Nov 26, 2020 in Coursework

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Market Share and Industry Output

Cartels refer to an arrangement between firms in the industry regarding their prices and output; most successful cartels involve fewer firms since a smaller number allows better joint decision making as well as quick agreements. In the event of many firms, tacit collisions occur with chances of collapse being high due to the diverse interests that become increasingly irreconcilable by a decision-making unit. In addition, cartels' stability is premised on the existence of homogeneous or fairly homogeneous products amongst the few members of the group. Furthermore, highly differentiated products imply a need for a detailed array of agreements over prices and quantities, which threaten the sustenance of the arrangement. Therefore, it is also notable that cartels are limited in maintaining very high prices in instances where many industry players fall outside the arrangement; in this case, new entrants or the non-cartel players would take their market shares (Varian, 1993).

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This report appreciates that the computation of market shares and cartel industry output depends on several factors. First, it is notable that Abba, Babba, and Cabba are in a fairly stable cartel from an external perspective. This follows from the fact that there are only three firms hence higher chances of coming to and maintaining an agreement exist. Second, the homogeneous communication services and the licensing restriction make the agreement easy and checks on potential competition. In addition to the above state on the firm's collusion, it is imperative to appreciate that there are varying models amongst cartels; notable ones being perfect cartels and market sharing cartels (Varian, 1993).

Under the perfect cartels, firms agree explicitly to surrender pricing and output decisions to a central agency that fixes them. Basically, this extreme form of collusion seeks to maximize joint profits in a monopoly fashion; the computation of market shares and industry output is mostly easy since firms are either allocated output quotas or are limited to a particular area like the OPEC. Under the joint profit maximization agenda, the cartel estimates the industry demand for the product, whose curve is downward sloping. The assumption is that there are similar cost functions and thus, the MC is obtained through horizontal additions of individual firms MCs. Mostly, the cartel maximizes profits jointly at an industry output level where the MC curve and MR curve intersect. Market share is distributed in a manner that the MCs are equal for the firms (Johany, 1980).

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The other form of a formal cartel is the market sharing cartel under which prices are set, but individual firms decide upon the output; in this model, colluding firms maximize individual as opposed to joint profits. The firms are thus free to engage in other aspects that promote their product such as incurring higher advertising costs. It is notable that even if quotas were to be agreed upon in the market sharing model, the output for each member differs if cost functions are different; the opposite of this leads to a monopoly solution with equal sharing of the market (Varian, 1993).

Abba, Babba, and Cabba belong to the market sharing type of a non-price competition cartel. It is also evident from the marginal costs data that the firms have different cost functions hence will have different market shares and output. Therefore, since Price (P) is stable and unlikely to change, it implies that this will become the individual firm's MR (Marginal Revenue). Notably, the three firms lean towards perfect competition (being price takers only) as opposed to a monopoly in joint profit maximization. Thus, they will maximize profits at the levels where MR=MC.

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Consequently:

Abbas Output will be at 6,000 units, Babba at 5,000 units, and Cabba at 5,000 units as well. At this level of output, all three firms will be maximizing individual profits.

Thus, the total Cartel Output=16,000

Market Shares:

Abba: 6000/16000*100= 37.5%

Babba: 5000/16000*100= 31.25%

Cabba: 5000/16000*100= 31.25%

If prices fall to $2,000 owing to regulatory constraints, the market shares will change as well as the cartel industrial output as presented below. This will result from lower output levels that do not exceed a $2,000 MC since the MR (being the price) will have fallen; however, they will still equate the MR to MC in determining the Q (output). Therefore, Abba will have Q=4,000 as well as Babba. On the other hand, Cabba will move out of the market leaving the market between Abba and Babba since its MC at any level of output, exceed the price and the MR as a consequence. On the other hand, since the cost function at Q=4,000 for both firms is the same, the cartel industry output will fall by half to 8,000 units. The market shares between Abba and Babba will be at 50% each. Furthermore, the changes in market share will be an increase of 12.5% (Abba), 18.75 (Babba), and a drop of 31.25% (Cabba).

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It is worth noting that the greatest challenge facing any cartel pertains to cheating; indeed, various aspects motivate cartels to cheat either internally or externally. Externally, falling demand such as the 1981-83 recessions created cracks in the OPEC cartel with some countries exceeding their quotas and selling at a price below the $34 per barrel. Moreover, new entrants may lower the cartel price as well as over-production by members among others. Since the above cartel faces few external challenges, the game theory aspects of the Prisoners Dilemma may explain the cheating incentive; it indicates that firms cheat although the fixed price maximizes profits for all since it is not the equilibrium for individual firms (Johany, 1980).

In the above context, the first instance at the price of $2,200 offers an incentive to cheat for all the firms; this is because the price of 2,200 is not fixed rather is a ceiling without the restriction of falling below it. Moreover, an analysis of the cost functions indicates that at Q=4,000 units, all firms have an extra margin of profit above their marginal costs given as $200 (Abba and Babba) and $100 (Cabba). Thus, either firm might increase its market share by selling at a discounted price below $2,200. They would be motivated by the prospect of poaching their cartel members' markets as well as supplying the portion left out due to the cartel price. However, for $2,000, no firm can cheat since their MCs are equal and they have no margins at their output levels of Q=4,000. Lastly, selecting any other level of output puts them at a higher cost curve hence the lack of incentive (Varian, 1993).

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