Collusion and price leadership

Overview

Collusion in an oligopolistic market, reasons why firms in oligopoly might choose to collude and reasons why firms in oligopoly might choose not to collude.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is collusion in an oligopolistic market?

   Model answer

   Collusion is an agreement or understanding between rival firms to coordinate their behaviour rather than compete, typically by fixing price, restricting output, sharing out the market or agreeing not to undercut one another. Its purpose is to capture the profit a monopolist would earn and divide it between the members.

2. 2

   Distinguish overt collusion from tacit collusion.

   Model answer

   Overt collusion is an explicit agreement between firms, such as a cartel that meets to set a common price or allocate quotas. Tacit collusion involves no agreement at all: firms independently recognise their interdependence and settle into a pattern of parallel behaviour, such as always matching the largest firm's price change, because each sees that competing would leave everyone worse off. They may reach that pattern through public signals, such as an announced price change, rather than through anything that could be called a bargain.

3. 3

   Why is tacit collusion harder for a competition authority to act against than a cartel?

   Model answer

   A cartel leaves evidence of an agreement, such as meetings, messages or shared price lists, and an agreement can be proved and punished. Tacit collusion produces the same parallel prices with no agreement to find, and parallel pricing is also exactly what a competitive market with identical costs would produce, so the behaviour is not by itself proof of wrongdoing.

4. 4

   What is a cartel, and what does a cartel have to do to raise price?

   Model answer

   A cartel is a formal association of producers that acts collectively as a single seller. To raise price it must restrict total output, because demand slopes downward and price can only be raised by putting less on the market. It therefore has to agree a total output and allocate quotas to members, and then police those quotas.

5. 5

   Explain the reasons why firms in oligopoly might choose to collude.

   Model answer

   Collusion raises joint profit towards the monopoly level and removes the risk of a mutually destructive price war. It reduces the uncertainty that makes long-term investment planning difficult, allows the group to raise price against a common cost shock without anyone losing share, and protects the incumbents' position by making it harder for a new entrant to pick off one firm at a time.

6. 6

   Explain the reasons why firms in oligopoly might choose not to collude.

   Model answer

   Collusion is illegal in most jurisdictions and carries severe penalties, so the expected cost of being caught can outweigh the extra profit. A firm with lower costs than its rivals may earn more by undercutting them and taking share than by accepting an equal slice of the joint profit. A firm with spare capacity or an ambitious growth target has a strong incentive to expand rather than restrict output, and any firm may simply distrust its rivals to keep their side of the bargain.

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