Explain whether each of the following characteristics will increase or decrease the likelihood that a firm will collude with other firms in an oligopoly to restrict output.
The firm’s initial market share is small. (Hint: Think about the price effect.)
This will decrease the likelihood that the firm will collude to restrict output. By increasing output, the firm will generate a negative price effect. But because the firm’s current market share is small, the price effect will fall mostly on its rivals’ revenues rather than on its own. At the same time, the firm will benefit from a positive quantity effect.
The firm has a cost advantage over its rivals.
This will decrease the likelihood that the firm will collude to restrict output. By acting noncooperatively and raising output, the firm will cause the price to fall. Because its rivals have higher costs, they will lose money at the lower price while the firm continues to make profits. So the firm may be able to drive its rivals out of business by increasing its output.
The firm’s customers face additional costs when they switch from one firm’s product to another firm’s product.
This will increase the likelihood that the firm will collude. Because it is costly for consumers to switch products, the firm would have to lower its price substantially (with a commensurate increase in quantity) to induce consumers to switch to its product. So increasing output is likely to be unprofitable, given the large negative price effect.
The firm and its rivals are currently operating at maximum production capacity, which cannot be altered in the short run.
This will increase the likelihood that the firm will collude. It cannot increase sales because it is currently at maximum production capacity, making attempts to undercut rivals’ prices as under the Bertrand model fruitless due to the inability to produce the output needed to steal the rivals’ customers. This makes the option to cooperate in restricting output relatively attractive.