All you need to know about collusion: Cartels vs tacit collusion
Oligopolistic Firms and Collusion
Introduction to Collusion in Oligopolistic Markets
Oligopolistic markets are characterized by a small number of firms that dominate the market. Unlike perfectly competitive markets where numerous firms compete, or monopolistic markets where a single firm controls the market, oligopolies lie somewhere in between. One of the significant features of oligopolistic markets is the potential for collusion among firms. Collusion refers to an agreement between firms to restrict competition, often by setting prices or output levels to maximize joint profits. In essence, colluding firms behave as though they are a single monopoly, leading to higher prices and reduced output compared to competitive markets.
The Mechanics of Collusion
In an oligopolistic market, a few dominant firms may find it beneficial to collaborate rather than compete. By restricting output and setting higher prices, these firms can increase their collective profits at the expense of consumer welfare. When firms collude, they typically aim to achieve monopoly-like outcomes. This involves setting a price that maximizes total industry profits and dividing the market output among themselves in a way that maximizes their individual profits while minimizing competitive pressures.
Formal vs. Tacit Collusion
Collusion can take two primary forms: formal collusion and tacit collusion.
Formal Collusion (Cartels): Formal collusion involves explicit agreements between firms to coordinate their actions. These agreements, known as cartels, are often legally binding among the participating firms. One of the most well-known examples of a cartel is the Organization of the Petroleum Exporting Countries (OPEC), where member countries collaborate to set production quotas and influence global oil prices. Despite their potential to stabilize markets and control prices, cartels are illegal in many countries due to their detrimental effects on competition and consumer welfare. Antitrust regulators actively monitor and dismantle cartels to ensure fair competition.
Tacit Collusion: Unlike formal collusion, tacit collusion does not involve explicit agreements. Instead, firms in an oligopoly may indirectly coordinate their actions through understanding and mutual recognition of their interdependence. Tacit collusion often manifests in price leadership models, where one firm (usually the dominant player) sets a price, and other firms follow suit. This form of collusion is more challenging to detect and prove because it lacks formal agreements or direct communication between firms. An example of tacit collusion is seen in the airline industry, where major airlines often match price changes initiated by a leading airline.
The Rarity of Cartels
In practice, cartels are relatively rare due to the presence of stringent antitrust regulations and the inherent difficulty in maintaining collusive agreements. Antitrust regulators in many countries actively investigate and prosecute firms engaged in cartel behavior. The penalties for forming or participating in a cartel can be severe, including hefty fines and imprisonment for executives involved. Additionally, the incentive for individual firms to cheat on the cartel agreement (by secretly lowering prices or increasing output) makes maintaining a cartel challenging. These factors contribute to the rarity of formal collusion in the real world.
Prevalence of Tacit Collusion
Given the difficulties associated with formal collusion, firms in oligopolistic markets often resort to tacit collusion. Tacit collusion allows firms to achieve similar outcomes without the risk of legal repercussions associated with explicit agreements. The price leadership model is a common form of tacit collusion, where the dominant firm sets the price, and other firms follow to avoid price wars and maintain stable profits. This form of collusion is more subtle and relies on mutual understanding rather than direct communication.
Challenges in Proving Tacit Collusion
Proving tacit collusion is inherently difficult due to the lack of explicit agreements or direct evidence of coordination. Antitrust authorities must rely on circumstantial evidence, such as parallel pricing behavior, to infer collusive conduct. However, parallel pricing alone is not sufficient to prove collusion, as firms may independently arrive at similar prices due to market conditions or cost structures. To establish tacit collusion, regulators must demonstrate that firms had an understanding and acted in a coordinated manner to restrict competition. The subtle nature of tacit collusion makes it challenging for regulators to differentiate between competitive behavior and collusion, resulting in fewer successful prosecutions.
Conclusion
Collusion in oligopolistic markets is a significant concern for regulators and policymakers due to its potential to harm consumers by raising prices and restricting output. While formal collusion in the form of cartels is relatively rare due to stringent antitrust laws, tacit collusion remains a prevalent issue. Understanding the dynamics of collusion and the challenges in proving tacit collusion is crucial for maintaining competitive markets and protecting consumer welfare.
Additional reading materials:
https://assignmentpoint.com/tacit-collusion/
https://econfix.wordpress.com/2017/07/16/tacit-collusion-at-marthas-vineyard-petrol-stations/