Why are Oligopolies Tempted to Collude Even if it Means Breaking the Law - Essay Example

?Why are Oligopolies tempted to collude even if it means breaking the law? Why are oligopolies tempted to collude, even if it means breaking the law? This essay deals with oligopolistic market structures and incentives that push them towards collusion. In doing so, it discusses the characteristics of oligopolies, collusion, cartels, game theory and the kinked demand curve. A firm achieves maximum profits when it operates where its marginal revenue equals marginal cost (MC=MR). However, it is mostly not as easy as a question of operating at this point; the more competition the firm faces, the lesser it will be able to manipulate the consumers for its own economic gain (Sloman and Wride, 2009). The two extremes in market structures are (i) Perfect Competition and (ii) Monopoly. However, in real life, firms often operate somewhere in the middle of these two extremes. Such market structures are characterized by Imperfect Competition. There are two main kinds of markets that practice imperfect competition: (i) Monopolistic Competition and (ii) Oligopolies. Some famous oligopolistic firms are Pepsi, Coke, Nike, Adidas, Reebok and Nintendo (Sloman and Wride, 2009). In an oligopoly, the number of competitors is less and limited and there are high barriers which prevent frequent entry of new firms into the market. Barriers of entry may be created in the form of brand names, sunk costs, firm size, economies of scale, and large firm advantage (Boyes and Melvin, 2009). Competition between firms in an oligopolistic market is high and intense, it sometimes leads to price wars which become extremely detrimental for their effective functioning. In other instances, these firms choose to collude amongst themselves to minimize the downsides of operating in an oligopolistic market and to simultaneously maximize their profits. The products these firms make can either be differentiated or homogenous. Depending on the product type, there emerge two distinct kinds of oligopolies: pure oligopolies which produce homogenous products, for example the steel industry. Sometimes, however, an oligopoly may produce differentiated products; such oligopolies are called impure oligopolies. An example of such an oligopoly would be the automobile industry. The demand curve for both types of oligopolistic firms is downward sloping and fairly inelastic, there is also a degree of dependency on the reactions of competitor firms to price changes. Another key feature is mutual interdependence, which means that each firm is affected by the actions of its competitors and thus, whenever any firm is going to take an action, it does so with its competitors’ possible reactions in mind. Due to these circumstances there is a high degree of uncertainty in an oligopolistic industry because firms can never accurately predict how exactly their competitors will react to their actions and this any sort of action involves an inherent degree of risk (Sloman and Wride, 2009). In oligopolistic markets, there is price rigidity because setting product price is not at one firm discretion but a decision in which all firms are factored in. If one firm lowers price below market price, this can cause a price war where all firms start lowering their prices to match the initial decrease and this will continue and form a vicious downward price spiral. However, if one firm raises its price above set market price, no other firm will raise its price to match it and the firm who raised prices will lose out as all its customers will shift to competitor firms who have the old, lower price (Bhaskar, 2007). Thus, in an oligopolistic market, prices mostly remain rigid and are not often seen increasing or decreasing as the prices in a perfectly competitive market that respond to the dynamic demand and supply levels. Therefore, the demand curve faces a kink at the existing market price level and market price will not change for small changes in production cost etc. (Sen, 2004). This is shown in the diagram below: (Sloman and Wride, 2009). Firms operating in an oligopoly are faced with two different choices: they might want to collude with each other because of the interdependence which would allow them to function collectively as a monopoly and maximize joint industry profits, or they might want to maintain a degree of freedom and compete with their competitors to maximize market and profit share in the industry. The problem with competing is that it will end up reducing overall profit levels either by raising the operating costs of the firm or by decreasing market price (Sloman and Wride, 2009). If the firms decide to compete, game theory comes into play. A game is a “formal description of a strategic situation” (Turocy and Stengel, 2001). The game theory provides with possible outcomes in a strategic situation where decision making firms have interaction by using models to understand them in theory. A given assumption is that all decision makers make rational decisions. In a standard model, there are two players, each with a possible set of choices and preferences of one choice over another (Osborne, 2000). All actions affect both parties. By going through every possibility, we can deduce which set of actions will make both better off together. The problems associated with competition in an oligopoly are eliminated under collusion because all firms work jointly to maximize joint profits. When firms formally enter into a collusive agreement, they form a cartel (Sloman and Wride, 2009). There are different methods of collusion. It can be in the form of a merger, though often this is illegal. More commonly, however, it will take the shape of the firms working jointly to set output and price (Stigler, 1964). Under a cartel, the firms fix output, price, market share and expenditures etc. Since all firms are working jointly, the degree of uncertainty and risk is considerably reduced. The following diagram shows how a cartel functions to maximize profits (Sloman and Wride, 2009). The MC curve of a cartel is deduced by horizontally summing up the individual MC curves of each firm. Profit is maximized at MC=MR, thus the cartel will operate at output Q1 and corresponding price P1. Once the collective output level and price are set, the cartel may decide to compete on non-price terms for market share, or the cartel leader which is the dominant firms might set and assign quotas to individual firms that they are expected to meet (Sloman and Wride, 2009). This diagram shows how the output quota system works under the leadership of a dominant firm in a cartel. The sum of all the quotas should always add up to the agreed output level that is Q1. The quota level for each firm is mostly decided based upon its pre-cartel market share so that it makes for an equitable output distribution (Sloman and Wride, 2009). Apart from output and price collusion, cartels also affect the innovation, development and launch of new products into the market. Being part of a cartel will also have an effect on the cost, quality and variety offered in existing and new products. Often cartels will be beneficial in these regards due to benefits reaped from economies of scale when functioning as a part of a cartel (Pakes and Fershtman, 2000). In most economies, however, cartel formation and functioning is illegal because it is seen to be functioning on the basis or market exploitation against the interest of the people by increasing market price and fixing output so that the firms can maximize profits at the expense of their consumers. Firms may still, however, choose to enter into a ‘tacit’ collusion where they operate along the same terms as a collusive oligopoly, but no formal agreement exists (Sloman and Wride, 2009). Collusion makes it possible for firms to attain supra-normal profits and is strengthened by the belief that any deviation from said collusion will result in aggressive retaliatory measures which may lead to a destructive price war. Incentives to collude include the foreseeable increase in profit levels, oftentimes profit levels without collusion are far less than profit levels after collusion and, thus, firms are tempted to enter into collusion even if it is illegal (Ivaldi et al., 2003). Firms are also tempted to collude when the number of firms in an oligopoly is less; it is easier to coordinate affairs between the firms and the returns of a collusive agreement are immense. Furthermore, since the number of competitor firms is less, the collective profit has to be divided among lesser firms and, thus, the individual profit share for a collusive firm is higher. This functions as an added incentive for collusion. Moreover, if market shares between colliding firms are approximately equal, then the desire to enter into a collusive agreement will also be symmetric because all firms have almost the same to gain and the same to lose from the collusion. Collusion is also more likely to occur in oligopolies where market barriers to entry are high so firms can expect lesser entrants and higher profit levels even in the long run. Moreover, the greater the degree of mutual interdependence and interaction, the higher the incentive to collude. In the same vein, if market demand for their product is growing, firms will exploit growing demand by restricting supply so that it will raise prices and help them accumulate higher profits as a result. Moreover, growing demand means that future profits will be higher and this becomes an added incentive. Collusion is also favoured by business cycles that are pre-deterministic and not random or sudden. Other factors that propel firms to enter into collusive agreements include product homogeneity, demand elasticity, buying power, structural links and cooperative agreements etc. (Ivaldi et al., 2003). Oftentimes, there are internal benefits to forming a cartel. The decision is normally taken at top management level due to temptation created by managerial incentives and bonuses. Sometimes stock options may also be offered to management as an incentive to collude. The general attitude and consensus of a firm’s stakeholders may also become a reason why companies join cartels. This would be in the shareholders’ best interests because if the firm earns higher profits, they will get higher dividends (Spagnolo and Buccirossi, 2007). Internal incentives are often extremely important as driving forces to form a cartel. The owners alter their managers incentives to be more geared towards being part of the cartel, and are motivated to do so themselves because they also have some personal gain at stake (Fershtman and Judd, 1987). In sum, it can be seen that the financial and economic decisions of a firm are closely linked to its marketing decisions and priorities (Lewis and Brander, 1986). Thus, in market settings where the market competition is oligopolistic, competing firms will be tempted to collude even when it is illegal or immoral, because the substantial gains they will reap (internally and externally) in the form of monetary and other incentives for owners and management and higher level of profits and market share earned by expertly manipulating the market will be higher than the benefits they would have achieved under a competitive market structure. What is more is that by colluding, these firms will also avoid the variables of uncertainty, risk, price wars and other retaliatory measures that can be extremely destructive for business. Reference List Bhaskar, V., 2007. The Kinked Demand Curve. University College London. Boyes, M. and Melvin, M., 2009. Fundamentals of Economics. 4th Edition. Boston: Houghton Mifflin Company. Brander, J.A. and Lewis, T.R., 1987. Oligopoly and Financial Structure: The Limited Liability Effect. The American Economic Review, 76 (5), pp.956-970. Fershtman, C. and Judd, K.L., 1987. Equilibrium Incentives in Oligopoly. The American Economic Review, 77 (5), pp.927-940. Ivaldi, M. et al., 2003. The Economics of Tacit Collusion. Final Report for DG Competition, European Commission. Osborne, M.J., 2000. An Introduction to Game Theory. Oxford University Press. Pakes, A. and Fershtman, C. 2000. A Dynamic Oligopoly with Collusion and Price Wars. The RAND Journal of Economics, 31 (2), pp.207-236. Sen, D., 2004. The Kinked Demand Curve Revisited. Economic Letters, 84, pp.99-105. Sloman, J. and Wride, A., 2009. Economics. 7th Edition. England: Pearson Education Limited. Spagnolo, G. and Buccirossi, P., 2007. Corporate Governance and Collusive Behavior. CEPR Discussion Paper. Stigler, G. J., 1964. A Theory of Oligopoly. The Journal of Political Economy, 72 (1), pp.44-61. Turocy, T. L. and Stengel, B. V., 2001. Game theory. CDAM Research Report. Read More