Question

if members of an oligopoly collude, what happens to output, price and profits?

Answer 1

Firms in an oligopoly can increase their profits through collusion, but collusive arrangements are inherently unstable. Oligopoly is a market structure in which there are a few firms producing a product. When there are few firms in the market, they may collude to set a price or output level for the market in order to maximize industry profits. As a result, the price will be higher than the market-clearing price, and output is likely to be lower. At the extreme, the colluding firms may act as a monopoly, reducing their individual output so that their collective output would equal that of a monopolist, allowing them to earn higher profits.

If oligopolists individually pursued their own self-interest, then they would produce a total quantity greater than the monopoly quantity, and charge a lower price than 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, because the most efficient firms will be tempted to break ranks by cutting prices in order to increase market share.

Several factors deter collusion. First, price-fixing is illegal in the United States, and antitrust laws exist to prevent collusion between firms. Second, coordination among firms is difficult and becomes more so the greater the number of firms involved. Third, there is a threat of defection. A firm may agree to collude and then break the agreement, undercutting the profits of the firms still holding to the agreement. Finally, a firm may be discouraged from collusion if it does not perceive itself to be able to effectively punish firms that may break the agreement.

In contrast to price-fixing, price leadership is a type of informal collusion which is generally legal. Price leadership, which is also sometimes called parallel pricing, occurs when the dominant competitor publishes its price ahead of other firms in the market, and the other firms then match the announced price. The leader will typically set the price to maximize its profits, which may not be the price that maximized other firms’ profits.