Introduction
Collusion in oligopoly markets can lead to market failure. Firms collude to raise prices, thereby lowering the price level and reducing consumer surplus. Reduced consumer surplus therefore lowers the overall welfare of individuals.
Collusion in oligopoly markets occurs when firms in the same industry coordinate their strategies to maximize profits (Ehrenberg & Smith, 2009). This is achieved by establishing an explicit or implicit agreement to restrict competition and maintain artificially high prices. As a result, oligopolistic firms can reap larger profits than a competitive market would generate.
Collusion is illegal in most countries since it violates antitrust laws. Collusion in oligopoly markets leads to market failure because it reduces market competition (Schwalbe, 2018). This, in turn, decreases the pressure on firms to produce the best products or services at the lowest prices. Consumers cannot benefit from the competition and must pay higher prices for inferior products or services.
An oligopoly is a market structure in which a few strong enterprises dominate the market. These companies possess significant market power, enabling them to influence the market’s prices, output, and other key factors. High entry barriers are a common feature of oligopoly markets, making it challenging for new businesses to enter and compete with the established ones (Callery, 2017). Markets with oligopoly structures include the automobile, airline, and banking sectors.
The analysis of oligopoly behavior and its potential market failures requires consideration of the underlying economic assumptions, the market structure, and the firms’ strategies. Oligopolistic markets are characterized by a few large firms competing in a market with limited entry, resulting in a range of outcomes, from perfect competition to complete collusion (Ehrenberg & Smith, 2009). The firm’s degree of market power will determine the extent of market failure.
Economic Assumptions
Oligopoly markets are characterized by interdependence between firms. This implies that the profits of other businesses in the market will be impacted by the decisions made by one firm. This interdependence incentivizes firms to cooperate and collude to maximize profits (Ehrenberg & Smith, 2009). This type of collusion, known as tacit or implicit collusion, is an agreement between firms to keep prices and output at levels that maximize their collective profits.
Market Structure
High concentration ratios, or the fact that a small number of companies dominate the market’s production, describe oligopoly marketplaces. Since there is little competition, firms can use their market dominance to set prices and output levels that maximize their combined profits (Ehrenberg & Smith, 2009). This situation could lead to market failure, as consumers would have to pay higher prices than they would in a competitive market.
Firm Strategies
Firms in an oligopoly market have an incentive to collude in order to increase their profits. Collusion can be price fixing, an agreement between firms to set a uniform product price. This increases the firms’ profits by raising prices above what would result from competition. Another form of collusion is output limitation, an agreement between firms to limit the supply of their products, thereby maintaining higher prices (Ehrenberg & Smith, 2009). Both forms can lead to market failure, as consumers are forced to pay higher prices than would be the case in a competitive market, and resources are prevented from being allocated to their highest-valued use.
A Model of Collusion in an Oligopoly Market
Two firms, Firm A and Firm B, are competing in a market. Both firms have equal market share and produce identical products. The two firms enter a collusive agreement to set a uniform product price. This price is higher than the price resulting from competition, increasing profits for both firms (Ehrenberg & Smith, 2009). The agreement also specifies that each firm will produce a certain quantity of the product to limit the supply and maintain the higher price.
In oligopoly markets, collusion can lead to market failure in several distinct ways. Essentially, collusion can lead to higher prices and reduced output, resulting in an inefficient allocation of resources because firms can restrict competition and charge more than they would in a competitive market (Horstmann et al., 2018). Additionally, cooperation can lower customer welfare and result in an inefficient revenue distribution, as it increases profits for the participating businesses.
Collusion can reduce the diversity of a market. When firms form a cartel and collude to limit competition, it can lead to a lack of competition and innovation, resulting in a less dynamic market with fewer consumer choices. This can be especially damaging for smaller firms, which may lack the resources to compete with established market players and be forced out of the market.
Additionally, collusion can lead to cheating. Despite the agreement to limit competition, one firm may attempt to gain an advantage by offering a lower price than the others. This practice, known as cheating, can lead to a price war, where firms compete to offer the lowest prices, resulting in lower profits for all parties involved and inefficient resource allocation (Shafiekhah et al., 2016).
Cheating can also lead to legal repercussions, as it is a form of market manipulation and is illegal in many countries. In most countries, collusion is illegal and can result in significant fines and other penalties (Ehrenberg & Smith, 2009). This can significantly impact the firms involved, as they may suffer substantial financial losses and potential reputational damage. Ultimately, collusion can have a negative impact on consumers. Collusion makes a market less diverse, which can lead to lower prices, fewer choices, and lower-quality products; lower-quality products are compelled to pay more for lower-quality goods and slower-quality products.
Conclusion
To conclude, when companies in an oligopoly reach agreements and operate as if they were a single entity, this is known as collusion. To obtain the monopoly pricing via production restriction, colluding enterprises must agree, tacitly or explicitly, to work together. This makes the companies reliant on one another, since each company’s profitability is affected by its actions and those of its competitors.
Reference List
Callery, C. (2017). Considering the oligopoly problem. In Dominance and Monopolization (pp. 243-254). Routledge.
Ehrenberg, R. G., and Smith, R. S. (2009). Modern Labor Economics, 10th edition, chapter 13. Boston, MA: Pearson Addison Wesley.
Horstmann, N., Krämer, J. and Schnurr, D. (2018). ‘Number effects and tacit collusion in experimental oligopolies,’ The Journal of Industrial Economics, 66(3), pp.650-700.
Schwalbe, U. (2018). ‘Algorithms, machine learning, and collusion,’ Journal of Competition Law & Economics, 14(4), pp.568-607.
Shafie‐khah, M., Moghaddam, M.P. and Sheikh‐El‐Eslami, M.K. (2016). ‘Ex‐ante evaluation and optimal mitigation of market power in electricity markets including renewable energy resources,’ IET Generation, Transmission & Distribution, 10(8), pp.1842-1852.