[MUSIC] Let's start with the simplest model of oligopoly, known as the lucrative oligopoly, or joint profit maximization. The cartel model provides insight into the price and quantity that oligopolists are likely to set when they can collude successfully. Consider then, a four-firm industry, in which each firm had grown tired of ruinous price wars. So, during the industries annual trade show in Las Vegas, the chief executive officers of all four companies ignore anti-trust laws against explicit collusion, and risk a possible jail sentence, as they slip off to a secret rendezvous. During that rendezvous, they then negotiate what price should be charged for the product. And of course, as part of their secret cartel agreement each firm will also have to agree to restrict its output so the price can be maintained in the market. So where do you think these oligopolies will set price? Okay, maybe that really was an obscure question. But if you think about it, the answer is simple. If the oligopolists can truly coordinate their activities, the obvious price to set is the same as that which would be set by a monopolist. That means of course that, price will be set by the profit maximizing rule of marginal revenue equals marginal cost. And if the price is set at that point, the oligopolists will jointly maximize their profits, which is why this model is often called the joint profit maximization model. Now one other point, in order for the monopoly price to hold in the marketplace, total industry output must equal the monopoly output. This is where problems with the cartel are likely to emerge. Because, if any one firm in the oligopoly decides to cheat by producing more than its agreed upon share of output, it can make higher profits. Than if it adheres to the cartel agreement. It is precisely such cheating that has made OPEC, the international oil cartel, so unsuccessful over the past several decades at propping up oil prices. Note however that in the dark days of 1973 and 1974. During those years, the members of OPEC banded together, slapped an oil embargo on the U.S for its support of Israel, and more than quadrupled prices. The result was long gas lines and a strong negative shock to the American economy. And I might add here that under international law, OPEC's cartel behaviour was quite legal. Even if cartels are illegal within the U.S. Note however that in the ensuing years the OPEC cartel has been unable to keep the price of oil high, and at least part of the problem has been on the demand side. After the 1970s oil price shocks, motorists started driving smaller, more fuel-efficient cars. Home owners more fully insulated their homes. Businesses adopted new technologies to dramatically cut energy use, and the world in general adopted wide-ranging energy conservation measures. At the same time, on the supply side, higher oil prices stimulated the search for new oil reserves. And many non-OPEC members like Norway and Mexico entered the global oil market. Nonetheless the biggest problem was not these forces of supply and demand, but rather that OPEC has faced wide scale cheating within its ranks. This is due largely to the economic and political diversity of members as well as the large number of members in the cartel. On the one hand, this sparsely populated and fabulously wealthy members of the cartel like Saudi Arabia, Kuwait and Qatar have been perfectly content with restrict output and enjoy monopoly profits. On the other hand, other much more populous and poorer nations, like Venezuela and Nigeria, haven't been able to resist the urge to cheat on their production quotas. Because of large external debts to be paid and growing needs for cash. The broader problem has been that OPEC has no effective enforcement mechanism to police its agreements. That is, OPEC has little effective way to punish any members who do cheat on the collusive bargain.
