The uncertainty that exists in an oligopoly can lead to
collusive behaviour by firms. When this happens the existing businesses
decide to engage in price fixing agreements or cartels. The aim of this is to
maximize joint profits and act as if the market was a pure monopoly.
Controlling Supply In A Cartel
For the cartel to work effectively the producers must
control supply to maintain an artificially high price. Collusion is easier to
achieve when there is a relatively small number of firms in the market and a
large number of customers, market demand is not too variable and the
individual firm's output can be easily monitored by the cartel organisation.
If we look at a cartel consisting of five equal sized
firms. The industry is shown in
the diagram below.
If the cartel sets the price at the industry profit
maximising price of £10, this will give an industry output of 1000.
If this is divided equally between its members, each firm will be
allocated a quota of 200 units. Now
look at the diagram for firm A below.
Provided that the cartelís price remains at £10, this
would also be the MR for the individual firm.
This will create an incentive for the firm to cheat and sell more than
its allocated quota. It could
maximise its own profits by selling 600 units, where MC = P (=MR), provided
it could do this by taking market share from the other companies, thus
leaving the industry output (and price) unaffected.
Alternatively, the firm may wish to undercut the
cartelís price. Again provided
the other firms maintained a price of £10, firm A would face a relatively
elastic demand curve, this is shown below.
A cut in price would attract customers away from other
members of the cartel. Firm A
would maximise its profits by cutting price to £8 and increasing output to
Either of these tactics would invite retaliation from
other members leading to a break up of the cartel.
Why Do Price Fixing Arrangements generally Collapse?
Some economists believe that price-fixing cartels are
inherently unstable and that at some point they inevitably come under
pressure and finally break down. There are a number of sources of potential
instability for price fixing cartel arrangements.
demand creates tension between firms e.g. during an economic downturn
entry of non-cartel firms into the industry increases market supply and
puts downward pressure on the cartel price
of illegal price fixing by the Government or other regulatory agencies
causes an arrangement to end
and excess supply by cartel members breaks the price fixing
Prisonersí Dilemma game suggests that all collusive agreements tend to
fall eventually because although price fixing is in the joint interests of
all members of a cartel, it is not a profit maximising equilibrium for
each individual firm
The End Of Price Fixing?
Collapse Of The Over-The-Counter Pharmaceutical Products In
Britain's last legal price
fixing agreement - maintained by chemists on the prices of over-the-counter
drugs, has collapsed leaving the major supermarket chains with the option of
cutting prices of branded products by up to 50 per cent.
The Office of Fair Trading
(OFT) had challenged the practice of Resale Price Maintenance in the
Restrictive Practices Court, arguing that it allowed drug companies to keep
branded over-the-counter products artificially high. The market for these
products is worth over £1.6 billion per year.
Tesco, one of the leading
challengers to the price fixing agreement responded to the news by saying
that it would cut prices on products such as 24 Nurofen tablets, which would
be reduced by £1.26 to £1.89, while shoppers would pay £1.29 for 16 Anadin
Extra, 86p less than previously.
The Community Pharmacy
Action Group - a consortium of pharmacists - had been attempting to keep a
price-fixing arrangement in place. They argued that if the agreement were
scrapped, it would lead to the closure of 12,000 smaller local chemists.
Smaller chemists do not have the buying (monopsony) power of the major food
retailers. Their profit margins are likely to come under intense pressure
leading to the possible closure of smaller chemists in rural areas.
The Government Regulator -
the Office of Fair Trading has welcomed the news on the end of the price
fixing agreement. They believe it is excellent news for consumers, who will
now benefit from lower and more competitive prices for common household