence.
• As the number of firms increases, there is more
temptation for a rogue firm to undercut the agreed
price, as it perceives a low risk of detection.
• High concentration indicates that the fringe of non-
colluding firms is relatively small, and may be
tolerated.
• If the non-colluding fringe makes serious inroads into
the cartel members’ market shares, however,
defensive strategies such as price-cutting may be
instigated.
• If a sizeable fringe of firms cannot be induced to join
a cartel, there is little chance of success in
maximizing joint profits.
Similar cost functions
• Firms with similar cost structures find it easier to
collude than those with pronounced differences in
costs.
• A firm faced with an average cost function that
decreases as output increases may be reluctant to
restrict its output as a condition of cartel membership.
Similar market shares
• If most of the firms in an industry are similar in size,
the likelihood of successful collusion is enhanced.
• Other symmetries conducive to collusion might include
– similar patterns of firm evolution,
– similar technologies,
– similar product ranges (types of products) and
– similar productive capacities.
• Small firms may be reluctant to adopt quotas based on
existing market shares, while large firms may collude
with each other to enhance their (collective)
dominance.
• Firms with spare capacity are tempted to defect from
a price-fixing agreement, while firms with limited
capacity are unable to issue credible threats to punish
defectors.
Similar products
• Firms selling similar goods need only focus on a
narrow range of pricing decisions.
• If many characteristics contribute to (either real or
perceived) product differences, it becomes difficult to
achieve agreement over price.
• Differentiated products has switching costs that
makes collusion difficult
• Switching costs are costs incurred when a buyer
switches between suppliers, but not incurred when
remaining with the original supplier.
• Switching costs include:
– Transaction costs incurred when changing a
suppliers;
– Compatibility costs incurred when changing
products that are linked to one another
– The learning costs incurred in using a new product
or service
• Switching costs reduce the incentive for producers to
join or adhere to cartel agreements
• Thus product differentiation inhibits successful
collusion.
No vertical integration
• If one member is vertically integrated downstream,
perhaps with ownership of retail outlets, it may be
able to undercut the cartel price by reducing its
transfer price to its own retailers.
• Thus vertical integration doesn’t encourage collusion
Low transaction costs
• Under transaction costs approach to the theory of the
firm, collusion is viewed primarily as a problem of
contracting.
• Collusive agreements may or may not be lawful, but
in either case participants cannot rely on the courts to
enforce agreements.
• Therefore firms must develop their own armory to
ensure compliance and punish noncompliant
behaviour.
• The ease with which collusion can be established and
sustained through contractual arrangements depends
on a number of factors:
 The ability to specify contractual relations correctly.
If the contract is to be comprehensive, all future
contingencies must be anticipated. And this is costly
 The extent to which agreement can be reached over
joint gains. Reaching an agreement that brings mutual
benefit is costly.
 The agreement is also subject to uncertainty. Firms
must agree on how to adapt to changes in the
economic environment which is uncertain. Getting
information about change in the environment is
costly.
 Monitoring. Individual firms may not be able to
detect fellow conspirators’ price cuts. Monitoring is
costly
 Penalties. Successful collusion must eventually rest
on the availability of effective sanctions against firms
that fail to comply with the terms of the agreement. In
the absence of legal protection, the cartel must
impose its own penalties through the market. This is
also costly
 One of the key distinction between monopoly and
oligopoly is that in monopoly there is no transaction
costs whereas with oligopoly there is transaction
costs of contracting to achieve market power.
 Influences on cartel stability
• Most cartels are impermanent
• The fundamental reason so many cartels fail to live
up to expectations is that what appears optimal for the
group as a whole may not be optimal for each
member individually.
• Therefore, bargaining is required to find a form of
agreement that reconciles this divergence of interests
• What are the factors that tend to frustrate long-term
cooperation?
• The factors include the following
• Seller concentration and the number of firms
• Different goals of members
• The process of cartel formation and the assignment of
quotas
• Non-price competition
• Monitoring and detection of cheating
• Sanctions
• Buyer concentration
• Fluctuations in demand
• Entry
• Competition law
• Non-economic influences on cartel stability
Seller concentration and the number of firms
• High seller concentration and small numbers of firms
are factors conducive to cartel formation.
• The same factors may also affect the stability of a
cartel after it has been formed, particularly if
effective communication and monitoring are easier
when numbers are small.
• With small numbers, in the event that non-
compliance is detected, retaliation is likely to be
quicker and more effective.
• Quick retaliation frustrates the long term cooperation
Different goals of members
• If a cartel comprises a heterogeneous collection of firms,
it is probable that individual members have differing
goals.
• Conflicting objectives might remain lightly buried in the
interests of group solidarity but might resurface at any
time.
• Members may disagree over issues such as
– the balance between short-run and long-run profit
maximization,
– the regard that should be paid to potential
competition, or
– how best to respond to changes in government policy.
• Tensions may also arise due to expectations that
market shares, at the inception of a cartel agreement,
remain fixed.
• Some firms however may be growth-focused and thus
there is an inherent conflict with those who prefer a
quiet life.
• Larger firms often tend to seek stable, long-run
policies, while smaller firms are more interested in
exploiting short-run opportunities.
• Thus, not all members are profit maximizers so that
disagreement may occur
The process of cartel formation and the assignment
of quotas
• Cartel can be formed either sequentially or
simultaneously.
• Cartel stability is shown to be more likely if decision-
making is sequential rather than simultaneous.
• The assignment of production quotas when the cartel
is established can have important implications
subsequently for its stability.
• If there is an incentive for either firm to cheat by
raising its output, if it believes the other firm will not
retaliate and the other firm also does the same then
their collusion is not stable
Non-price competition
• A cartel is likely to be unstable if there are significant
opportunities for non-price competition.
• Little purpose is served by agreeing to fix prices if,
soon afterwards, intense non-price competition
between cartel members breaks out in the form of
expensive rival advertising campaigns, or the
simultaneous launch of new and competing brands.
Monitoring and detection of cheating
• Collusion is successful when it is accompanied by
efficient mechanisms for monitoring compliance with
the agreement.
• The most effective method for detecting secret price-
cutting might be to check transaction prices in the
market.
• Another evidence of cheating can be inferred by
observing unexpected changes in the market shares of
individual firms.
• Poor monitoring and weak detection of cheating
makes the collusion unstable
Sanctions
• The ability of a cartel to impose effective sanctions if
cheating occurs is another important determinant of
cartel stability.
• If additional profits can be realised through non-
compliance, then non-compliance probably will occur
unless some policy of deterrence is adopted.
• The ability of a cartel to discipline its own members
for breaches of agreement is essential, as the courts
cannot be used to enforce an illegal contract.
• Punishment can be effected either
– By taking action that reduces the demand for the
non-compliant firm’s product (undercutting price)
or
– By increasing its costs (raw material suppliers
cooperate with the cartel and agree not to supply
nonmembers. )
• Weak sanction on non compliance firm leads to cartel
instability
Buyer concentration
• Cartel stability should be enhanced if buyers lack
market power or if buyer concentration is low.
• Buyers with market power may threaten agreed prices
by switching to alternative suppliers, or by suggesting
reciprocal transactions with individual producers.
• When an industry supplies a small number of large
buyers, orders are often large and infrequent.
• Under these conditions, it is tempting for parties to a
collusive agreement to defect by offering secret price
reductions, in an effort to secure these valuable
contracts.
• In such cases it may be difficult for other cartel
members to detect and punish defection.
• If buyers are atomistic, defection becomes more
difficult: the more buyers there are, the greater the
chance of being found out.
• Thus, high buyer concentration leads to unstable
cartel
Fluctuations in demand
• A reduction in total demand may place strains on a
cartel agreement
• As demand falls, firms are tempted to undercut the
cartel price in a bid to protect their sales volumes
• Collusion may be more difficult to enforce in times of
increasing demand.
• In an expanding market, a firm being undercut by
rivals may not immediately detect that cheating is
occurring, since its own sales are rising
Entry
• In the long run, the stability and profitability of
collusion depends on the ease or difficulty of entry.
• If a cartel shelters behind effective entry barriers, it
may enjoy the necessary time and space to prosper
and resolve the conflicting demands of its members.
• If entry barriers are low, the cartel faces competitive
pressure from potential entrants.
• If a cartel has agreed to fix the price above the
competitive level, there is an incentive for an entrant
to move in and set a price just below the cartel price,
encroaching on the profits of group members.
• Unrestricted entry lead to the destruction of the cartel
Competition law
• In most countries, competition law threatens the
stability of cartels
• In a free market fixing price is illegal
• Detection of anti-competitive practices can result in
heavy fines and possible loss of public goodwill.
Non-economic influences on cartel stability
• Non-economic factors such as leadership, trust and
social background may be relevant
• The formation of a cartel requires that someone takes
the lead and organizes discussions and negotiations.
• People need to be persuaded, coaxed or even
threatened to join the cartel, and leadership qualities
are necessary to create and sustain a successful
agreement.
• Likewise, a strong personality hostile to the notion of
cooperation might prevent the formation of a cartel.
• Trust between cartel members is another important
requirement for successful collusion.
• If the participants to an agreement share the same
social background, group stability is likely to be
enhanced.
• If most owners and managers come from a similar
and preferably closely knit social background,
stability is likely to be enhanced.
• To cheat on one’s peers is to run the risk of suffering
not only economic retaliation but also social
stigmatization.
• The cheat is branded as an outsider, and denied the
support and comfort of the social group.