The Prisoners Dilemma and the Ability of Firms to Collude

The Prisoners Dilemma and the Ability of Firms to Collude

An oligopoly is a market consisting of a few large interdependent firms who are usually always trying to second-guess each other's behaviour. There is a high degree of interdependence between each firm in the industry meaning individual firms must take into account the effects of their actions on their rivals, and the course of action that will follow as a result on behalf of the rival firm which will also have consequences. The market as we will see is also allocatively inefficient as price is above marginal cost. There are barriers to entry and exit in an oligopoly meaning that potential new firms will have huge costs if they try to enter the industry and sometimes firms collude in order to prevent new firms from becoming any threat. For example if a new firm tries to enter the industry the cartel can quite easily reduce its prices in the short run so as to remove the new firm. An example of a heavy barrier to entry for new firms is the cost of National or even International advertising. As a result of the firms being interdependent, there are various varieties of collusion in oligopolies to try and create some stable space for the firms to operate in. There are three kinds of collusion:

· cartel (contractual)

· covert

· tacit

Cartels usually exist where there are agreements between incumbent firms with prices so that they can share what would be monopoly supernormal profits between them, acting as a monopoly. Firms will get together to decide to restrict the output and raise the price, for example OPEC (Organisation for Petroleum Exporting Countries). In the UK legally binding agreements in cartels are against the restrictive practices legislation and are therefore illegal. Some cartels last longer than others do as some cartels may break contracts. Some examples of cartels include Rowntrees, Cadbury's, the concrete industry with three firms (Rugby, Blue Circle and United).

An example of covert collusion would be the cement industry, which was found guilty of rigging contracts and was fined eight million pounds.

Tacit collusion is forming implicit contracts as if they are colluding; for example the soap powders industry. In this type of market rather than competing using prices, non-price competition occurs. Examples of non-price competition are special offers, advertising and quality of service, all of which are to establish their own brand loyalty and maintain a high concentration ratio of the market.