Collusive Oligopoly Essay Example

in price, output, or forms of non-price competition.

Collusive oligopoly

There are two types of collusive oligopoly

• Price leadership – tacit collusion This occurs when one firm has a clear dominant position in the market and the firms with lower market shares follow the pricing changes driven by the dominant firm.
• Overt collusion: This occurs when firms openly agree on a price, output, and other decisions aimed at achieving high profits.

Firms who coordinate their activities through overt collusion and by forming collusive coordinating mechanisms, such a group of independent firms working in unison is called a cartel. When this happens the existing firms 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. Price fixing in collusive oligopoly Collusion is often explained as a product of motive to achieve joint-profit maximization within a market or circumvent price and revenue instability in an industry.

Price fixing can be deemed as an attempt by suppliers to control supply and fix prices at a level close to the level expected from a monopoly. However, in order to fix prices,

the producers in the market must be able to exert control over market supply. Figure 1 below depicts a producer cartel fixes the cartel price at output Qm and price Pm decided by the fact where marginal revenue of the cartel MR is equal to the marginal cost MC of the cartel. The distribution of the cartel output among the cartel members could be decided on the basis of an output quota system or through mutual agreement. Although the cartel as a whole is maximizing profits, the individual firm’soutput quota is unlikely to be at their profit-maximizing point. For anyone firm, within the cartel, expanding output and selling at a price that slightly undercuts the cartel price can achieve extra profits.

Unfortunately, if one firm indulges in this, the other firms will probably same path same. If all firms break the terms of their cartel agreement, the result will be an excess supply in the market and a sharp fall in the price. Under these circumstances, a cartel agreement might break down.

Price fixation by cartel and effect on the partner of the firm Conditions conducive for the formation of cartels

1. Only a small number of firms exist in the industry and barriers that prevail to entry protect the monopoly power of existing firms in the long run.
2. Market demand is not too variable i. e. it is reasonably predictable and not subject to erratic fluctuations which may result in excess demand or excess supply.
3. Demand is fairly inelastic with respect to price so that a higher cartel price fetch increased total revenue to suppliers in the market. 4. It is easier to monitor each firm’s output.
   

This enables the cartel to more easily regulate total supply and identify firms, cheating on output quotas.

Reasons for possible breakdowns of cartels Most cartel arrangements experience difficulties and tensions and some producer cartels collapse completely. Several factors can create problems within a collusive agreement between suppliers:

 Enforcement problems

1.  The primary objective of the cartel is to restrict total production to maximize the total profits of members. But in reality, each individual member of the cartel finds it profitable to raise its own production. Thus the enforcement of output quota becomes difficult for the cartel leading to disputes about sharing of the profits. Non-members of the cartel may opt to take a free ride by producing close to but just under the cartel price.
2. Falling market demand during a recession creates excess capacity in the industry and exerts pressure on individual firms to reduce prices to maintain their revenue. E. g. collapse of the coffee export cartel.
3. The successful foray of non-cartel firms into the industry undermines a cartel control of the market – e. g. the emergence of online retailers in the book industry in the mid-1990s.
4.  The exposure of illegal price-fixing by market regulators Governments appoint market regulators to monitor the markets and identify the firms indulging in collusion. Collusion is undesirable from the standpoint of society as a whole, because of the inefficient allocation of resources at high prices. In order bring the allocation of resources closer to the social optimum, policymakers try to induce firms in an oligopoly to compete rather than cooperate through an instrument of antitrust laws. Regulatory bring legal suits to enforce the antitrust laws for example to prevent mergers
   

leading to excessive market power prevent.

OPEC case study: Most successful cartel Organization of petroleum exporting countries (OPEC) was formed in 1960. Initially, it contained only 5 members, the membership of the cartel however expanded to 13 by 1973. During the period 1960-73, OPEC could not be reckoned as a successful cartel. In fact world oil prices declined slightly over the 1960-1970 decade. However, the situation underwent a dramatic change in 1973 with the Arab-Israel war.

During the war, the Arab members of OPEC temporarily cut off oil exports. The outcome was ominous: Oil prices more than tripled in a matter of months. The estimated price of a barrel of oil on the world market was $2. 91 in 1973 but jumped to $10.77 in 1974. This demonstrated that output restriction could wreak havoc after resuming exports OPEC continued to hold down output. Subsequently, oil prices remained relatively stable. However, another jolt was inflicted in 1978 when the revolution took place in Iran. Iranian exports at that time accounted for 20 percent of all OPEC exports, fell almost to zero. Prices escalated once again and the new government in Iran continued to limit exports, maintaining prices at high levels.

The Iran-Iraq War, which started in 1980, resulted in the extensive destruction of oil-producing facilities in both counties and brought down oil exports further. The relative success of OPEC can be attributed to the following advantages it has enjoyed relative to other cartels.

1. The price elasticity of demand for oil, especially in the short run, is quite low, implying that moderate output restrictions will produce large price increases- a favorable environment for a cartel. In 1973 OPEC output contributed
   

to two-thirds of the total world oil production.

(Iran, Iraq, Kuwait, and Saudi Arabia) and Venezuela formed OPEC, the purpose of which was to obtain higher prices for crude oil. By 1973 eight other nations (Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, and Gabon) had joined OPEC. Ecuador withdrew on the last day of 1992. OPEC was unsuccessful in its first decade. Real (that is, inflation-adjusted) world prices for crude oil continued to fall until 1971.

In 1958 the real price was $10. 85 per barrel (in 1990 dollars). By 1971 it had fallen to $7. 46 per barrel. However, real prices began to rise slowly beginning in 1971 and then jumped dramatically in late 1973 and 1974 from roughly $8 per barrel to over $27 per barrel in the wake of the Arab-Israeli War.

Contrary to what many non-economists believe, the 1973 price increase was not caused by the oil "embargo" (refusal to sell) directed at the United States and the Netherlands that year by the Arab members of OPEC. Instead, OPEC reduced its production of crude oil, thus raising world oil prices substantially. The embargo against the United States and the Netherlands had no effect whatever: both nations were able to obtain oil at the same prices as all other nations. The failure of this selective embargo was predictable. Oil is a fungible commodity that can easily be resold among buyers.

Therefore, sellers who try to deny oil to buyer A will find other buyers purchasing more oil, some of which will be resold by them to buyer A. Nor, as is commonly believed, was OPEC the cause of oil shortages and gasoline lines in the United States. Instead, the shortages

were caused by price and allocation controls on crude oil and refined products, originally imposed in 1971 by President Nixon as part of the Economic Stabilization Program. By preventing prices from rising sufficiently, the price controls stimulated desired consumption above the quantities available at the legal maximum prices.

Shortages were the inevitable result. Countries that avoided price controls, such as West Germany and Switzerland, also avoided shortages, queues, and the other perverse effects of the controls.OPEC is a cartel—a group of producers that attempts to restrict output in order to keep prices higher than the competitive level. The heart of OPEC is the Conference, which comprises national delegations, usually at the level of the oil minister.

The Conference meets twice each year to assign output quotas, which are upper limits on the amount of oil each member is allowed to produce. The Conference may also meet in special sessions when deemed necessary, particularly when downward pressure on prices becomes acute. OPEC faces the classic problem of all cartels: overproduction and cheating by members. At the higher cartel price, less oil is demanded. That is why OPEC assigns output quotas.

Each member of the OPEC cartel has an incentive to produce more than its quota and "shave" (cut) this price because the cost of producing an additional barrel of crude is typically well below the cartel price. The methods available to shave official OPEC prices are numerous. Credit can be extended to buyers for periods longer than the standard thirty days. Higher grades (or blends) of oil can be sold for prices applicable to lower grades. Transportation credits can be given. Buyers can be offered side payments or rebates.

This

tendency for individual producers to cheat on the cartel agreement is a long-standing feature of OPEC behavior. Individual producers usually have exceeded their production quotas, and so official prices have been unstable. But OPEC is an unusual cartel in that one producer—Saudi Arabia—is much larger than the others. That is why the Saudis are the "swing" producer. When prices start downward, they cut their production to keep prices up. One reason the Saudis have behaved that way is that departures from the official prices impose larger total losses on them than on other OPEC members in the short run.

Because other producers have huge incentives to produce in excess of their quotas, the Saudis, in order to defend the official OPEC price, have had to reduce their sales dramatically at times. This erosion of Saudi production and sales has tended to reduce their revenues and profits substantially. In 1983 and 1984, for example, the Saudis found themselves producing only about 3. 5 million barrels per day, despite their (then) production capacity almost three times that level.

How successful has OPEC been since the early seventies? Not as successful as many people perceive. Except in the wake of the 1979 Iranian revolution, and in anticipation of the possible destruction of substantial reserves in the 1990-91 Persian Gulf conflict, real (inflation-adjusted) prices of crude oil have fallen since 1973. Prices began dropping very rapidly in the early eighties after the Saudis concluded that lower prices and higher production were in their best interests. Official prices fell from $34 (for the benchmark crude oil, Arabian light) to $29 in 1983, $24 in 1984, and about $18 in 1986 to 1988.

Indeed, even prices unadjusted for inflation often have fallen. For example, prices fell from $35.10 per barrel ($49. 10 in 1990 dollars) in 1981 to $16. 69 ($18. 69 in 1990 dollars) in 1987.

Source: U. S.

Department of Energy, Central Intelligence Agency. This downward trend has increased tensions between two rival groups within OPEC. The price "hawks," usual nations with smaller crude oil reserves relative to population, argue for lower oil output and higher prices. The principal hawks within OPEC are Iran and Iraq. The price "doves," usual nations with larger reserves relative to population, argue for higher output and lower prices to preserve, over the longer term, their oil markets and thus the economic value of their oil resources. The principal doves within OPEC are Saudi Arabia, Kuwait, and the United Arab Emirates.

Such relatively lower prices serve the interests of the doves because oil consumers have used less oil in response to prior price increases. For example, U. S. energy use per dollar of GNP (adjusted for inflation) was 27.49 thousand BTUs in 1970. By 1988, after the price increases of 1973 and 1979, it had decreased to 19. 93 thousand BTUs. Thus, the price "doves," led by Saudi Arabia, generally have resisted pressures for higher prices. Over the long run, real prices of natural resources and commodities usually fall, largely because of technological advances.

Crude oil is no exception. Technological advances in seismic exploration have dramatically reduced the cost of finding new reserves, thus increasing oil reserves greatly. Horizontal drilling and other new techniques have reduced the cost of recovering known reserves. Also, improvements in technology provide both substitutes for oil and ways to use

less oil to achieve given ends. Moreover, advances in technology will reduce prices for such substitute fuels like natural gas, thus exerting continuing downward pressure on crude oil prices.

And increasing willingness to devote resources toward environmental improvement suggests that the market for crude oil will decline relative to those for such "cleaner" energy sources as natural gas and nuclear technology unless other technical advances yield substantial improvement in the ability to use oil cleanly. Thus, the demand for crude oil is likely over the long term to decline relative to the demand for competing fuels. This has been the experience of mankind, as wood gradually gave way to coal, which in turn declined as the use of oil expanded. These facts suggest that the economic power of OPEC inexorably will erode. Conclusion Collusive oligopolies are more like a monopoly. However, it is very fragile since self-interest to earn a maximum profit of members can tip off the balance and can lead to a price war. The success of a collusive oligopoly is quite dependent on the number of firms involved and their level of cooperation. It can be observed that it is difficult to maintain cartels in the long run with an exception of OPEC.

Policymakers regulate the behavior of oligopolies through antitrust laws. The proper scope of these laws is the subject of ongoing controversy.