Understanding Oligopoly

How much will a firm produce? Up to this point, we have always answered: the quantity that maximizes its profit. Together with its cost curves, the assumption that a firm maximizes profit is enough to determine its output when it is a perfect competitor or a monopolist.

When it comes to oligopoly, however, we run into some difficulties. Indeed, economists often describe the behavior of oligopolistic firms as a “puzzle.”

A Duopoly Example

An oligopoly consisting of only two firms is a duopoly. Each firm is known as a duopolist.

Let’s begin looking at the puzzle of oligopoly with the simplest version, an industry in which there are only two producing 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 14-2 shows a hypothetical demand schedule for lysine and the total revenue of the industry at each price-quantity combination.

Price of lysine (per pound)

Quantity of lysine demanded (millions of pounds)

Total revenue (millions)

$12

  0

 $0

 11

 10

110

 10

 20

200

  9

 30

270

  8

 40

320

  7

 50

350

  6

 60

360

  5

 70

350

  4

 80

320

  3

 90

270

  2

100

200

  1

110

110

  0

120

  0

Table : TABLE 14.2 Demand Schedule for Lysine

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 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 that stupid. With only two firms in the industry, each would realize that by producing more, it drives down the market price. So each firm would, like a monopolist, realize that profits would be higher if it and its rival limited their production.

So how much will the two firms produce?

Sellers engage in collusion when they cooperate to raise their joint profits. A cartel is an agreement among several producers to obey output restrictions in order to increase their joint profits.

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, an arrangement between producers that determines how much each is allowed to produce. The world’s most famous cartel is the Organization of Petroleum Exporting Countries (OPEC), described in an Economics in Action later in the chapter.

As its name indicates, OPEC is actually an agreement among governments rather than firms. There’s a reason this most famous of cartels is an agreement among governments: 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).

So 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. It’s obvious from Table 14-2 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 with revenues for each firm 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.

Why do individual firms have an incentive to produce more than the quantity that maximizes their joint profits? Because neither firm has as strong an incentive to limit its output as a true monopolist would.

Let’s go back for a minute to the theory of monopoly. We know that a profit-maximizing 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. In the case of oligopoly, when considering the effect of increasing production, a firm is concerned only with the price effect on its own units of output, not 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 does a monopolist; therefore, the marginal revenue that such a firm calculates is higher. So it will seem to be profitable for any one company 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!

When firms ignore the effects of their actions on each others’ profits, they engage in noncooperative behavior.

Until now, we have been able to analyze producer behavior by asking what a producer should do to maximize profits. But even if 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 sound like 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 materialize.

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, you can’t do that—at least not legally. Companies cannot make a legal contract to keep prices high: not only is the contract unenforceable, but writing it is a one-way ticket to jail. Neither can they sign an informal “gentlemen’s agreement,” which lacks the force of law but perhaps rests on threats of retaliation—that’s illegal, too.

In fact, executives from rival companies 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 you 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. The two 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.

Sometimes, as we’ve seen, oligopolistic firms just ignore the rules. But more often they find ways to achieve collusion without a formal agreement, as we’ll soon see.

!worldview! ECONOMICS in Action: Bitter Chocolate?

Bitter Chocolate?

The lysine price-fixing cartel prosecution is an especially memorable case because investigators had indisputable evidence of collusion in the form of recorded conversations. However, without solid evidence, the prosecution of price-fixing can be a tricky business, made clear by the different outcomes of Canadian and American investigations into price-fixing in the chocolate industry in 2013 and 2014.

Prompted by disclosures by Cadbury Canada of its collusion with the other three major Canadian chocolate makers—Hershey Canada, Nestlé Canada, and Mars Canada, Canadian regulators began an investigation into price-fixing in the Canadian chocolate market in 2007. In the case, Cadbury Canada received immunity from prosecution. While Hershey Canada eventually pleaded guilty and paid a nearly $4 million fine, Nestlé Canada and Mars Canada refused to settle. In the ensuing court proceedings, 13 Cadbury Canada executives voluntarily provided information about contacts with the other companies, including a 2005 episode in which a Nestlé Canada executive handed over a brown envelope containing details about a forthcoming price hike to a Cadbury Canada employee. And, according to affidavits filed in court, top executives of Hershey Canada, Nestlé Canada, and Mars Canada met secretly to set prices. In 2013, after protracted litigation, all four producers agreed to settle, paying a fine of more than $23 million to be distributed among consumers.

Are chocolate makers engaging in price-fixing?
istockphoto/thinkstock

However, prosecutions south of the border were much less successful. Many of the largest U.S. grocery stores and snack retailers were convinced that they, too, had been the victims of collusion. So in 2010, one of those stores, SUPERVALU, filed a lawsuit against the American divisions of the big four chocolate makers. In contrast to Canada, where the big four controlled a little less than 50% of the market, in the United States they controlled over 75%. SUPERVALU claimed that the American divisions of the big four had been fixing prices since 2002, regularly increasing prices by mid-single to double-digit amounts within a few days of one another.

Indeed, the price of chocolate candy had been soaring in the United States, climbing by 17% from 2008 to 2010, far in excess of the rate of inflation. Chocolate makers defended their actions, contending that they were simply passing on the higher costs of cocoa beans, dairy products, and sugar. And, as antitrust experts have pointed out, price collusion is often very difficult to prove because it is not illegal for producers to raise their prices at the same time. To prove collusion, there must be proof in the form of conversations or written agreements.

In March 2014 an American judge threw out the charges of collusion, stating that there was no evidence that executives at the big four chocolate producers were aware of the anti-competitive behavior of their colleagues in Canada, and that closely timed price increases were not sufficient proof of collusion. Federal Judge Christopher Conner concluded that the defendants engaged in “rational, competitive behavior” when they increased prices to counter anticipated cost increases. The case was a bitter reversal for American chocolate consumers who had hoped that they could soon enjoy their candy fix at lower prices.

Quick Review

  • Some of the key issues in oligopoly can be understood by looking at the simplest case, a duopoly—an industry containing only two firms, called duopolists.

  • By acting as if they were a single monopolist, oligopolists can maximize their combined profits. So there is an incentive to form a cartel.

  • However, each firm has an incentive to cheat—to produce more than it is supposed to under the cartel agreement. So there are two principal outcomes: successful collusion or behaving noncooperatively by cheating.

14-2

  1. Question 14.3

    Which of the following factors increase the likelihood that an oligopolist will collude with other firms in the industry? The likelihood that an oligopolist will act noncooperatively and raise output? Explain your answers.

    1. The firm’s initial market share is small. (Hint: Think about the price effect.)

    2. The firm has a cost advantage over its rivals.

    3. The firm’s customers face additional costs when they switch from the use of one firm’s product to another firm’s product.

    4. The oligopolist has a lot of unused production capacity but knows that its rivals are operating at their maximum production capacity and cannot increase the amount they produce.

Solutions appear at back of book.