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12.3: Collusion or Competition?

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    Learning Objectives

    • Explain collusion and cartels
    • Explain and analyze profits and losses in an oligopoly (including how to maximize profits and how cut-throat competition can result in zero economic profits)
    • Explain why oligopolies are inefficient

    When oligopolist firms consider what quantity to produce and what price to charge, they face a temptation to work with the other firms to act as if they were a single monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide the profit among themselves. When firms act together in this way to reduce output and keep prices high, it is called collusion. A group of firms that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel.

    We can see what collusion looks like in Figure 1. If the firms decide to collude, they choose to produce the monopoly output, Qc, and charge a corresponding price, Pc, which can be read off the market demand curve. Since they produce together where MR = MC, they will maximize industry profits, just like an actual monopoly would.

    Graph showing Price on the y-axis and Quantity on the x-axis. There is a downward-sloping demand curve, and then a downward sloping marginal revenue curve that originates at the same price point, but marginal revenue intersects quantity at half the quantity of the demand curve. The marginal cost curve intersects both curves as a horizontal line. A monopolist maximizes profit where MC crosses demand at a lower price point, instead of where MC crosses MR, like a monopolist.
    Figure 1.Profit Maximization for an Oligopoly. The profit maximizing point for colluding oligopolies is found where MR=MC, where price is Pc, just as in a monopoly. Because of cutthroat competition, oligopolies may instead act as perfect competitors, moving the profit maximizing point to where demand and MC intersect, just as in perfect competition. This is found at the intersection of Qcc and Pcc.

    COLLUSION VERSUS CARTELS: HOW TO DIFFERENTIATE

    In the United States, as well as many other countries, it is illegal for firms to collude since collusion is anti-competitive behavior, which is a violation of antitrust law. Both the Antitrust Division of the Justice Department and the Federal Trade Commission have responsibilities for preventing collusion in the United States.

    The problem of enforcement is finding hard evidence of collusion. Cartels are formal agreements to collude. Because cartel agreements provide evidence of collusion, they are rare in the United States. Instead, most collusion is tacit, where firms implicitly reach an understanding that competition is bad for profits.

    Economists have understood for a long time the desire of businesses to avoid competing so that they can instead raise the prices that they charge and earn higher profits. Adam Smith wrote in Wealth of Nations in 1776: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

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    Cut-throat Competition

    Even when oligopolists recognize that they would benefit as a group by acting like a monopoly, each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep prices high. If at least some oligopolists give in to this temptation and start producing more, then the market price will fall. A small handful of oligopoly firms may end up competing so fiercely that they all find themselves earning zero economic profits—as if they were perfect competitors. This situation is called cut-throat competition, and is shown in Figure 1 at Qcc and Pcc. Since Pcc equals average cost, firms end up just breaking even.

    Watch It

    Watch this video for an explanation of collusion and to learn more about why cartels often fall apart.

    An interactive or media element has been excluded from this version of the text. You can view it online here: http://pb.libretexts.org/mecon/?p=418

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    Tradeoffs of Imperfect Competition

    Oligopoly is probably the second most common market structure (monopolistic competition being the first). When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers. Oligopolies are often protected by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods of time. They typically operate at a level of output where price is greater than marginal cost, so oligopolistic industries are not allocatively efficient. Unlike in the simple example in Figure 1, oligopolists also do not typically produce at the minimum of their average cost curves, so they are not productively efficient. When they lack vibrant competition, they may lack incentives to provide innovative products and high-quality service.

    The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers.

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    THE TEMPTATION TO DEFY THE LAW

    Oligopolistic firms have been called “cats in a bag,” as mentioned earlier. The French detergent makers we mentioned at the beginning of our discussion on oligopolies chose to “cozy up” with each other. The result? An uneasy and tenuous relationship. When the Wall Street Journal reported on the matter, it wrote: “According to a statement a Henkel manager made to the [French anti-trust] commission, the detergent makers wanted ‘to limit the intensity of the competition between them and clean up the market.’ Nevertheless, by the early 1990s, a price war had broken out among them.” During the soap executives’ meetings, which sometimes lasted more than four hours, complex pricing structures were established. “One [soap] executive recalled ‘chaotic’ meetings as each side tried to work out how the other had bent the rules.” Like many cartels, the soap cartel disintegrated due to the very strong temptation for each member to maximize its own individual profits.

    How did this soap opera end? After an investigation, French antitrust authorities fined Colgate-Palmolive, Henkel, and Proctor & Gamble a total of €361 million ($484 million). A similar fate befell the icemakers. Bagged ice is a commodity, a perfect substitute, generally sold in 7- or 22-pound bags. No one cares what label is on the bag. By agreeing to carve up the ice market, control broad geographic swaths of territory, and set prices, the icemakers moved from perfect competition to a monopoly model. After the agreements, each firm was the sole supplier of bagged ice to a region; there were profits in both the long run and the short run. According to the courts: “These companies illegally conspired to manipulate the marketplace.” Fines totaled about $600,000—a steep fine considering a bag of ice sells for under $3 in most parts of the United States.

    Even though it is illegal in many parts of the world for firms to set prices and carve up a market, the temptation to earn higher profits makes it extremely tempting to defy the law.

    Glossary

    [glossary-page][glossary-term]cartel:[/glossary-term]
    [glossary-definition] a group of firms that collude to produce the monopoly output and sell at the monopoly price[/glossary-definition][glossary-term]collusion: [/glossary-term]
    [glossary-definition]when firms act together to reduce output and keep prices high[/glossary-definition][glossary-term]cut-throat competition: [/glossary-term]
    [glossary-definition]oligopolistic outcome when firms decide to cut prices to capture market share; in the limit, this leads to zero economic profits[/glossary-definition][/glossary-page]

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    12.3: Collusion or Competition? is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

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