A Course project Report On Collusive Oligopoly By
Nikhil V. Edlabadkar (05317402) Ashish Hazare (05301006) Prasad Parulekar(05317302) Submitted as Course work In Applied Economics to Humanities and social science Department Indian Institute of Technology Bombay Apr 2006
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Table of contents Page no.
1.0 Introduction
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2.0 Collusive oligopoly:
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2.1 Price fixing in collusive oligopoly
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3.0 Conditions conducive for formation of cartels
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4.0 Reasons for Possible break-downs of cartels
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5.0 OPEC case study : Most successful cartel
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6.0 Collusion in Fuel Oil Public Bidding in Japan and Korea
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7.0 Conclusion
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References
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1.0 Introduction
In a perfectly competitive market it is assumed that owing to presence of many buyers and many sellers selling homogeneous products ,the actions of any single buyer or seller has a negligible impact on the market price of product .
However in reality this situation is seldom realized. Most of the time individual sellers have some degree of control over the price of their outputs. This condition is referred as imperfect competition.
Barriers to entry are the factors that make it difficult for new firms to enter an industry which lead to imperfect competition. Mostly commonly known barriers of entry are economies of scale, legal restrictions, high cost of entry and advertising and product differentiation.[1]
Imperfect competitive markets can be classified into three categories
1. Monopoly where single seller has control over the industry and no other firm exists producing a close substitute. True monopolies are rare nowdays. 2. Monopolistic competition where a large number of sellers exist selling differentiated products 3. Oligopoly is an intermediate form of imperfect competition in which only a few sellers exist in the market with each offering a product similar or identical to the others[1]. Oligopoly usually exhibits the following features: 1. Entry barriers: Significant entry barriers prevail in the market that thwart the dilution
of competition in the long run.This helps dominant firms to maintain
supernormal profits. Though many smaller firms can operate on the periphery of an oligopolistic market, but none of them is large enough to have any considerable effect on market prices and output 2. Interdependent decision-making: Interdependence implies that firms must take into account probable reactions of their rivals to any change in price, output or forms of non-price competition. 1
3. Non-price competition: Non-price competition a consistent feature of the competitive strategies of oligopolistic firms. Examples of non-price competition such as free deliveries and installation, longer opening hours (e.g. supermarkets and petrol stations),branding of products and heavy spending on advertising and marketing
If firms operate in
cooperative mode to minimize the competitions between
themselves this behaviour is called as Collusion. When two or more firms agree to set their outputs or prices to divide the market among themselves is called as collusive oligopoly.[2]
2.0 Collusive oligopoly:
There are two types collusive oligopoly
A. Price leadership – tacit collusion
This occurs when one firm has a clear dominant position in the market and the firms with lower market shares follow the pricing changes driven by the dominant firm. .
B. Overt collusion when firms openly agree on price, output, and other decisions
aimed at achieving monopoly profits. Firms who coordinate their activities through overt collusion and by forming collusive coordinating mechanisms. Such a group of independent working in unison called as cartel.
When this happens the existing firms decide to engage in price fixing agreements or cartels. The aim of this is to maximise joint profits and act as if the market was a
pure monopoly.
2.1 Price fixing in collusive oligopoly
Collusion is often explained
as a product of motive to achieve joint-profit
maximisation within a market or circumvent price and revenue instability in an industry. Price fixing can be deemed as an attempt by suppliers to control supply and fix price at a level close to the level expected from a monopoly.
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However in order to fix prices, the producers in the market must be able to exert control over market supply.
The figure 1 below depicts a producer cartel fixes the cartel price at output Qm and price Pm decided by the fact where marginal revenue of the cartel MR is equal to marginal cost MC of the cartel. The distribution of the cartel output among the cartel members could be decided on the basis of an output quota system or through mutual agreement. Although the cartel as a whole is maximising profits, the individual firm’s output quota is unlikely to be at their profit maximising point.
For any one firm, within the cartel, expanding output and selling at a price that slightly undercuts the cartel price can achieve extra profits. Unfortunately if one firm indulges in this, the other firms will probably same path same. If all firms break the terms of their cartel agreement, the result will be an excess supply in the market and a sharp fall in the price. Under these circumstances, a cartel agreement might break down.[2]
Fig.1 Price fixation by cartel and effect on partner of the firm
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3.0 Conditions conducive for formation of cartels
1. Only a small number of firms exist in the industry and barriers prevail to entry protect the monopoly power of existing firms in the long run
2. Market demand is not too variable i.e. it is reasonably predictable and not subject to erratic fluctuations which may result to excess demand or excess supply
3. Demand is fairly inelastic with respect to price so that a higher cartel price fetches increased total revenue to suppliers in the market
4. It is easier to monitor each firm’s output. This enables the cartel more easily to regulate total supply and identify firms, cheating on output quotas
4.0 Reasons for possible break-downs of cartels
Most cartel arrangements experience difficulties and tensions and some producer cartels collapse completely. Several factors can create problems within a collusive agreement between suppliers:
1. Enforcement problems: The primary objective of the cartel is to restrict total production to maximize total profits of members. But in reality each individual member of the cartel finds it profitable to raise its own production. Thus the enforcement of output quota becomes difficult for the cartel leading disputes about o sharing of the profits. Non members of the cartel may opt to take a free ride by producing close to but just under the cartel price.
2. Falling market demand during a recession creates excess capacity in the industry and exerts pressure on individual firms to reduce prices to maintain their revenue. E.g. collapse of the coffee export cartel
3. The successful foray of non-cartel firms into the industry undermines a cartel’s control of the market – e.g. the emergence of online retailers in the book industry in the mid 1990s[2] 4
4. The exposure of illegal price fixing by market regulators
Governments appoint market regulators to monitor the markets and identify the firms indulging in collusion. Collusion is undesirable from the standpoint of society as a whole, because inefficient allocation of resources at high prices. In order bring allocation of resources closer to the social optimum, policymakers try to induce firms in an oligopoly to compete rather than cooperate through instrument of antitrust laws. Regulatory bring legal suits to enforce the antitrust laws for example to prevent mergers leading to excessive market power prevent[3]
5.0 OPEC case study : Most successful cartel
Organization of petroleum Exporting countries (OPEC) was formed in 1960. Initially it contained only 5 members, the mebership of cartel however expanded to 13 by 1973. During period 1960-73, OPEC could not be reckoned as a successful cartel. In fact world oil prices declined slightly over the 1960-1970 decade.
However the situation underwent a dramatic change in 1973 with the Arab-Israel war. During the war the Arab members of OPEC temporarily cut off oil exports. The outcome was ominous: Oil prices more that tripled in a matter of months.
The
estimated price of a barrel of oil on the world market was $2.91 in 1973 but jumped ot $10.77 in 1974.This demonstrated that output restriction could wreak havoc After resuming exports OPEC continued to hold down output. Subsequently, oil prices remained relatively stable. However another jolt was inflicted in 1978 when revolution took place in Iran. Iranian exports at that time accunted for 20 percent of all OPEC ex-ports, fell almost to zero. Prices escalated once again and the new government in Iran continued to limit exports, maintaining prices at high levels. The Iran-Iraq War, which started in 1980, resulted in the extensive destruction of oilproducing facilities in both counties and brought down oil exports further.
The relative success of OPEC can be attributed to the following advantegs it has enjoyed relative to other cartels. 5
1. The price elasticity of demand for oil, especially in the short run, is quite low, implying that moderate output restrictions will produce large price increases- a favorable environment for a cartel. In 1973 OPEC output contributed to two-thirds of the total world oil production, 2. In 1975 OPEC countries held 70 percent of the world’s proven oil resources which imparted it a substantial market power. 3.
OPEC contains a few members, many of the internal problems that usually trouble a cartel are reduced e.g. reaching agreements, monitoring the output and coordinating price policies of individual members, is simpler with a few members involved. In fact, since just four countries (Saudi, Arabia, Kuwait, Iran and Venezuela) regulate ¾ of OPEC’s oil reserves, the effectiveness of cartel is further enhanced.
4. The biggest danger to a cartel comes from the increased production by nonmembers. However exploration, production and building new supplies is time consuming hence this gives OPEC significant short-run power. 5. OPEC has also been benefited by policies of oil importing nations.e.g In the United states for example, price controls on oil and gas kept the price received by domestic oil producers artificially low and discouraged production and exploration.. In addition, tough environmental restrictions on the mining and use of coal slowed the transition to coal as another energy alternative. On one hand domestic consumption was encouraged and production was discouraged resulted in additional demand for oil from OPEC and the United states inevitably became more dependent on imported oil during the 1970s.
But the situation had changed dramatically by early 1982. In March 1982 the price for Saudi Arabian light crude oil was $29 a barrel, down in real terms more that 30 percent from a year earlier. So also the fraction of oil production had fallen to 40 percent by 1984. This ultimately resulted in erosion of power of OPEC.[4]
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6.0 Collusion in Fuel Oil Public Bidding in Japan and Korea[5]
Case study 1: Japanese Case
This case study is of the collusive oligopoly of the participants in bids foe oil delivery work ordered by the Self-Defense Forces of Japan. The three reasons why this industry is more conducive to collusion are there is not so large payoff in deviation than in collusion, larger gain in bid rotation than in competition and sufficiently large discount factor. This section will discuss the collusive oligopoly behavior of the eleven oil companies, which had engaged in bid rigging in oil procurement by the defense facilities administration agency. The defense facilities administration agency orders almost all gasoline, kerosene, diesel oil, crude oil, and jet fuel by means of designated competitive bidding. In the bidding only those companies were allowed to participate who registered the list with some qualification. The agency had to do bidding for six to seven times per year for their procurement and each competitive bidding were involved different type of oil and location of bases. The agency was following the specific process for the procurement. First, the agency makes designations of competitive bidding i.e. low price bidding depending upon the t ype of oil and location of bases. And when no participant reaches the agency’s estimated price for the contract, the bidding process is repeated. This process is repeated three times. And after that also if no bidder agrees with the price set by the agency then the agency negotiates with the company whose bid was minimum in the last round of bidding so that they can agree upon the some intermediate price. If there is no agreement on the price between agency and the company, then the agency terminates the negotiation calls for fresh bidding. And this time the price set lower than previous. This lower price depends on the negotiation with the lowest bidder. These eleven oil companies decide among themselves that who will win the competitive bidding. This is decided by the companies depending upon the quantity and profit a firm got from bidding from this agency. For every bidding all these company holds the meeting to decide who will be the successful bidder. They choose the successful bidder based on a plan to distribute the jet fuel bids among the firms made by a manager of Cosmo Oil Corporation. The manager was the fixer of this case. Depending upon the type of oil like gasoline, kerosene, diesel and crude oil they
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reveal their primary interest to each other, which are their preferential base and items as well as their individual evaluation of the base and items. If the bidding involves only one bidder then he gets the contract but if the bidding involves more than one bidder then who will get the contract is decided by the Cosmo manager depending upon the profit acquired by the firms in previous year. If there are no firms bidding, then the Cosmo manager awards the contract to a firm. All of them have a consensus of ill usage of the procurement system and practice. The actions are decided in advance to how to cheat the agency. Whenever the agency asks from the companies for bid, the companies sets very high price, which is unacceptable to agency. Again the agency asks for bidding and again these entire again sets very high price for contract. This process is repeated thrice and in the subsequent processes all the players other than one, who was decided to be the successful bidder, declines the bid. This successful bidder as decided earlier by companies bids lowest. Then the company negotiates with the company for any agreement but as decided by the firm they do not reach any consensus. Finally, the agency establishes a new estimated price for the contract and another designated competitive bidding based on the new estimated price. Now the lowest bidder who had proposed price to the agency accepts the new estimated price and all other companies help him in this by not participating in the bid as planned. These eleven companies had been receiving almost every order from the agency in such a manner, respectively.
Case study 2: Korean Case
The oil bidding and acquisition system: Based on the demand of military annually, the acquisition office of the Ministry of National defense concludes oil acquisition contracts for each bidding company after the Ministry completes the designated competitive bidding. This bidding formality is of two types: First is unit price bidding, this bidding involves competition in terms of unit price for a contract within the annual budget. The second is request quantity bidding. When it is necessary to acquire many goods, this bidding involves competition in terms of unit price and ability to supply a specific quantity of the goods. The office of the Ministry announces the year’s bidding schedule in the beginning of the year, then collects bidding firms’ application price for the Ministry 8
of Commerce, Industry and Energy. The office estimates the price for a contract, then conducts bidding to acquire a winning bid. When no bidder meets the estimated contract price, then the office raises the contract estimate and announces a new round of bidding and the process is repeated. Five oil companies including SK, LGCaltex, and S-Oil, When they participate in oil acquisition bidding, before the bidding, executives of the firms meet agree on who will be the successful bidder, price, and dummy price for all schedules of the military oil bidding and implement these things jointly. Different points (in two cases)
In the case of Japan, the participants decide on the successful bidder for every bidding round In the case of Korea, the participants decide on the successful bidder, price, and dummy price for all schedules of the military oil bidding before making their respective bids. The Japanese case involves twelve participants, the Korean case five. Each firm in Japan and in Korea has an independent and different cost and benefit function. Japanese bidding is segmented base-by-base and oil-by-oil; Korean bidding is unit price bidding.
Common points (in two cases)
The purchaser is the only governmental entity. The participants are fixed; Japan is almost all of twelve firms, and Korea is all of five. The bidding is scheduled more frequent of the year in Japan or annually in Korea.[5] 7.0 Conclusion
Collusive oligopolies is more like a monopoly. However it is very fragile since selfinterest to earn maximum profit of member can tip off the balance and can lead to price war. The success of collusive oligopoly is quite dependent on the number of firms in involved and their level of cooperation. It can be observed that it is difficult to maintain cartels in the long run with an exception of OPEC. Policymakers regulate the behavior of oligopolists through the antitrust laws. The proper scope of these laws is the subject of ongoing controversy.
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References:
1.0 Samuleson
Paul S. and Nodhaus William D., Economics, 6th edition, Tata
McGraw Hill ,1998 2.0 URL/www.tutor2u.net 3.0 Mankiw .G.N., Principles of microeconomics 2nd edition, Harcourt, Brace, Jovanovich Publishing. Company, 2001 4.0 Browning E.K and Browning J.M., Microeconomic Theory and Applications, 2nd edition, Little,Brown and company,1986 5.0 :URL/aslea.org/paper/aria.pdf
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