1.1 Module 31: Oligopoly

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Although much that we have learned about both perfect competition and monopoly is relevant to oligopoly, oligopoly also raises some entirely new issues. Among other things, firms in an oligopoly are often tempted to engage in the kind of behavior that got ADM, Ajinomoto, and other lysine producers into trouble with the law. We will devote three modules to the study of oligopoly, beginning here, where we examine what oligopoly is and why it is so important.

Interdependence and Oligopoly

Earlier we learned that an oligopoly is an industry with only a few sellers. But what number constitutes a “few”? There is no universal answer, and it is not always easy to determine an industry’s market structure just by looking at the number of sellers. Economists use various measures to gain a better picture of market structure, such as the Herfindahl–Hirschman Index, as explained in Module 24.

In addition to having a small number of sellers in the industry, an oligopoly is characterized by interdependence, a relationship in which the outcome (profit) of each firm depends on the actions of the other firms in the market. This is not true for monopolies because, by definition, they have no other firms to consider. And competitive markets contain so many firms that no one firm has a significant effect on the outcome of the others.

However, in an oligopoly, an industry with few sellers, the outcome for each seller depends on the behavior of the others. Interdependence makes studying a market much more interesting because firms must observe and predict the behavior of other firms. But it is also more complicated. To understand the strategies of oligopolists, we must do more than find the point where the MC and MR curves intersect!

Understanding Oligopoly

How much will a firm produce? Up to this point, we have always answered: the quantity that maximizes its profit. When a firm is a perfect competitor or a monopolist, we can assume that the firm will use its cost curves to determine its profit-maximizing output. When it comes to oligopoly, however, we run into some difficulties. In fact, economists often describe the behavior of oligopolistic firms as a “puzzle.”

A Duopoly Example

Let’s begin looking at the puzzle of oligopoly with the simplest version, an industry in which there are only two firms—a duopoly—and each is known as a duopolist.

Going back to our opening story, imagine that ADM and Ajinomoto are the only two producers of lysine. To make things even simpler, suppose that once a company has incurred the fixed cost needed to produce lysine, the marginal cost of producing another pound is zero. So the companies are concerned only with the revenue they receive from sales.

Table 31-1 shows a hypothetical demand schedule for lysine and the total revenue of the industry at each price–quantity combination.

If this were a perfectly competitive industry, each firm would have an incentive to produce more as long as the market price was above marginal cost. Since the marginal cost is assumed to be zero, this would mean that at equilibrium, lysine would be provided for free. Firms would produce until price equals zero, yielding a total output of 120 million pounds and zero revenue for both firms.

However, surely the firms would not be foolish enough to allow price and revenue to plummet to zero. Each would realize that by producing more, it drives down the market price. So each firm would, like a monopolist, see that profits would be higher if it and its rival limited their production.

So how much will the two firms produce?

One possibility is that the two companies will engage in collusion—they will cooperate to raise their joint profits. The strongest form of collusion is a cartel, a group of producers with an agreement to work together to limit output and increase price, and therefore profit. The world’s most famous cartel is the Organization of Petroleum Exporting Countries (OPEC), whose members routinely meet to try to set targets for oil production.

As its name indicates, OPEC is actually a cartel made up of governments rather than firms. There’s a reason for this: cartels among firms are illegal in the United States and many other jurisdictions. But let’s ignore the law for a moment (which is, of course, what ADM and Ajinomoto did in real life—to their own detriment).

It is in OPEC’s interest to keep oil prices high and output low.

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Suppose that ADM and Ajinomoto were to form a cartel and that this cartel decided to act as if it were a monopolist, maximizing total industry profits. We can see from Table 31-1 that in order to maximize the combined profits of the firms, this cartel should set total industry output at 60 million pounds of lysine, which would sell at a price of $6 per pound, leading to revenue of $360 million, the maximum possible. Then the only question would be how much of that 60 million pounds each firm gets to produce. A “fair” solution might be for each firm to produce 30 million pounds and receive revenues of $180 million.

But even if the two firms agreed on such a deal, they might have a problem: each of the firms would have an incentive to break its word and produce more than the agreed-upon quantity.

Collusion and Competition

Suppose that the presidents of ADM and Ajinomoto were to agree that each would produce 30 million pounds of lysine over the next year. Both would understand that this plan maximizes their combined profits. And both would have an incentive to cheat.

To see why, consider what would happen if Ajinomoto honored its agreement, producing only 30 million pounds, but ADM ignored its promise and produced 40 million pounds. This increase in total output would drive the price down from $6 to $5 per pound, the price at which 70 million pounds are demanded. The industry’s total revenue would fall from $360 million ($6 × 60 million pounds) to $350 million ($5 × 70 million pounds). However, ADM’s revenue would rise, from $180 million to $200 million. Since we are assuming a marginal cost of zero, this would mean a $20 million increase in ADM’s profits.

But Ajinomoto’s president might make exactly the same calculation. And if both firms were to produce 40 million pounds of lysine, the price would drop to $4 per pound. So each firm’s profits would fall, from $180 million to $160 million.

The incentive to cheat motivates ADM and Ajinomoto to produce more than the quantity that maximizes their joint profits rather than limiting output as a true monopolist would. We know that a profit-maximiz ing monopolist sets marginal cost (which in this case is zero) equal to marginal revenue. But what is marginal revenue? Recall that producing an additional unit of a good has two effects:

1. A positive quantity effect: one more unit is sold, increasing total revenue by the price at which that unit is sold.
2. A negative price effect: in order to sell one more unit, the monopolist must cut the market price on all units sold.

The negative price effect is the reason marginal revenue for a monopolist is less than the market price. But when considering the effect of increasing production, a firm is concerned only with the price effect on its own units of output, not on those of its fellow oligopolists. Both ADM and Ajinomoto suffer a negative price effect if ADM decides to produce extra lysine and so drives down the price. But ADM cares only about the negative price effect on the units it produces, not about the loss to Ajinomoto.

This tells us that an individual firm in an oligopolistic industry faces a smaller price effect from an additional unit of output than a monopolist; therefore, the marginal revenue that such a firm calculates is higher. So it will seem to be profitable for any one firm in an oligopoly to increase production, even if that increase reduces the profits of the industry as a whole. But if everyone thinks that way, the result is that everyone earns a lower profit!

Because collusion is more profitable than noncooperative behavior, firms have an incentive to collude if they can.

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Until now, we have been able to analyze producer behavior by asking what a producer should do to maximize profits. But even if our duopolists, ADM and Ajinomoto, are both trying to maximize profits, what does this predict about their behavior? Will they engage in collusion, reaching and holding to an agreement that maximizes their combined profits? Or will they engage in noncooperative behavior, with each firm acting in its own self-interest, even though this has the effect of driving down everyone’s profits? Both strategies can be carried out with a goal of profit maximization. Which will actually describe their behavior?

Now you see why oligopoly presents a puzzle: there are only a small number of players, making collusion a real possibility. If there were dozens or hundreds of firms, it would be safe to assume they would behave noncooperatively. Yet, when there are only a handful of firms in an industry, it’s hard to determine whether collusion will actually occur.

Since collusion is ultimately more profitable than noncooperative behavior, firms have an incentive to collude if they can. One way to do so is to formalize it—sign an agreement (maybe even make a legal contract) or establish some financial incentives for the companies to set their prices high. But in the United States and many other nations, firms can’t do that—at least not legally. A contract among firms to keep prices high would be unenforceable, and it could be a one-way ticket to jail. The same goes for an informal agreement.

In fact, executives from rival firms rarely meet without lawyers present, who make sure that the conversation does not stray into inappropriate territory. Even hinting at how nice it would be if prices were higher can bring an unwelcome interview with the Justice Department or the Federal Trade Commission. For example, in 2003 the Justice Department launched a price-fixing case against Monsanto and other large producers of genetically modified seed. The Justice Department was alerted by a series of meetings held between Monsanto and Pioneer Hi-Bred International, two companies that account for 60% of the U.S. market in maize and soybean seed. These companies, parties to a licensing agreement involving genetically modified seed, claimed that no illegal discussions of price-fixing occurred in those meetings. But the fact that the two firms discussed prices as part of the licensing agreement was enough to trigger action by the Justice Department.

!world_eia!BITTER CHOCOLATE?

Millions of chocolate lovers around the world have been spending more to satisfy their cravings, and regulators in Germany, Canada, and the United States have become suspicious. They have been investigating whether the seven leading chocolate companies—including Mars, Kraft Foods, Nestlé, Hershey, and Cadbury—have been colluding to raise prices. The amount of money involved could well run into the billions of dollars.

Many of the nation’s largest grocery stores and snack retailers are convinced that they have been the victims of collusion. They claim that the chocolate industry has responded to stagnant consumer sales by price-fixing, an allegation the chocolate makers have vigorously denied.

In 2010, one of those stores, Supervalu, filed a lawsuit against Mars, Hershey, Nestlé, and Cadbury, who together control about 76% of the U.S. chocolate market. Supervalu claimed that the confectioners had been fixing prices since 2002, regularly increasing prices by mid-single to double-digit amounts. Supervalu also claimed that grocers who resisted or refused to raise prices were systematically penalized with delayed or insufficient product deliveries.

What’s clear is that chocolate candy prices have been soaring while sales fell. Chocolate makers defend their actions, contending that they were simply passing on increases in their costs.

Are chocolate makers engaging in price-fixing?

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But, as antitrust experts point out, price collusion is often very difficult to prove because it is not illegal for businesses to increase their prices at the same time. To prove collusion, there must be some evidence of conversations or written agreements.

Such evidence did emerge in our chocolate case. According to the Canadian press, 13 Cadbury executives voluntarily provided information to the courts about contacts between the companies. And, according to affidavits submitted to a Canadian court, top executives at Hershey, Mars, and Nestlé met secretly in coffee shops, in restaurants, and at conventions to set prices.

More recently, in 2013, Nestlé, Mars, and others were accused of conspiring to fix the prices of popular chocolate bars in Canada. This episode came not too long after similar charges were filed against chocolate sellers in Germany, including Nestlé and Mars, that resulted in multi-million-dollar fines for the companies involved.

Critics of the chocolate makers may get some sweet vindication in the end.

Module 31 Review

Check Your Understanding

What are the two major reasons we don’t see cartels among oligopolistic industries in the United States today?