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Forms of collusion

Formal collusion

The most common type of formal collusion is through the cartel; where a small number of rival firms, selling a similar product, come to the conclusion that it is in their joint interests to formally collude rather than compete, they may establish a cartel arrangement in which they agree to set an industry price and output which enables them to achieve a common objective. This is likely to involve the setting of agreed output quotas for each member in order to maintain the agreed price.

A successful cartel arrangement, from the point of view of the participating firms, would be one in which the cartel acts like a single monopolist to maximise profits of individual members. This is illustrated in figure 1 below.

Figure 1 Profit maximisation for the cartel

This is the familiar monopoly diagram, with each curve representing the aggregated situation for all the firms in the cartel. In order to maximise profits, MC is equated with MR and a price of OP is set, with an output of OQ, which represents the potential level of sales. The allocation of this market quota between members could be decided by such criteria as geography, productive capacity or pre-cartel market share, or cartel members, having set a price of OP, could engage in non-price competition to each gain as large a slice of OQ as they can.

In practice, cartels may tend to be rather fragile and may not last for very long. This is because individual members may have an incentive to renege on the agreement by secretly undercutting the cartel price. The almost inevitable necessity to limit output to keep price high will tend to leave individual firms with spare productive capacity, and provide the temptation to increase profits by expanding output. Such an expansion would not only generate profit on the additional sales, but would also increase the profits on existing sales, as average fixed costs would fall as output expanded.

As the end result of successful collusion will be to create a situation similar to monopoly, with its consequent drawbacks and loss of economic efficiency, cartels are illegal in many countries, including the UK and the USA. Various cartels do, however, operate internationally, the most famous of which is OPEC. Another example of an international cartel is IATA (The International Air Transport Association) which has sought to set prices for international airline routes. However, the experience of both these cartels has been one of price cutting amongst its members, particularly during periods of declining product demand and competition from non-members.

Informal or tacit collusion

The most usual method of tacit collusion is priceleadership which occurs where one firm sets a price which is subsequently accepted as the market price by the other producers. There need be no formal or written agreement for this to happen; it is sufficient that firms believe this to be the best way of maintaining or increasing their profits. Price leadership may take various forms:

Dominant firm price leadership

This type of price leadership occurs where a firm, probably by virtue of its size comes to dominate an industry in terms of its power to influence market supply. The dominant firm sets a price to suit its own needs and the smaller firms then adjust their planned output in line with the market price that has been set for them. An example of such price leadership is provided by Ford Motor Company, who have often been the first to raise prices in the car industry.

Barometric price leadership

A barometric price leader need not necessarily be the dominant firm in the industry; rather it will be a firm, possibly small in size, which is acknowledged by others in the industry as having an informed insight into current market conditions, perhaps because it employs the best team of accountants and market analysts. The firm's reputation will therefore enable it to act as a 'barometer' to others in the industry, and its price movements will be closely followed.

Collusive price leadership

This involves a form of tacit group collusion in which prices within an industry change almost simultaneously and is linked to price parallelism where there are identical prices and price movements in a given market. In practice collusive price leadership might be difficult to distinguish from dominant firm leadership, especially in circumstances where the price leader is quickly followed.

Tacit collusion may also occur where firms in the industry follow a set of 'rules of thumb' instead of a price leader. Such rules may be designed to prevent destructive competition and thus maintain longer term profitability, although some short run profitability may be sacrificed as the rules do not require MC and MR to be equated. One such rule of thumb is cost-plus pricing.

Cost-plus pricing

This is also known as average cost pricing, mark-up pricing and full-cost pricing, and empirical evidence suggests that it is the most common pricing procedure adopted by firms. It involves firms setting price by adding a standard percentage profit margin to average costs, so that:

Price = AFC+ AVC + profit margin

Cost-plus pricing is consistent with the idea of relatively stable oligopoly prices as, providing costs are stable, prices will also remain stable in the short run, even though demand might be changing. Conversely, if costs rise on average by 5%, then prices in the industry will also be rising by a similar percentage.

Coursework task

Choose a particular market to study, e.g. the market for soap powders, chocolate bars, computers or any other of your choice.

Investigate the degree and nature of competition in your chosen market and the implications of this for producers and consumers.