Markets existing in both perfect competition and complete monopoly have their own respective economic models demonstrating how they function. Oligopolies are no exception. But as we’ve seen in our last article, there are 2 types of oligopolistic markets (in theory, at least): cartels and good ol’ competition. This means 2 different models, one for each of the market types.
The Cartel Model
The term “cartels” is practically interchangeable with the term “monopoly.” If a handful of firms collude with one another and agree on a set market price, this cartel has a monopoly on the market and is thus treated as such.
The graph above is the exact same as the one in our Monopoly Firm: Part 2 article. The only difference is the title and how both the price and quantity is proportionally increased to represent a handful of firms as opposed to just one. Cartel cost curves seem pretty standard from here: they’re a monopoly and so they have monopoly cost curves. But a cartel is a group of firms and as we mentioned in our last article, it’s possible for a firm to suddenly break the agreement and undercut everyone else. There’s actually a graph just for this exact scenario, and it’s called the deviant firm equilibrium:
What we have here are 2 sets of MR-demand curves, one of the cartel’s and one of the deviant firm’s (DF). Now the market has gone from a cartel to a duopoly between the cartel and the deviant firm, the fact that there are 2 demand curves is particularly important. The deviant firm’s demand curve is referred to as the residual demand curve.
But to understand why this is happening, we must first turn to what’s known as demand elasticity. Remember that the law of demand exists as an inverse relationship: if the price of a product goes up, people buy less and if the price goes down, people buy more. Elasticity simply refers to how sensitive demand is to price changes.
Let’s look at 2 different products, say Coca-Cola and insulin. If the insulin company were to all of a sudden start charging hundreds of extra dollars, the demand wouldn’t change that much. Why? Because people need insulin and it often serves as a life-saving medicine. Hence, insulin is very inelastic - people are willing to pay for it regardless of its price. Coca-Cola, on the other hand, doesn’t have this advantage. If they all of a sudden increase the price of each bottle ten-fold, people will eventually stop buying Coke and instead switch to Pepsi. Hence, Coca-Cola is very elastic - people are sensitive to its price.
Think of elastic and inelastic demand in the literal sense: elastic demand is flexible like a rubber band, but inelastic demand is rigid like a pencil. There’s a way we can calculate how elastic a given good is:
The percent change in the quantity demanded divided by the percent change in price. If the absolute value of the yielded quotient is:
Equal to 0, then it’s perfectly inelastic
Less than 1, relatively inelastic
Equal to 1, unit elastic (meaning a change in price will cause a proportional change in quantity demanded)
Greater than 1, relatively elastic
Infinite (yes, this is theoretically possible), perfectly elastic
The price increases by $1, but the quantity demanded decreases by 2
The price increases by $1, but the quantity demanded doesn’t even increase by 1
But we don’t need seperate demand curves to illustrate varying degrees of elasticity. In fact, each demand curve has both an elastic and inelastic “section” so to speak. The reason for this is pretty simple: the top half of the demand curve is more elastic than the bottom half of the demand curve, hence allowing us to divide a single demand curve into “elastic” and “inelastic.”
Instead of using percentage change in quantity and price, economists will sometimes instead use the average percent change in both quantity and price. This is known as the Midpoint Method:
Say we go from 2 units (Q1) at $9 each (P1) to 3 units (Q2) at $8 (P2) each and then plug in the numbers into our elasticity formula:
And so, our demand is elastic. But say we instead go from 7 units (Q1) at $4 each (P1) to 8 units (Q2) at $3 each (P2):
Same demand curve, different elasticities. This same principle applies to cartel demand curves. Recall that inelasticity means the demand stays roughly the same regardless of the price. So, if the demand is inelastic, the increase in price translates into an increase in revenue. Since cartels are price-makers, they have no reason not to increase the price whilst on the inelastic portion of the demand curve. Eventually, however, they’ll reach the elastic part of the demand curve, and that’s when they are no longer incentivized to raise their price.
But this is for a cartel. For a deviant firm, the rules change. A company that breaks the cartel agreement will naturally undercut the cartel simply because they can - the goal would be to lessen the cartel’s market share by attracting more consumers. How would the deviant firm do this? By attracting the most price sensitive consumers, also known as those with the more elastic demand. As such, the deviant firm’s demand curves (and hence, the MR curve, which is derived from demand) is less steep than that of the cartel’s. A less steep demand curve is a more elastic demand curve.
An easier way to think about it would be to imagine the cartel as focusing on the inelastic demand section of the market and getting as much money from that. But all of a sudden, the deviant firm swoops in and starts focusing on the elastic demand section of the market - the very section the cartel avoided - and exploits it by charging lower prices. Deviant firms, in short, ought to be celebrated.
Econ IRL:
A 2018 study by MIT economist Alexander Wolitzky and Stanford economist Takuo Sugaya challenges the idea that firms need to share information with each other in order to collude and form a cartel. Although a certain degree of transparency among cartel members is obviously necessary, there are cases in which less transparent cartels end up more successful. Pointing to cartels monitored by the European Commission, several of them shared with their members data that was already available to the public as opposed to extensive firm-level information.
The main takeaway from this? Greater transparency may be useful only under volatile business conditions. A more stable market, however, may call for greater secrecy among cartel members.
‘Till next time,
SoBasically