The firms have no option, but to cooperate formally or informally so as to reduce uncertainty of rivals’ actions. This is ensured by having some sort of understanding among the firms regarding price fixation, leadership or market sharing.
In the absence of mutual understanding in the oligopolistic markets, price wars may emerge due to price competition. However, difficulties crop up in reaching and maintaining such understanding, particularly, in the case of differentiated oligopoly (which is more common than pure oligopoly). Some important collusive models are discussed here.
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(A) Explicit Collusion (Cartels):
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Cartel is a sort of almost perfect collusion model, where the firms recognise their interdependence and collaborate in the matter of price fixing. The organisation of petroleum exporting countries (OPEC) is the most prominent cartel, which serves the common interests of its members.
In India, tyre, cement and synthetic fibre industries coordinate their actions and influence public policy through fairly vocal industrial associations. The oligopoly, here, is better in a ‘cooperative mode’ than in a competitive one. The cooperation may be subtle, informal and manifestly unnoticeable.
The extent of success under cartels depends on Government legislations (MRTP Act, Companies Act, etc.), level of entry barriers, attitudes of managements, and nature of demand as well as cost conditions and so on. Coordination will be difficult, if the market demand is booming and there is enough scope for at least some firms to expand.
The ideal conditions for coordination are provided by combination of weak demand, excess capacity, low entry barriers and weakly differentiated products. In the extreme case, when oligopolistic coordination is perfect, all the firms may be able to act as a monopolist and maximise joint industry profits.
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In such a case of pure oligopoly, the pricing would be similar to that under pure monopoly with multi-plant operations (see Chapter 14 on Pricing under Monopoly under heading ‘Equilibrium of Multiplan Monopolist’. In this method of pricing, all firms in the industry sell at the same price, determined by the condition MCA = MCB = ——– = MC = MR.
However, their outputs and profits may not be equal. The cost efficient firms will make more profits than others. Some firms might even lose under this system of pricing. The differences in the profits may even threaten the survival of the cartel. Efficient firms can avoid the problem of breakdown of the cartel by transferring a part of their profit to the less efficient firms.
Cartel with perfect collusion has a number of advantages. It avoids price war among the rivals. As a result, each firm gains at the cost of the consumers. Further, as the firms operate like a pure monopolist, their joint profits under perfect collusion would generally be more than the total profit that all of them together would have made, had they acted independently or through any partial collusion or no collusion.
In other words, aggregate profit would generally be more under the perfect collusion model than in any other model of oligopoly pricing. But, the profit of an individual oligopolist as obtained through the above procedure could, of course, be less than what it could have made without collusion. Still, in that case also, the loss could be more than compensated through the transfer of a part of extra profit of some other oligopolist, so as to survive the cartel.
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Cartel system is not free from a number of shortcomings. Firstly, the consumers revolt against this system, as they are adversely affected by it in the form of high prices and restricted outputs. Secondly, the possibility of arriving at a common understanding would be difficult, particularly, when the number of firms under oligopoly is large or the product is differentiated.
Thirdly, some firms may enter into secret dealings on under cutting of price in order to raise their profits. Fourthly, during the period of recession or bumper crops, all the oligopolists would suffer and a suffering unit can hardly afford to be honest. Thus, certain countries have provisions for legal barriers on the formation of cartel.
(B) Tacit Cooperation (Price Leadership):
Price leadership is regarded as imperfect collusion among the oligopolistic firms, where all firms follow the lead of one firm. The firm which takes the initiative of setting the price and announcing the changes in price from time to time is called as price leader.
He fixes the price by tacit understanding rather than formal agreement. The price leader is generally a leader in all the markets for long periods. He can maintain his leadership by pursuing a definite and a consistent price policy, i.e., by using his power with restraint.
The leader should change the price, when he feels that the change in cost and demand conditions are permanent to maintain followers’ loyalty, i.e., when the market is ready for the change. Other firms in the industry, which match the leader’s price and variation over time, are called as price followers.
Price leadership is more common in natural and stable markets, where highly standardised products like steel, oil, cement, etc., are produced. However, price leadership can prevail under both pure as well as differentiated oligopoly. In U.S.A., General Motors is considered the leader of the U.S. car industry. It is important to note that if an inefficient firm becomes the leader, the outcome would be unfavourable.
Price leadership may be dominant or barometric. Under dominant price leadership, the leader firm is large and powerful enough to fix a price, which all other firms will be forced to follow. Each follower firm takes this market price as given and produces the output at which marginal cost equals marginal revenue (or the price set by the price leader).
Here, the dominant firm acts as a monopolist, who maximises profit by taking the supply curve of the followers as given. While, the followers offer products at competitive prices, dampening the control of dominant firm over the market price.
The leader gets only the residual share of the market. If the market share of the followers goes up, the monopoly power of the leader suffers. Therefore, in this version, the equilibrium price is lower than what would be obtained by a pure monopolist.
The dominant firm can maintain its dominance in the market by innovating on ‘non-price competitive areas’, i.e., new brands, product improvements, promotion, distribution, dealer concessions, free gifts, easier credit terms, free home delivery, after sales services, longer period of guarantee, etc. or by keeping the market price low enough to deter entry.
When this leader firm sets a very low price, it may force some of the firms to leave the industry. On the other hand, under barometric price leadership, leader firm (not necessarily dominant firm) is regarded as a wise firm, which sets the price reflecting the market forces and the needs of the other firms in the industry. Any alternation in price cannot be done by a barometric firm in an arbitrary fashion, as the dominant price leader can do.
It is clear from the two types of price leadership explained above that price leadership arises through cost or productive capacity advantage. Low cost firm can withstand the losses of a price war and grab leadership through lower price.
Such firm can increase market share by snatching large and profitable markets from conservative rivals. It is presumed to have the greatest stake in the welfare of the industry; the greatest power to enforce followership, the greatest capability of demand forecasting, the best informed about market demand-supply conditions so as to determine the price policy of the entire industry. Besides this, long-term profit history, sound management and product innovation by a firm may also lead to price leadership.
Advantages of Price Leadership:
Though a large firm can exert a decisive influence on the level of prices, small firms can also provide troublesome competition by pursuing a flexible pricing policy. These small firms with less regular clientele may take the initiative of reducing prices to improve their cash position.
A large firm should not forget that a competitor charging a low price must not necessarily suffer a loss. Therefore, a large firm should think twice before starting a price war against the small firms to drive them out. Even if some small firms are eliminated from the market, new small firms may be established in a course of time.
Furthermore, it is better to have some competition, no matter how insignificant it is. Thus, it will pay both large firm as well as small firms to act as a leader and followers respectively by operating under price leadership.
Price leadership has a number of advantages both for followers as well as for leader. Price leadership reduces the number of possible reactions to a price change and thus provides an element of certainty to the pricing aspects of forecasting.
The leader influences the price in the direction of stability, even during boom and depression periods by dampening the amplitude of cyclical fluctuations. The price leader exerts his power to stop a sharp and rapid reduction in price on the part of any firm, for which he will have to strive hard, particularly, when a product has more inelastic demand.
Further, price leadership avoids the severe price wars. Finally, small firms lacking adequate insights into the principles of costing can safely avoid the expenses on market surveys as well as production and cost analysis by adopting the sound judgement of a price leader.