supernormal profit is competed away. Obviously the price will be £40 in this
case, and the total market output will be 180 units (from the demand
equation).
If the firms form a cartel they can charge the monopoly price. In order to
determine this we have to determine the output where MC¼MR. This is done
as follows:
P=400-2Q
R=400-2Q 2
MR=400-4Q
MC=40
400-4Q-40
4Q=360; Q=90
P=400-2(90)=£220
In this case the industry will make a profit given by
(P-AC)Q=(220-40)90=£16;200:
Thus, assuming that the profits are shared equally, each firm can make a profit
of £8,100. This is clearly preferable to the competitive situation. At this stage
we are ignoring the more complicated situation where the firms compete in
terms of output by considering what output the other firm will put on the
market. This is called Cournot competition, and both Cournot and Bertrand
competition are discussed in the next chapter.
Although both firms can make supernormal profit by forming a cartel, this
profit can only be sustained if the firms agree to restrict total output. This
usually involves setting output quotas for each firm; in the above example the
quotas would be 45 units each. The enforcement of output quotas creates a
problem for cartels; each member firm can usually profit at the expense of the
others by ‘cheating’ and producing more than its output quota, thus making
the cartel unstable. We now need to consider the factors that affect the likelihood
of success of a cartel.
b. Factors affecting success of a cartel
There are a number of factors that are relevant, and the most important ones
are examined here.
1. Number of sellers. As the number of sellers increases it is more likely that
individual firms will ignore the effects of their pricing and output on other
firms, since these will be smaller. A big increase in one firm’s output will not
have as much effect on the industry price when there are a dozen firms in the
industry than when there are just two firms. Furthermore, firms are more likely
to have disagreements regarding price and output strategies if there are more
firms, and therefore they are again more likely to act independently. This has
been a problem for OPEC because of the relatively large number of members.
OPEC’s problems are increased because, having once controlled 55 per cent of
world oil output, it currently only controls less than 30 per cent.
2. Product differentiation. Co-operation is easier for firms if they are producing
a homogeneous or standardized product, because in this case the firms
can only compete in terms of price. With differentiated products competition
can occur over a whole array of product characteristics. Even with a product
like crude oil there is not complete homogeneity; there are different grades
according to country of origin, and sellers can also vary payment terms as a
form of competition.
3. Cost structures. As with differences in product, differences in cost structures
can make co-operation more difficult. Co-operation is also more difficult in
capital-intensive industries where fixed costs are a high proportion of total
costs. This is because if firms are operating at less than full capacity it is possible
to increase profits considerably by increasing output and cutting prices.
4. Transparency. If the market is transparent it will not be possible for a firm
to undercut its competitors secretly. Cartels may therefore take steps to publicize
information regarding the transactions of members in order to prevent
them from conducting secret negotiations. However, it may still be possible to
hide certain details of transactions, such as payment terms, which in effect can
amount to a price reduction.
Because many of the above characteristics have not been favourable, many
cartels have proved to be unstable in practice, and have been short-lived.
Again, the stability of cartels is examined in the next chapter, since the behavior
of the members tends to conform to a repeated game. Some cartels in
Europe that have in the past enjoyed government protection, for example the
coal and steel industries, are now also in trouble; recent pressures related to
competition in the so-called single market have undone much of this valued
protection. However, recent protectionist measures by the US administration
involving these industries and others may change this picture to some extent.
These aspects of government policy will be examined in more detail in
Chapter 12.