Oligopoly - Collusion | tutor2u Economics
Study notes

Oligopoly - Collusion

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

When a few large firms dominate a market there is always the potential for businesses to seek to reduce uncertainty and engage in some form of collusive behaviour

Oligopoly and Collusion - revision video

When this happens the existing firms engage in price fixing cartels. This behaviour is deemed illegal by UK and European competition law. But it can be hard and complex to prove that a group of firms have deliberately joined together to increase prices.

Overt or Explicit Price Fixing

  • Overt means spoken, open or traceable
  • Collusion is often explained by a desire to achieve joint-profit maximisation within a market or prevent price and revenue instability in an industry.
  • Price fixing represents an attempt by suppliers to control supply and fix price at a level close to the level we would expect from a monopoly.
  • To collude on price, producers must be able to exert some control over market supply.
  • In the diagram below a producer cartel is assumed to fix the cartel price at price Pm. The distribution of the cartel output may be allocated on the basis of an output quota system or another process of negotiation.
  • Although the cartel as a whole is maximising profits, the individual firm's output quota is unlikely to be at their profit maximising point. For any one firm, expanding output and selling at a price that undercuts the cartel price can achieve extra profits!
  • Unfortunately if one firm does this, it is in each firm's interests to do exactly the same and, if all firms break the terms of their cartel agreement, the result will be excess supply in the market and a sharp fall in the price. Under these circumstances, a cartel agreement can break down

What are the main aims of price fixing?

  • Businesses recognise their interdependence – act together to maximise joint profits
  • Cut some of the costs of competition e.g. marketing wars
  • Reduces industry uncertainty – higher profits increases producer surplus / shareholder value

Collusion in a market or industry is easier to achieve when:

  1. There are only a small number of firms in the industry and there are significant barriers to prevent new firms entering the industry
  2. Market demand is not too variable (or cyclical) i.e. it is reasonably predictable and not subject to violent fluctuations which may lead to excess demand or excess supply.
  3. Demand is fairly inelastic with respect to price so that a higher cartel price increases the total revenue to suppliers – this is easier when the product is viewed as a necessity.
  4. Each firm's output can be easily monitored (this is important!) – This enables the cartel more easily to control total supply and identify firms who are cheating on output quotas.

Incomplete information about motivation of other firms may induce tacit collusion

Reasons for the Possible Breakdowns of Cartels

Most cartel arrangements experience difficulties and tensions and some cartels collapse completely.

Several factors can create problems within a collusive agreement between suppliers:

  1. Enforcement problems: The cartel aims to restrict production to maximize total profits of members. But each individual seller finds it profitable to expand production. It may become difficult for the cartel to enforce its output quotas and there may be disputes about how to share out the profits. Other firms – not members of the cartel – may opt to take a free ride by selling just under the cartel price.
  2. Falling market demand creates excess capacity in the industry and puts pressure on individual firms to discount prices to maintain their revenue
  3. The successful entry of non-cartel firms into the industry undermines a cartel's control of the market. Rapid technological change can often undermine a cartel e.g. a new entrant with an innovative and success alternative business model.
  4. The exposure of illegal price-fixing by market regulators such as the European Union Competition Commission and the UK's Competition and Markets Authority.
  5. The exposure of price-fixing by whistle-blowing firms – these are firms previously engaged in a cartel that decides to withdraw from it and pass on information to the competition authorities

Horizontal and vertical collusion

Horizontal collusion involves price fixing / market rigging between companies in the same industry and at the same stage of production

Vertical collusion

Vertical collusion occurs when businesses in the same industry engage in anti-competitive practices at different stages of the supply chain.

A good recent example has been the dispute between the US competition authorities and Apple who have been accused of trying to force higher the prices of e-books through collusion with the major book publishers.

Evaluation: Fear of fines or other control mean that there is strong incentive to conceal collusion


Evaluating the Costs and Benefits of Collusion - Revision Video

E-books price fixing claims

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