Unit 3: Oligopoly & Collusion

Collusive behaviour is thought to be a common feature of many oligopolistic markets. Collusion is often explained by a desire to achieve joint-profit maximisation within a market or prevent price and revenue instability in an industry.


Tacit collusion

Price leadership refers to a situation where prices and price changes established by a dominant firm, or a firm are usually accepted by others and which other firms in the industry adopt and follow. When price leadership is adopted to facilitate tacit (or silent) collusion, the price leader will generally tend to set a price high enough that the least cost-efficient firm in the market may earn some return above the competitive level.

We see examples of this with the major mortgage lenders and petrol retailers where many suppliers follow the pricing strategies of leading firms. If most firms in a market are moving prices in the same direction, it can take some time for relative price differences to emerge which might cause consumers to switch their demand.

Firms who market to consumers that they are “never knowingly undersold” or who claim to be monitoring and matching the cheapest price in a given geographical area are essentially engaged in tacit collusion.

Tacit collusion occurs where firms undertake actions that are likely to minimise a competitive response, e.g. avoiding price cutting or not attacking each other’s market It is often observed that when a market is dominated by a few large firms, there is always the potential for businesses to seek to reduce uncertainty and engage in some form of collusive behaviour. When this happens the existing firms engage in price fixing cartels. This behaviour is deemed illegal by UK and European competition law. But it is hard to prove that a group of firms have deliberately joined together to raise prices.

Explicit Price Fixing

Price fixing represents an attempt by suppliers to control supply and fix price at a level close to the level we would expect from a monopoly.

To collude on price, producers must be able to exert some control over market supply. In the diagram below a producer cartel is assumed to fix the cartel price at price Pm. The distribution of the cartel output may be allocated on the basis of an output quota system or another process of negotiation.

Although the cartel as a whole is maximising profits, the individual firm’s output quota is unlikely to be at their profit maximising point. For any one firm, expanding output and selling at a price that slightly undercuts the cartel price can achieve extra profits! Unfortunately if one firm does this, it is in each firm’s interests to do exactly the same and, if all firms break the terms of their cartel agreement, the result will be excess supply in the market and a sharp fall in the price. Under these circumstances, a cartel agreement can break down.

Collusion in a market or industry is easier to achieve when:

1. There are only a small number of firms in the industry and barriers to entry protect the monopoly power of existing firms in the long run.

2. Market demand is not too variable (or cyclical) i.e. it is reasonably predictable and not subject to violent fluctuations which may lead to excess demand or excess supply.

3. Demand is fairly inelastic with respect to price so that a higher cartel price increases the total revenue to suppliers – this is easier when the product is viewed as a necessity.

4. Each firm’s output can be easily monitored (this is important!) – This enables the cartel more easily to control total supply and identify firms who are cheating on output quotas.

5. Incomplete information about motivation of other firms may induce tacit collusion.

Possible break-downs of cartels

Most cartel arrangements experience difficulties and tensions and some cartels collapse completely. Several factors can create problems within a collusive agreement between suppliers:

1. Enforcement problems: The cartel aims to restrict production to maximize total profits of members. But each individual seller finds it profitable to expand production. It may become difficult for the cartel to enforce its output quotas and there may be disputes about how to share out the profits. Other firms – not members of the cartel – may opt to take a free ride by producing close to but just under the cartel price.

2. Falling market demand creates excess capacity in the industry and puts pressure on individual firms to discount prices to maintain their revenue. There are good recent examples of this in commodity markets including the collapse of the coffee export cartel.

3. The successful entry of non-cartel firms into the industry undermines a cartel’s control of the market – e.g. the emergence of online retailers in the book industry in the mid 1990s led ultimately to the end of the Net Book Agreement in 1995.

4. The exposure of illegal price fixing by market regulators such as UK Office of Fair Trading and the European Competition Commission