Collusion in business can lead to higher prices and reduced competition. Firms coordinate pricing or production, acting as a monopoly to maximize joint profits. This practice often results in decreased consumer welfare and reduced innovation, as competitive pressure diminishes.
Cartel stability depends on factors like agreement, monitoring, and punishment mechanisms. Firms have incentives to cheat, but long-term losses from retaliation can outweigh short-term gains. Collusion sustainability increases with repeated interactions and higher discount factors, while legal risks deter explicit agreements.
Collusion and Market Outcomes
Definition and impact of collusion
- Collusion involves competing firms agreeing to coordinate pricing, production, or other decisions limiting competition and increasing profits
- Collusive agreements can be explicit formal contracts or implicit informal understandings
- Explicit collusion often illegal, while implicit collusion more difficult to detect and prosecute
- Collusion leads to higher prices, reduced output, and decreased consumer welfare compared to competitive market equilibrium
- Colluding firms act as monopoly, maximizing joint profits rather than competing
- Collusion results in reduced innovation and efficiency, as firms have less incentive to improve products or processes when not facing competitive pressure
Cartel Stability and Sustainability
Conditions for stable cartels
- Cartel members must agree on key decision variables, such as prices, production levels, or market shares
- Reaching agreement challenging when firms have different costs, capacities, or preferences
- Cartel members must monitor each other's compliance with the agreement
- Cheating on agreement (secretly cutting prices or increasing output) must be detectable
- Cartel members must punish defectors or cheaters effectively
- Punishment mechanisms include price wars, retaliation in other markets, or legal action
- Number of firms in market should be relatively small
- Coordination and monitoring become more difficult as number of firms increases
- Products offered by firms should be relatively homogeneous
- Differentiated products make it harder to agree on prices and detect cheating
- Barriers to entry should be high
- New entrants can disrupt cartel by undercutting prices or refusing to join agreement
Incentives for cartel cheating
- Each firm in cartel has incentive to cheat by secretly lowering prices or increasing output
- By cheating, firm can increase market share and profits at expense of other cartel members
- Short-term gains from cheating can be significant, especially if cheating goes undetected for some time
- However, if cheating detected, other cartel members may retaliate by starting price war or reverting to competitive behavior
- Long-term losses from price war or breakdown of cartel can outweigh short-term gains from cheating
- Incentive to cheat stronger when short-term gains large relative to expected long-term losses
- Occurs when discount rate high (firms value current profits more than future profits) or probability of detection low
Sustainability of collusion over time
- Collusion more sustainable when firms interact repeatedly over time (repeated game)
- Repeated interaction allows for development of trust, reputation, and threat of future punishment
- Discount factor ($\delta$) plays key role in sustainability of collusion
- Discount factor represents weight firms place on future profits relative to current profits
- Higher discount factor (closer to 1) means firms more patient and value future profits more, making collusion more sustainable
- Critical discount factor ($\delta^*$) is minimum discount factor required for collusion to be sustainable
- If $\delta \geq \delta^$, collusion sustainable; if $\delta < \delta^$, collusion breaks down
- Critical discount factor depends on factors such as number of firms, difference between collusive and competitive profits, and effectiveness of punishment strategies
- Firms can use trigger strategies to sustain collusion in repeated games
- Trigger strategy involves cooperating as long as all firms cooperate, but permanently reverting to competition if any firm cheats
- Threat of permanent punishment can deter cheating and make collusion more sustainable, but may not be credible if firms have incentive to renegotiate after deviation occurs
Legal and Regulatory Issues
Legal issues of collusion
- In many countries, explicit collusion (price-fixing, market allocation) illegal under antitrust or competition laws
- Antitrust laws promote competition and protect consumer welfare by prohibiting anticompetitive agreements and practices
- Implicit collusion, where firms coordinate behavior without explicit agreement, more difficult to detect and prosecute
- Parallel pricing or other forms of tacit coordination may not be illegal if they result from independent decision-making rather than agreement
- Antitrust authorities use various methods to detect and investigate collusion, such as market monitoring, leniency programs, and dawn raids
- Leniency programs offer reduced penalties to firms that report involvement in cartel and cooperate with investigation
- Dawn raids involve unannounced inspections of company premises to seize evidence of collusion
- Firms found guilty of collusion can face significant penalties, including fines, damages, and even criminal charges for individuals involved
- Threat of penalties can deter collusion, but effectiveness of enforcement varies across jurisdictions and industries
- Some industries may be exempted from antitrust laws or subject to sector-specific regulations that allow for certain forms of coordination
- Agricultural cooperatives or export cartels may be permitted in some cases to achieve other policy objectives
- International cartels pose additional challenges for enforcement, as they involve firms from multiple jurisdictions and may require cooperation between different antitrust authorities
- Differences in legal systems, priorities, and resources can complicate investigation and prosecution of international cartels