Question

1. Please explain how collusion makes firms in a market beter off. If there are strong incentives to collude, briefly explain why every industry or market doesn’t become a cartel?

Answer 1

A collusion is common in oligopolistic market structures where there are few sellers for the entire industry. In such cases, the firms tend to collude for price and output decisions, still keeping competition among themselves in other basis such as product quality, features, technological innovation, customer care services etc.

Let us see why firms are better off with a collusion among them;

A collusive decision on price and output on behalf of all the firms in the market, tends to make the venture profitable for all the firms in industry. Take the diagram above as an example. With collusion on decisions over price and output, firms are in a position to keep prices at (P) and quantity supplied at (Q) thus fetching them profits (Green patch). Say that the firms do not collude, this makes them to sell at point (E) with price (P1) and quantity supplied (Q1), and thus not enabling them the earn the profits that they could have.

Firms in an oligopoly understands this advantage and uses it to earn more profits. A collusion in decisions on price and output is advantageous as firms are able to sell products at a higher price, yet still keeping their autonomy and freedom in taking managerial decisions on the output that they sell, and  keeping the competition brewing in the markets.

Take a case of firms in a cartel. They are bound by a lot of rules and restriction to which they have to adhere to. Cartels tend to keep the prices very high and restrict supply of firms. Firms thus do not have the option or choice to sell the quantity they need and thus tend to cheat over cartel's regulations by increasing supply more than the set limit with an objective to earn higher profits. Firms in cartels lose autonomy and their freedom in decision making. Firms lose their creativity and the hunger for technological innovation as the market conditions set by the cartel is stagnant as there is no incentive for any innovation. There is a lot of politics that go behind the scenes in decision making of the rules and regulations that the cartel puts up. Firms eventually lose their competitive edge and freedom in decision and are simply instructed to listen to the rules set up by the cartels.

Aware of the consequences of being part of a cartel or forming one, firms in an competitive oligopolistic market, tend to collude on taking price and output decisions, yet still compete against each other over other factors such as product quality, features, technological innovations, customer services etc , and refrain from forming a cartel.