There can be two types of collusion (a) Cartels where firms jointly fix a price and output policy through agreement, and(b) Price Leadership where one firm sets the price and others follow it.
A cartel is a formal collusive organisation of the oligopoly firms in an industry. There may either be an open or secret collusion. A perfect cartel is an extreme form of collusion in which member firms agree to abide by the instructions from a central agency in order to maximise joint profits. The profits are distributed among the member firms in a way jointly decided by the firms in advance and may not be in proportion to its share in total output or the costs it incurs.
If A and B are two firms which join together to form a cartel, the cartel’s marginal cost curve can be shown as a lateral summation of MC1 (marginal cost of firm A) and MC2 (marginal cost of firm B), as in Figure 12.4. The cartel is in equilibrium at point E when MC=MR. P is the cartel equilibrium price. Each firm will be in equilibrium when it produces output corresponding to the MC of the cartel equilibrium, i.e., at points E1 and E2 respectively. Each firm takes price as given i.e., P. The shaded areas represent the shares of profits contributed to the aggregate cartel profit. The division of this profit between the firms depends upon their relative bargaining strengths.
This is an example of imperfect collusion among duopoly firms. It may result through tacit or formal agreement as one firm sets the price and others follow it. Price leadership has two forms.
Price Leadership by a Low Cost Firm
Say, two firms A and B face identical demand curves (i.e., AR) and MR. If firm A has lower MC and AC curves then MC1 < MC2 and AC1 < AC2, as shown in Figure 12.5, firm A will maximise its profit by equating MR to MC1 at point E1 and selling Q1 units at price P1. Firm B will maximise its profits by equating MR to MC2 at point E2 and selling Q2 units at price P2. But firm B will not be able to charge P2 price as firm A is charging P1 which is lower than P2. The high cost firm will then accept the leadership of the low cost firm and sell Q2 units at price P1. The high cost firm shall earn less profit than low cost firm.