The demand curve of a monopolistically competitive firm is tilted downward, suggesting that the firm has some market power. Market power results from product differentiation, as each company produces a different product. Each good has many narrow substitutes, so market power is limited: if the price is too high, consumers will switch to competitors` products. In a highly competitive industry, free entry leads to a price equal to the marginal cost (P = MC). In the case of the numerical example, PC = 7. If this competitive price is substituted in the inverse demand equation, 7 = 40 – Q or Qc = 33. Profits are determined by solving (P – MC) Q or πc = (7 – 7) Q = 0. The competitive solution is given in equation (5.2). The outcome of this situation is uncertain. If both inmates are able to reach an agreement and “collusion” or act cooperatively, they both choose NOT to confess, and they each receive three years in prison, in the lower right result of Figure 5.6.
This is the cooperation agreement: (NO, NO) = (3,3). However, once prisoners are in this outcome, they are tempted to “cheat” the agreement by opting for a CONFESSION and reducing their own sentence to a single year at the expense of their partner. How should a prisoner proceed? One option is to look at all possible outcomes, depending on what the other prisoner chooses. The Cournot duopoly is an economic model that describes an industrial structure in which companies compete at the level of production. The model makes the following assumptions: a collusive agreement or cartel leads to a circular flow of incentives and behaviors. When companies in the same sector act independently, they are each encouraged to collude or collaborate to make higher profits. If firms can jointly determine monopoly production, they can share the profit level of the monopoly. When companies act together, there is a strong incentive to cheat on the deal in order to get higher individual profits at the expense of other members. The business world is competitive and, therefore, oligopolistic companies will strive to maintain collusive agreements as much as possible. These types of strategic decisions can be understood significantly with game theory, the subject of the next two chapters. Suppose there are two companies in the toaster market with a specific demand function. Company A determines the performance of Company B, keeps it constant and then determines the rest of the market demand for toasters.
Company A then determines its production maximizing profits for this residual demand, as if it were the entire market, and produces accordingly. Company B will simultaneously perform similar calculations in relation to Company A. Perhaps the best-known and most effective cartel in the world is OPEC, the Organization of the Petroleum Exporting Countries. In 1973, OPEC members reduced their oil production. As middle Eastern crude oil was known to have few substitutes, OPEC members` profits soared. From 1973 to 1979, the price of oil rose by $70 a barrel, an unprecedented figure at the time. In the mid-1980s, however, OPEC began to weaken. The discovery of new oil fields in Alaska and Canada has led to new alternatives to Middle Eastern oil, leading to lower OPEC prices and profits.
Around the same time, OPEC members also began cheating to increase individual profits. Many real oligopolies, driven by economic change, legal and political pressures, and the egos of their senior executives, are going through episodes of collaboration and competition. If oligopolies could maintain cooperation with each other in terms of production and prices, they could make profits as if they were a single monopoly. However, any company in an oligopoly has an incentive to produce more and gain a larger share of the overall market. When companies start to behave in this way, the outcome of the market can be similar to that of a highly competitive market in terms of price and quantity. Companies in an oligopoly can increase their profits through collusion, but collusive deals are inherently unstable. A cartel is an agreement between competing companies in order to make higher profits. Cartels usually occur in an oligopolistic industry where the number of sellers is small and the products traded are homogeneous. The cartel members can agree on these issues: price agreements, total industry production, market share, customer division, territories division, tender agreements, creation of joint sales agencies and distribution of profits. A numerical example shows the result of Bertrand`s model, which is a Nash equilibrium. Suppose two firms sell a homogeneous product and compete with each other by choosing prices at the same time while keeping the price of the other firm constant. If the demand function is given by Qd = 50 – P and the costs are summarized by MC1 = MC2 = 5.
Once established, cartels are difficult to maintain. The problem is that cartel members will be tempted to cheat on their production limitation agreement. By producing more production than it promised, a cartel member can increase its share of the cartel`s profits. Therefore, there is a built-in incentive for each cartel member to cheat. Of course, if all members cheated, the agreement would stop making monopoly profits and companies would no longer be encouraged to stay in the agreement. The problem of fraud has plagued both the OPEC cartel and other cartels, which may explain why there are so few cartels. Like the prisoner`s dilemma, it is difficult to maintain cooperation in an oligopoly because cooperation is not in the best interests of individual actors. However, the collective result would be improved if the companies cooperated and were thus able to maintain low production, high prices and monopoly profits. There are many examples of price leadership, including General Motors in the auto industry, local banks can track interest rates from a leading bank, and US Steel in the steel industry.
The dominant business model is illustrated in Figure 5.9. The supply curve for marginal firms is indicated by SF and the marginal cost of the dominant firm is MCdom. Remember that the marginal cost curve is the supply curve of the company. The dominant company has the advantage of reducing costs through economies of scale. Below, the dominant firm will set a price that marginal firms will allow to produce as much as they want, and then find the quantity and price maximising profits with the rest of the market. If the companies were able to agree, they could divide the market into stocks and collectively produce the monopoly amount by restricting production. This would lead to the monopoly price and the companies would make monopoly profits. However, in such circumstances, there is always an incentive to “cheat” the deal by producing and selling more production. If other companies in industry limited production, one company could increase its profits by increasing production, to the detriment of the other companies in the collusive agreement. We will discuss this possibility in the next section. Bertrand Duopoly: The diagram shows the reaction function of a company competing on prices.
If P2 (the price set by enterprise 2) is less than the marginal cost, enterprise 1 is valued at the marginal cost (P1 = MC). If the prices of enterprise 2 are higher than MC but lower than the monopoly prices, enterprise 1 is just below enterprise 2. . .