Price Rigidity, Cartels and Price Leadership Model

16/04/2020 0 By indiafreenotes

Price Rigidity

In oligopoly, price rigidity means: Once equilibrium price is determined by sellers (which are few in numbers and are interdependent in their behavior). After that! no one, wants to change for simple reasons:

  • If one is going to increase the price then others will grab the market share without doing the same.
  • If one is going to decrease the price then every one will follow the same
  • Ultimately, in both cases the profit maximization condition will not be satisfied.
  • So, in oligopoly price becomes rigid nobody want to change it.

Cartels and Price Leadership Model

In order to avoid uncertainty arising out of interdependence and to avoid price wars and cut throat competition, firms working under oligopolistic conditions often enter into agreement regard­ing a uniform price-output policy to be pursued by them.

The agreement may be either formal (open) or tacit (secret). But since formal or open agreements to form monopolies are illegal in most countries, agreements reached between oligopolists are generally tacit or secret. When the firms enter into such collusive agreements formally or secretly, collusive oligopoly prevails.

But collusions are of two main types:

(a) Cartels and

(b) Price leadership.

In a cartel type of collusive oligopoly, firms jointly fix a price and output policy through agreements. But under price leadership one firm sets the price and others follow it. The one which sets the price is a price leader and the others who follow it are its followers.

The follower firms adopt the price of the leader, even though they have to depart from their profit-maximising position, as they think that it is to their advantage not to compete with their leader and between themselves.

Originally, the term ‘cartel’ was used for the agreement in which there existed a common sales agency which alone undertook the selling operations of all the firms that were party to the agree­ment. But now-a-days all types of formal or informal and tacit agreements reached among the oligopolistic firms of an industry are known as cartels.

Since these cartels restrain competition among the member firms, their formations have been made illegal in some countries by the Govern­ments passing laws against them. For instance, the formation of a cartel is illegal in U.S.A. under the Anti-Trust Laws passed there. However, in spite of the illegality of cartels they are still formed in U.S.A. through secret devices and by adopting some means or the other shrewd businessmen are able to evade the anti-monopoly laws.

Formal collusion or agreement among the oligopolists may itself take various forms. An extreme form of collusion is found when the member firms agree to surrender completely their rights of price and output determination to a ‘Central Administrative Agency’ so to secure maximum joint profits for them.

Formation of such a formal collusion is generally designated as perfect cartel. Thus under perfect cartel type of collusive oligopoly, the price and output determination of the whole industry as well as of each member firm is determined by the common administrative authority so as to achieve maximum joint profits for the member firms.

The total profits are distributed among the member firms in a way already agreed between them. The share from total profits of each member firm is not necessarily in proportion to the output quota it has to supply and the cost it incurs on it.

The output quota to be produced by each firm is decided by the central administrative authority in such a way that the total costs of the total output produced is minimum. In fact, under perfect cartel, the central authority determines the separate outputs to be produced by the various members and the price they have to charge in the same way as a monopolist operating multiple plants would do.

Now, the question arises as to what outputs different firms in a cartel will be asked to produce so that the total cost is made minimum. Total cost will be minimised when the various firms in the cartel produce such separate outputs so that their marginal costs are equal.

This is because if the marginal costs of the member firms are not equal, then the marginal units of output could be produced at a smaller cost by the firms with a lower marginal cost than by those with a higher marginal cost.

Let us now see how the cartel works and determines its price and output. Let us assume that two firms have formed a cartel by entering into an agreement. We assume that the cartel will aim at maximizing joint profits for the member firms.

First of all, the cartel will estimate the demand curve of the industry’s product. As the demand curve facing a cartel will be the aggregate demand curve of the consumers of the product, it will be sloping downward as is shown by the curve DD in Fig. 1(c) Marginal revenue curve MR showing the addition to cartel’s revenue for successive additions to its output and sales will lie below the demand curve DD.

Cartel’s marginal cost curve (MCc) will be given by the horizontal addition of the marginal cost curves of the two firms. This has been done in Fig. 1(c) where MCc curve has been obtained by adding horizontally marginal cost curves MCa and MCb of firms A and B respectively.

It should be noted that cartel’s marginal cost curve MCc, obtained as it is by horizontal addition of marginal cost curves of the two firms, will indicate the minimum possible total cost of producing each industry output on it; each industry output being distributed among the two firms in such a way that their marginal costs are equal.

Now, the cartel will maximize its profits by fixing the industry’s output at the level at which MR and MC curves of the cartel intersect each other. It will be seen in Fig. 1 (c) that MR and MC curves cut each other at point R or output OQ. It will also be seen from the demand curve DD that the output OQ will determine price equal to QL or OP.

Having decided the total output OQ to be produced, the cartel will allot output quota to be produced by each firm so that the marginal cost of each firm is the same. This can be known by drawing a horizontal straight line from point R towards the Y-axis.

It will be seen from the figure that when firm A produces OQ1 and firm B produces OQ1 the marginal costs of the two firms are equal. The output quota of firm A will be OQ1 and of firm B will be OQ1. It is worth noting that the total output OQ will be equal to the sum of OQ1 and OQ2.

Thus, the determination of output OQ and price OP and the outputs OQand OQ2 by the two firms A and B will ensure the maximum joint profits for the member firms constituting the cartel. It will be seen from Fig. 1 (a) that with output OQ and cartel price OP. the profits made in firm A are equal to PFTK and with output OQ, and cartel price OP the profits made in firm B are equal to PEGH.

The sum of the profits, that is, the joint profits made by the cartel will be maximum under the given demand and cost conditions as they have been arrived at as a result of equating combined marginal cost (MCc) with the combined marginal revenue (MRc).

The allocation of output quota to each of them is made on the grounds of minimizing cost and not as a basis for determining profit distribu­tion. Prof. J.S. Bain rightly says, “There is no particular reason for believing that the operating firms will retain just the profits resulting from the sale of their quotas, which are determined on cost grounds alone. Relative bargaining strengths will presumably determine the division of profits.”

Market -Sharing Cartels

The formation of perfect cartels, as described above, has been quite rare in the real world even where their formation is not illegal. In a perfect cartel not only the price but also the output to be produced by each member of a cartel is decided by a central management authority and profits made in all of them are pooled together and distributed among the members according to the terms of a prior agreement.

But when cartels are loose, instead of being perfect, the distribution of profits and fixation of outputs of individual firms are not determined in a manner perfect cartel does. In a loose type of cartel the market-sharing by the firms occurs. Further, there are two methods of market sharing: non-price competition and quotas.

Market-Sharing by Non-Price Competition

Under market sharing by non-price competition, only a uniform price is set and, the member firms are free to produce and sell the amount of outputs which will maximize their individual profits. Though the firms agree not to sell at a price below the fixed price they are free to vary the style of their product and the advertising expenditure and to promote sales in other ways.

That is, the price being a fixed datum, the firms compete on non-price basis. If the different member firms have identical costs, then the agreed uniform price will be the monopoly price which will ensure maximization of joint profits. But when there are cost differences between the firms as is generally the case, the cartel price will be fixed by bargaining between the firms. The level of this price will be such as will ensure some profits to high-cost firms.

But with cost differences such loose cartels are quite unstable. This is because the low cost firms will have an incentive to cut price to increase their profits and therefore they will tend to break away from the cartel. However, they may not openly charge lower price than the fixed one and instead cheat the other firms by giving secret price concessions to the buyers. However, as the rivals gradually loose their customers, the cheating by the low-cost firms will be ultimately discovered and consequently open price war may commence and cartel breaks down.

Market-Sharing by Output Quota

The second type of market-sharing cartel is the agreement reached between the oligopolistic firms regarding quota of output to be produced and sold by each of them at the agreed price. If all firms are producing homogeneous product and have same costs, the monopoly solution (that is, the maximization of joint profits) will emerge with the market being equally shared by them.

However, when costs of member-firms are different, the different quotas for various firms will be fixed and therefore their market shares will differ. The quotas and market shares in case of cost differences are decided through bargaining between the firms. During the bargaining process, two criteria are usually adopted to fix the quotas of the firms.

One is the past level of sales of the various firms and the second is the productive capacity of the firms. However, the past-period sales’ and ‘productive capacity’ of various firms are not very firm criteria as they can be easily manipulated. Ultimately the quotas fixed for various firms depend upon their bargaining power and skill.

The second common basis for the quota system and market sharing is the division of market region-wise, that is, the geographical division of the market between the cartel firms. In this arrange­ment, price and also style of the product of cartel firms may vary.

It is worth noting that all types of cartels are unstable when there exists cost differences between firms. The low cost firms always have a tendency to-reduce price of the product to maximise their profits which ultimately results in the collapse of the collusive agreement.

Further, if the entry of firms in the oligopolistic industry is free, the instability of the cartel is intensified. The new entrants may not join the cartel and may fix a lower price of the product to sell a large quantity. This may start a price war between the cartel firms and the new entrants. We thus see that the stability of the cartel arrangement is always in danger.