Chapter 7 · Market failure and socially undesirable outcomes III: Market power (HL only)
Oligopoly: collusive cartel
Explain joint profit maximisation by a collusive cartel. Use industry MR = MC to find output and price, then consider the incentive to cheat.
The economic idea
An oligopoly is a market structure dominated by a small number of large, interdependent firms. Each firm must consider how rivals may respond to changes in price, output, advertising or product design, so strategic behaviour and game theory are central.
Collusion occurs when firms cooperate to reduce competition. A cartel is a formal collusive agreement to coordinate price, total output, market shares or territories. When effective, the cartel behaves like a joint monopoly even though its members remain legally separate firms.
The cartel maximises joint profit where industry MR = industry MC, then charges the price on market demand. It restricts combined output below the competitive P = MC quantity and allocates production quotas among members.
The agreement is inherently unstable because the cartel price gives an individual member an incentive to sell more than its quota. If cheating is difficult to observe, demand is uncertain, costs differ or legal penalties are strong, coordinated output may break down.
Non-collusive oligopoly can produce very different outcomes, including price competition, price rigidity, product differentiation and strategic investment. Those outcomes are not represented by this joint-monopoly diagram.
Reading the joint-profit-maximising cartel outcome
“Price, costs, revenue” is measured vertically and “Output” horizontally. Revenue and cost values are expressed per unit.
“D = AR” is the firm or cartel’s average-revenue curve: each point shows the price buyers will pay for a particular output.
“MR” lies below “D = AR” because selling another unit requires a price reduction that affects revenue from earlier units.
“MC” shows the extra cost of producing the next unit, while “AC” is total economic cost per unit.
Choose output at E
“E” is the profit-maximising outcome where “MR” equals “MC”. The firm produces “Q” and then charges “P” on “D = AR”. Price exceeds marginal cost, showing allocative inefficiency and market power at the displayed outcome.
Compare Q with Q*
“Q” lies below “Q*”, the output where “D = AR” meets “MC”. Mutually beneficial units are forgone and the resulting triangle is deadweight welfare loss.
Identify the current profit position
“P” lies above “AC” at “Q”, so the firm earns abnormal profit. The profit rectangle has a height equal to price minus average cost and a width equal to output.
Keep profit, surplus and welfare loss separate
Consumer surplus is below “D = AR” and above “P”, up to “Q”. Producer surplus is above “MC” and below the price over the units sold; it covers fixed cost as well as economic profit. The profit rectangle instead compares price with “AC” at that output.
The welfare-loss triangle lies between “D = AR” and “MC”, from “Q” to “Q*”. Buyers would value those missing units more than they cost to produce. A transfer from consumers to the seller is not itself deadweight loss.
A cartel must coordinate the members’ output restrictions to sustain this joint outcome. Each member may want to sell extra output at the high cartel price, so cheating and enforcement affect whether the result persists.
Why MR = MC comes before the price decision
For outputs below “Q”, “MR” exceeds “MC”, so another unit adds more to revenue than to cost.
At “E”, “MR” equals “MC”, fixing the profit-maximising quantity “Q”.
Move vertically from “Q” to “D = AR” to find the price “P” consumers are willing to pay.
Compare “P” with “AC” to identify profit. “P” lies above “AC” at “Q”, so the firm earns abnormal profit. The profit rectangle has a height equal to price minus average cost and a width equal to output.
Common mistakes to avoid
- Do not read price from “MR”. It is found on “D = AR” after output has been chosen.
- MR = MC identifies profit maximisation, not allocative efficiency. Allocative efficiency requires price, or marginal benefit, to equal marginal cost.
- Market power does not guarantee abnormal profit; high average cost can leave the firm earning normal profit or making a loss.
- This diagram represents collusion as a joint monopoly. It does not describe every oligopoly or show the strategic response of each member.
How to draw this diagram
- Title the diagram “Oligopoly: collusive cartel”. Label the horizontal axis “Quantity” and the vertical axis “Price, costs, revenue”.
- Draw D = AR first and label it clearly.
- Draw MR next and label it clearly.
- Draw MC next and label it clearly.
- Draw AC next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The model assumes successful collusion and therefore cannot explain a non-collusive oligopoly outcome.
- It combines member firms into one cost structure even though their marginal costs and objectives may differ.
- The allocation and enforcement of individual production quotas are not shown.
- Cartel power depends on barriers to entry, the availability of substitutes, fringe supply and demand elasticity.
- Repeated interaction may support cooperation, while antitrust enforcement, secret discounting and demand volatility may destabilise it.