ChainWhat it assumes · how to break it
Start
The few large firms in an oligopoly agree to fix prices, or follow a price leader without any formal agreement, instead of competing on price.
1
As a result, the firms act together like a single monopolist, setting joint output where industry MC = MR.
cartel · joint profit maximisation
cartel · joint profit maximisation
Assumes: All the main firms take part.
But: Firms outside the agreement, or new entrants, can undercut the agreed price and win customers.
2
This means industry output is restricted, with each firm given a quota, so the price rises towards the level a monopoly would charge.
output quotas · collusive price
output quotas · collusive price
Assumes: Firms have similar costs, so they can agree on one price.
But: If costs differ, low-cost firms want a lower price and more output than high-cost firms, so agreement is hard.
3
Since each firm keeps to its quota, the high price holds over time.
cartel stability
cartel stability
Best link to attack
Assumes: No firm cheats on the agreement.
Assumes: No firm cheats on the agreement.
But: Each firm can gain by secretly cutting price or producing above its quota, so cartels are unstable, especially with many firms, falling demand or hidden prices.
4
Therefore, consumers face higher and more stable prices, with firms competing through advertising and branding instead of price.
price rigidity · non-price competition
price rigidity · non-price competition
Assumes: The collusion is not detected.
But: Cartels are illegal in the UK, and leniency for the first member to confess encourages firms to report the cartel to the CMA.
End
Prices rise towards the monopoly level and stay high and stable.
Evaluation chain
- E1However, the higher price lasts only if every firm keeps to the agreement.
- E2Because each firm can raise its own profit by secretly cutting price while the others keep theirs high, there is a strong incentive to cheat, as the prisoners' dilemma shows.
- E3As a result, collusion tends to break down, especially where there are many firms, demand is falling or prices are hard to monitor.
- E4So collusion raises prices most where there are a few similar firms with transparent prices, and its effect may be short-lived where cheating is easy to hide.
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Questions this answers
- Assess the likely effects of collusion on the prices charged in an oligopoly.
- Explain why firms in an oligopoly have an incentive to collude.
- Discuss why collusive agreements often break down.
Diagram
Cartel diagram: industry MC and MR set joint output and a monopoly-level price, with quotas for each firm. Use the kinked demand curve to show why prices stay rigid under tacit collusion, and a game theory payoff matrix to show the incentive to cheat.
Reverse and related
Breakdown of collusion (a price war) → firms compete on price and prices fall towards average cost.