Collusive Oligopoly

1. 0Introduction In a perfectly competitive market it is assumed that owing to presence of manybuyers and many sellers selling homogeneous products,the actions of any singlebuyer or seller has a negligible impact on the market price of product. However in reality this situation is seldom realized. Most of the time individual sellershave some degree of control over the price of their outputs. This condition is referredas imperfect competition. Barriers to entry are the factors that make it difficult for new firms to enter an industry, which lead to imperfect competition.

Mostly commonly known barriers of entry areeconomies of scale, legal restrictions, high cost of entry and advertising and productdifferentiation. Imperfect competitive markets can be classified into three categories 1. Monopoly where single seller has control over the industry and no other firmexists producing a close substitute. True monopolies are rare in the present situation. 2. Monopolistic competition where a large number of sellers exist sellingdifferentiated products 3.

Oligopoly is an intermediate form of imperfect competition in which only afew sellers exist in the market with each offering a product similar or identicalto the others.

Oligopoly usually exhibits the following features: 1. Entry barriers: Significant entry barriers prevail in the markets that thwart thedilution of competition in the long run. This helps dominant firms to maintainsupernormal profits. Though many smaller firms can operate on the periphery of anoligopolistic market, but none of them is large enough to have any considerable effecton market prices and output. 2.

Interdependent decision-making: Interdependence implies that firms must take into account probable reactions of their rivals to any change in price, output or forms of non-price competition.

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3. Non-price competition: Non-price competition is a consistent feature of thecompetitive strategies of oligopolistic firms. Examples of non-price competition suchas free deliveries and installation, longer opening hours (e. g. supermarkets and petrolstations),branding of products and heavy spending on advertising and marketing. If firms operate in cooperative mode to minimize the competitions betweenthemselves this behavior is called as Collusion.

When two or more firms agree to settheir outputs or prices to divide the market among themselves, it is called as collusive oligopoly. 2. 0 Collusive oligopoly: There are two types of collusive oligopoly A. Price leadership – tacit collusion This occurs when one firm has a clear dominant position in the market and thefirms with lower market shares follow the pricing changes driven by the dominant firm. B. Overt collusion:This occurs when firms openly agree on price, output, and other decisions aimed at achieving high profits.

Firms who coordinate their activities throughovert collusion and by forming collusive coordinating mechanisms, such a group ofindependent firms working in unison is called as cartel. When this happens the existing firms decide to engage in price fixing greements orcartels. The aim of this is to maximize joint profits and act as if the market was apure monopoly. 2. 1 Price fixing in collusive oligopoly Collusion is often explained as a product of motive to achieve joint-profitmaximization within a market or circumvent price and revenue instability in anindustry.

Price fixing can be deemed as an attempt by suppliers to control supply andfix price at a level close to the level expected from a monopoly. However in order to fix prices, the producers in the market must be able to exertcontrol over market supply. The figure 1 below depicts a producer cartel fixes the cartel price at output Qm andprice Pm decided by the fact where marginal revenue of the cartel MR is equal tomarginal cost MC of the cartel. The distribution of the cartel output among the cartelmembers could be decided on the basis of an output quota system or through mutualagreement.

Although the cartel as a whole is maximizing profits, the individual firm’soutput quota is unlikely to be at their profit maximizing point. For any one firm, within the cartel, expanding output and selling at a price thatslightly undercuts the cartel price can achieve extra profits. Unfortunately if one firmindulges in this, the other firms will probably same path same. If all firms break theterms of their cartel agreement, the result will be an excess supply in the market and asharp fall in the price. Under these circumstances, a cartel agreement might breakdown. Fig. Price fixation by cartel and effect on partner of the firm 3. 0 Conditions conducive for formation of cartels 1. Only a small number of firms exist in the industry and barriers prevail to entryprotect the monopoly power of existing firms in the long run. 2. Market demand is not too variable i. e. it is reasonably predictable and not subject toerratic fluctuations which may result to excess demand or excess supply. 3. Demand is fairly inelastic with respect to price so that a higher cartel price fetchesincreased total revenue to suppliers in the market. 4. It is easier to monitor each firm’s output.

This enables the cartel more easily toregulate total supply and identify firms, cheating on output quotas. 4. 0 Reasons for possible breakdowns of cartels Most cartel arrangements experience difficulties and tensions and some producercartels collapse completely. Several factors can create problems within a collusiveagreement between suppliers: 1. Enforcement problems: The primary objective of the cartel is to restrict totalproduction to maximize total profits of members. But in reality each individualmember of the cartel finds it profitable to raise its own production.

Thus theenforcement of output quota becomes difficult for the cartel leading disputes about sharing of the profits. Non-members of the cartel may opt to take a free ride byproducing close to but just under the cartel price. 2. Falling market demand during a recession creates excess capacity in the industryand exerts pressure on individual firms to reduce prices to maintain their revenue. E. g. collapse of the coffee export cartel. 3. The successful foray of non-cartel firms into the industry undermines a cartel’scontrol of the market – e. g. he emergence of online retailers in the book industry in the mid 1990s. 4. The exposure of illegal price fixing by market regulators Governments appoint market regulators to monitor the markets and identify the firmsindulging in collusion. Collusion is undesirable from the standpoint of society as awhole, because inefficient allocation of resources at high prices. In order bringallocation of resources closer to the social optimum, policymakers try to induce firmsin an oligopoly to compete rather than cooperate through instrument of antitrust laws.

Regulatory bring legal suits to enforce the antitrust laws for example to preventmergers leading to excessive market power prevent. 5. 0 OPEC case study: Most successful cartel Organization of petroleum Exporting countries (OPEC) was formed in 1960. Initiallyit contained only 5 members, the membership of cartel however expanded to 13 by1973. During period 1960-73, OPEC could not be reckoned as a successful cartel. Infact world oil prices declined slightly over the 1960-1970 decade. However the situation underwent a dramatic change in 1973 with the Arab-Israel war.

During the war the Arab members of OPEC temporarily cut off oil exports. Theoutcome was ominous: Oil prices more that tripled in a matter of months. Theestimated price of a barrel of oil on the world market was $2. 91 in 1973 but jumped to $10. 77 in 1974. This demonstrated that output restriction could wreak havoc afterresuming exports OPEC continued to hold down output. Subsequently, oil pricesremained relatively stable. However another jolt was inflicted in 1978 whenrevolution took place in Iran. Iranian exports at that time accounted for 20 percent ofall OPEC ex-ports, fell almost to zero.

Prices escalated once again and the newgovernment in Iran continued to limit exports, maintaining prices at high levels. The Iran-Iraq War, which started in 1980, resulted in the extensive destruction of oilproducing facilities in both counties and brought down oil exports further. The relative success of OPEC can be attributed to the following advantages it hasenjoyed relative to other cartels. 1. The price elasticity of demand for oil, especially in the short run, is quitelow, implying that moderate output restrictions will produce large priceincreases- a favorable environment for a cartel.

In 1973 OPEC outputcontributed to two-thirds of the total world oil production. 2. In 1975 OPEC countries held 70 percent of the world’s proven oilresources that imparted it a substantial market power. 3. OPEC contains a few members, many of the internal problems thatusually trouble a cartel are reduced e. g. reaching agreements, monitoringthe output and coordinating price policies of individual members, issimpler with a few members involved. In fact, since just four countries(Saudi, Arabia, Kuwait, Iran and Venezuela) regulate ? of OPEC’s oilreserves, the effectiveness of cartel is further enhanced. . The biggest danger to a cartel comes from the increased production bynon-members. However exploration, production and building new supplies are time consuming hence this gives OPEC significant short-run power. 5. OPEC has also been benefited by policies of oil importing nations. E. g. Inthe United states for example, price controls on oil and gas kept the pricereceived by domestic oil producer’s artificially low and discouragedproduction and exploration. In addition, tough environmental restrictionson the mining and use of coal slowed the transition to coal as anotherenergy alternative.

On one hand domestic consumption was encouragedand production was discouraged resulted in additional demand for oil fromOPEC and the United States inevitably became more dependent onimported oil during the 1970s. But the situation had changed dramatically by early 1982. In March 1982 the pricefor Saudi Arabian light crude oil was $29 a barrel, down in real terms more that 30percent from a year earlier. So also the fraction of oil production had fallen to 40percent by 1984. This ultimately resulted in erosion of power of OPEC.

In September 1960 four Persian Gulf nations (Iran, Iraq, Kuwait, and Saudi Arabia) and Venezuela formed OPEC, the purpose of which was to obtain higher prices for crude oil. By 1973 eight other nations (Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, and Gabon) had joined OPEC. Ecuador withdrew on the last day of 1992. OPEC was unsuccessful in its first decade. Real (that is, inflation-adjusted) world prices for crude oil continued to fall until 1971. In 1958 the real price was $10. 85 per barrel (in 1990 dollars).

By 1971 it had fallen to $7. 46 per barrel. However, real prices began to rise slowly beginning in 1971, and then jumped dramatically in late 1973 and 1974 from roughly $8 per barrel to over $27 per barrel in the wake of the Arab-Israeli (“Yom Kippur”) War. Contrary to what many non-economists believe, the 1973 price increase was not caused by the oil “embargo” (refusal to sell) directed at the United States and the Netherlands that year by the Arab members of OPEC. Instead, OPEC reduced its production of crude oil, thus raising world oil prices substantially.

The embargo against the United States and the Netherlands had no effect whatever: both nations were able to obtain oil at the same prices as all other nations. The failure of this selective embargo was predictable. Oil is a fungible commodity that can easily be resold among buyers. Therefore, sellers who try to deny oil to buyer A will find other buyers purchasing more oil, some of which will be resold by them to buyer A. Nor, as is commonly believed, was OPEC the cause of oil shortages and gasoline lines in the United States.

Instead, the shortages were caused by price and allocation controls on crude oil and refined products, originally imposed in 1971 by President Nixon as part of the Economic Stabilization Program. By preventing prices from rising sufficiently, the price controls stimulated desired consumption above the quantities available at the legal maximum prices. Shortages were the inevitable result. Countries that avoided price controls, such as West Germany and Switzerland, also avoided shortages, queues, and the other perverse effects of the controls.

OPEC is a cartel—a group of producers that attempts to restrict output in order to keep prices higher than the competitive level. The heart of OPEC is the Conference, which comprises national delegations, usually at the level of oil minister. The Conference meets twice each year to assign output quotas, which are upper limits on the amount of oil each member is allowed to produce. The Conference may also meet in special sessions when deemed necessary, particularly when downward pressure on prices becomes acute. OPEC faces the classic problem of all cartels: overproduction and cheating by members.

At the higher cartel price, less oil is demanded. That is why OPEC assigns output quotas. Each member of the OPEC cartel has an incentive to produce more than its quota and “shave” (cut) this price because the cost of producing an additional barrel of crude is typically well below the cartel price. The methods available to shave official OPEC prices are numerous. Credit can be extended to buyers for periods longer than the standard thirty days. Higher grades (or blends) of oil can be sold for prices applicable to lower grades. Transportation credits can be given. Buyers can be offered side payments or rebates.

This tendency for individual producers to cheat on the cartel agreement is a long-standing feature of OPEC behavior. Individual producers usually have exceeded their production quotas, and so official prices have been unstable. But OPEC is an unusual cartel in that one producer—Saudi Arabia—is much larger than the others. That is why the Saudis are the “swing” producer. When prices start downward, they cut their production to keep prices up. One reason the Saudis have behaved that way is that departures from the official prices impose larger total losses on them than on other OPEC members in the short run.

Because other producers have huge incentives to produce in excess of their quotas, the Saudis, in order to defend the official OPEC price, have had to reduce their sales dramatically at times. This erosion of Saudi production and sales has tended to reduce their revenues and profits substantially. In 1983 and 1984, for example, the Saudis found themselves producing only about 3. 5 million barrels per day, despite their (then) production capacity almost three times that level. How successful has OPEC been since the early seventies? Not as successful as many people perceive.

Except in the wake of the 1979 Iranian revolution, and in anticipation of possible destruction of substantial reserves in the 1990-91 Persian Gulf conflict, real (inflation-adjusted) prices of crude oil have fallen since 1973. Prices began dropping very rapidly in the early eighties after the Saudis concluded that lower prices and higher production were in their best interests. Official prices fell from $34 (for the benchmark crude oil, Arabian light) to $29 in 1983, $24 in 1984, and about $18 in 1986 to 1988. Indeed, even prices unadjusted for inflation often have fallen.

For example, prices fell from $35. 10 per barrel ($49. 10 in 1990 dollars) in 1981 to $16. 69 ($18. 69 in 1990 dollars) in 1987. (Price data are shown in table 1, and current reserves, production capacity, and production levels are shown in table 2. ) TABLE 1 ________________________________________ World Crude Oil Prices (U. S. dollars per barrel) ________________________________________ Year Nominal Price In 1990 Dollars Year Nominal Price In 1990 Dollars 1955 2. 25 10. 88 1973 3. 27 8. 69 1956 2. 36 11. 04 1974 11. 17 27. 20 1957 2. 73 12. 34 1975 11. 7 25. 66 1958 2. 45 10. 85 1976 12. 41 25. 86 1959 2. 27 9. 82 1977 13. 33 26. 05 1960 2. 23 9. 49 1978 13. 43 24. 46 1961 2. 27 9. 57 1979 20. 19 33. 78 1962 2. 26 9. 32 1980 32. 27 49. 52 1963 2. 25 9. 13 1981 35. 10 49. 10 1964 2. 23 8. 91 1982 32. 11 42. 22 1965 2. 22 8. 64 1983 27. 73 35. 10 1966 2. 24 8. 42 1984 27. 44 33. 50 1967 2. 27 8. 31 1985 25. 83 30. 63 1968 2. 24 7. 81 1986 12. 52 14. 47 1969 2. 27 7. 50 1987 16. 69 18. 69 1970 2. 35 7. 36 1988 13. 25 14. 36 1971 2. 52 7. 46 1989 16. 89 17. 59 1972 2. 64 7. 47 1990 20. 42 20. 42 SOURCE: U. S.

Departments of Energy, Commerce, and Labor. ________________________________________ TABLE 2 ________________________________________ OPEC Reserves, Production Capacity, and Production Levels ________________________________________ Nation ReservesaCapacitybProductionc Algeria 9,200 800 750 Ecuador 1,514 330 280 Gabon 733 200 260 Indonesia 8,200 1,300 1,200 Iran 92,860 3,000 3,100 Iraq 100,000 3,500 3,100 Kuwait* 97,125 2,200 1,800 Libya 22,800 1,600 1,250 Neutral Zone NA600 300 Nigeria 16,000 1,700 1,700 Qatar 4,500 600 365 Saudi Arabia* 257,559 7,000 5,300 Un. Arab Em. 4,105 2,210 2,060 Venezuela 58,504 2,400 2,000 OPEC Total 763,100 27,440d23,465 World Total 1,001,572 63,740d60,320 aMillions of barrels on January 1, 1990. bMaximum sustainable as of August 1990, thousands of barrels per day. cThousands of barrels per day as of May 1990, excluding natural gas liquids. dNon-OPEC capacity for first quarter 1991, from internal Department of Energy/Energy Information Administration estimate. * Includes one-half of the Neutral Zone. n. a. —not available. SOURCE: U. S. Department of Energy, Central Intelligence Agency. ________________________________________

This downward trend has increased tensions between two rival groups within OPEC. The price “hawks,” usually nations with smaller crude oil reserves relative to population, argue for lower oil output and higher prices. The principal hawks within OPEC are Iran and Iraq. The price “doves,” usually nations with larger reserves relative to population, argue for higher output and lower prices to preserve, over the longer term, their oil markets and thus the economic value of their oil resources. The principal doves within OPEC are Saudi Arabia, Kuwait, and the United Arab Emirates.

Such relatively lower prices serve the interests of the doves because oil consumers have used less oil in response to prior price increases. For example, U. S. energy use per dollar of GNP (adjusted for inflation) was 27. 49 thousand BTUs in 1970. By 1988, after the price increases of 1973 and 1979, it had decreased to 19. 93 thousand BTUs. Thus, the price “doves,” led by Saudi Arabia, generally have resisted pressures for higher prices. Over the long run, real prices of natural resources and commodities usually fall, largely because of technological advances.

Crude oil is no exception. Technological advances in seismic exploration have dramatically reduced the cost of finding new reserves, thus increasing oil reserves greatly. Horizontal drilling and other new techniques have reduced the cost of recovering known reserves. Also, improvements in technology provide both substitutes for oil and ways to use less oil to achieve given ends. Moreover, advances in technology will reduce prices for such substitute fuels as natural gas, thus exerting continuing downward pressure on crude oil prices.

And increasing willingness to devote resources toward environmental improvement suggests that the market for crude oil will decline relative to those for such “cleaner” energy sources as natural gas and nuclear technology, unless other technical advances yield substantial improvement in the ability to use oil cleanly. Thus, the demand for crude oil is likely over the long term to decline relative to the demand for competing fuels. This has been the experience of mankind, as wood gradually gave way to coal, which in turn declined as the use of oil expanded. These facts suggest that the economic power of OPEC inexorably will erode. . 0 Conclusion Collusive oligopolies are more like a monopoly. However it is very fragile since self-interest to earn maximum profit of member can tip off the balance and can lead toprice war. The success of collusive oligopoly is quite dependent on the number offirms in involved and their level of cooperation. It can be observed that it is difficultto maintain cartels in the long run with an exception of OPEC. Policymakers regulate the behavior of oligopolies through the antitrust laws. The proper scope of these laws is the subject of ongoing controversy.