"Even without a formal agreement firms in oligopolistic markets may be able to sustain a joint monopoly equilibrium. Discuss."

For an oligopolistic market to remain so, there must be a reason for competitors to stay out, this could be due to firms not earning supernormal profits or due to high entry barriers. Positive profits will induce entry, which, will have the effect of increasing supply and decreasing price; this is detrimental for all firms in an industry. To prevent this firms will want to erect entry barriers. Bain defines entry barriers as “the extent to which in the long run, established firms can elevate their selling prices above the minimum average costs of production and distribution without inducing potential entrants to enter the industry”. Baumol and Willig cite “anything that requires an expenditure by a new entrant into an industry, but that imposes no equivalent cost upon an incumbent.”

If firms in oligopolistic markets persue their own interests and do not cooperate, joint output is greater than the monopoly quantity but less that the competitive industry quantity. Market price will be lower than in a monopoly.

Tacit collusion is “unorganized and unstated attempts by informally coordinated oligopolies to practice joint actions”. An example of this would be price leadership where the dominant firm sets the price or initiates changes and the other firms follow that lead, a good example being Brooke Bond, which has 43% of the UK tea market. However as the number of firms in an oligopoly increases the cost of coordinating behaviour also increases. If barriers to entry are low and new firms enter the market it is possible they will destroy the coordination mechanisms in place. We can compare firms operating without a formal agreement with the aim to sustain a joint monopoly equilibrium to a cartel, which is a type of formalized collusion. A cartel would usually involve the establishment of a central body to sets prices and output for all of its member firms, which tends to be the whole industry. A good example of this is the OPEC cartel, which, in the 1970’s through to the 80’s succeeded in hiking up the price of oil. Profit maximization for a cartel as a whole is not always consistent with profit maximization for each individual member. Self interest can make it difficult to maintain a cooperative outcome. However the strong incentive for collusion is to reduce production, raise prices and ultimately increase profits. Firms that care about the future profits of the industry will cooperate rather than cheat on the agreement to achieve a one-time gain. The incentive to cheat on an agreement is clearly profit, but cheating can be a destabilizing force. A member can make more profit for itself by cheating on the cartel, by increasing its own output or by lowering price. The cheater is considered a free rider, exploiting the restraint of the other firms. If too many firms cheat, the cartel collapses. To prevent cheating punishment must be enforced (there is simply not enough time to undertake a discussion of this point).

If the number of sellers in a market increases, the market moves towards being a competitive market and price will approach MC and quantity will approach the socially efficient level. Another way of looking at this is the more concentrated the market and the higher the entry barriers, the easier it is for a non-collusive equilibrium to be maintained, as firms only need be concerned with current rivals actions.

Joint profit maximizing is where firms seek to coordinate prices, output and other variables to achieve maximum profit for the industry as a whole (they behave like monopolists). The equilibrium output in an imperfectly competitive market tends to exceed the monopoly level, also giving firms an incentive to restrict output.

A good method of maintaining equilibrium is through the adoption of a ‘tit-for-tat’ strategy, where one firm may take the initiative to raise the price and lower the quantity produced which sends a signal to other firms in the market, if all firms follow suit they will earn monopoly profits instead of a share of oligopoly profits. It must however be made clear that any price cutter will be penalized by the leader by them also decreasing their price even if the other firm has since increased its price. Axelrod proved that tit-for-tat, compared to all other strategies is robust strategy. A firm playing this strategy is never the first firm to defect, it only retaliates by punishing the deviant. It will then return to the cooperative strategy as soon as the punishment has occurred. The one apparent major flaw in this strategy would be that through punishing too quickly or too severely the firm may be misunderstood and other firms could interpret this action as an aggressive move. The initial deviant could also have been behaving in a manner with non-aggressive intentions i.e. in response to slack demand. Misunderstanding can be avoided if firms played a strategy of tit-for-two-tats, where firms allow one unpunished defection. Therefore if a firms intentions were non aggressive, the period following the defection would see the firm returning to cooperative behaviour. This has the effect that the firm is not punished and that firm does not see its punishment as aggressive behaviour on the part of its competitor, it will not retaliate by also acting in an aggressive manner. Clearly this strategy is beneficial to all firms involved as it has the effect of maintaining high profits rather than accepting a cut in profits to punish its competitor. Defection may occur randomly, maybe through interventions by nature as the real world mimics a game of incomplete information. For example, the big three motor companies in the 70’s, where GM set the percentage price increases and Ford and Chrysler followed (this would follow the model of dominant firm price leadership). Sometimes Ford and Chrysler would introduce new models before GM, so they would attempt to guess the price increase of GM and set theirs accordingly. If they guessed too high they would lower their prices, as they had to be seen to be competitive with the industry leader, but if they guessed too low, as they did in the years 1970 and 1974, they could have used the lower prices to gain market share at the expense of GM but instead acted ‘nicely’ and revised their price increases to levels similar to GM. This allowed price stability in the industry to be maintained.

As price competition can be destabilizing in oligopolies, firms often channel their competitive activities into activities such as advertising. A prisoner’s dilemma (how to remain at the perfectly collusive level when the incentive to cheat exists for each firm) may result from this with firms spending excessive amounts, but on the other hand it will also raise entry barriers and protect established firms’ positions. Advertising is underpinned by product differentiation (which also includes trademarks and copy writes, quality differences, design, packaging, credit terms, after sales services, location of store etc). Bain found that product differentiation was the most important entry barrier. New entrants will face higher costs than established firms, who may have to overcome consumer resistance and ‘shout louder’ to make them heard. A new firm will have to compete with all established firms previous advertising. New entrants must also take into consideration the learning effects which firms already established in the industry have experienced which will have allowed them to move down their average cost curves and produce at a rate unavailable to the new entrant.

The question firms in oligopolistic markets face, is whether to compete or to collude. If they choose to compete they must take into account rivals responses to their actions, so when deciding upon a change in price or output the oligopolist must consider expected changes that a rival will make to its price or output. 

Antitrust law says it is illegal to restrain trade or attempt to monopolize a market. The FT reported that in the year 2002 a total of one billion euros in fines were levied in the EU due to collusive practices. This is simply another incentive for firms to erect and attempt to maintain joint monopoly equilibrium without formal agreements.

References

Gilbert, R 1989 The role of potential competition in Industrial Organization, Journal of economic perspectives

Gilbert, R 1989 Mobility Barriers and the value of incumbency in Schmalensee and Willig Handbook of Industrial Organisation, vol 1 North Holland

Rees, R 1993 Collusive Equilibrium in the Great Salt Duopoly, Economic Journal vol. 103, July

Walman and Jenson 2001 Industrial Organisation chapters 7,8,10 Addison-Wesley

Lecture Notes Week 12