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What’s it: Collusion is tacit cooperation or agreement to deceive others and achieve mutual benefits for the parties involved. Such agreements exist to avoid direct competition, reduce market uncertainty, and achieve higher profits. Collusion is anti-competitive behavior and, therefore, will usually come under strict government scrutiny.
When a deal is formally made, we call it a cartel. It is illegal in many countries because it is detrimental to the public interest. However, this may not apply to state-backed cartels, as in the Organization of the Petroleum Exporting Countries (OPEC).
Some collusive practices are still practiced, and it is often difficult for the government to prove it.
Factors affecting collusion
Collusion often occurs in oligopoly markets. The market consists of only a few players, and each of them has strategic dependencies. Companies observe each other and consider competitors’ strategies to design their strategies.
This strategic dependence is even greater if the market consists of two players (duopoly). Success in one company creates an unfavorable position for competitors. To avoid adverse effects, companies may resort to collusion. For example, they can tell each other about pricing, capacity, or commercial strategies, to reduce competition.
In general, the chances of collusion are higher when:
There are fewer companies in the market. An increased number of players makes it more challenging to collude and communicate. Collusion may also arise when there is one dominant company. The company can get other competitors to adopt a follower strategy. If they don’t, the dominant company will force them out of the market.
The company produces a similar product. The basis of market competition is the price. Players find it easier to coordinate pricing. A homogeneous product also reduces consumer preference for one product compared to other products.
Companies have a similar fee structure. If costs vary significantly between firms, it is more difficult to set prices to improve supply.
Demand for each company is relatively equal. Suppose one of the firms has a substantial demand (e.g., 80% of the total market demand). It that case, the company may not organizes collusion instead tries to get a competitor out of the market.
The output and price of each company can be easily monitored. That facilitates tacit coordination in determining production and selling prices.
Market demand is relatively inelastic. Thus, when the player sets a higher price, the consumer does not switch and, in the end, increases the players’ total profit in the market.
Entry barriers are high. Conversely, when new firms can easily enter the industry, they can set a new price and eliminate collusion.
Weak law enforcement. In extreme cases, the government does not have a policy and legal framework for unfair competition practices. In this case, the company has more freedom to run collusion.
Collusion types
Collusion can take many different forms. Companies can collectively choose to coordinate the market supply, quality, or selling price of an item.
The following are common forms of collusion:
- Uniform pricing
- Agreement to reduce production levels
- Penalties for rebates, as in vertical pricing
- Internal company information exchange before it is made available to the public
- Collusion to increase barriers to entry and prevent new players from entering the market
Price leadership
One of the most common ways to collude is pricing. Price collusion is often done when only a few suppliers are in the market (oligopoly market).
When there is no collusion, players compete with each other and sometimes lead to price wars. The price war harms the companies involved and the profits of all firms in the market.
One way to avoid this is to agree on a selling price. That way, the entire company’s profits can be maximized.
The players then colluded secretly. They set the price following the market leader price. That way, the price remains high, even though they don’t meet and agree on a joint selling price.
Formal collusion
Formal collusion is also called a cartel. The players make formal agreements to maximize mutual benefits. They may coordinate output, product standards, distribution of distribution areas, or product standards. Its primary purpose is to keep prices high.
There are various examples of cartels. The most frequently cited is OPEC, which is the world’s largest cartel in the petroleum business.
Tacit collusion
Under tacit collusion, companies enter into informal agreements or collude without actually communicating directly with their rivals. This tacit agreement avoids detection by government regulators.
Price leadership is a tacit collusion example. Firms may also use output information to influence market supply. To be successful, all players provide output information publicly. Any player can easily access it and use it to set output.
Collusion pros and cons
Collusion is a form of anti-competitive practice and, therefore, illegal in some countries. However, it is more difficult to prove legally than cartels.
Collusion is detrimental to the interests of consumers because producers will pursue maximum profits for them. By inhibiting competition, prices are likely to be higher than if competition were present in the market. As a result, it led to a decrease in consumer surplus. The allocation of resources is also inefficient because prices rise above marginal cost.
Apart from making it difficult for market prices to fall, this kind of practice can also increase entry barriers. High entry barriers reduce competitive pressure from new entrants.
If it lasts a long time, collusion provides a disincentive to become more competitive. As competitive pressures diminish, they are less likely to strive to be more innovative and productive.
Some countries, such as the European Union, still allow some collusive practices, especially those that contribute to economic welfare, such as developing industry standards, some public disclosure of information, and joint research and development.