Essay on Oligopoly and Collusion

Here is what I feel is a superbly clear and well-structured essay answer to a question on the economic and social effects of collusion within an oligopoly.

Question

Evaluate the view that collusion between firms in an oligopoly always works against consumer and society’s interests. Use game theory in your answer.

KAA 1:

An oligopoly is where the industry or market is dominated by a few producers/firms with a high level of market concentration, where the component firms have a high level of interdependent decision making. Collusion can be tacit and/or explicit, and the aim of which is to achieve higher supernormal profits, with the firms as a whole achieving joint profit maximisation. Collusion between firms is harmful to consumers. This is because firms collude to raise prices, as mentioned earlier, resulting in the price level seen below. This reduces the consumer surplus available, reducing the welfare of individuals. This can often be highly regressive, if the impact of increased prices, such as with the Big Six Gas Suppliers, has a disproportionate impact on the less well off. Furthermore, because firms are working together, with internal quotas to divide up sales, there is less need to compete, resulting in less dynamic efficiency. This results in less innovation, and thus little improvement in the quality of products available to individuals. Indeed, the UK Competition and Markets Authority supports this claim, arguing that collusion can result in “reductions of output, efficiency, innovation and choice, all of which are harmful to consumers.” An example of this can be seen with Apple, who were sued by consumers for price-fixing with publishers to force consumers to over pay for e-books.

EVAL 1:

However, collusion between firms can often derive benefits for consumers. For instance, tacit collusion includes firms who monitor what other firms sell to ensure that they are matching the cheapest price in a geographical area, or who market that consumers are “never knowingly undersold” such as John Lewis. This is a case in which firms are technically engaging in tacit collusion, but which may also result in driving down of prices as firms seek to match improvements in cost efficiencies made by other firms. This is also true with products such as mobile phone contracts where it is easy to compare prices.

KAA2:

Collusion in an oligopoly can hugely benefit firms, which can have beneficial consequences for society. For instance, collusion between coffee growers allows small firms to push for fairer prices against more dominant monopsonistic corporations such as Starbucks. Furthermore, because these producer cooperatives like Fairtrade are often based overwhelmingly in less developed regions, this can also be useful in helping to alleviate extreme poverty. Furthermore, collusion allows for firms to lower the costs of competition, that can then be passed onto consumers. Because oligopolies exist in highly concentrated markets dominated by a few firms, there is often a huge degree of branding and differentiation that needs to take place in order for firms to stand out, e.g. with the UK retail banking industry with firms such as Barclays and HSBC. If all firms engage in marketing wars, there is no net societal benefit. However, if firms collude, they can reduce the need to fund these marketing wars, that can allow for cost savings to be passed onto consumers. Additionally, collusion allows for agreed upon industry standards, for instance with procedures in testing on humans in pharmaceutical research, which benefits both consumers and firms.

EVAL 2:

However, the extent to which this occurs depends on a few factors. Firstly, the vast majority of collusion that takes place isn’t that of poor farmers working together - oligopolies are more concentrated industries with very high barriers to entry, such as the Big Four Accountancy Firms, and pharmaceutical companies. Furthermore, the benefits that accrue from firms working together are dependent on those firms passing those cost savings onto consumers - however, if they are all explicitly colluding, they may decide to spend that money on share buy-back schemes and dividends, which may not benefit society at large. Indeed, in 2017, US firms spent more money on share buy-backs than they did on research and development. Lastly, the benefits from firms agreeing upon industry standards are likely to be very marginal given the government and regulatory bodies, such as the Financial Conduct Authority (FCA) tend to set industry standards centrally.

Conclusion:

In conclusion, the extent of the impact on consumers and firms depends fundamentally on how long the oligopoly is able to carry on collusion - we can analyse this through game theory. Assuming the following pay offs in a cartel such as OPEC, where states agree to collude to reduce production levels and benefit from a higher price:

If all firms cooperate, they will achieve £4bn revenue. However, if one firm decides to defect and to increase production while still gaining from higher prices, they will gain £5bn. The socially optimal equilibrium in this model (for firms) is to cooperate, because the total utility is greater than any other option. However, this is an unstable equilibrium: no matter what the other firm does, each agent is better off by defecting, resulting in a Nash equilibrium of Defect, Defect. Indeed, this model can be shown by how in October 2018, Iran accused Saudi Arabia and Russia of breaking OPEC’s agreement on cutting output. Thus, the effects of collusion are very much dependent on how long it is able to last.

Author: Cary Godsal (February 2019)

More resources available here on the topic of oligopoly