Lecture 11 oligopoly

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  • 1. Lecture 11 HE 101 Monopolistic Competition and Oligopoly Source: Pyndyck, Rubinfeld and Koh (2006) complemented with own materials
  • 2. Monopolistic Competition
    • Characteristics
      • Many firms
      • Free entry and exit
      • Differentiated product but highly substitutable
    Similar as in Perfectly Competitive Market determined the degree of monopoly power that each firm has (c) Y.E. Riyanto
  • 3. Monopolistic Competition
    • Examples of this very common market structure include:
      • Toothpaste
      • Soap
      • Cold remedies
        • The greater the preference ( degree of differentiation ) the higher the price.
    (c) Y.E. Riyanto
  • 4. A Monopolistically Competitive Firm in the Short and Long Run Quantity $/Q Quantity $/Q Short Run Long Run (c) Y.E. Riyanto MC AC MC AC D SR MR SR D LR MR LR Q SR P SR Q LR P LR
  • 5. A Monopolistically Competitive Firm in the Short and Long Run
    • Short-run
      • Downward sloping demand – differentiated product
      • Demand is relatively elastic – good substitutes
      • MR < P
      • Profits are maximized when MR = MC
      • This firm is making economic profits
    (c) Y.E. Riyanto
  • 6. A Monopolistically Competitive Firm in the Short and Long Run
    • Long-run
      • Profits will attract new firms to the industry (no barriers to entry)
      • The old firm’s demand will decrease to D LR
      • Firm’s output and price will fall
      • Industry output will rise
      • No economic profit (P = AC)
      • P > MC  some monopoly power
    (c) Y.E. Riyanto
  • 7. Monopolistically and Perfectly Competitive Equilibrium (LR) $/Q Quantity $/Q Quantity Perfect Competition Monopolistic Competition (c) Y.E. Riyanto Deadweight loss MC AC D = MR Q C P C MC AC D LR MR LR Q MC P
  • 8. Monopolistic Competition & Economic Efficiency
    • The monopoly power yields a higher price than perfect competition  Dead Weight Loss. If price was lowered to the point where MC = D, consumer surplus would increase – lower deadweight loss.
    • With no economic profits in the long run, the firm’s output is still below the one that minimize AC  excess capacity exists.
    (c) Y.E. Riyanto
  • 9. Monopolistic Competition
    • If inefficiency bad for consumers, should monopolistic competition be regulated?
      • Market power relatively small. Usually enough firms to compete with enough substitutability between firms – deadweight loss relatively small
      • Inefficiency is balanced by the benefit of increased product diversity – could outweigh deadweight loss
    (c) Y.E. Riyanto
  • 10.
    • Each market has much differentiation in products and try to gain consumers through that differentiation.
    • How much monopoly power do each of these producers have?
      • How elastic demand for each brand?
    Monopolistic Competition (c) Y.E. Riyanto
  • 11. Oligopoly – Characteristics
    • Small number of firms
    • Product differentiation may or may not exist
    • Barriers to entry
      • Scale economies
      • Patents
      • Technology
      • Brand name recognition/ loyalty
      • Strategic action by firms
    (c) Y.E. Riyanto
  • 12. Oligopoly
    • Examples
      • Automobiles
      • PC operating systems
      • Internet Browsers
      • Petrochemicals
      • Electrical equipment
    (c) Y.E. Riyanto
  • 13. Oligopoly – Equilibrium
    • A monopoly does not have to worry about how rivals will react to its action simply because there are no rivals .
    • A competitive firm potentially faces many rivals , but the firm and its rivals are price takers  also no need to worry about rivals’ actions.
    • An oligopoly firm when deciding a strategic action (e.g. cut their price, or increase quantity, etc) must consider what the rival firms in the industry will do .
    (c) Y.E. Riyanto
  • 14. Oligopoly – Equilibrium
    • The oligopolist needs to choose an appropriate response to the rivals’ actions  similarly, rivals also need to anticipate the firm’s response and act accordingly  interactive setting .
    • Actions and reactions are dynamic, evolving over time
    • Game Theory is an appropriate tool to analyze strategic actions in such an interactive setting  important assumption: firms (or firms’ managers) are rational decision makers .
    Will be covered in more detailed in lecture 11 (c) Y.E. Riyanto
  • 15. Oligopoly – An Intermezzo 
    • Consider the following story (taken from Dixit and Skeath (1999), Games of Strategy )
      • …” There were two friends taking Chemistry at Duke. Both had done pretty well on all of the quizzes, the labs, and the midterm , so that going to the final they had a solid A. They were so confident that the weekend before the final exam they decided to go to a party at the University of Virginia. The party was so good that they overslept all day Sunday , and got back too late to study for the Chemistry final that was scheduled for Monday morning. Rather than take the final unprepared, they went to the professor with a sob story . They said they had gone to the University of Virginia and had planned to come back in good time to study for the final but had had a flat tire on the way back. Because they did not have a spare , they had spent most of the night looking for help . Now they were too tired, so could they please have a make-up final the next day?  the professor was so kind to agree with this 
      • The two studied all of Monday evening and came well prepared on Tuesday morning. The professor placed them in separate rooms and handed the test to each. Each of them wrote a good answer, and greatly relieved , but …
      • when they turned to the last page . It had just one question, worth 90 points. It was: “Which tire?”….
    (c) Y.E. Riyanto
  • 16. Oligopoly – Equilibrium
    • Defining Equilibrium
      • Firms are doing the best they can and have no incentive to change their strategy (e.g. output or price)
      • All firms assume competitors are taking rival decisions into account.
    • Nash Equilibrium  John Nash (remember Russel Crowe’s movie “A Beautiful Mind”)
      • Each firm is doing the best it can given what its competitors are doing  no incentive to deviate .
    • We will focus on duopoly  Markets in which two firms compete
    (c) Y.E. Riyanto
  • 17. Oligopoly
    • The Cournot Model
      • With a homogenous good  Oligopoly model in which firms produce a homogeneous good.
      • Firm will adjust its output based on what it thinks the other firm will produce
    (c) Y.E. Riyanto
  • 18. Firm 1’s Output Decision Q 1 P 1 (c) Y.E. Riyanto MC 1 50 MR 1 (75) D 1 (75) 12.5 If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is shifted to the left by this amount. D 1 (0) MR 1 (0) Firm 1’s demand curve, D 1 (0), if it thinks that Firm 2 produces nothing. D 1 (50) MR 1 (50) 25 If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is shifted to the left by this amount.
  • 19. Oligopoly
    • The Reaction Curve
      • The relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce.
      • A firm’s profit-maximizing output is a decreasing schedule of the expected output of Firm 2.
    (c) Y.E. Riyanto
  • 20. Reaction Curves and Cournot Equilibrium Firm 2’s reaction curve shows how much it will produce as a function of how much it thinks Firm 1 will produce. Q 2 Q 1 25 50 75 100 25 50 75 100 x x x x Firm 1’s reaction curve shows how much it will produce as a function of how much it thinks Firm 2 will produce. The x’s correspond to the previous model. (c) Y.E. Riyanto Firm 2’s Reaction Curve Q*2(Q 2 ) Firm 1’s Reaction Curve Q* 1 (Q 2 )
  • 21. Reaction Curves and Cournot Equilibrium Q 2 Q 1 25 50 75 100 25 50 75 100 x x x x In Cournot equilibrium, each firm correctly assumes how much its competitors will produce and thereby maximize its own profits. (c) Y.E. Riyanto Firm 2’s Reaction Curve Q*2(Q 2 ) Firm 1’s Reaction Curve Q* 1 (Q 2 ) Cournot Equilibrium
  • 22. Cournot Equilibrium
    • Each firms reaction curve tells it how much to produce given the output of its competitor.
    • Equilibrium in the Cournot model, in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly.
    (c) Y.E. Riyanto
  • 23. Oligopoly
    • Cournot equilibrium is an example of a Nash equilibrium (Cournot-Nash Equilibrium)
    (c) Y.E. Riyanto
  • 24. The Linear Demand Curve
    • An Example of the Cournot Equilibrium
      • Two firms face linear market demand curve
      • We can compare competitive equilibrium and the equilibrium resulting from collusion
      • Market demand is P = 30 - Q
      • Q is total production of both firms:
      • Q = Q 1 + Q 2
      • Both firms have MC 1 = MC 2 = 0
    (c) Y.E. Riyanto
  • 25. Oligopoly Example
    • Firm 1’s Reaction Curve  derived from firm 1’ profit max problem  MR=MC
    (c) Y.E. Riyanto
  • 26. Oligopoly Example
    • An Example of the Cournot Equilibrium
    (c) Y.E. Riyanto
  • 27. Oligopoly Example
    • An Example of the Cournot Equilibrium
    (c) Y.E. Riyanto
  • 28. Duopoly Example Q 1 Q 2 The demand curve is P = 30 - Q and both firms have 0 marginal cost. (c) Y.E. Riyanto Firm 2’s Reaction Curve 30 15 Firm 1’s Reaction Curve 15 30 10 10 Cournot Equilibrium
  • 29. Oligopoly Example
    • Profit Maximization with Collusion
    (c) Y.E. Riyanto
  • 30. Profit Maximization w/Collusion
    • Collusion Curve
      • Q1 + Q2 = 15
        • Shows all pairs of output Q1 and Q2 that maximizes total profits
      • Q1 = Q2 = 7.5
        • Less output and higher profits than the Cournot equilibrium
    (c) Y.E. Riyanto
  • 31. Duopoly Example Q 1 Q 2 30 30 For the firm, collusion is the best outcome followed by the Cournot Equilibrium and then the competitive equilibrium (c) Y.E. Riyanto Firm 1’s Reaction Curve Firm 2’s Reaction Curve 10 10 Cournot Equilibrium Collusion Curve 7.5 7.5 Collusive Equilibrium 15 15 Competitive Equilibrium (P = MC; Profit = 0)
  • 32. First Mover Advantage – The Stackelberg Quantity Competition Model
    • Oligopoly model in which one firm sets its output before other firms do.
    • Assumptions
      • One firm can set output first
      • MC = 0
      • Market demand is P = 30 - Q where Q is total output
      • Firm 1 sets output first and Firm 2 then makes an output decision seeing Firm 1 output
    (c) Y.E. Riyanto
  • 33. First Mover Advantage – The Stackelberg Model
    • Firm 1
      • Must consider the reaction of Firm 2
    • Firm 2
      • Takes Firm 1’s output as fixed and therefore determines output with the Cournot reaction curve: Q 2 = 15 - ½(Q 1 )
    Firm 1 sets Q 1, anticipating Firm 2’s best response quantity Q 2 . Firm 2 sets it best response quantity Q 2, against Q 1 . period 1 period 2 (c) Y.E. Riyanto
  • 34. First Mover Advantage – The Stackelberg Model
    • By backward induction : Using Firm 2’s Reaction Curve for Q2:
    • Firm 1:
    (c) Y.E. Riyanto
  • 35. An Intermezzo: Backward Induction
    • Consider the following ‘ immunity challenge ’ in the reality TV game show ‘ Survivor ’ (Survivor Thailand (season 5) - episode 6)
    • This is a sequential move game , use backward induction to find what is the best strategy for the first mover (thinking ahead and see the implication for your action now).
    Player A Player B A moves first  must pick 1 or 2 or 3 flags. B moves second  must Also pick 1 or 2 or 3 flags. The player who removes the last remaining flag(s) (1, or 2, or 3 last flag(s) is the winner of the challenge. (c) Y.E. Riyanto 21 Flags
  • 36. First Mover Advantage – The Stackelberg Model
    • Profits:
    (c) Y.E. Riyanto
  • 37. First Mover Advantage – The Stackelberg Model
    • Conclusion
      • Going first gives firm 1 the advantage
      • Firm 1’s output is twice as large as firm 2’s
      • Firm 1’s profit is twice as large as firm 2’s
    • Going first allows firm 1 to produce a large quantity. Firm 2 must take that into account and produce less unless wants to reduce profits for everyone
    (c) Y.E. Riyanto
  • 38. Price Competition
    • Competition in an oligopolistic industry may occur with price instead of output.
    • The Bertrand Model is used instead of Cournot Model.
      • Oligopoly model in which each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge
    (c) Y.E. Riyanto
  • 39. Price Competition – Bertrand Model
    • Assumptions
      • Homogenous good
      • Market demand is P = 30 - Q where Q = Q 1 + Q 2
      • MC 1 = MC 2 = $3
    • If we have Cournot competition  Q 1 = Q 2 = 9 and P=$12 giving each firm a profits of $81 .
    (c) Y.E. Riyanto
  • 40. Price Competition – Bertrand Model
    • Assume here that the firms compete with price , not quantity.
    • Since good is homogeneous  consumers will buy from lowest price seller
      • If firms charge different prices, consumers buy from lowest priced firm only
      • If firms charge same price, consumers are indifferent who they buy from
    (c) Y.E. Riyanto
  • 41. Price Competition – Bertrand Model
    • Bertrand-Nash equilibrium : firms have incentive to cut prices below rivals
      • Both firms set P=MC  like in compt. Mkt.
      • P = MC; P1 = P2 = $3
      • Q = 27; Q1 & Q2 = 13.5
    • Both firms earn zero profit
    (c) Y.E. Riyanto
  • 42. Price Competition – Bertrand Model – A real example (c) Y.E. Riyanto
  • 43. Price Competition – Bertrand Model
    • Why not charge a different price (P>MC)?
      • If charge more, sell nothing
      • If charge less, lose money on each unit sold
    • The Bertrand model demonstrates the importance of the strategic variable
      • Price versus output
    (c) Y.E. Riyanto
  • 44. Bertrand Model – Criticisms
    • When firms produce a homogenous good, it is more natural to compete by setting quantities rather than prices.
    • Even if the firms do set prices and choose the same price, what share of total sales will go to each one?
      • It may not be equally divided  e.g. brand name loyalty  product differentiation.
    (c) Y.E. Riyanto
  • 45. Price Competition – Differentiated Products
    • Market shares are now determined not just by prices, but by differences in the design, performance, and durability of each firm’s product  products are no longer homogeneous but instead differentiated .
    • In these markets, more likely to compete using price instead of quantity
    (c) Y.E. Riyanto
  • 46. Price Competition – Differentiated Products
    • Example
      • Duopoly with fixed costs of $20 but zero variable costs
      • Firms face the same demand curves
        • Firm 1’s demand: Q 1 = 12 - 2P 1 + P 2
        • Firm 2’s demand: Q 2 = 12 - 2P 1 + P 1
      • Quantity that each firm can sell decreases when it raises its own price but increases when its competitor charges a higher price
    (c) Y.E. Riyanto
  • 47. Price Competition – Differentiated Products
    • Firms set prices simultaneously
    (c) Y.E. Riyanto
  • 48. Price Competition – Differentiated Products
    • Reaction Curves can be derived:
    (c) Y.E. Riyanto
  • 49.
    • Bertrand Nash equilibrium:
    • Profit 
    Price Competition – Differentiated Products (c) Y.E. Riyanto
  • 50. Nash Equilibrium in Prices
    • A digression  What if both firms collude?
      • They both decide to charge the same price that maximized both of their profits
      • Firms will charge $6 and will be better off colluding since they will earn a profit of $16
    (c) Y.E. Riyanto
  • 51. Nash Equilibrium in Prices P 1 P 2 Equilibrium at price of $4 and profits of $12 (c) Y.E. Riyanto Firm 1’s Reaction Curve Firm 2’s Reaction Curve $4 $4 Nash Equilibrium $6 $6 Collusive Equilibrium
  • 52. Nash Equilibrium in Prices
    • What if they move sequentially in A Stackelberg fashion?  If Firm 1 sets price first and then firm 2 makes pricing decision
      • Firm 1 would be at a distinct disadvantage by moving first
      • The firm that moves second has an opportunity to undercut slightly and capture a larger market share
    (c) Y.E. Riyanto
  • 53.
    • Collusion with competitors will give larger profits.
    • If all agree to charge $6, each earn profit of $16.
    • Collusive agreement hard to enforce  temptation to undercut the rival and charge slightly below $6  gets the whole market.
    Competition Versus Collusion: The Prisoners’ Dilemma (c) Y.E. Riyanto
  • 54. Competition Versus Collusion: The Prisoners’ Dilemma
    • Assume:
    (c) Y.E. Riyanto
  • 55. Competition Versus Collusion: The Prisoners’ Dilemma
    • Possible Pricing Outcomes:
    (c) Y.E. Riyanto
  • 56. Payoff Matrix for Pricing Game Firm 2 Firm 1 Charge $4 Charge $6 Charge $4 Charge $6 Dominant Strategy Nash Eq. ($4;$4) better outcomes (c) Y.E. Riyanto $12, $12 $20, $4 $16, $16 $4, $20
  • 57. Competition Versus Collusion: The Prisoners’ Dilemma
    • We can now answer the question of why firm does not choose cooperative price.
    • Cooperating means both firms charging $6 instead of $4 and earning $16 instead of $12
    • Each firm always makes more money by charging $4, no matter what its competitor does
    • Unless enforceable agreement to charge $6, will be better off charging $4
    (c) Y.E. Riyanto
  • 58. Competition Versus Collusion: The Prisoners’ Dilemma
    • An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face.
      • Two prisoners have been accused of collaborating in a crime.
      • They are in separate jail cells and cannot communicate.
      • Each has been asked to confess to the crime.
    (c) Y.E. Riyanto
  • 59. Payoff Matrix for Prisoners’ Dilemma Prisoner A Don’t confess Don’t confess Prisoner B Would you choose to confess? Confess Confess (c) Y.E. Riyanto -5, -5 -1, -10 -2, -2 -10, -1 Dominant Strategy Nash Eq. (confess;confess) better outcomes
  • 60. Intermezzo: (c) Y.E. Riyanto
    • Is this a PD game?
  • 61.
    • It is indeed difficult for them to cooperate!! The matrix form representation of the game shown in the movie clip.
    • Stealing is a ‘weakly dominant’ strategy.
    • (Splitting; Splitting) does not constitute as a Nash-equilibrium  unilateral incentive to deviate.
    (c) Y.E. Riyanto Prisoner’s Dilemma (PD) Multiple Nash Equilibrium Female Male 50 , 50 Split (Sp) Steal (St) Split (Sp) Steal (St) 0 , 0 100 , 0 0 , 100
  • 62. Collusion
    • Do the same analysis for the Cournot competition we derived earlier! (Homework  ).
    • Conclusions
    • Collusion will lead to greater profits
    • Explicit and implicit collusion is possible  need a ‘binding’ agreement  cartel agreement .
    (c) Y.E. Riyanto
  • 63. Collusion (Price Fixing) BA and Virgin: Flying in formation Aug 2nd 2007 From The Economist print edition It takes two to fix prices FOR years British Airways (BA) described itself as “the world's favorite airline”. It no longer looks so popular in London and Washington. On August 1st the firm was hit with a transatlantic double whammy after it was found guilty of colluding with a rival, Virgin Atlantic, to fix prices on long-haul passenger routes . Britain's Office of Fair Trading (OFT) handed down a record fine of £121.5m ($246m). A few hours later, America's Department of Justice (DoJ) imposed a $300m penalty of its own. The severity of the American fine also reflected BA's role in a different international conspiracy involving Korean Air and Lufthansa. A clearer example of illegal price-fixing than that between BA and Virgin would be hard to imagine. The two firms discussed “fuel surcharges” at least six times between August 2004 and January 2006, during which time they rose from £5 to £60 on a return ticket. A transatlantic bust was particularly fitting for the OFT. During Labour's period in office, it has introduced American-style, cartel-busting sanctions on companies that prefer cozy deals with rivals to the bracing winds of competition. But despite many protracted investigations into sectors such as banking and supermarkets that attract consumers' ire, the OFT has struggled to find the kind of smoking-gun evidence of collusion it needed to look as terrifying as it and the government wished. That is partly the nature of the beast. Collusion is difficult to prove : as Mr Collins observes, the tricky thing about colluders is that they do their business in secret. Indeed, the airlines' price-fixing came to light only after Virgin's legal department alerted the authorities . This was no selfless dedication to consumers' welfare. Virgin hoped to benefit from the “ leniency policy ”, which was introduced in the 1998 Competition Act and copied from similar laws in America, granting immunity to firms that blow the whistle . Virgin was just as complicit as BA in the price-fixing and has, presumably, benefited from it financially. Not only was the airline saving itself from the risk of prosecution, but it was also grassing up a rival with whom it has had a bruising relationship in the past. It grates to see one firm get away with something while another is punished, but leniency policies are, probably, a good thing. The ability to claim immunity gives a powerful incentive for businesses to police their own industries, which ought to improve things for consumers. After all, half a victory is better than none. (c) Y.E. Riyanto
  • 64. Collusion (Price Fixing) (c) Y.E. Riyanto
  • 65. Price Rigidity
    • Firms have strong desire for stability
    • Price rigidity – characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change
      • Fear lower prices will send wrong message to competitors leading to price war
      • Higher prices may cause competitors to raise theirs
    (c) Y.E. Riyanto
  • 66. Price Signaling and Price Leadership
    • Price Signaling
      • Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit
    • Price Leadership
      • Pattern of pricing in which one firm regularly announces price changes that other firms then match
    (c) Y.E. Riyanto
  • 67. Price Signaling and Price Leadership (c) Y.E. Riyanto
  • 68. Price Signaling and Price Leadership
    • The Dominant Firm Model
      • In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market.
      • The large firm might then act as the dominant firm, setting a price that maximizes its own profits.
    (c) Y.E. Riyanto
  • 69. Source: http://apple20.blogs.fortune.cnn.com/2008/01/29/beyond-the-incredible-shrinking-ipod-market/ The Dominant Firm Model (c) Y.E. Riyanto
  • 70. The Dominant Firm Model source: Hitwise and http://www.marketingpilgrim.com/2007/05/google-market-share-up-again.html (c) Y.E. Riyanto
  • 71. The Dominant Firm Model (c) Y.E. Riyanto
  • 72. Collusive Agreement  Cartels
    • Producers in a cartel explicitly agree to cooperate in setting prices and output.
    • Typically only a subset of producers are part of the cartel and others benefit from the choices of the cartel
    • If demand is sufficiently inelastic and cartel is enforceable , prices may be well above competitive levels
    (c) Y.E. Riyanto
  • 73. Cartels
    • Examples of successful cartels
      • OPEC
      • De Beers (Diamond Cartel)
    • Examples of unsuccessful cartels
      • Copper
      • Tin
      • Coffee
      • Tea
      • Cocoa
    (c) Y.E. Riyanto
  • 74. Cartels – Conditions for Success
    • Stable cartel organization must be formed – price and quantity settled on and adhered to  sometimes difficult because;
      • Members have different costs, assessments of demand and objectives
      • Tempting to cheat by lowering price to capture larger market share
    (c) Y.E. Riyanto
  • 75. Cartels – Conditions for Success
    • Potential for monopoly power
      • Even if cartel can succeed, there might be little room to raise price if faces highly elastic demand
      • If potential gains from cooperation are large, cartel members will have more incentive to make the cartel work
    (c) Y.E. Riyanto
  • 76. Cartels
    • To be successful:
      • Total demand must not be very price elastic
      • Either the cartel must control nearly all of the world’s supply or the supply of noncartel producers must not be price elastic
    (c) Y.E. Riyanto
  • 77. Cartels (c) Y.E. Riyanto
  • 78. Cartels (c) Y.E. Riyanto