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 cartel’s 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 cartel’s 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 400.

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.

• Falling demand creates tension between firms e.g. during an economic downturn 
• The entry of non-cartel firms into the industry increases market supply and puts downward pressure on the cartel price
• Exposure of illegal price fixing by the Government or other regulatory agencies causes an arrangement to end 
• Over-production and excess supply by cartel members breaks the price fixing 
• The Prisoners’ 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 The UK

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 medicines.