collusion

collusion, secret agreement and cooperation between interested parties for a purpose that is fraudulent, deceitful, or illegal.

An example of illegal collusion is a secret agreement between firms to fix prices. Such agreements may be reached in a completely informal fashion. Indeed, enforcing competitive practices may not even require evidence that the firms have had any sort of contact at all. They may merely refrained from undercutting each other’s prices or from selling in each other’s market areas. Such collusion occurs when antimonopoly laws exist that prohibit formal agreements over such activities. Collusion is hard to prove and may involve enforcers arguing that the activity of firms suspected of colluding in setting prices and output targets makes sense only in terms of the benefits of collusion. In such cases, firms may be forced to reduce prices or to sell to suppliers in areas outside of their normal markets. In that manner, competitive practices are forced on firms without actually demonstrating that they were engaging in illegal activity prior to those orders.

How can firms collude without ever meeting? In a competitive setting, each firm will market its goods until the marginal cost of producing the last good is equal to the selling price. However, if each restricts output, the price will be forced up and the firms may each enjoy their share of oligopoly profits. A firm can announce its price and output, which rivals might see as being higher than is sustainable in a competitive situation. They can choose to follow suit. Such choices are difficult to sustain in large markets with many sellers, because it is in the interests of each to sell at a slightly lower price, produce more, and take more of the market. Once one firm starts to behave competitively, all firms must follow suit or face losing their entire market.

Sustaining prices and output at oligopolistic levels is thus a collective action problem that may be modeled similarly to a “prisoner’s dilemma” game. In the prisoner’s dilemma game there is a strictly dominant strategy to defect from cooperation, and hence collusion should fail. However, collusion may be sustained, just as collective action may be sustained in prisoner’s dilemma situations. If the game is repeated, the folk theorem predicts, cooperative solutions are possible. If a firm sees that all other firms are keeping prices high and restricting output, then it may also do the same. Collusion is thus easiest in markets with fewer firms and where the price of the commodity is readily gauged by all firms. Therefore, collusion is much easier in markets for new cars, especially where firms control the outlets for their cars, than it is in markets for fresh fruit.

David M. Kreps, A Course in Microeconomic Theory (1990).