Lecture 16.pptxjsndndnddnjdjjjdjdjddjdjjdjd

Department of
Humanities and Social Sciences
Collusive oligopoly Model
i) Cartel or collusion model
ii) Price leadership
i) A cartel is a group of firms acting together to limit output,
raise price, and increase economic profit
• When a small number of firms share a market, they can
increase their profit by forming a cartel and acting like a
monopoly.
• Cartels can aim at a) joint profit maximisation or b) sharing
of markets
• Cartels are illegal but they do operate in some markets.
• Despite the temptation to collude, cartels tend to collapse.

Department of
Two types of collusion:
- Horizontal collusion takes place between firms in the
same industry. Bus service operators (in some cities)
might decide to share the market, and decide the price
- Vertical collusion refers to the methods used by
manufacturers to restrict the ways in which retailers can
market their product. Car manufacturers, movie
producers can have agreements with distributors
regarding price of their products

Department of
Cartel is formed with the view :
• To eliminate uncertainty surrounding the market
• Restraining competition and thereby ensuring gains to
cartel group.
• Cartel works through a Board of Control which
determines the total quantity to be produced and price to
be charged to maximise joint profit
–It also allocates the output to be produced among the
firms, and distributes the joint profit based on each
firm’s cost conditions

Department of
a) Profit Maximising Cartels
–Firms in a cartel act like a monopoly and maximize economic
profit by setting the cartel’s MC = MR.
–The cartel’s marginal cost curve is the horizontal sum of the
MC curves of the two firms.
–The marginal revenue curve is like that of a monopoly.
–The firm having a flatter MC produces more output. But this
by no way means that the firm with the flatter MC gets a
bigger share of cartel profit

Department of
Mathematical representation of Cartel equilibrium
• Suppose there are two firms in the market (duopoly)
• Products are perfect substitutes
• Price is the sole parameter of action for each firm
• Buyers have perfect information

Department of
Joint profit maximisation implies that the firms maximise their
respective profits
maximise
Let P = f(Q) = f(q1 + q2) is the inverse demand function
C1= f1(q1) and C2= f2(q2) are cost functions of the two
firms
Then, 1 = R1 - C1 and 2 = R2 – C2.
 =1+= R1 - C1 + R2 – C2= R – C1 – C2
Using the F.O.C for profit maximization for each firm
∂/∂q1 = ∂R/∂q1 – ∂C1/∂q1 = 0
∂/∂q2 = ∂R/∂q2 – ∂C2/∂q2 = 0

Department of
• From the above equations, the optimality condition is
MR = MC1 = MC2
That is, at the optimum, the marginal costs from each plant
must be equal and as well as equal to the marginal revenue
Otherwise, the firms would still have some incentive to
increase the level of output production from each plant.
The second order condition for joint profit maximisation requires
∂2
R/∂ < ∂2
C1/ ∂and
∂2
R/∂ < ∂2
C2/ ∂
 This implies that for each plant, once the profit maximising
output level has been reached, any additional unit of output
would have MR falling at a faster rate than MC

Department of
Exercise:
• The market demand function
P = 100 – 0.5(Q) = 100 – 0.5(q1+ q2)
• The cost functions of the two firms are C1 = 5q1 and C2
= 0.5
Find the joint profit maximising output

Department of
b) Market Sharing Cartels
• Firms agree to share the market but at the same time
maintain a considerable degree of freedom regarding
product differentiation, selling activities and other
business decisions.
• There are two basic methods of sharing the market
(1) Non-price competition and
(2) Quota system

Department of
i) Non-price competition
• This is a form of ‘loose’ cartel where member firms agree
on a common price, at which each of them can sell any
quantity.
• The price is set through bargaining, with the low-cost firms
pressing for a lower price and high-cost ones for a higher
price.
• The firms agree not to sell at a price below that decided by
the cartel, but they are free to vary the style of their
product and/or their selling activities.
• In other words, firms compete on a non-price basis

Department of
ii) Quota system
It is an agreement on the quantity that each member may
sell at the agreed price(s)
- If costs are identical, then firms share the market equally
among themselves
- If costs differ, then market share is decided by bargaining.
- The final quota of each firm depends on the level of it’s
cost as well as on it‘s bargaining skill.
- Most often adopted criteria for determining quotas are
‘past-period sales’ and ‘productive capacity’.
- Another is geographical sharing of the market.

Department of
Reasons why industry profits may not be maximized
in a cartel:
• Falling demand creates excess capacity in the industry
e.g., during an economic downturn / recession
• Disruption caused by the entry of non-cartel firms into
the industry which creates fresh competition
• Exposure of price fixing by Government agencies
• Over-production which breaks the price fixing - i.e., if
firms produce excess output, this drives prices and
profits down

Department of
ii) Price Leadership
- In this form of collusion, one firm sets the price
according to the marginalistic principle (MR = MC) and
the followers merely act as price takers
- This helps to reduce the uncertainty about the
competitors’ reactions, even though the firms may have
to depart from their profit maximising position.
• Three models of price leadership
a) Price leadership by low-cost firm
b) Dominant firm price leadership
c) Barometric price leadership

Department of
Overview of the price leadership models
• Price Leadership by Low-Cost Firm: The firm with the
lowest costs sets the price for the market.
- Examples are airline industry, retail stores/marts, automobile..
• Dominant Firm Price Leadership: The firm with the largest
market share or competitive power determines the price
- Examples are oil industry, German automobile industry
• Barometric Price Leadership: A firm, usually with the best
information about the market, leads price changes, and
others follow
- Examples are health drinks industry, smartphone industry

Department of
a) Price Leadership by low-cost firm
Assumptions:
-Duopoly market with firm A and firm B
-Heterogenous costs: Firms selling homogeneous product
with different cost structures. The low-cost firm can set a price
that is profitable for it but may not be profitable for other higher-
cost firms.
-Price taking behaviour: Other firms in the industry are price
takers, i.e. they follow the price set by the low-cost leader to
remain competitive in the market.
-Non-collusive behaviour: There is no formal collusion
between firms, i.e., price leadership arises naturally due to cost
advantages, rather than through coordination.

Department of
Conditions for Price Leadership by a Low-Cost Firm
• Cost Disparity: Significant difference in the cost structures of firms in
the market. The low-cost firm must have a notable cost advantage
over competitors.
• Market Transparency: Prices and cost structures of competitors must
be known or easily inferred by the low-cost firms in the market that
allows the low-cost firm to be seen as the price setter and followers to
adjust their prices accordingly.
• Price Elasticity: Demand curve faced by the firms must be sufficiently
elastic. This ensures that if the low-cost leader reduces its price, there
will be enough market demand to make the price reduction profitable.
• Lack of Close Substitutes: If the product has close substitutes, firms
may be more inclined to engage in price competition. However, in the
absence of close substitutes, the leader firm can more easily maintain
price leadership.

Department of
b) Dominant Firm Price Leadership
Assumptions
• One dominant firm with large market share and some
smaller firms each having a small market share.
• The market demand is assumed known to dominant firm
and it sets the market price.
• All other firms act like pure competitors, which act as
price takers. Their demand curves are perfectly elastic for
they sell the product at the dominant firm’s price.
• Dominant firm knows the cost structures of the smaller
firms, and have lower costs

Department of
- At price P1 the demand for the product
of the leader will be zero, because the
total quantity demanded (D1) is supplied
by the smaller firms
- As price falls below P1 the demand for
the leader’s product increases
- At P3 total demand is D3 and the total
quantity is supplied by the leader since
at that price the small firms do not
supply any quantity.
- Below P3 the market demand coincides
with the leader’s demand curve.
- Based on its demand curve, the
dominant firm leader maximises its profit
by equating MC and MR.

Department of
c) Barometric Firm Price Leadership
• A barometric firm is a firm that has better knowledge of the
prevailing market conditions and only initiates a reaction to change
market situation
• The leading firm has to be accurate (based on past behaviour)
while forecasting market demand and cost conditions, so that the
suggested price is accepted by other organizations.
• Other industries follow as they try to avoid the continuous
recalculation of costs, as economic condition changes
• Unlike the dominant firm model, the firm leading in barometric price
leadership does not necessarily have the largest market share or
the lowest costs
• Barometric price leadership does not involve collusion among firms,
but rather a consensus on the leader’s judgment and perception.

Department of
Barometric price leadership takes place due to the lack of
capacity and desire of organizations to estimate
appropriate supply and demand conditions.
 This influences organizations to follow price
changes made by the barometric organization, which has a
proven ability to make correct forecasts.
 It needs regular observing of industry dynamics,
adjusting price strategies, execution and tactics
Example:
In 2002, Coca Cola introduced 200 ml bottle at Rs 5. Pepsi
followed suit in just 5 days to keep their market share.

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