Economics International Baccalaureate (IB) Practice Question: 1. Using real-world examples, discuss whether an oligopolistic firm should collude rather than compete. 2. Explain why...

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Definitions

1. Oligopoly: A market structure dominated by a few large firms.
2. Collusion: An agreement between firms in an oligopoly to set prices or output to maximize joint profits.

Economic Theory

• Interdependence:
  • Firms in an oligopoly are interdependent, meaning the actions of one firm affect the others.
  • This interdependence can lead to strategic behavior, such as collusion or competition.
• Collusion:
  • Collusion can take the form of formal agreements (cartels) or tacit understandings.
  • By colluding, firms can act as a monopoly, setting higher prices and restricting output to maximize joint profits.
  • Collusion can lead to higher prices for consumers and reduced consumer surplus.
• Competition:
  • Competing firms may engage in price wars, leading to lower prices and potentially lower profits.
  • Non-price competition (e.g., advertising, product differentiation) can also occur, increasing costs but potentially increasing market share.
• Game Theory:
  • The Prisoner's Dilemma illustrates the tension between collusion and competition.
  • While collusion maximizes joint profits, the incentive to cheat can lead to competitive outcomes.
• Diagram:
• No diagram required

Evaluation (SLAP)

• Stakeholders:
  • Consumers: May face higher prices and less choice under collusion, but benefit from lower prices and more innovation under competition.
  • Firms: Collusion can lead to higher profits, but the risk of legal penalties and the temptation to cheat can undermine stability.
  • Government: May intervene to prevent collusion through antitrust laws, promoting competition to protect consumer welfare.
• Long-run vs. Short-run:
  • In the short run, collusion can lead to higher profits and stability for firms.
  • In the long run, the risk of detection and legal penalties can make collusion unsustainable.
  • Competitive strategies may lead to innovation and efficiency gains over time.
• Advantages vs. Disadvantages:
  • Collusion: Advantages include higher profits and market stability; disadvantages include legal risks and potential for consumer harm.
  • Competition: Advantages include consumer benefits and innovation; disadvantages include potential for destructive price wars.
• Prioritize:
  • Firms must weigh the benefits of higher short-term profits from collusion against the long-term benefits of competition, such as innovation and market growth.
  • Real-world example: The OPEC cartel, which has historically colluded to control oil prices, but faces challenges from non-member countries and alternative energy sources.

Conclusion

1. Collusion can offer short-term benefits for firms but poses significant legal and ethical risks.
2. Competition, while potentially reducing short-term profits, can drive innovation and consumer benefits in the long run.
3. The decision to collude or compete depends on market conditions, legal environment, and firm objectives.

Answers may include:

Definitions

1. Oligopoly: A market structure dominated by a few large firms.
2. Price Rigidity: A situation where prices remain constant despite changes in demand or cost conditions.

Diagram

• No diagram required

Explanation

• Interdependence and Strategic Behavior:

  • In an oligopoly, firms are interdependent; each firm considers the potential reactions of rivals when making pricing decisions.
  • This interdependence leads to strategic behavior, where firms are reluctant to change prices due to the uncertainty of competitors' responses.

• Kinked Demand Curve Model:

  • The kinked demand curve illustrates price rigidity. The curve is kinked at the prevailing market price.
  • If a firm raises its price, competitors are unlikely to follow, leading to a loss of market share. This is represented by the more elastic upper segment of the demand curve.
  • If a firm lowers its price, competitors are likely to match the price cut to maintain market share, leading to a less elastic lower segment.
  • The result is a stable price, as firms have little incentive to change prices due to the asymmetric response of competitors.

• Marginal Revenue and Cost Implications:

  • The MR curve has a discontinuity at the kink, meaning that small changes in marginal cost do not affect the profit-maximizing price and output.
  • This discontinuity contributes to price rigidity, as firms will maintain prices even if costs change slightly.

• Barriers to Entry and Non-Price Competition:

  • High barriers to entry in oligopolistic markets reduce the threat of new entrants, allowing existing firms to maintain stable prices.
  • Firms often engage in non-price competition (e.g., advertising, product differentiation) rather than price competition, further contributing to price rigidity.

• Additional Explanation:

  • Complex Point: In some oligopolistic markets, firms may engage in tacit collusion, where they implicitly agree to maintain stable prices to maximize joint profits without explicit communication. This behavior reinforces price rigidity.