Collusive Oligopoly and the Formation of Cartels

In one of my previous articles, I’ve tried to portray that Uncertainty is the most important factor in the studies of Oligopoly.( http://www.articlesbase.com/...expert-articles/uncertainty-the-basic-nature-of-oligopoly-219699.html)

So, due to its own virtue, setting prices independently is very rare or almost non-existent in the oligopolistic markets. Some kind of understanding between the firms arises, may be either in the form of a formal agreement or even in a tacit way. A formal agreement is one when the oligopolists agree after discussion to observe certain common rules of conduct in regard to price and output determination. So this kind of an oligopolistic situation is generally termed as Collusive Oligopoly. But more often we find that the agreement between the firms is a tacit one, as in most of the countries a formal or open agreements to form monopolies are illegal.

Collusions can be of two major types:
A. Cartels

B. Price Leadership

In this article I’m concentrating on Cartels only. In a Cartel type of collusion, firms jointly fix a price and output policy through agreements. Basically, the term ‘cartel’ was used for the agreement in which there existed a common agency which alone undertook the selling operations of all the firms that were party to the agreement. But now-a-days all types of formal and informal agreements reached among the oligopolistic firms of an industry are known as Cartels.

Formal collusion or agreement among the oligopolists may itself take a various forms. An extreme form of collusion is found when the member firms agree to surrender completely their rights of price and output determination to a ‘Central Agency’, so as to secure maximum ‘joint profits’. This type of cartel is treated as the ‘perfect cartels’.

Let us take a closer look into the mechanism of working of a ‘perfect cartel’. Let us assume that there are two firms who have formed a perfect cartel by entering the industry with an agreement to maximize the joint profit. Here, the cartel will firstly estimate the demand curve of the industry which is nothing but the aggregate demand curve of the consumers. The Marginal Revenue curve of the cartel will show the addition to cartel’s revenue for successive additions to its output and sales. The Marginal Cost curve of the cartel can easily be got by horizontally adding the marginal cost curves of the individual firms. Now, the cartel will maximize its joint profits by fixing the industry output at the point where the marginal revenue and marginal cost curves intersect each other.


But in reality the existence of the so called ‘perfect cartel’ is quite rare. In most of the cases, cartels are found to be ‘loose’ and in those cases, the distribution of profits and fixation of outputs of individual firms are not determined in a manner perfect cartels do. Generally a market sharing approach gets generated and it may work in two different manners:

1. Market Sharing by Non Price Competition: Here only a uniform price is set and the member firms are free to produce and sell amount of outputs which will maximize their individual profits. Though the firms agree not to sell products below a certain floor level, but they are free to vary the style of their products and advertising expenditure and to promote sales in the other ways.

2. Market Sharing by Quota: Here the member firms agree regarding the quota of output to be produced and sold by each of them at the agreed price.

It is worth mentioning that the all types of cartels are unstable, when there exists cost difference between the firms. The low cost firms always have the tendency to reduce the price of the product to maximize their profits which ultimately result in the collapse of the collusive agreement. Again, if the entry of the firms in the oligopolistic industry is free, the instability of the cartels is intensified as the new entrants may not join the cartel and may fix a lower price of the product to sell a larger quantity. This means that the stability of the cartel agreement is always in danger and it again shows the Uncertainty is the very basic nature of Oligopoly.