Collusion

Collusion is a pejorative word. Collusion occurs when there is a secret agreement and cooperation that benefits those who collude. The agreement is kept secret because the activity may be fraudulent, deceitful, or illegal. It has been recognized for centuries. Adam Smith wrote in 1776 that any get-together of tradesmen in the same industry most likely ended in a conspiracy, resulting in either higher prices or another such conspiracy against the public.

Such collusion between firms that fixes prices may be illegal. Collusion may be reached without any formal agreement. Indeed, enforcing competitive practices may not even require evidence that the firms have any sort of contact at all. They may merely refrain 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 colluding in setting prices and output targets only makes sense 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 [Page 114]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 costs of producing the last good is equal to the selling price. However, if each restricts output, the price will be forced up and firms may enjoy their share of oligopoly profits. A firm can announce its price and output, which rivals might see is 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, hence collusion should fail.

However, collusion may be sustained just as collective action may be sustained in prisoner's dilemma–type situations. If the game is repeated, the folk theorem tells us that cooperative solutions are possible. If each firm sees that all other firms are keeping prices high and restricting output, then each 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.