How Collusion Affects the Economy: A Guide for Savvy Consumers

To Collude, or Not to Collude: The Economics Behind Collusion Explained

Collusion is a term that often has negative connotations in the business world. It refers to a secret or illegal agreement between two or more firms to coordinate their actions in order to gain an unfair advantage over their competitors. Collusion can take many forms, such as fixing prices, dividing markets, limiting output, or sharing confidential information. Collusion can also occur at different levels of the supply chain, such as between suppliers and retailers, or between buyers and sellers.

But why do firms collude in the first place? And what are the consequences of collusion for consumers, producers, and society as a whole? In this blog post, we will explore the economics behind collusion and its pros and cons.

The Incentive to Collude

The main reason why firms collude is to increase their profits by reducing competition and increasing their market power. By colluding, firms can act as if they were a monopoly and charge higher prices, produce less output, or lower their quality or innovation. This allows them to earn more revenue and reduce their costs, resulting in higher profits.

To illustrate this, let us consider a simple example of two firms, A and B, that produce a homogeneous product and compete in a duopoly market. Suppose that the market demand curve is given by Q = 100 - P, where Q is the quantity demanded and P is the price. The marginal cost of production for both firms is constant and equal to 10. If the firms compete in a Cournot duopoly, where each firm chooses its output level independently, the equilibrium output for each firm is 30, the equilibrium price is 40, and the equilibrium profit for each firm is 900.

However, if the firms collude and act as a monopoly, they can jointly maximize their profit by setting the monopoly output and price. The monopoly output is 45, the monopoly price is 55, and the monopoly profit is 2025. By colluding, the firms can increase their profit by 1125, or 562.5 each. This shows that collusion is more profitable than competition for the firms.

The Problems of Collusion

However, collusion is not always easy or stable. There are several factors that can prevent or undermine collusion, such as:

• Legal barriers: Collusion is illegal in many countries and can be punished by fines, imprisonment, or other sanctions. Antitrust laws and regulations aim to prevent and detect collusion and promote fair competition in the market.
• Cheating incentives: Even if firms collude, they may have an incentive to cheat on the agreement and undercut the collusive price or increase their output. By doing so, they can increase their market share and profit at the expense of their partners. However, if all firms cheat, the collusion breaks down and the market returns to the competitive outcome.
• Entry barriers: Collusion can attract new entrants to the market who can offer lower prices or higher quality products and erode the collusive profits. Therefore, colluding firms need to erect entry barriers, such as patents, licenses, or exclusive contracts, to deter potential competitors.
• Number and size of firms: Collusion is more difficult and less effective when there are many firms in the market or when the firms have different sizes, costs, or preferences. This makes it harder to reach and enforce a collusive agreement and increases the likelihood of defection or detection.
• Demand and cost fluctuations: Collusion can be disrupted by changes in the market demand or the production costs. For example, a decrease in demand or an increase in costs can reduce the collusive profits and make cheating more attractive. Conversely, an increase in demand or a decrease in costs can increase the collusive profits and make cheating less attractive.

The Impact of Collusion

Collusion has significant implications for the welfare of consumers, producers, and society. The main effects of collusion are:

• Higher prices and lower output: Collusion leads to higher prices and lower output than the competitive outcome. This reduces the consumer surplus and increases the producer surplus, creating a deadweight loss for society. The deadweight loss is the net loss of social welfare due to the inefficient allocation of resources.
• Lower quality and innovation: Collusion can also lead to lower quality and innovation, as colluding firms have less incentive to improve their products or services or invest in research and development. This can harm the consumers’ satisfaction and the long-term growth of the industry and the economy.
• Redistribution of income: Collusion can also result in a redistribution of income from consumers to producers, or from one group of producers to another. For example, collusion between suppliers and retailers can lower the prices paid to suppliers and increase the prices charged to consumers, benefiting the retailers at the expense of the suppliers and the consumers. Similarly, collusion between buyers and sellers can lower the prices paid to sellers and increase the prices charged to buyers, benefiting the buyers at the expense of the sellers and the buyers.

Conclusion

Collusion is a phenomenon that occurs when firms cooperate to gain an unfair advantage over their competitors. Collusion can increase the profits of the colluding firms, but it can also harm the consumers, the society, and the industry. Collusion is influenced by various factors, such as legal barriers, cheating incentives, entry barriers, number and size of firms, and demand and cost fluctuations. Collusion is illegal in many countries and can be prevented or detected by antitrust laws and regulations.