Principles of Economics Essay Example | Topics and Well Written Essays - 1500 words

Principles of Economics - Essay Example Other significant feature of this market model is the presence of a great deal of non-price competition as control over price is limited by their mutual interdependence. This is one of the significant behaviors of oligopolies when it comes to their pricing strategy. To have a better understanding of this oligopolistic pricing behavior, we will adopt a game theory model and use the matrix illustrated below. FIGURE 1. GAME THEORY AND PRICING STRATEGY Applying game theories in pricing strategies work like what is shown in Figure 1. Supposed we have the two oligopolists, Firm 1 and Firm 2 and each can choose either a high or low price. Their payoff matrix shows that if both firms will choose a high price, each will make $6 million but if both decided to sell at a low price, each will make $4 million. However, if one of them chooses a high price and the other one chooses a low price, the low- priced firm will make $8 million but the high-priced firm will only make $2 million. So, they wil l end up charging the low price because it is the dominant strategy. Oligopolists who are independent compete with respect to price and this will result to lower prices and lower profits. Consumers will end up benefitting from this. On the other hand, the oligopolists are at disadvantage because they will experience lower profits than if they both had charged high price. To avoid the outcome lower profit, they would rather choose to collude than to establish price competitively or independently. But the positive effect of collusion on variety and quality more than compensates consumers for the negative effect of collusive prices, so that consumer surplus is larger with collusion (Pakes 2000, p.1). Collusion is a situation in which firms act together and in agreement to set price of the product and the output each firm will produce or determine the geographic area in which each firm will sell (McConnell and Brue 1993 p.224). It may be in an overt or covert form. The most comprehensiv e form of an overt collusion is the cartel which typically involves a written agreement with respect to both price and production. Cartels can control output by making sure that the market is shared among members and the agreed price is maintained in the market (Lande and Marvel 2008, par. 2). The Organization of Petroleum Exporting Countries (OPEC) is one of the most successful oil cartel in the world. There are countries like United States where cartels are illegal and there is a strict enforcement of anti-trust laws (Danieljensenlaw.com par.2). So, in cases like this, oligopolists tend to collude implicitly This can be done through tacit collusion. â€Å"Tacit collusion† need not involve any â€Å"collusion† in the legal sense, and in particular need involve no communication between the parties. It is referred to as tacit collusion only because the outcome (in terms of prices set or quantities produced, for example) may well resemble that of explicit collusion or ev en of an official cartel. A better term from a legal perspective might be â€Å"tacit coordination† (Marc, Julliene and Rey 2003, p.4). This may be seen in form of a price leadership. In the theory of price leadership, the basic assumption is that the dominant firm- usually the largest or the most efficient firm in the industry- sets the price and allows the other firms to sell all they can at that price