What Is Formal Agreement in Oligopoly

Imagine if both companies placed the same prices above the marginal cost. Each company would receive half of the market at a higher price than the marginal cost price. However, by lowering prices slightly, a company could conquer the entire market. As a result, both companies are tempted to lower prices as much as possible. However, it would be irrational to be below the marginal cost because the company would make a loss. Therefore, both companies will lower prices until they reach the marginal cost limit. According to this model, a duopoly leads to a result that corresponds exactly to what prevails under perfect competition. The result of corporate strategies is a Nash equilibrium – a pair or strategies where neither company can increase its profits by unilaterally changing the price. When oligopolistic firms decide on a given market how much they produce and how much they charge, they are tempted to pretend to be a monopoly. By acting together, oligopolistic companies can keep the industry`s production low, charge a higher price, and share profits with each other. When companies work together in this way to reduce production and keep prices high, it`s called collusion. A group of companies that have entered into a formal agreement to produce monopoly production and sell it at the monopoly price is called a cartel. For a more in-depth analysis of the difference between the two, see the following Clear It Up feature.

Assuming the payments are known to both companies, what is the likely outcome in this case? A cartel is a formal collusive agreement between companies with the aim of increasing their profits. The theoretical situation of the game that the two prisoners are confronted with is presented in Table 3. To understand the dilemma, first look at the decisions from the perspective of prisoner A. If A believes that B will confess, then A should also confess so as not to get stuck with the eight years in prison. But if A believes that B will not confess, then A will be tempted to act and selfishly confess to serve only one year. The crucial point is that A has an incentive to confess, regardless of the choice B makes! B faces the same decisions and will therefore have an incentive to confess, regardless of the choice A. Confess is considered the dominant strategy or strategy that one person (or company) will pursue, regardless of the decision of the other person (or company). The result is that when prisoners pursue their own interests, both are likely to confess and end up serving a total of 10 years in prison between them.

A true duopoly is a certain type of oligopoly where there are only two producers in a market. There are two main models of duopoly: the duopoly of the Court and the duopoly of Bertrand. Many real oligopolies, driven by economic change, legal and political pressures, and the egos of their senior executives, are going through episodes of collaboration and competition. If oligopolies could maintain cooperation in production and pricing, they could make profits as if they were a single monopoly. However, each company in an oligopoly has an incentive to produce more and conquer a larger share of the overall market; When companies start to behave in this way, the outcome of the market can be similar to that of a highly competitive market in terms of price and quantity. In 2015, Apple and Google were investigated for an agreement between the two companies in which they agreed not to hire employees of the other company. This was an attempt to prevent wage spirals due to the change of worker between companies. The companies agreed to reach a settlement instead of suing it. Several factors deter collusion.

First, prices are illegal in the United States, and antitrust laws are in place to prevent collusion between companies. Secondly, coordination between undertakings is difficult and becomes so, all the more so as the number of undertakings concerned is large. Third, there is a risk of overflow. A company can agree to enter into agreements and then break the agreement, thus jeopardizing the profits of companies that still keep the agreement. Finally, a company can be deterred from collusion if it is not able to effectively punish companies that might violate the agreement. Game theory provides a framework for understanding how companies behave in an oligopoly. In an oligopoly, products can be homogeneous or differentiated. Oligopolies are able to set prices (they have marketing power), but they also compete with other companies in the industry based on product differentiation. OPEC is the cartel of oil-producing countries. Murray Rothbard saw the Federal Reserve as a public cartel of private banks. In the United States, telecommunications and broadband services are oligopolistic industries. Health insurance is another example of an oligopoly, as there are very few insurers in each state.

The quantity demanded on the market can also be two or three times greater than the quantity needed to produce at least the average cost curve – meaning that the market would only have room for two or three oligopolistic companies (and they don`t have to make differentiated products). Again, small businesses would have higher average costs and would not be able to compete, while other large companies would produce such a high amount that they would not be able to sell them at a profitable price. This combination of economies of scale and market demand creates the barrier to entry that led to the Boeing-Airbus oligopoly for large passenger aircraft. Game theory suggests that cartels are inherently unstable because the behavior of cartel members is a prisoner`s dilemma. Each member of a cartel would be able to make a higher profit, at least in the short term, by breaking the agreement (by producing a larger quantity or selling it at a lower price) than if it joined it. However, if the cartel collapses because of the defectors, the companies would return to competition, profits would fall and everything would be worse. An example of the pressure these firms can exert on each other is the curved demand curve, in which competing oligopolistic firms commit to price reductions, but not price increases. This situation is illustrated in Figure 1. Suppose an oligopolistic airline has agreed with the rest of a cartel to provide a 10,000-seat package on the route from New York to Los Angeles for $500. This choice defines the bend of the company`s perceived demand curve.

The reason the company faces a fold in its demand curve is due to how other oligopolistics react to changes in the company`s price. If the oligopoly decides to produce more and lower its price, the other members of the cartel will immediately adjust all price reductions – and therefore a lower price will result in very little increase in the quantity sold. Even if oligopolises realize that they would benefit as a group if they acted as a monopoly, each individual oligopoly faces a private temptation to produce only a slightly higher amount and make a slightly higher profit – while relying on other oligopolists to keep their production low and prices high. If at least some oligopolistics give in to this temptation and start producing more, then the market price will fall. In fact, a small handful of oligopolistic companies could end up competing so fiercely that they would all end up making no economic profit – as if they were perfect competitors. The problem with law enforcement is finding hard evidence of collusion. Cartels are formal collusion agreements. Because collusion between cartels provides evidence of collusion, it is rare in the United States.

Instead, most collusions are tacit, where companies implicitly come to understand that competition is bad for profits. The Cournot-Nash model is the simplest oligopoly model. The model assumes that there are two “equally positioned companies”; Companies compete on the basis of quantity, not price, and each company makes a “decision-making performance assuming that the behavior of the other company is fixed”. [9] The market demand curve is assumed to be linear and marginal costs constant. To find the Cournot-Nash balance, you determine how each company reacts to a change in the production of the other company. The path to equilibrium is a series of actions and reactions. The trend continues until a point is reached where neither company “wants to change what it does, because it believes the other company will react to any change.” [10] Equilibrium is the intersection of the reaction functions of the two societies. The reaction function shows how one company reacts to the other company`s quantity selection. [11] For example, suppose the demand function of the enterprise is 1 P = (M − Q2) − Q1, where Q2 is the quantity produced by the other company and Q1 is the quantity produced by the company 1,[12] and M = 60 is the market.

Suppose the marginal cost is CM = 12. Company 1 wants to know its maximum quantity and price. Company 1 begins the process by following the profit maximization rule, which equates marginal revenues with marginal costs. The total turnover function of company 1 is RT = Q1 P = Q1(M − Q2 − Q1) = MQ1 − Q1 Q2 − Q12. The limit yield function is R M = ∂ R T ∂ Q 1 = M − Q 2 − 2 Q 1 {displaystyle R_{M}={frac {partial R_{T}}{partial Q_{1}}}=M-Q_{2}-2Q_{1}}. [Note 1] How did this soap opera end? Following an investigation, French antitrust authorities imposed fines totaling 361 million euros ($484 million) on Colgate-Palmolive, Henkel and Proctor & Gamble. A similar fate befell the ice cream makers. Bagged ice cream is a commodity, a perfect substitute, usually sold in 7 or 22 pound bags. .