Under what conditions will the oligopolists agree to co-operate in their decisions




Oligopoly is a market structure under which only a  few  suppliers  dominate
the market and the entrance  of  new  suppliers  is  either  constrained  or
impossible.[1] Usually, the oligopoly market is  dominated  by  2-10  firms,
who have a joint share of the market of 50% or more. Automobile, steel,  air
transport are common examples of oligopolies. Or,  in  a  global  sense,  we
could call oil producer countries oligopolies and OPEC  a cartel. At  least
some firms may influence price due to their important  contribution  to  the
total output. Every firm in the situation of oligopoly knows that if it,  or
its competitors either change prices or output,  the  revenues  of  all  the
participants  on  the  market  will  change.  That  means  that  firms   are
interdependent. For example, if General Morors Corporation decides to  raise
prices on its cars, it should consider retaliative moves by Ford,  Chrysler,
and other competitors in order to calculate the ultimate changes  in  sales.

      It is generally assumed that every firm on the  market  realizes  that
its changes in prices or output will cause other  firms  to  retaliate.  The
kind of retaliation any supplier expects from its competitors as a  reaction
to his changes in prices, output, or change of  marketing  strategy  is  the
main factor that influences its decisions[2]. That  expected  reaction  also
influences the balance of oligopoly markets.
Oligopolies may interact in two main ways:
1) Price wars, when a firm tries to increase it sales  by  reducing  prices,
   expecting that other firms will not be able to respond by doing the same.
   This stops when no firm can low its prices  anymore,  which  occurs  when
   P=AC and profit equals 0. Unfortunately for consumers, price wars do  not
   usually last long. Firms have temptations to co-operate with  each  other
   in order to set up higher prices and to share markets in such a  way,  as
   to avoid new price wars and their bad impact on revenues.
2) From the above  factor  results  co-operation.  Its  closest  form  is  a
   cartel, when a union of oligopolies  acts  as  a  monopoly.  Cartels  are
   illegal in many countries of the World.
Another reason for co-operation is to  increase  the  entrance  barriers  to
prevent other firms (especially the so-called hit and  run  firms)  to  join
the market and drop prices. In that situation firms try to coordinate  their
activities.



To answer this question, I first need to describe the way agreement  between
oligopolies form. Let us suppose that there are 15 suppliers in the  area  A
who want to co-operate with each other. These firms set their  prices  equal
to their average costs. Each of the firms is afraid to raise prices for  the
reason its competitors might not follow  that  move  and  its  profits  will
become negative. Let us suppose that the production is  at  the  competitive
level Qc (pic. A), that corresponds to the production quantity  under  which
the demand curve crosses MC, which is a horizontal sum of the marginal  cost
curves of each supplier. MC would coincide with  the  demand  curve  if  the
market were perfectly competitive. Each firm  produces  1/15  of  the  total
output Qc.



Pic. 



          Pm

         Pc                                          E

      MR`
                              MC
    D

                                                    MR

                                       Qm         Qc  Q`


   The original balance exists at the point E.;  the  competitive  price  is
Pc. At that price each of the producers gets normal revenue.  At  the  price
Pm, resulting from the co-operation agreement, each firm could maximize  its
profits by setting Pm=MC. If each of the firms does that,  than  there  will
be an over supply on the market, equal to QmQ units  per  month.  The  price
would fall to Pc. In order to maintain  cartel  price,  each  of  the  firms
should produce no more than the quota qm.
      When the  firms  decide  to  co-operate,  they  should  implement  the
following policies to be able to maximize their profits.
1) They should make sure that  there  exists  an  entrance  barrier  to  the
   market in which they operate in order to prevent other firms from selling
   a good at an old price after they increase prices for  their  output.  If
   the barriers do not exist, then the  increase  in  prices  would  attract
   other producers. The supply would then increase  and  prices  would  fall
   below the monopoly level, co-operating firms aim to maintain.
2) They should decide on the general pattern of production.  This  could  be
   done by estimating market demand and by calculating marginal  profit  for
   all levels of production. Firms need to produce so that their  MC=MR  (we
   assume that all  firms  have  similar  production  costs).  The  monopoly
   production level would maximize revenues of each of the firms  (see  Pic.
   A). The demand curve for the output is in the region of D.  The  marginal
   revenue that corresponds to that curve is  MR.  The  monopoly  production
   level equals to Qm, which corresponds to the point where MR  crosses  MC.
   The monopoly price equals Pm. The current price equals Pc and the current
   output  Qc. That means that the current balance is the same as it  would
   be under competition.
3)  Each  participant  in  co-operation  agreement  should  have  production
   quotas. The monopoly production Qm should be divided between all  members
   of the treaty. For example, each firm could produce a 1/15  share  of  Qm
   per month. If all the firms had identical  cost  functions  it  would  be
   equivalent to recommending them to balance their  production  till  their
   marginal costs become equal to the market marginal revenue  (MR).  Until
   the sum of the monthly outputs of all producers equals Qm, it is possible
   to maintain the monopoly price.
Firms under co-operation agreement usually encounter problems when they  try
to make a decision about monopoly prices and  the  level  of  output.  These
problems are especially serious if the firms cannot agree  on  the  estimate
of the market demand, its price  elasticity;  or,  if  they  have  different
production costs.[3] Firms with higher production costs  try  to  insist  on
higher prices.



Every firm has incentives to increase its production at  cartel  prices.  At
the same time, if everyone will increase production then the agreement  will
fail because prices will decrease to  their  initial  level.  Pic.  B  shows
marginal and average costs of a typical producer. Before the  conclusion  of
co-operation agreement the firm behaves as if the demand for its  output  at
the price Pc was perfectly elastic. It does not increase prices  because  it
fears to lose all its sales to its competitors.  It  produces  the  quantity
qc. As all firms behave in the same way, the industrial  output  equals  Qc,
which is the value that would exist under  perfect  competition.  Under  the
newly established agreed prices the firm is allowed to produce qm  units  of
output, corresponding to the point at which MR equals  MC  of  each  of  the
firms.

Pic. 



                                           AC                            MC

         Pm                                 A                          F


           C                                     B

           H
  G

       MR`



                                                 qm           qc         q`

Let us suppose that the owners of any  one  of  the  firms  think  that  the
market price will not fall if they start selling more  than  that  quantity.
If they take Pm as price lying beyond their  influence,  then  their  profit
maximizing output will be q, under which Pm=MC. If the  market  price  does
not decrease, the firm can increase its  profits  from  PmABC  to  PmFGH  by
producing above the quota.
Just one firm could be able to  increase  its  output  without  causing  any
significant decrease in market prices. Let us  suppose,  however,  that  all
producers start producing above their quotas  in  order  to  maximize  their
profits under cartel[4]  prices  Pm.  The  industrial  output  would  then
increase to Q, under which Pm=MC, which will result in excess supply as  at
that price the demand would be lower than the supply.  Consequently,  prices
will fall until the market clears, i.e. till they become  equal  to  Pc  and
the producers will come back where they have initially started.
Cartels usually try to penalize  those  who  cheat  with  quotas.  The  main
problem however occurs when the  cartel  price  gets  set  up,  some  firms,
aiming to maximize their profits, could earn more by cheating.  If  everyone
is cheating the co-operation agreement breaks down as profits fall to 0.



1. Grebenschikov P.I., Leusskiy A.I., Tarasevitch L.S,  Microeconomics,  St.
   Petersburg 1996., pp. 213- 216
2. Livshits A.Y. Introduction to the Market Economy,  Moscow  1991,  pp.158-
   161
3. McConnell C.P., et al., Economics, Moscow 1993, pp. 125-7
4. Begg D., Fisher S., Dornbusch R., Economics, 5th ed.,  McGraw-Hill  1997,
   pp. 151-51, 176, 146, 148
5. Lancaster K., Introduction to Modern Microeconomics, 2nd ed.,  N-Y  1974,
   p. 200-1
6. Nicholson W., Microeconomic Theory, 7th ed., The Dryden Press  1998,  pp.
   580-4



-----------------------
[1] Grebenschikov P.I., Leusskiy A.I., Tarasevitch L.S, Microeconomics, St.
Petersburg 1996., p. 213
[2] Livshits A.Y. Introduction to the Market Economy, Moscow 1991, p.159
[3] Livshits A.Y. Introduction to the Market Economy, Moscow 1991, p. 161
[4] I am using the expression cartel price for the purpose of
simplification. What I mean by it is the high price that resulted from the
co-operation agreement between oligopolies.



"Under what conditions will the oligopolists agree to co-operate in their decisions"