Question

Consider an oligopoly industry whose firms have identical demand and cost conditions. If the firms decide to collude, then they will want to collectively produce the amount of output that would be produced by: a. A monopolistic competitor. b. A pure competitor. c. A pure monopolist. d. None of the above.

Short answer

c. A pure monopolist.

Step-by-step solution

Understand the Nature of Collusion

Collusion in an oligopoly occurs when firms agree to join forces to set prices or output like a monopoly. By acting together, they can maximize joint profits instead of competing against each other.

Analyze Each Option

Examine the characteristics of each market structure: Monopolistic competition involves many firms with differentiated products, not maximizing joint profits. Pure competition involves many firms as price takers, producing at market equilibrium. A pure monopoly results in maximum profit by restricting output to raise prices.

Identify the Optimal Collusive Strategy

Firms in collusion aim to maximize profits which aligns with the strategy of a pure monopolist, who controls output and prices to maximize profits.

Select the Correct Option

Since colluding firms mimic a pure monopolist to maximize profits, the correct option aligns with the behavior described in a pure monopoly.

Key concepts

Collusion

Collusion occurs in an oligopoly when firms decide to work together instead of competing against one another. They can do this by agreeing on prices or the amount of output produced. Thus, rather than driving prices down due to competition, they can keep prices at a certain level to ensure higher profits. This collective approach allows them to behave as a single entity, much like a monopoly.

When firms engage in collusion, they can avoid the natural consequences of price wars and unstable market conditions, leading to a more predictable and controlled environment. However, collusion is typically illegal in many countries as it undermines free market competition, harms consumers and leads to higher prices.

Despite its illegal status, collusion remains a significant concept in understanding how firms might attempt to maximize profits when restrictions or enforcement are weak. It reveals the strategic thinking used by companies to secure better financial returns at the potential cost of consumer welfare.

Monopoly

A monopoly is a market structure where a single firm dominates the entire market. This firm is the only producer of a particular good or service, which gives it significant power over pricing. Unlike competitive markets where prices are influenced by multiple firms, a monopoly can set prices higher because it faces little to no competition.

A pure monopolist aims to maximize profits by restricting output and raising prices. By producing less, the monopolist creates scarcity, which drives prices up. This strategy is possible because consumers do not have alternative suppliers for the product or service.

In a monopoly, barriers to entry are high, making it difficult for other firms to enter and provide competition. These barriers could be due to patents, resource control, or government regulations. Monopolies can lead to inefficient outcomes, such as reduced consumer choice, lower quality of goods, and less innovation.

Profit Maximization

Profit maximization is the process by which a firm determines the price and output level that leads to the highest possible profit. In economic terms, profit is maximized when the difference between total revenue and total cost is the greatest.

For a firm to maximize profit, it should produce where marginal cost (MC) equals marginal revenue (MR). At this point, the cost of producing an additional unit equals the revenue it generates. If MR is greater than MC, the firm should increase production to maximize profit. Conversely, if MC is greater than MR, production should be decreased.

In the case of an oligopoly, firms may collude to act as a monopoly in order to achieve profit maximization. By controlling prices and output together, they can effectively set conditions for maximized joint profits. These strategies can have profound impacts on the market, often leading to regulatory scrutiny to prevent anti-competitive practices.