Oligopoly markets are those in which a large market share is controlled by just a few firms. What constitutes a few firms controlling a large market share is not rigidly defined. Further, these firms can sell either a homogeneous product (e.g., gasoline, sugar) or a differentiated product (e.g., automobiles, pharmaceuticals).

Industries can be composed of a dominant firm with a few smaller firms making up the rest of the industry (e.g., computer operating systems), or the industry can be composed of a few similarly sized firms (e.g., automobiles, tobacco). The point of this discussion is that oligopoly models are numerous and varied, and we will explore only a few. Oligopoly models do, however, have several common characteristics.

All oligopoly models share several common assumptions:

Because there are only a few firms, each firm possesses substantial market power. However, because the products sold by oligopolists are similar to each other, the actions of one will affect the ability of the others to sell or price their output successfully. If one firm changes the specifications of its product or increases its advertising budget, this will have an impact on its rivals, and they can be expected to respond in kind. Thus, one firm cannot forecast its change in sales for a new promotion without first making some assumptions about the reaction of its rivals.

In an industry composed of just a few firms, entry scale is often huge. Plus, with just a few firms, typically brand preferences are quite strong on the part of consumers, and a new firm may need a substantial marketing program just to get a foot in the door.

258

Cartels are theft—usually by well-dressed thieves.

GRAEME SAMUEL, HEAD OF AUSTRALIA’S ANTITRUST OFFICE

The first oligopoly model we examine is collusive joint profit maximization, or a cartel model. Here, we assume that a few firms collude (combine secretly) to operate like a monopoly, using maximum market power to set the monopoly price and output and share the monopoly profits. Cartels are illegal in the United States and in the European Union, although international laws do not ban them.

Cartels are not as common today as they were two or three decades ago. The most famous cartel is OPEC, the Organization of Petroleum Exporting Countries, which consists of twelve countries that set production quotas in order to limit overall oil production to drive up prices. Although OPEC was powerful from the 1970s up until the last decade, today, competition from non-OPEC countries in Africa, Europe, and North America has made OPEC considerably less influential. Perhaps more influential in today’s economy are underground cartels, such as those that distribute narcotics and hold substantial market power.

Figure 4 illustrates a hypothetical cartel consisting of five firms. By forming a cartel, these five firms agree to fix their overall output equal to the profit-maximizing output of a monopolist, which is 100. At this restricted output, each cartel member produces its fixed quota of output (20 units per firm, assuming the cartel divides total output equally), and shares the resulting profit. Under this scenario, the cartel exhibits maximum market power equal to a single-firm monopolist.

However, cartels are inherently unstable because of the incentive to cheat by individual members. Although the cartel as a whole is maximizing profits, each individual member can potentially earn more profits by producing more than its output quota. As illustrated in Figure 4, if one firm exceeds its quota by doubling output from 20 to 40, the overall output of the cartel increases from 100 to 120 units. By expanding production, the market price falls from $10 to $8, causing revenues to fall by $200 ($2 × 100 units), shown as the yellow area. This reduction in revenues is shared by all five firms, with each firm losing $40 (or one share of the yellow area). Despite this loss, the cheating firm benefits because the extra 20 units it produces earn the firm $160 in additional revenue ($8 × 20 units), shown as the green area. The marginal revenue from cheating is therefore $160 − $40 = $120. As long as the marginal cost of producing the extra 20 units is less than $120, the firm benefits from cheating on the cartel agreement.

259

However, when one firm cheats, this often leads to other firms cheating. As more and more cartel members cheat, the price continues to fall toward the competitive price, greatly hurting the noncheating members. The instability of cartels is enhanced when a member can increase its output relatively undetected, and when the cost of production is low, making cheating more profitable. Over time, the cartel falls apart when all members increase their output, resulting in a competitive outcome. Therefore, market power in a cartel can range from the monopoly case (if all members adhere to their quotas) to the competitive case when cartels completely break down.

Although cartels are inherently unstable, certain factors can enhance the likelihood of the cartel’s survival. First, cartel stability is enhanced with fewer members with similar goals. With fewer members, any action that breaches the cartel agreement is more easily noticed and punishable. Second, stability is improved if the cartel is maintained with legal provisions (such as government protection). Third, stability is improved if firms are unable to differentiate their products (such as providing enhanced service or some other product as an inducement to purchase). Fourth, stability is improved when each firm’s cost structure is similar, thereby not giving any firm a cost advantage over another. Finally, a cartel is more stable when there are significant barriers to entry preventing new firms from competing against existing cartel members.

These factors do not bode well for the future of the twelve member countries of OPEC. Although OPEC members produce a uniform product (crude oil) and have similar cost structures, enforcement of the quotas has at times been shaky with politically unstable countries. Further, OPEC’s total share of world oil production has been surpassed by non-OPEC countries, led by the United States, Russia, China, Canada, Mexico, and Brazil. Maintaining an effective oil cartel will become more difficult as more countries enter the industry and as new alternative fuels are developed.

Oligopoly industries share a characteristic that prices tend to be stable for extended periods of time. For example, prices for wireless data plans are similar across all major wireless providers and rarely fluctuate. Why do these prices tend to stay the same when the underlying costs of providing the services change?

Figure 5 provides an explanation for the price stability in oligopoly industries by showing two demand curves. Demand curve d is relatively elastic, and represents demand for one firm when competing firms choose not to follow its price changes. Therefore, any change in price is generally met with significant changes in quantity demanded. On the other hand, demand curve D is relatively inelastic, and represents the demand for one firm when competing firms do match price changes. As a result, any change in price will not lead to much change in quantity demanded.

The kinked demand curve model assumes the following:

As a result, the relevant demand curve facing the firm is the darkened portion of demand curves d and D that is kinked at point e. The relevant portion of the marginal revenue curve is the darkened dashed curve MR with the discontinuity between points a and b. Notice, we are just using the relevant portions of MR_d and MR_D. The graph shows MC₁ and MC₀ intersecting the MR curve at points a and b, respectively. However, the equilibrium price and output remain at P₀ and Q₀. In fact, any marginal cost curve located between MC₁ and MC₀ will result in the same equilibrium price and output.

260

The analysis of unstable and stable oligopoly models underscores the importance of the mutual interdependence of firms. How one firm reacts to a competitor’s market strategy determines the nature of competition in the industry. These ideas led to game theory, which we consider in the next section.