Economics Online Tutor
Oligopoly: Cooperation
The prisoner's dilemma model illustrates that firms in oligopoly can be better
off if they are able to cooperate rather than compete. If they cooperate in the
form of a secret agreement, this is called collusion. The practice of collusion is
illegal in the United States and many other nations, but it is not illegal in all
nations.

Cooperation might make firms better off, but at the same time it is likely to
make consumers worse off. Cooperation often means higher prices and lower
quantities for consumers. Cooperation also reduces the incentive for firms to
develop new and improved products. This could lead to domestic industries
losing out to foreign competitors who are not a party to any cooperative
agreements.
One method that firms in oligopoly may use to cooperate is called price leadership. In the price
leadership method, one firm changes its price, and other firms automatically match the price change.

You can see an example of this in virtually every neighborhood in the united states. When one gas
station changes its price, every other gas station in the same neighborhood will change to the exact
same price on the same day.

Different strategies can be employed to determine which firm is the price leader. One is to have the
largest firm set the price, and then other firms follow suit. This method appears to be useful in markets
where one firm is a dominant firm.

Another strategy is to have the lowest-cost firm be the price leader.

Another strategy that is commonly used in real world situations is to have a barometric firm set the
price for others to follow.

The barometric firm would be a firm that makes a public announcement, such as through a press
release, of its intentions to change prices. In this public announcement, it will explain the reasons for a
price change, such as trends in the costs of production. This would be a signal for other firms to match
the price change.

Still another price leadership strategy would be for firms to hide their cooperation by using secret
codes. They could agree to rotate the firm that is the price leader through a secret method in order to
avoid having consumers and regulators know about this strategy. However, this strategy falls under
the category of collusion.

Price leadership eliminates the kink in the demand curve, since both price increases and price
decreases will be followed.

It also eliminates the prisoner's dilemma, since each firm will have knowledge of the strategy of the
other firms.
CARTEL

A cartel is an organization of firms in an industry that agrees to restrict competition between its
members in order to maximize the profits of the entire organization. All members of a cartel agree
formally or informally to set prices and / or output levels as if the cartel were a monopoly.

An international cartel is a cartel composed of firms from different countries.

Since profits are maximized for the cartel as a unit, and not for individual firms in a cartel, an incentive
to cheat exists. If one firm in a cartel can find a way to secretly break the agreement, such as by selling
more output at a lower price, that firm will be able to increase its profits over what it could make within
the agreement. This would decrease the profits of the cartel as a unit.

Such cheating can easily break up the cartel, especially if the cheating is detected; all firms would then
be made worse off. Enforcement of agreements is the key to avoid cheating that will break up a cartel.
Because of the incentive to cheat, most cartels are not successful for very long.  The conditions
necessary for a successful cartel include:

  • few firms in the industry
  • significant barriers to entry
  • identical products
  • few opportunities for secret actions
  • no legal barriers to sharing agreements
Cartels are generally illegal in the United States and many other countries. However, international
cartels are not illegal. The most famous cartel, OPEC (the organization of petroleum exporting
countries), is an international cartel whose enforcement mechanism is aided by the fact that its firms
are actually the countries themselves rather than private organizations.

Even in the United States, where cartels are illegal, some cartel-like organizations are endorsed by the
government. The NCAA (national collegiate athletic association) is a cartel of colleges and universities
with a governing board that sets and enforces rules. Congress has granted Major League Baseball a
special exemption to antitrust laws in order to allow it to function as a cartel.
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