When Firms In An Industry Reach An Agreement To Fix Prices

Sometimes companies do not fail with each other, even if cooperation leads to a better collective outcome. The prisoner`s dilemma is a canonical example of a game that is analyzed in game theory and shows why two individuals may not work together, even if it seems that it is in their best interest to do so. An agreement is an agreement between competing companies to obtain higher profits. Agreements generally occur in an oligopolistic industry where the number of sellers is low and the products marketed are homogeneous. Cartel members can agree on price fixing, total industry production, market share, customer distribution, allocation of territories, supply manipulation, creation of common distribution agencies and profit sharing. 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. If the oligopolists pursued their own interests individually, they would then produce a total greater than the monopoly quantity, and would demand a price below the monopoly price, thus making a lesser profit. The promise of greater gains encourages oligopolies to cooperate.

However, the oasis of collusion is inherently unstable, as the most efficient companies will be tempted to break ranks by reducing prices in order to increase their market share. Can the two companies trust each other? Think of the situation of Company A: perhaps the best known and most effective cartel in the world is OPEC, the organization of oil-exporting countries. In 1973, OPEC members reduced their oil production. As we know that middle Eastern crude oil had few substitutes, the profits of OPEC members exploded. From 1973 to 1979, the price of oil increased by $70 per barrel, a figure not seen at the time. However, in the mid-1980s, OPEC began to weaken. The discovery of new oil deposits in Alaska and Canada introduced new alternatives to Middle Eastern oil, sending OPEC prices and profits down. At about the same time, OPEC members began cheating in an attempt to increase individual profits. Suppose there are two companies in the toaster market with some demand function. Company A will determine the production of Company B, keep it constant and then determine the rest of the market demand for toasters.

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