Describe the characteristics of oligopoly. How are the price and the output determined under cartel? [5+10]

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Characteristics of Oligopoly

Oligopoly is a market structure characterized by a small number of large firms that dominate the industry. These firms are interdependent in their decision-making, particularly regarding pricing and output. Below are the key characteristics of an oligopoly:

1. Few Large Firms

• The market is dominated by a few large firms, which control a significant portion of the market share.
• Entry barriers are high, preventing new firms from entering the market easily.
• Example: The automobile industry (Toyota, Ford, Hyundai) or the telecommunications sector (Ncell, NTC, Smart).

2. Interdependence Among Firms

• Since there are only a few firms, each firm’s decisions (such as pricing, advertising, or output) directly affect its competitors.
• Firms must consider the reactions of their rivals when making business decisions.
• Example: If Coca-Cola reduces its prices, Pepsi may respond with a price cut or an aggressive advertising campaign.

3. High Barriers to Entry

• Economies of scale, high capital requirements, and legal restrictions (such as patents or licenses) prevent new firms from entering the market.
• Existing firms can maintain their dominance by controlling resources or technology.

4. Non-Price Competition

• Since price wars can be detrimental to all firms, oligopolies often engage in non-price competition such as:
  • Advertising and branding (e.g., Nike vs. Adidas).
  • Product differentiation (e.g., different models of smartphones).
  • Loyalty programs and discounts.

5. Price Rigidity

• Prices tend to be sticky (do not change frequently) because:
  • A price increase may lead to loss of market share to competitors.
  • A price decrease may trigger a price war, reducing overall profits.
• Firms often maintain prices at a stable level unless forced to change due to external factors (e.g., cost changes, government regulations).

6. Mutual Interdependence and Strategic Behavior

• Firms follow strategic behavior, meaning they anticipate competitors' reactions before making decisions.
• Game theory is often used to analyze oligopolistic behavior, where firms make decisions based on expected responses from rivals.

7. Possible Collusion (Cartel Formation)

• Firms may engage in collusion to maximize joint profits by acting like a monopoly.
• A cartel is a formal agreement among firms to fix prices, limit output, and divide markets.
• Example: OPEC (Organization of Petroleum Exporting Countries) controls oil prices through collective decision-making.

8. Economies of Scale

• Large firms in oligopolies benefit from economies of scale, allowing them to produce at lower average costs.
• This further strengthens their dominance in the market.

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Price and Output Determination Under Cartel

A cartel is a formal agreement among oligopolistic firms to coordinate their actions (such as fixing prices and output levels) to maximize joint profits, similar to a monopoly. Below is how price and output are determined under a cartel:

1. Formation of the Cartel

• Firms in an oligopoly may agree to act as a single entity to maximize collective profits.
• They set a common price and total industry output to eliminate competition.
• Example: OPEC members agree on oil production quotas to control global oil prices.

2. Joint Profit Maximization

• The cartel behaves like a monopolist, treating the entire industry as a single firm.
• The Marginal Revenue (MR) curve for the cartel is derived from the market demand curve.
• The Marginal Cost (MC) curve is the sum of the MC curves of all firms in the cartel.

3. Determination of Optimal Output and Price

• The cartel sets output where MR = MC (profit-maximization condition).
• The corresponding price is read from the market demand curve at that output level.
• Each firm is then allocated a production quota based on pre-agreed shares (e.g., 50% for Firm A, 30% for Firm B, etc.).

4. Incentives to Cheat

• While cartels aim for joint profit maximization, individual firms have an incentive to cheat by producing more than their quota to capture additional market share.
• If one firm increases output while others comply, it can increase its profits at the expense of others.
• Example: If OPEC members secretly produce more oil, they can sell at higher profits while keeping prices artificially high.

5. Stability of the Cartel

• Cartels are unstable in the long run because:
  • Incentive to cheat leads to breakdowns (e.g., OPEC’s occasional failures in maintaining quotas).
  • Government regulations (antitrust laws) often prohibit cartels.
  • New entrants may exploit loopholes to gain market share.

6. Numerical Example of Cartel Behavior

Assume an oligopoly with two identical firms (Firm A and Firm B) producing a homogeneous product. The market demand curve is: $$P=10-Q$$ where $Q$ is the total market quantity.

• Step 1: Find the Market Demand and MR

  • Total revenue ($TR$) = $P\times Q=(10-Q)\times Q=10Q-Q^2$.
  • Marginal revenue ($MR$) = $\frac{d(TR)}{dQ}=10-2Q$.

• Step 2: Assume MC is Constant at $2 per unit

  • The cartel will set output where $MR=MC$: $$10-2Q=2$$ $$2Q=8$$ $$Q=4\text{ units (total market output)}$$

• Step 3: Determine Price

  • Substitute $Q=4$ into the demand curve: $$P=10-4=6$$

• Step 4: Allocate Output Among Firms

  • If the cartel divides output equally:
    • Each firm produces $Q_A=Q_B=2$ units.
    • Each firm earns a profit of: $$\text{Profit}=(P-MC)\times Q=(6-2)\times 2=8\text{ per firm}$$ $$\text{Total cartel profit}=8\times 2=16$$

• Step 5: Incentive to Cheat

  • Suppose Firm A increases its output to 3 units (while Firm B stays at 2).
  • New total output $Q=5$, so price drops to: $$P=10-5=5$$
  • Firm A’s profit: $$(5-2)\times 3=9$$
  • Firm B’s profit: $$(5-2)\times 2=6$$
  • Total industry profit drops to 15, but Firm A gains at Firm B’s expense.

7. Graphical Representation

The figure above illustrates a cartel’s profit-maximizing output ($Q^{\ast }=5$) and price ($P^{\ast }=7$) under the assumption of identical firms with a combined MR and MC curve. The shaded area represents the joint profit under cartel behavior.

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Key Takeaways on Cartel Behavior

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Conclusion

Oligopolies are characterized by few large firms, interdependence, high barriers to entry, and strategic behavior. Under a cartel, firms act collectively to maximize joint profits, leading to higher prices and lower output compared to competitive markets. However, cartels are unstable due to the temptation to cheat, making long-term collusion difficult to sustain. Government regulations further discourage cartel formation to protect consumer welfare.