Oligopoly: Collusive Models- Cartel & Price Leadership

Models of Oligopoly

1. Collusive Models

• Cartel: Profit Sharing and Market Sharing
• Price Leadership

2. Non-Collusive Models

• Cournot Model
• Stackelberg Model
• Bertrand Model
• Sweezy Model or Kinked Demand Curve

Collusive Models

Cartel: Profit Sharing and Market Sharing

A cartel is an organization created from a formal agreement between groups of producers of a good or service to regulate the supply in an effort to regulate prices. Under a cartel, producers or countries act together as a single producer and by controlling production and marketing, influencing the prices. The cartel is successful in creating an oligopoly. Though a cartel has market power but not like a monopoly.

OPEC- As an Example or A Case Study of Cartel:

OPEC- Organization of Petroleum Exporting Countries was set up in 1973. The behaviour of OPEC provides an example of cartelization of an industry that contained a large number of competitive firms, most of which were price-takers.

Before 1973, the oil industry was not perfectly competitive. There were several oil-producing countries, so no country withholding its output in the market influenced the prices. But OPEC attracted attention in 1973 when its members voluntarily agreed to restrict their outputs by negotiating quotas for the first time.

During 1973, OPEC countries accounted for about 70 per cent of the world’s oil exports. As a result of this output restriction, OPEC countries succeed in raising the prices of oil in the world market.

OPEC exports were about 31 million barrels per day in 1973. And in order to raise prices from $3.37 per barrel to an average of $11.25 a barrel, exports had only to be rusticated to 28.5 million barrels per day. So a reduction in OPEC’s exports of less than 10 per cent was sufficient to more than triple the world price.

The higher prices were maintained for the remainder of the decade. And as a result, there is a tremendous increase in the wealth of the OPEC countries.

OPEC’s policy was successful because of several reasons:

1. The OPEC member countries provided a large proposition of the total world supply, i.e. nearly 70 % of the world’s supply of crude oil.
2. Non-OPEC countries were not able to increase their supplies in response to a price increase.
3. The world demand for crude oil was relatively inelastic in the short run.

OPEC as a Successful Cartel

How OPEC successfully restricted output and influenced prices is shown in Figure 1. Price is measured on X-axis, and quantity is on the Y-axis. Sw is the world supply curve. SN is the non-OPEC supply curve of oil. S’w is also the world supply curve after the fixation of production by OPEC. PW is the world price. And DD is the world’s demand curve for oil.

When the OPEC countries were prepared to supply all that was demanded at the world price PW, the world supply curve was SW. The world’s supply cuts the world’s demand curve for oil DD at point E. At price PW, the total quantity of oil produced is OQ out of which OQ1 was produced by non-OPEC countries and Q1Q [OQ- OQ1] by OPEC.

Now suppose OPEC, by fixing its production quota, OPEC shifted the world supply curve to S’W. And the horizontal difference between SN and S’W shows the production by OPEC. Now the new world supply curve S’W intersects the demand curve DD at E1. The new world’s higher price is now P’W. At price P’ W, the total quantity of oil produced is OQ2, out of which OQ3 is produced by non-OPEC and Q3 Q2 [OQ2-OQ3] by OPEC.

As a result, with higher prices, OPEC increased its oil revenues. Though there was a decline in sales by the OPEC countries but the price rises more than the fall in sales. Non-OPEC countries also gained because they were also selling at the new higher world prices.

Price Leadership

Price leadership is an important form of Collusive oligopoly. Under price leadership, the leader firm sets the price, and other firms follow it. The price leader firm has a major share of total sales, and a group of smaller firms supply the remainder of the market. The large firm acts as a dominant firm which sets a price that maximizes its own profit.

The other firms have no option but to take the price set by the dominant firm as given and maximize their profits accordingly. These other firms have a very small share of total sales, so individually other firms would have very little influence over the price.

Thus, other firms act as perfect competitors and take prices decided by the dominant firm as given. Now let us take the case of the dominant firm and see how it sets the price to maximize its profit.

When a leader firm maximizes its profit it takes into account how the output of the other firms depends on the price it sets. It is shown in Figure 2.

In the figure, price is measured on Y-axis and quantity on X-axis. D is the market demand curve which is negatively sloped. SS is the supply curve which is the aggregate marginal cost curve of the follower firms. DD is the demand curve of the dominant firm. The demand curve of the dominant firm is the difference between market demand and the supply curve of the follower firm.

At price OP1, the market demand is equal to the supply by the followers firm so that the dominant firm can sell nothing at this price. At a price of OP2 or less, the follower firm will not supply any good. So, at price OP2 or less, the dominant firm faces the market demand curve D., And between prices OP2 and OP1, the dominant firm faces the demand curve DD.

Corresponding to the demand curve DD faced by the dominant firm, the dominant’s firm is facing marginal revenue MRD. MCD is the marginal cost faced by the dominant firm. The dominant firm, in order to maximize profit, should produce a level of output where marginal revenue is equal to marginal cost. The dominant firm is maximizing profit at point E where marginal revenue is equal to marginal cost.

The equilibrium price is OP*, and the equilibrium quantity produced by the dominant firm is OQD. At this price, follower firms sell a quantity OQS. The total quantity that is sold at price OP* is OQT which is the sum of the quantity produced by dominant firms (OQD) and the quantity produced by the small firms (OQs).

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6. Concept of Equilibrium & Dis-equilibrium in Economics
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65. Difference Between Perfect Competition and Monopolistic Competition
66. Oligopoly Market: Concept, Types and Characteristics
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69. Oligopoly: Non-Collusive Models- Cournot, Stackelberg, Bertrand, Sweezy or Kinked Demand Curve
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71. Bilateral Monopoly Market Structure
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