Question

Explain how cartel theory and oligopoly are related. Does this imply that most firms in oligopolies are colluding? Why or why not?

Answer 1

A cartel is described as a group of companies that come together to make decisions about production and cost. Additionally, the conditions which give rise to an oligopolistic market are conducive to the creation of a cartel; in particular, cartels appear to develop in markets where there are few companies and each company has a significant market share. Cartels are illegal in the U.S.; however, there are no international limits on the creation of cartels. OPEC is perhaps the best-known example of a global cartel; OPEC leaders meet regularly to determine how much oil each cartel member will be allowed to produce.

Oligopolistic companies join a cartel to increase their market power, and members work together to jointly determine the level of output each member will produce and/or the price each member will charge. The members of the cartel can act like a monopolist by working together. Of example, if each business in an oligopoly sells an undifferentiated commodity like oil, the demand curve that each company faces at the market price will be horizontal.

Nevertheless, if oil-producing companies join a cartel like OPEC to decide their supply and value, they must face, like a monopolist, a downward-sloping market demand curve together. Indeed, as Figure reveals, the profit-maximizing decision of the cartel is the same as that of a monopolist. At the point where their combined marginal revenue is equal to their combined marginal cost, the cartel members select their combined production. The price of the cartel is determined by the curve of market demand at the output level chosen by the cartel.

When formed, it is hard to maintain cartels. The concern is that members of the cartel will be tempted to cheat on their supply control deal. A cartel member will increase its share of the profits of the cartel by generating more production than it has agreed to generate. Therefore, any leader of the cartel has a built-in incentive to cheat. Of course, if all participants stole, the cartel would stop earning monopoly income, and companies would no longer be encouraged to stay in the cartel. The question of corruption has troubled both the OPEC cartel and other cartels and maybe explains why there are so few cartels.