13 Collusion
Imagine a market in which, when firms compete with one another, they end up producing a quantity that gives them a certain profit lower than in a monopoly. If firms competing in this market start cooperating, and agree to restrict the quantity produced to the same quantity that a monopolist would produce, they will increase their profits. This type of cooperation between firms to increase profits is called a cartel.
The UK Competition and Markets Authority (CMA) defines a cartel as an agreement between businesses to not engage in competition. Cartel members might agree to a determined level of production, but they can also do the same with prices, discounts, credit terms, customers, geographies or bids in auctions. In the case of cartels, there are verbal agreements, contracts or other strategies to maintain firms working through the same conditions, because a firm can gain extra profit by defecting whilst the other participants in the cartel maintain their agreed behaviour. For example, if oligopolists decide to restrict output to increase prices and gain extra profit, the colluding firms will have an incentive to increase their output beyond the agreed quota to earn even more profit.
There is another type of agreement that is not necessarily coordinated and explicit, called tacit collusion. Tacit collusion refers to coordination that competitors reach without contracts or verbal agreements. Firms send signals to competitors around the quantity, product or price they will set and expect competitors to follow their direction. An example of this is price leadership, where a firm with market power sets a price level that other firms follow. Other firms have used tacit collusion in different ways, for example using an intermediary to set pricing, or to share price intentions with others.
Activity 4: A cartel game
This activity models cartel behaviour using a technique from mainstream economics called game theory.
Two firms, A and B, are involved in a cartel where they arrange to restrict the amount of quantity to produce so they can get monopoly profits. Firms have two decisions to make: cooperate or defect. This situation can be modelled using a game whose structure is used in many situations and is called ‘prisoner’s dilemma’ because of its first application. The game is described by the payoff matrix, in which the payoffs represent the profits of the firms. In the example below, firms A and B have made a cartel agreement to restrict their output (Q) so as to raise industry prices and profits. Each can choose to cooperate with the agreement (setting a low output) or defect from the agreement (keeping output high). Firm A’s possible choices are represented in the rows whilst Firm B’s choice are in the columns. Each cell in the payoff matrix shows Firm A’s profits first and Firm B’s profits after the comma. So, for example: if Firm A defects (top row), and set high Q, whilst Firm B cooperates (right column) the payoff (150, 30) shows a profit of 150 for A and 30 for B.
| Firm A | Firm B | ||
Defect (high Q) |
Cooperate (low Q) | ||
Defect (high Q) |
50,50 | 150,30 | |
Cooperate (low Q) |
30, 150 | 100,100 | |
Using the payoff matrix and assuming both firms are only motivated by their own payoffs, answer the following questions:
- The game can be solved finding its ‘Nash equilibrium’, which is the pair of choices where both players choose their best response given the other player’s choice. What is the Nash equilibrium of the game? (HINT: In order to find it, you have to identify each player’s best choices for each possible choice of the other player.)
- What would be the best outcome for the two firms?
- What is the result of the game if it is repeated a indefinite number of rounds over time?
Comment
The Nash equilibrium of the game is when the two firms play their best responses, which are represented by the corresponding payoffs that are underlined as shown in the table below.
| Firm A | Firm B | ||
Defect (high Q) |
Cooperate (low Q) | ||
Defect (high Q) |
50,50 | 150,30 | |
Cooperate (low Q) |
30, 150 | 100,100 | |
- The Nash Equilibrium of the game is when both firms defect. For Firm A, Defect is better than cooperate (50 is greater than 30 and 150 is greater than 100). Then same applies to Firm B.
- Both firms, however, would be better off cooperating because they would earn 100 each instead of 50.
- If the game is repeated an indefinite number of rounds, its outcome is unclear since each player could punish the other when they defect, for example by defecting in the following round. So, it is possible that both players would end cooperating although this is not certain.