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Practice exam questions

Oligopoly and Collusion (Revision Essay Plan)

  • Levels: A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

Here is an essay plan for the following title: "Evaluate the degree to which oligopolistic markets will result in collusion."

Revision Video - Oligopoly and Collusion

Define oligopoly:

Highly concentrated market dominated by a cluster of large firms, protected by entry barriers and where product branding is a key part of non-price competition. Business behaviour is inter-dependent, i.e. one firm must take into account the likely reactions of their rivals to changes in prices and other variables.

Contextual examples of oligopoly:

Petrol retailing, grocery retailing, commercial banks, airlines competing on routes, mobile phone networks

Explanation of collusion:

A form of anti-competitive behaviour where a group of businesses act to collude on price / market sharing

  • Tacit collusion - unspoken, price-matching schemes
  • Explicit collusion - formal agreement to fix prices / surcharges / share markets etc

What might drive collusion in an oligopoly?

  1. Businesses in a cartel may recognise their mutual interdependence and decide act together – the main aim is to maximise joint profits i.e. achieve the level of total profits that might occur in a monopoly
  2. Successful collusion leads to rising profits/producer surplus / shareholder value – leading to higher share prices
  3. Collusion lowers the costs of competition e.g. highly expensive marketing wars which can run into millions of pounds
  4. Collusion is a way of reducing uncertainty in a market - uncertainty is a key feature of an oligopoly
  5. Colluding on research projects helps bring down the cost of innovation

Game theory and collusion

  • Application of the basic but classic Prisoners’ Dilemma can help to understand why firms collude on price
  • A high price / high price combination leads to an increase in total (joint) profits compared to a low price / low price option
Game theory and the gains from price fixing

What makes collusion more likely in an oligopoly?

  • Industry regulators are weak and/or ineffective (a possible source of regulatory failure)
  • Penalties for being caught colluding / price-fixing are low relative to the potential gains in revenues / profits
  • Participating firms have a high percentage of total sales – this allows them to control market supply
  • Firms trust each other and they have similar strategic objectives over a period of time
  • Industry products are standardised and output is easily measurable e.g easier in cement, maple syrup, bitumen
  • Brands are strong so that consumers will not switch demand when collusion raises price (i.e. a low cross price elasticity of demand)

Real world examples of price fixing

  • 2015 - Fines for French Yoghurt Cartel
  • 2016 - EU slaps record $3 bil cartel fine on truck firms
  • 2014 - German brewers fined 106.5m euros for price-fixing
  • 2016 - UK model agencies found guilty of price-fixing
  • 2015 - Banks fined for manipulating LIBOR interest rates

Evaluation

Discuss the barriers to collusion / circumstances under which collusion breaks down in an oligopoly

Game theory suggests that price collusion between firms will break down because there is an incentive to cheat on a price-fixing deal whereby lowering price and increasing output will increase total profits.

In a cartel, although joint profits might be maximised, this is not the same as any individual firm maximising their own profits. There are good reasons for expecting cartels to weaken as time goes by.

Threats to cartels include:

  • Enforcement problems: The cartel aims to restrict production to maximise total profits. Each individual seller finds it profitable to expand their production.
  • Other firms who are not members of the cartel may opt to take a free ride by selling just under the cartel price
  • Falling market demand in a recession creates excess capacity in the industry and puts pressure on profits and cash-flow
  • The successful entry of non-cartel firms into the industry undermines a cartel’s control of the market
  • The exposure of price-fixing by whistle-blowing firms – these are firms previously engaged in a cartel that pass on information to the competition authorities in order to escape prosecution
  • When trust breaks down within a cartel, it is highly likely to come under pressure and many eventually collapse.
Fines imposed by the EU as part of competition policy

Final reasoned comment:

There are good reasons to expect more collusion in an oligopoly than in any other market structure. The crucial point is that firms in an oligopoly are inter-dependent, they must consider the likely reactions of their rivals. Collusion is a way of lowering some of the costs of competition and maintaining supernormal profits in the long run.

But most cartels either collapse or are under-mined by the entry of disruptive businesses who do not follow the same pricing model and are looking to make the market more contestable and take some of the supernormal profits. Although there is probably significantly more tacit collusion in markets than consumers are aware of, industry regulators seem to becoming more effective in investigating and tackling cartel behaviour.

The size and volume of fines for anti-competitive behaviour in the UK and more widely in the EU has grown in recent years. From 2014-17, the EU imposed fines in 133 cartel cases totalling Euro 7.5 billion.

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