Market power with few firms – the case of oligopoly

    The case of monopoly, in which just one seller dominates the entire market, is

useful for illustrative purposes. However, in reality single-seller monopolies are

the exception. More common is the case of markets dominated by a few large

firms. Economists call this oligopoly. Oligopoly and monopoly are close cousins

from an economic viewpoint. For example, a firm needs to supply only one

quarter of the total market in order to be characterised by the UK’s Office of Fair

Trading as possessing a ‘monopoly position’.

    Oligopolies come in many guises. There are different ways in which market

power can be exercised when interdependence between the small number of

firms prevails in the market. Firms might try to form a cartel, whereby price,

market share and investment decisions are made collectively, with the objective

of maximising profits. At the international level, the best-known cartels include

OPEC and the De Beers diamond ‘monopoly’. Within the EU, cartels have been found in a diverse range of industries: cases involving dyestuffs, quinine, vitamins and cement have come to attention in recent years.

    Suppose there are two producers, firm 1 and firm 2. They form a cartel in order

to avoid competing away their profits. Total profits are maximised when MR # MC for the industry as a whole. This is the level of profits the profit-maximising cartel will seek to earn. To determine the marginal cost curve for the industry, each firm’s MC curve is laterally summated by finding out how much output can be produced in each firm at each MC level. The MR curve is derived from the industry demand curve, estimated by the techniques described  in Chapter 4. The profit-maximising output for the two-firm cartel in Figure 6.5 is OQ and price OP. Total industry profits are represented by the area PRSF.

    The cartel then has the task of determining production quotas for each firm.

This is not an easy task. One possibility would be to order each firm to sell at OP and to allocate a quota of OQ_1 to firm 1 and OQ_2 to firm 2. Because of firm 1’s lower cost structure, however, it earns more profits than firm 2. Some haggling might take place as to the share-out. Each participant has a selfish interest in the other participant being reasonably satisfied with the outcome, but the unbalanced nature of the distribution in Figure 6.5 may lead to tension. If this imbalance is not corrected, firm 2 will be tempted to ‘cheat’, i.e. to sell a few extra units at OP, in order to obtain a larger share of the cartel’s profits. This will be a profitable exercise for firm 2 if undetected, since MC is well below OP at its assigned production level OQ_2. Of course, if everyone cheats, the cartel’s effectiveness is undermined. Hence a mechanism for detecting and limiting cheating is an essential requirement for a cartel. Many cartels have self-destructed because of their inability to implement such a mechanism.

    In some instances, rather than form a cartel, oligopolists may decide to allow a

dominant firm to assume a leadership role. If the leader raises price, the others

follow, and vice versa in the event of a fall in price. The price leader then decides

on the price that maximises its profits, on the assumption that all other producers

will sell as much as they find profitable at the price chosen by the leader. The

net result is a higher price and more profits for all in the industry. It is not as

advantageous for the producers as a cartel, but it is less transparent and, therefore,

less likely to encounter legal problems. Too blatant price leadership behaviour

can, of course, attract attention. In the US, the Department of Justice has taken

exception to ‘conscious parallelism’ of price decisions, even in the absence of

overt collusion – and hence can object to the leader advertising price changes._15

A well-publicised example of price leadership is the case of ICI and British Salt.

The two firms accounted for a 45 per cent and 50 per cent share, respectively, of

the UK market. In its 1986 Report on the UK Salt Market, the Monopolies and

Mergers Commission criticised British Salt for having chosen to ‘follow’ the price

increase of ICI. The Commission recommended that the price of salt should be

controlled through the use of an index, based on the costs of the more efficient

producer, British Salt.