QUESTION-6: {10 marks}

Given below is the Case Study taken from US Automobile Industry, Please read it carefully and answer the Questions given at the END.

US Automobile Industry

The US automobile industry is a good example of an oligopoly. It consists mainly of three major firms, General Motors (GM), and Ford and Chryslers, The influence of this oligopoly can be seen in the prices and the development and introduction of new car models into the American car market. Extensive work has been done on the field of collusive behaviour in the US automobile market and moreover the introduction of the small car in the 1950s shows how the firms collude when it comes to the introduction of a new car. The oligopoly in the American automobile industry is collusive, because of that, it will after that be pointed out how price cheaters are punished in that cartel.

The Price Leader in the Oligopoly:

In the oligopoly of the American automobile industry a vivid dynamic between price leaders and price followers can be found. Here the example of the pricing decisions between 1965 and 1971 shows strong evidence that General Motors is the price leader in this oligopoly (Boyle &Hogarty, 1975). In this time span Chrysler always announced its price increases first, after that General Motors announced a price increase which was smaller than Chrysler's. General Motors' move then led to Chrysler reducing its own price to be roughly the same as General Motors' (Boyle & Hogarty, 1975). Boyle and Hogarty (1975) do not mention explicitly how Ford behaved in that pricing arrangement but it can be assumed that Ford is a price follower who in the end copies General Motors' chosen price.

How Prices are determined:

It is clear that there is a difference between how prices are chosen in perfect competition markets and the oligopolistic market. In perfect competitions the market participants can maximize their profit by producing the quantity where the marginal costs of producing a unit is equal to the market price which itself is equal to the marginal revenue. This yields to the fact that the market is efficient and competitive because the market participant just charges the price where economic profit is zero. In contrast to that, the collusive companies of General Motors, Ford, and Chrysler are trying to avoid this competitiveness in the market by pricing jointly (Bresnahan, 1987). The oligopolists act like a single monopolist when it comes to pricing decisions and want to maximize the joint profit instead of the firm's single profit (Bresnahan, 1987). This pricing decision leads to the result that the collusive price is way above the marginal costs at this quantity, so maximizing the profit of the single companies to be as the maximized profit in the perfect competitive market (Bresnahan, 1987).

Influences on the Surpluses and Welfare:

This collusive price setting behaviour leads, as usual in oligopolies or in this specific case of oligopolists acting like one single monopolist, to a loss in total welfare and in the consumer surplus. At the same time there is an increase in producer surplus because the price in the collusive oligopoly acts like a mark-up on the price-quantity equation of equalizing marginal costs with marginal revenues. In figures, the collusive price generates a produce surplus of $4billion in each year, while the loss of the consumers is $7billion in each year (Bresnahan, 1981). The total loss in welfare is over $3billion in each year (Bresnahan, 1981). This figures show that there is a big loss in market efficiency after the introduction of the collusive price by the oligopolists.

The General Motors introduced zero interest financing or price rebates in the sale of its automobiles. Ford and other car manufacturers also followed suit and started offering attractive schemes to consolidate their position. Usually the oligopolists avoid price cutting methods to compete since it can lead to ruinous price wars and will mean losses for everyone. Therefore, advertising other sales promotional measures and product differentiation are the methods used to capture new markets. If G.M. Motors launches a major advertising campaign, Ford and Chrysler will surely be forced to react to this and do something to promote their products.

QUESTIONS: Answer BOTH Questions

a)With reference to the case, identify the oligopolistic features of the car market and draw the diagram for oligopolistic market structure? (5 marks).

b)Discuss the conditions within an oligopolistic market structure that make it possible for dominant firms to collude? Is collusion "cheat-proof"? (5 marks).