To compete or collude? Pricing strategy under oligopoly

When price stability in an oligopoly breaks down, it can lead to price wars. These wars drive prices down but hurt profits, which is why oligopolies often prefer non-price competition (e.g., advertising or product features).

Cartel with a monopoly price

Oligopolistic firms face a conflict: they want to compete to gain market share, especially if they have cost advantages, but they also want to collude to avoid uncertainty and maintain profits. Collusion helps reduce the risks of aggressive price cuts or retaliatory actions that could harm the entire industry. Oligopolists may limit competition by agreeing—formally or informally—to set output quotas, fix prices, or restrict product promotion or development. A formal agreement of this kind is known as a cartel, which can earn monopoly-level profits. The cartel maximizes profit where marginal cost equals marginal revenue (MC = MR), setting a price of p1 and output q1, often by assigning quotas to each member. In contrast, under perfect competition, the price would be p2 with a higher output q2. So, compared to perfect competition, a cartel leads to higher prices and lower output.

Collusion between firms can be covert (formal), involving secret meetings to set prices or output, or tacit (informal), where firms behave as if they have an agreement without direct communication. Collusion is more likely when:

• There are few firms, making coordination and detection of cheating easier.

• Firms have similar production costs and methods.

• They produce similar products.

• Demand is price inelastic, so higher prices increase revenue.

• Anti-collusion laws are weak or poorly enforced.

However, collusive agreements are hard to maintain. They’re often illegal, can’t be legally enforced, and each firm has an incentive to cheat by producing more to gain extra profit. Despite this, collusion is more sustainable in stable markets with few firms, similar costs, and high barriers to entry.

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