The Economist ‘Free Exchange’ had an article about tacit collusion and the role of algorithms in setting prices. Martha’s Vineyard, a popular holiday retreat for the wealthy in the US, has four petrol stations who had a price-fixing suit brought against them for what was seen as extremely high petrol prices when compared to those at nearby Cape Cod. The judges found no evidence that there was agreement between petrol stations to raise prices although they did note that the market encouraged tacit (silent) collusion amongst the four petrol stations. Whereas explicit collusion over prices is illegal, tacit collusion is not. The conditions conducive for tacit collusion include:
- The market is concentrated and there are strong barriers to entry from competitors. Martha’s Vineyard is cut off from the mainland.
- Prices are transparent in a way that renders any attempt to steal business by lowering prices self-defeating. A price cut posted outside one petrol station will soon be matched by the others. And if one station raises prices, it can always cut them again if the others do not follow.
- The product is a small-ticket and frequent purchase, such as petrol. Markets for such items are especially prone to tacit collusion, because the potential profits from “cheating” on an unspoken deal, before others can respond, are small.
Petrol Price App
Although the consumer maybe able to find out the price of petrol at various stations through a smartphone app but this app makes it easier for the petrol stations to monitor and match each others’ prices. A retailer would have little incentive to cut prices and as other competitors would be able to match their prices instantly leaving everyone worse off.
Collusion in oligopoly
It is often observed that oligopolistic firms are torn between two conflicting desires: The wish to compete on one hand, and the wish to collude on the other. The hope of winning any price war tempts some firms (particularly those with significant advantages, such as lower costs) but collusion is an attractive proposition given the desire to remove the uncomfortable uncertainty that interdependence brings to the market. Collusion reduces the fear of competitive price cutting or retaliatory advertising which could reduce industry profits.
Where oligopolists agree formally or informally to limit competition between themselves they may set output quotas, fix prices, or limit product promotion or development.
A formal collusive agreement is called a cartel. A cartel can achieve the same profits as if the industry were a monopoly. In the graph below the total market or industry demand curve is shown as D and the corresponding marginal revenue curve is MR. The cartel’s marginal cost curve (MC) is the horizontal sum of the marginal cost curves of the members of the cartel. The cartel will set a price of p1 (MC = MR) where profits are maximised. Alternatively the cartel could set output at q1 by giving each cartel member an output quota. This would produce the same price (p1).
By contrast, p2 shows the marginal cost price which would be the price under perfect competition, with q2 showing the corresponding output. This means that the cartel will operate with a higher price and lower output when compared to perfect competition.
Cartel with a monopoly price
Covert (formal) collusion occurs where firms meet secretly and make decisions about prices or output. Tacit (informal) collusion is much more difficult to control. This is when firms act as if they have agreements in place without actually having communicated with each other.
Collusion between firms whether formal or informal is more likely when:
• there are only a few firms in the industry, so reaching an agreement is easier and any cheating can be spotted quickly.
• they have similar costs of production and methods of production making any agreement on price easier to reach.
• the firms produce similar products. Cartels have been common in industries such as cement production in recent years.
• the products have price inelastic demand meaning that a rise in price by the cartel will lead to a rise in sales revenue for the firms.
• the laws against collusion in a country are weak or ineffective.
Collusive agreements often prove difficult to sustain. Most are illegal as they raise prices to the detriment of the consumer. They cannot, therefore, be enforced by contract, even if cheating could be detected. Each and every party to the collusive agreement has an incentive to cheat by producing more than agreed. This will suppress price slightly, but the firm can still take advantage of artificially high prices as long as the other firms do not cheat as well. However, stable market conditions (a small number of firms; similar costs of production; similar products; high barriers to entry; easy detection of cheating on the agreement) make joint profit maximisation feasible.