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COLLUSION:

A usually secret agreement among competing firms in an industry (primarily oligopoly) to dominate the market, control the market price, and otherwise act like a monopoly. The reason for the secrecy is that such behavior is illegal in the United States under antitrust laws. Collusion can take one of two forms. Explicit collusion occurs when two or more firms in the same industry formally agree to control the market. Implicit collusion occurs when two or more firms in the same industry control the market through informal, interdependent actions. Collusion is one of two ways oligopoly firms cooperate to avoid competition. The other is through mergers.
Collusion is a characteristic trait of oligopolistic industries. Intense competition and interdependent decision-making encourages oligopolistic firms to cooperate. One way to lessen the competition among an oligopolistic rival is to join forces through collusion.

Two Types of Collusion

Collusion can take one of two forms--explicit collusion and implicit collusion.
  • Explicit Collusion: Also termed overt collusion, this occurs when two or more firms in the same industry formally agree to control the market. Admittedly, because collusion in the United States and most industrialized countries is illegal, such a formal agreement is likely to be highly secret and unlikely to be documented in any way. It might involve nothing more than a "casual" lunch among company presidents, a "chance" meeting at a conference of industry executives, or company decision-makers skulking around back alleys in the dead of the night discussing price charges.

  • Implicit Collusion: Also termed tacit collusion, this occurs when two or more firms in the same industry informally agree to control the market, often through nothing more than interdependent actions. A prime example of implicit collusion is price leadership. In this case, one firm takes the lead of setting a price that will boost profits for the entire industry. Other firms then go along with this price, knowing that they stand to benefit by doing so.
Whether explicit or implicit, collusion is often difficult to detect. Firms that engage in explicit collusion are usually shrewd enough to avoid documenting this illegal activity. These firms seldom leave a paper trail that could provide evidence for government prosecution. With no formal agreement, implicit collusion is even more difficult because. In fact, implicit collusion is just a notch away from normal, interdependent oligopolistic behavior. The firms might be colluding or they might be competing.

For example:

  • Oligopolistic firms tend to have rigid prices and engage in nonprice competition. But are these prices rigid because of competitive behavior suggested by a demand curve',500,400)">kinked-demand curve or game theory decision making, or are they rigid because firms have colluded to fix prices?

  • Oligopolistic firms often raise prices at the same time to the same degree. But are they doing so in response to the same market conditions or because they are colluding?

  • Oligopolistic firms commonly follow the leader when it comes to price changes. But are they using price leadership as a legitimate competitive practice or are they practicing implicit collusion?

Cartel

One of the most noted examples of explicit collusion is a cartel. While the term cartel can be used to mean any type of explicit collusion, it is often reserved for international agreements, such as the Organization of Petroleum Exporting Countries (better know as OPEC).

OPEC is perhaps the most famous international cartel, which exerts control over the world petroleum market. International cartels, more often than not, officially are political treaties among countries. However, when the countries also control the production of a good like petroleum, and when the treaty is primarily designed as a means of influencing the global market for this good, then the treaty also becomes a formal economic arrangement and an example of explicit collusion.

Acting Like Monopoly

In general, collusion among oligopolistic firms means that two or more firms decide to act like a monopoly. Rather than maximizing profit for each individual firm, the firms maximize total industry profit just as if a monopoly controlled the industry.

Motivation behind collusion is relatively straightforward. Total profit is greater when firms collude than when they compete. Cooperating firms can agree to charge a higher price and produce less output--just like a monopoly.

A side benefit for the colluding firms is that non-colluding firms can be driven from the market. For example, the top two soft drink firms that control a sizeable share of the hypothetical Shady Valley soft drink market might decide to do a little colluding. While their ultimate goal is to raise the price, they might first agree to lower the price. By so doing, they can force other smaller firms out of the market. Once these other firms have left, then their market control increases, making their collusion more effective. They can then raise the price and more effectively act like a monopoly, without concern that the smaller firms will undercut their collusion price.

Collusion Production

Collusion Production
Collusion Production
The exhibit to the right summarizes collusion among two firms, OmniCola and Juice-Up, in the hypothetical oligopolistic Shady Valley soft drink industry. Here is a overview of the analysis:
  • Two Firms: The cost curves for the two oligopoly firms in this analysis are presented in the far left (for OmniCola) and middle (Juice-Up) panels. Juice-Up has higher costs than OmniCola.

  • Industry Marginal Cost: The marginal cost curves for the two firms are combined in an industry marginal cost curve, labeled MCm, presented in the far right panel. This curve indicates the change in cost, using the production plants of both firms, that is incurred by producing one more unit of output.

  • Demand and Marginal Revenue: The far right panel also presents the demand curve for the soft drink market, labeled D, and what would be the marginal revenue curve, labeled MR, for a monopoly seller, which is what the two firms have become.

  • Profit Maximization: Total industry profit is maximized by equating the industry marginal cost curve (MCm) with the monopoly marginal revenue curve (MR). This is achieved at a quantity of 16,000 cans.

  • Setting Price: Once the profit-maximizing quantity is identified, the colluding firms act just like a monopoly to set the price. They determine the demand price that buyers are willing to pay for the 16,000 cans quantity, which is $1 per can.

  • Dividing Production: The 16,000 cans of total production is divided between OmniCola and Juice-Up based on their individual marginal costs. OmniCola produces 10,000 cans and Juice-Up produces 6,000 cans.

  • Profit to Each: The profit received by each firm is then the difference between revenue generated at the $1 price and the total cost each firm incurs when producing its quota of soft drinks. This profit is indicated by the yellow areas.
The key to this collusion is that the yellow areas, in total, are larger with collusion than with competition.

A Little Cheating

A major problem with collusion, whether explicit, implicit, or a highly-structured cartel, is the incentive for each firm to cheat on the agreement. Collusion works only if all firms in the industry maintain the same price. And this is often accomplished by restricting the quantity supplied by each firm. If all firms keep prices high, then all firms enjoy higher profits. However, if one firm reduces its price and produces more AS LONG AS THE OTHER FIRMS KEEP PRICES HIGH AND REDUCE OUTPUT, then it can boost its market share and profit.

Each firm has this same incentive to cheat. And if one cheats, then others have less incentive to continue with the collusive arrangement and more incentive to cheat. Collusive arrangements, as such, tend to break down.

Cheating is more easily avoided and collusion is easier to maintain if the following conditions hold:

  • Few Firms: Maintaining a collusive agreement between two firms is substantially easier than between two hundred firms. The more firms in an industry, the easier it is for a single firm to cheat. And if it is easier for one firm to cheat, it is easier for all firms to cheat.

  • Barriers to Entry: The downside for colluding firms is that high economic profit entices other firms to enter the industry. If other firms are prevented from entering the industry through high entry barriers, then the colluding firms can safely keep prices high without this threat of competition.

  • Stable Industry: If market conditions, such as production cost, input prices, demand, prices of other goods, regulations, and taxes change very little, then it is easier to maintain collusion. If nothing changes, then the colluding firms can set their price and go about the business of maximizing industry profit. However, if industry conditions are highly unstable, then firms need to adjust and adapt to the changes. Some firms may find it easier to adjust than others. Some firms may be affected differently by the instability. Some firms may have different expectations about what future instability will bring.

  • Ample Information: To maintain a collusive agreement, it is important to know if each firm is actually charging the agreed price and production level. If none of the firms know what price each is actually charging, then any given firm can easily deviate from the collusive price. The more complicated the price structure used by the firms, such as volume discounts, supporting goods or services, delivery charges, and differentiated products, then the more difficult it is to know exactly what price is being charged by a given firm.

  • Limited Government Regulation: While collusion is illegal under antitrust laws, government cannot watch all industries at all times. When it comes to antitrust, government generally keeps a close eye on industries that are nationally prominent and produce important products. Transportation, energy, and communications industries are prime candidates. Industries that produce "unimportant" products, such as entertainment, household products, or processed food, or have limited geographic markets, such as small towns, tend to be less scrutinized by antitrust enforcers. Limited enforcement makes it easier to maintain a collusive agreement.

Competition and Cooperation

Collusive behavior and the tendency to cheat on a collusive agreement illustrate the constant tug-and-pull between competition and cooperation in oligopoly. Because firms grow weary of competition and see the benefits of cooperation they tend to pursue collusion. However, the competitive forces never leave, inducing firms to cheat on any collusive agreement. Then, if collusion falls apart, and competition dominates the market, the pressure to collude anew is always present.

Even without government antitrust action, the "natural" course of events for an oligopolistic industry is to ebb and flow between competition and collusion.

<= COINCIDENT ECONOMIC INDICATORSCOLLUSION, EFFICIENCY =>


Recommended Citation:

COLLUSION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: September 24, 2018].


Check Out These Related Terms...

     | explicit collusion | implicit collusion | cartel | merger | conglomerate merger | horizontal merger | vertical merger |


Or For A Little Background...

     | oligopoly | oligopoly, behavior | oligopoly, characteristics | industry | market structures | market control | firm | industry | competition among the few | short-run production analysis | profit maximization | production |


And For Further Study...

     | market share | concentration ratios | four-firm concentration ratio | eight-firm concentration ratio | barriers to entry | product differentiation | game theory | kinked-demand curve | kinked-demand curve analysis | collusion production analysis | collusion, efficiency |


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