Collusion in an Oligopoly Topic 3.3.9

Oligopoly and Collusion Collusion is a form of anti-competitive behaviour Collusion can be Horizontal Vertical Explicit v Tacit collusion Some collusion between businesses is legal

3 Key Aim of Business Collusion Businesses in a cartel recognise their mutual interdependence and act together – the main aim is to maximise joint profits Collusion lowers the costs of competition e.g. wasteful marketing wars which can run into millions of pounds Collusion reduces uncertainty in a market – and higher profits increases producer surplus / shareholder value – leading to higher share prices

Basic Analysis of Price Fixing in Oligopoly Cost & Price Output (Q) Cost & Price Output (Q) Industry Demand and CostsCartel Price and the Individual Member MC MRAR When there are only a few dominant firms in a market, they can engage in RESTRICTIVE PRACTICES (such as cooperation to restrict output or fix higher prices)

Basic Analysis of Price Fixing in Oligopoly Cost & Price Output (Q) Cost & Price Output (Q) Industry Demand and CostsCartel Price and the Individual Member MC MRAR Q1 P1 P1 becomes cartel price When there are only a few dominant firms in a market, they can engage in RESTRICTIVE PRACTICES (such as cooperation to restrict output or fix higher prices)

Basic Analysis of Price Fixing in Oligopoly P1 Q1 Cost & Price Output (Q) Cost & Price Output (Q) Industry Demand and CostsCartel Price and the Individual Member MC MRAR MC Firm A AC Firm A P1 becomes cartel price P1

Basic Analysis of Price Fixing in Oligopoly P1 Q1 Cost & Price Output (Q) Cost & Price Output (Q) Industry Demand and CostsCartel Price and the Individual Member MC MRAR MC Firm A AC Firm A P1 becomes cartel price P1 Output quota for firm

Basic Analysis of Price Fixing in Oligopoly P1 Q1 Cost & Price Output (Q) Cost & Price Output (Q) Industry Demand and CostsCartel Price and the Individual Member MC MRAR MC Firm A AC Firm A P1 becomes cartel price P1 Output quota for firm C1 Super-normal profit for this firm in the cartel Profit at cartel price and staying within the quota

Basic Analysis of Price Fixing in Oligopoly P1 Q1 Cost & Price Output (Q) Cost & Price Output (Q) Industry Demand and CostsCartel Price and the Individual Member MC MRAR MC Firm A AC Firm A P1 becomes cartel price P1 Output quota for firm C2 Cheating – exceeding the quota Higher profit from producing in excess of the output quota Increasing output to achieve higher profits

Basic Analysis of Price Fixing in Oligopoly P1 Q1 Cost & Price Output (Q) Cost & Price Output (Q) Industry Demand and CostsCartel Price and the Individual Member MC MRAR MC Firm A AC Firm A P1 becomes cartel price P1 Output quota for firm C2 Cheating – exceeding the quota RISK! Over-supply threatens stability of cartel

Price Fixing (Collusion) is easier when…. 1.Industry regulators are weak / ineffective 2.Penalties for collusion are low relative to the potential gains in revenues / operating profits 3.Participating firms have a high percentage of total sales – this allows them to control market supply 4.Firms can communicate well and trust each other and they have similar strategic objectives 5.Industry products are standardised and output is easily measurable 6.Brands are strong so that consumers will not switch demand when collusion raises price

Background on the OPEC cartel The Organization of the Petroleum Exporting Countries (OPEC) is a cartel of oil-producing countries which was established in Baghdad, Iraq, in OPEC generates approximately 45 percent of the world’s total crude oil production, and more than 20 percent of the world’s natural gas production. OPEC owns more than four fifths of total global crude oil reserves, and around 48 percent of global natural gas reserves

OPEC's share of global crude oil output

Canadian Maple Syrup Cartel Threatened Quebec has 7,500 mostly family-run farms – who produce 70% of world supply Since 1990 producers have been required to hand over the bulk of what they produce to the Federation of Quebec Maple Syrup Producers (FPAQ) which has a monopoly control over the market The cartel sets output quotas. Farmers who produce in excess of the quota must send excess output to a strategic reserve FPAQ sets the price for how much it pays producers The Quebec maple syrup cartel is being challenged by independent producers who argue that it penalizes producers who want to expand One key threat for the Quebec cartel is the rapid growth of maple syrup production in the United States

Quebec is the dominant supply source

Why do many cartels break down? Enforcement problems: 1.The cartel aims to restrict production to maximize total profits. 2.But each individual seller finds it profitable to expand their production. 3.Other firms who are not members of the cartel may opt to take a free ride by selling just under the cartel price Falling market demand creates excess capacity in the industry and puts pressure on profits and cash-flow The successful entry of non-cartel firms into the industry undermines a cartel’s control of the market The exposure of price-fixing by whistle-blowing firms – these are firms previously engaged in a cartel that pass on information to the competition authorities When trust breaks down within a cartel it is highly likely to come under pressure and many eventually collapse.

Why do many cartels break down? Falling market demand in a recessionOver-production by some members Exposure by competition authoritiesEntry of non-cartel firms into industry

Costs of Collusive Behaviour Damages consumer welfare Higher prices / lost consumer surplus Hits lower income families – regressive impact Absence of competition hits efficiency X-inefficiencies / higher unit costs Less incentive to innovate / dynamic efficiency Reinforces monopoly power Harder for new businesses to enter the market – reduces contestability

Potential Benefits from Collusion Industry standards bring social benefits Pharmaceutical research Car safety technology Fair Prices for producer cooperatives Competing with monopsonistic corporations May help to reducing extreme income poverty Profits have value – how are they used? Capital investment Research and development Higher wages for employees

Collusion in an Oligopoly Topic 3.3.9