Collusion and also Competition

Firms in one oligopoly can increase their profits through collusion, but collusive arrangements are inherently unstable.

You are watching: An extreme case of oligopoly in which firms collude to raise joint profits is known as a:


Learning Objectives

Assess the considerations associated in the oligopolist’s decision about whether to complete or cooperate


Key Takeaways

Key PointsFirms in an oligopoly might collude to collection a price or calculation level for a sector in order to maximize market profits. At an extreme, the colluding firms deserve to act as a monopoly.Oligopolists pursuing their individual self-interest would create a higher quantity 보다 a monopolist, and charge a lower price.Collusive kinds are typically illegal. Moreover, the is complicated for this firm to name: coordinates actions, and also there is a threat that firms might defect and also undermine the rather in the arrangement.Price leadership, which occurs when a dominant competitor sets the industry price and also others monitor suit, is an informal kind of collusion which is usually legal.Key TermsPrice leadership: Occurs when one company, commonly the leading competitor amongst several, leader the means in determining prices, the others shortly following.collusion: A mystery agreement because that an illegal purpose; conspiracy.price fixing: one agreement between sellers to sell a product just at a addressed price, or keep the market problems such that the price is kept at a provided level by regulating supply.

Oligopoly is a industry structure in i beg your pardon there are a couple of firms creating a product. As soon as there are few firms in the market, they may collude to collection a price or output level for the sector in order come maximize industry profits. Together a result, price will be higher than the market-clearing price, and output is most likely to it is in lower. In ~ the extreme, the colluding firms might act as a monopoly, reducing your individual output so that their collective output would certainly equal the of a monopolist, enabling them to earn greater profits.


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OPEC: The oil-producing nations of OPEC have actually at time cooperated to raise human being oil price in order come secure a steady revenue for themselves.


If oligopolists individually sought their own self-interest, then they would create a full quantity higher than the monopoly quantity, and charge a lower price 보다 the monopoly price, thus earning a smaller profit. The promise of bigger profits gives oligopolists an incentive to cooperate. However, collusive oligopoly is inherently unstable, since the most effective firms will be tempted to break ranks through cutting prices in stimulate to rise market share.

Several determinants deter collusion. First, price-fixing is illegal in the united States, and antitrust regulations exist to avoid collusion between firms. Second, coordination amongst firms is difficult, and becomes an ext so the higher the variety of firms involved. Third, there is a danger of defection. A firm may agree to collude and also then rest the agreement, undercutting the profits of the firms tho holding to the agreement. Finally, a firm may be discouraged from collusion if that does not perceive itself to be able to effectively punish firms that may break the agreement.

In comparison to price-fixing, price management is a type of unshened collusion i beg your pardon is generally legal. Price leadership, which is likewise sometimes referred to as parallel pricing, occurs once the dominant contender publishes that price ahead of various other firms in the market, and the other firms then enhance the announced price. The leader will certainly typically set the price come maximize that is profits, which might not it is in the price the maximized other firms’ profits.


Game theory Applications to Oligopoly

Game theory gives a frame for understanding how firms law in one oligopoly.


Learning Objectives

Explain how video game theory uses to oligopolies


Key Takeaways

Key PointsIn an oligopoly, that company are influenced not only by their own production decisions, however by the manufacturing decisions of various other firms in the sector as well. Game theory models instances in which every actor, as soon as deciding top top a course of action, must also consider how others can respond to that action.The prisoner’s dilemma is a kind of game that illustrates why teamwork is daunting to preserve for oligopolists even when the is support beneficial. In this game, the leading strategy of every actor is come defect. However, acting in self-interest leader to a sub-optimal cumulative outcome.The Nash equilibrium is crucial concept in game theory. The is the set of tactics such the no player deserve to do far better by unilaterally changing his or her strategy.Game theory is usually not required to understand competitive or monopolized markets.Key TermsPrisoner’s dilemma: A game that shows why two individuals might not cooperate, also if it shows up that the is in their finest interests to execute so.game theory: A branch of used mathematics that researches strategic cases in which people or organisations select various action in an attempt to maximize their returns.Nash equilibrium: The collection of players’ techniques for i beg your pardon no player can benefit by transforming his or she strategy, assuming the the other players save theirs unchanged.

In one oligopoly, firms are interdependent; lock are influenced not only by their very own decisions concerning how lot to produce, but by the decision of other firms in the industry as well. Video game theory provides a valuable framework because that thinking around how firms may act in the paper definition of this interdependence. An ext specifically, video game theory have the right to be provided to model instances in which each actor, as soon as deciding on a food of action, must also consider just how others could respond to that action.

For example, game theory can describe why oligopolies have actually trouble maintaining collusive arrangements come generate syndicate profits. If firms would certainly be far better off jointly if lock cooperate, each individual firm has actually a solid incentive to cheat and undercut their competitors in stimulate to rise market share. Because the incentive to defect is strong, firms may not even enter into a collusive covenant if they don’t perceive there to be a way to efficiently punish defectors.

The prisoner’s dilemma is a specific type of game in game theory the illustrates why teamwork may be challenging to preserve for oligopolists also when that is mutually beneficial. In the game, 2 members of a criminal gang space arrested and imprisoned. The detainees are separated and also left come contemplate your options. If both prisoners confess, each will serve a two-year prison term. If one confesses, however the various other denies the crime, the one that confessed will walk free, if the one the denied the crime would get a three-year sentence. If both deny the crime, they will both serve just a one year sentence. Betraying the partner by confessing is the dominant strategy; that is the better strategy because that each player nevertheless of just how the other plays. This is known as a Nash equilibrium. The result of the game is that both prisoners pursue separation, personal, instance logic and also betray, when they would have collectively gotten a far better outcome if they had both cooperated.


Prisoner’s Dilemma: In a prisoner’s dilemma game, the leading strategy because that each player is come betray the other, also though cooperation would have actually led to a better collective outcome.


The Nash equilibrium is crucial concept in game theory. It is the set of tactics such that no player deserve to do far better by unilaterally an altering his or she strategy. If a player knew the tactics of the other players (and those strategies might not change), and also could not advantage by changing his or her strategy, climate that collection of strategies represents a Nash equilibrium. If any kind of player would benefit by transforming his or her strategy, then that collection of strategies is no a Nash equilibrium.

While game theory is important to knowledge firm habits in oligopolies, it is usually not required to know competitive or monopolized markets. In vain markets, firms have such a small individual effect on the market, that taking other firms into account is merely not necessary. A monopolized market has only one firm, and thus strategy interactions do not occur.


The Prisoner’s Dilemma and Oligopoly

The prisoner’s dilemma mirrors why two individuals might not cooperate, also if that is jointly in their best interest to execute so.


Learning Objectives

Analyze the prisoner’s dilemma utilizing the principles of strategic dominance, Pareto optimality, and also Nash equilibria


Key Takeaways

Key PointsIn the game, 2 criminals space arrested and imprisoned. Each criminal have to decide even if it is he will cooperate with or betray his partner. The criminals cannot connect to coordinate their actions.Betrayal is the dominant strategy because that both football player in the game. Betrayal leads to ideal individual outcome regardless the what the other person does.Both players selecting betrayal is the Nash equilibrium the the game. However, this result is not Pareto-optimal. Both players would certainly have clearly been much better off if they had cooperated.Cooperation by that company in oligopolies is daunting to achieve because defection is in the finest interest of every individual firm.Key TermsPareto optimal: relenten a situation in which the profit of one party cannot be boosted without to reduce the benefit of another.Nash equilibrium: The collection of players’ methods for i beg your pardon no player can advantage by transforming his or she strategy, assuming the the various other players keep theirs unchanged.Strategic dominance: Occurs as soon as one strategy is much better than another strategy for one player, no matter how that player’s opponents may play.

Sometimes this firm fail come cooperate v each other, even when cooperation would bring around a far better collective outcome. The prisoner’s dilemma is a canonical example of a game analyzed in video game theory that shows why two individuals could not cooperate, even if it shows up that it is in their finest interest to execute so.

In the game, two members of a criminal gang room arrested and imprisoned. Each sinner is in solitary confinement with no way of speak to or trading messages v the other. The police sell each prisoner a bargain:


Prisoner’s Dilemma: betrayal in the leading strategy because that both players, as it provides for a better individual result regardless that what the various other player does. However, the resulting result is not Pareto-optimal. Both players would clearly have been better off if they had actually cooperated.


If sinner A and also Prisoner B both confess come the crime, each of them will serve two years in prison.If A confesses yet B denies the crime, A will certainly be collection free, if B will serve 3 years in jail (and evil versa).If both A and B deny the crime, both of them will just serve one year in prison.

For both players, the choice to betray the partner by confessing has actually strategic prominence in this situation; it is the far better strategy because that each player regardless of what the other player does. This collection of tactics is therefore a Nash equilibrium in the game–no player would be far better off by transforming his or she strategy. As a result, every purely self-interested detainees would betray every other, leading to a two year prison sentence for both. This result is no Pareto optimal; that is clearly possible to enhance the outcomes for both players with cooperation. If both players had denied the crime, they would certainly each be serving just one year in prison.

Similarly come the prisoner’s dilemma scenario, collaboration is challenging to keep in one oligopoly because cooperation is not in the ideal interest of the separation, personal, instance players. However, the cumulative outcome would certainly be boosted if firms cooperated, and were for this reason able to keep low production, high prices, and syndicate profits.

One traditional example of video game theory and also the prisoner’s dilemma in practice entails soft drinks. Coca-Cola and also Pepsi complete in one oligopoly, and also thus are highly competitive versus one one more (as they have restricted other vain threats). Considering the similarity the their assets in the soft drink industry (i.e. Varying varieties of soda), any price deviation on part of one contender is viewed as an plot of non-conformity or betrayal of an established status quo.

In together a scenario, there space a variety of plausible reactions and outcomes. If Coca-Cola reduces their prices, Pepsi might follow come ensure they perform not lose sector share. In this situation, defection results in a lose-lose. I beg your pardon is to say that, because of the early stage price palliation by Coca-Cola (betrayal of standing quo), both companies likely see diminished profit margins. Top top the other hand, Pepsi might uphold the price suggest despite Coca-Cola’s deviation, sacrificing market share to Coca-Cola however maintaining the created price point. Prisoner dilemma scenarios are difficult strategic choices, as any type of deviation from established competitive exercise may an outcome in less profits and/or market share.


Duopoly Example

The Cournot model, in i beg your pardon firms contend on output, and the Bertrand model, in i m sorry firms complete on price, explain duopoly dynamics.


Key Takeaways

Key PointsThe Cournot model concentrates on the manufacturing output decision of a solitary firm. A firm determines its competitor’s calculation level and the residual sector demand. It climate determines its profit -maximizing output for the residual demand as if it were the entire market, and also produces accordingly.In the Bertrand model, firms set profit-maximizing prices in an answer to what they intend the challenger to charge. The design predicts the both firms will lower prices till they reach the marginal price limit, arriving at an end result equivalent come what prevails under perfect competition.The accuracy of the Cournot or Bertrand design will vary from market to industry, depending on how straightforward it is to adjust output levels in the industry.Key TermsCournot duopoly: An financial model relenten an market in i beg your pardon companies contend on the amount of calculation they will produce, which they decision on individually of each other and also at the same time.Bertrand duopoly: A design that defines interactions amongst firms completing on price.

A true duopoly is a specific type of oligopoly where only two producer exist in a market. There room two rule duopoly models: Cournot duopoly and Bertrand duopoly.

Cournot Duopoly

Cournot duopoly is an economic model that explains an sector structure in i m sorry firms contend on calculation levels. The version makes the following assumptions:

There are two firms, which create a homogeneous product;The variety of firms is fixed;Firms execute not cooperate (there is no collusion);Firms have actually market power, and each firm’s calculation decision affects the good’s price;Firms are financially rational and also act strategically, seeking to maximize profit provided their competitor’s decisions; andFirms compete on quantity, and also choose amount simultaneously.

The Cournot model focuses on the production output decision the a solitary firm. The firm identify its rival’s output level, evaluate the residual sector demand, and then changes its very own output level come maximize profits. That is assumed the the firm’s calculation decision will certainly not impact the output decision that its competitor.

For example, intend that there are two this firm in the market for toasters through a given need function. Firm A will recognize the calculation of for sure B, hold it constant, and also then identify the remainder of the market need for toasters. Certain A will certainly then identify its profit-maximizing calculation for that residual demand as if it were the entire market, and produce accordingly. For sure B will be conducting comparable calculations v respect to Firm A in ~ the exact same time.

Bertrand Duopoly

The Bertrand model describes interactions among firms that contend on price. Firms collection profit-maximizing prices in response to what they expect a competitor to charge. The design rests top top the complying with assumptions:

There are two firms producing homogeneous products;Firms carry out not cooperate;Firms complete by setup prices simultaneously; andConsumers buy whatever from a firm v a reduced price. If every firms fee the very same price, consumer randomly select among them.

In the Bertrand model, certain A’s optimum price relies on whereby it believes certain B will set its price. Pricing just below the other firm will obtain full industry demand, despite this choice is no optimal if the other firm is pricing listed below marginal cost, together this would an outcome in an adverse profits. If certain B is setup the price listed below marginal cost, firm A will collection the price at marginal cost. If certain B is setup the price over marginal cost but below syndicate price, climate Firm A will set the price just below that of certain B. If for sure B to adjust the price above syndicate price, firm A will collection the price at syndicate level.


Bertrand Duopoly: The diagram shows the reaction role of a firm competing on price. As soon as P2 (the price set by for sure 2) is less than marginal cost, for sure 1 price at marginal price (P1=MC). Once Firm 2 prices above MC yet below monopoly prices, certain 1 price just listed below Firm 2. As soon as Firm 2 prices above syndicate price (PM), firm 1 price at monopoly level (P1=PM).


Imagine if both firms collection equal prices over marginal cost. Each firm would get fifty percent the market at a greater than marginal expense price. However, by lowering prices simply slightly, a firm could gain the whole market. Together a result, both firms space tempted to reduced prices as lot as they can. However, it would be irrational to price below marginal cost, because the firm would certainly make a loss. Therefore, both firms will reduced prices till they reach the marginal expense limit. Follow to this model, a duopoly will an outcome in an outcome exactly equivalent to what prevails under perfect competition. The result of the firms’ strategies is a Nash equilibrium –a pair or techniques where no firm have the right to increase earnings by unilaterally transforming the price.

Colluding to charge the syndicate price and supplying one fifty percent of the industry each is the best that the firms can do in this scenario. However, no colluding and also charging the marginal cost, which is the non-cooperative outcome, is the just Nash equilibrium the this model.

The accuracy of the Cournot or Bertrand model will differ from industry to industry. If capacity and output have the right to be quickly changed, Bertrand is usually a much better model that duopoly competition. If output and capacity are challenging to adjust, then Cournot is typically a much better model.


Cartel Example

A cartel is a formal collusive arrangement amongst firms through the goal of raising profits.


Key Takeaways

Key PointsCartel members cooperate to set industry price and also output.Game theory suggests that cartels are inherently unstable. Every individual member has an incentive to cheat in order come make greater profits in the brief run.Cheating may bring about the please of a cartel. V the collapse, firms would certainly revert come competing, which would certainly lead to reduced profits.OPEC, the company of Petroleum Exporting Countries, provides an instance of a historically efficient cartel.Key TermsCartel: A team of businesses or nations that collude to border competition in ~ an market or market.

A cartel is an agreement among competing firms come collude in order come attain higher profits. Cartels usually take place in an oligopolistic industry, whereby the variety of sellers is tiny and the products being traded are homogeneous. Cartel members may agree on such matters room price fixing, full industry output, industry share, allocation of customers, allocation of territories, bid rigging, facility of common sales agencies, and also the division of profits.

Game theory argues that cartels are inherently unstable, because the behavior of cartel members to represent a prisoner’s dilemma. Each member that a cartel would have the ability to make a higher profit, at the very least in the short-run, by breaking the covenant (producing a better quantity or offering at a lower price) 보다 it would certainly make by abiding by it. However, if the cartel collapses since of defections, the firms would certainly revert come competing, profits would drop, and also all would be worse off.

Whether members the a cartel select to cheat top top the covenant depends on whether the short-lived returns come cheating outweigh the permanent losses from the possible breakdown of the cartel. It also partly depends on how difficult it is for firms come monitor whether the covenant is being adhered to by various other firms. If security is difficult, a member is likely to acquire away through cheating because that longer; members would then be an ext likely to cheat, and the cartel will certainly be more unstable.

Perhaps the most internationally recognizable and also effective cartel is OPEC, the company of Petroleum Exporting Countries. In 1973 members that OPEC diminished their manufacturing of oil. Due to the fact that crude oil indigenous the Middle eastern was well-known to have few substitutes, OPEC member’s earnings skyrocketed. Native 1973 to 1979, the price the oil raised by $70 per barrel, an unmatched number at the time. In the mid 1980s, however, OPEC started to weaken. Exploration of brand-new oil areas in Alaska and Canada introduced brand-new alternatives to middle Eastern oil, causing OPEC’s prices and also profits come fall. Approximately the same time OPEC members likewise started cheating to try to rise individual profits.

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OPEC: In the 1970s, OPEC members properly colluded to alleviate the worldwide production the oil, leading to greater profits because that member countries.