Why Firms Have An Incentive To Cheat On Agreements

Oligopolistic companies partner with a cartel to increase their market power and members work together to jointly determine the level of production of each member and/or the price each member will charge. Cooperation allows cartel members to behave like a monopoly. If z.B. each company sells an undifferentiated product such as oil in an oligopoly, the demand curve that each company faces will be horizontally at market price. However, if oil producers form a cartel like OPEC to determine their production and price, they will collectively face a declining market demand curve, as will a monopoly. In fact, the decision to maximize the profits of the cartel is the same as that of a monopoly, as Figure shows. Cartel members choose their combined production at the level where their combined marginal income corresponds to their common marginal costs. The price of the agreement is determined by the market demand curve at the level of production chosen by the agreement. The gains of the agreement correspond to the area of the rectangular box, called abcd in the figure.

Note that a cartel such as a monopoly will choose to produce less production and demand a higher price than could be found in a fully competitive market. Game theory provides a framework for understanding how companies behave in an oligopoly. A traditional example of game theory and the prisoner`s dilemma in practice are soft drinks. Coca-Cola and Pepsi compete in an oligopoly and are therefore very competitive against each other (since they have limited other competitive threats). Given the similarity of their products in the soft drink industry (i.e. different species of soda), any price differential of a competitor is considered an act of non-compliance or betrayal of an established status quo. Agreements to calculate the monopoly price and provide half the market each are the best thing companies could do in this scenario. However, the Nash balance alone of this model is not the only Nash balance of this model if the marginal costs that are the uncooperative result were not agreed upon and insisted. Gambling theory suggests that cartels are inherently unstable because the behaviour of cartel members is a prisoner`s dilemma.

Any cartel member would be able to make a higher profit, at least in the short term, by breaking the agreement (a larger quantity produced or sold at a lower price) than it would under the agreement. However, if the deal collapses because of resignations, companies will return to competition, profits would go down and things would be worse. Unlike pricing, pricing is a kind of informal collusion that is generally legal. The price leader, sometimes referred to as the “parallel price,” occurs when the dominant competitor publishes its price in front of other companies in the market and other companies match the advertised price. The market leader will generally set the price to maximize profits, which may not be the price that maximized the profits of other companies. By producing more production than expected, a cartel member can increase its share of the cartel`s profits. As a result, every cartel member is encouraged to cheat. If all members were deceived, the agreement would clearly no longer have monopolies and there would be no more incentive for companies to stick to the agreement. In an oligopoly, companies are interdependent; they are concerned not only with their own decisions about the quantity to be produced, but also with the decisions of other companies in the market. Game theory provides a useful framework for thinking about how companies can act in the context of this interdependence. Specifically, game theory can be used to model situations in which each player must also think about how other actors might react to this action in deciding how to proceed.

Perhaps the best known and most effective cartel in the world is OPEC, the Organization of the Petroleum Exporting Countries. In 1973, OPEC members reduced their oil production.