Oligopoly is a market structure under which only a few suppliers dominate the market and the entrance of new suppliers is either constrained or impossible. Grebenschikov P.I., Leusskiy A.I., Tarasevitch L.S, Microeconomics, St. Petersburg 1996., p. 213 Usually, the oligopoly market is dominated by 2-10 firms, who have a joint share of the market of 50% or more. Automobile, steel, air transport are common examples of oligopolies. Or, in a global sense, we could call oil producer countries oligopolies and OPEC – a cartel. At least some firms may influence price due to their important contribution to the total output. Every firm in the situation of oligopoly knows that if it, or its competitors either change prices or output, the revenues of all the participants on the market will change. That means that firms are interdependent. For example, if General Morors Corporation decides to raise prices on its cars, it should consider retaliative moves by Ford, Chrysler, and other competitors in order to calculate the ultimate changes in sales.
It is generally assumed that every firm on the market realizes that its changes in prices or output will cause other firms to retaliate. The kind of retaliation any supplier expects from its competitors as a reaction to his changes in prices, output, or change of marketing strategy is the main factor that influences its decisions Livshits A.Y. Introduction to the Market Economy, Moscow 1991, p.159. That expected reaction also influences the balance of oligopoly markets.
Oligopolies may interact in two main ways:
Price wars, when a firm tries to increase it sales by reducing prices, expecting that other firms will not be able to respond by doing the same. This stops when no firm can low its prices anymore, which occurs when P=AC and profit equals 0. Unfortunately for consumers, price wars do not usually last long. Firms have temptations to co-operate with each other in order to set up higher prices and to share markets in such a way, as to avoid new price wars and their bad impact on revenues.
From the above factor results co-operation. Its closest form is a cartel, when a union of oligopolies acts as a monopoly. Cartels are illegal in many countries of the World.
Another reason for co-operation is to increase the entrance barriers to prevent other firms (especially the so-called hit and run firms) to join the market and drop prices. In that situation firms try to coordinate their activities.
To answer this question, I first need to describe the way agreement between oligopolies form. Let us suppose that there are 15 suppliers in the area A who want to co-operate with each other. These firms set their prices equal to their average costs. Each of the firms is afraid to raise prices for the reason its competitors might not follow that move and its profits will become negative. Let us suppose that the production is at the competitive level Qc (pic. A), that corresponds to the production quantity under which the demand curve crosses MC, which is a horizontal sum of the marginal cost curves of each supplier. MC would coincide with the demand curve if the market were perfectly competitive. Each firm produces 1/15 of the total output Qc.
Pic. А
Pm
Pc E
MR`
MC D
MR
Qm Qc Q`
The original balance exists at the point E.; the competitive price is Pc. At that price each of the producers gets normal revenue. At the price Pm, resulting from the co-operation agreement, each firm could maximize its profits by setting Pm=MC. If each of the firms does that, than there will be an over supply on the market, equal to QmQ units per month. The price would fall to Pc. In order to maintain cartel price, each of the firms should produce no more than the quota qm.
When the firms decide to co-operate, they should implement the following policies to be able to maximize their profits.
They should make sure that there exists an entrance barrier to the market in which they operate in order to prevent other firms from selling a good at an old price after they increase prices for their output. If the barriers do not exist, then the increase in prices would attract other producers. The supply would then increase and prices would fall below the monopoly level, co-operating firms aim to maintain.
They should decide on the general pattern of production. This could be done by estimating market demand and by calculating marginal profit for all levels of production. Firms need to produce so that their MC=MR (we assume that all firms have similar production costs). The monopoly production level would maximize revenues of each of the firms (see Pic. A). The demand curve for the output is in the region of D. The marginal revenue that corresponds to