cartels - collusion between firms

The uncertainty that exists in an oligopoly can lead to collusive behaviour by firms. When this happens the existing businesses decide to engage in price fixing agreements or cartels. The aim of this is to maximize joint profits and act as if the market was a pure monopoly.

CONTROLLING SUPPLY IN A CARTEL

For the cartel to work effectively the producers must control supply to maintain an artificially high price. Collusion is easier to achieve when there is a relatively small number of firms in the market and a large number of customers, market demand is not too variable and the individual firm's output can be easily monitored by the cartel organisation.

PRICE AND OUTPUT UNDER A DUOPOLY

If two firms share the market equally and have the same cost structures, then each firm will profit maximise at output Q and each gain the same level of super-normal profit. Consider the case of Firm A in the diagram below. The firm is assumed to have half the total market demand. It can profit maximise and still achieve economic profit. The other firm in the market will also profit maximise at the same point and earn the same total profits. In the absence of a change in demand (which may not go equally to each firm) and/or a change in each firm's costs of production, neither firm has any reason to undercut the other.

WHY DO PRICE FIXING ARRANGEMENTS OFTEN COLLAPSE?

Some economists believe that price-fixing cartels are inherently unstable and that at some point they inevitably come under pressure and finally break down. There are a number of sources of potential instability for price fixing cartel arrangements.

• Falling demand creates tension between firms e.g. during an economic downturn 

• The entry of non-cartel firms into the industry increases market supply and puts downward pressure on the cartel price

• Exposure of illegal price fixing by the Government or other regulatory agencies causes an arrangement to end 

• Over-production and excess supply by cartel members breaks the price fixing 

• The Prisoners’ Dilemma game suggests that all collusive agreements tend to fall eventually because although price fixing is in the joint interests of all members of a cartel, it is not a profit maximising equilibrium for each individual firm