In economics, collusion occurs when rival firms agree to work together, e.g. setting higher prices in order to make higher profits.
In the above example, a competitive industry will have price P1 and Qcompetitive. If firms collude, they can restrict output to Q2 and increase price to P2.
Collusion usually involves some form of agreement to seek higher prices. This may involve:
- Agreeing to increase prices faced by consumers.
- Deals between suppliers and retailers. For example, vertical price fixing e.g. retail price maintenance.
- Monopsony pricing – where retailers collude to reduce the amount paid to suppliers.
- Collusion between existing firms in an industry to exclude new firms from deals to prevent the market becoming more competitive.
- Sticking to output quotas.
- Collusive tendering. For example, ‘cover prices’ for competitive tendering in bidding for public construction contracts. This is when a rival firm agrees to set artificially high price to allow the firm of choice to win with a relatively high contract offer.
Types of collusion
- Formal collusion – when firms make formal agreement to stick to high prices. This can involve the creation of a cartel. The most famous cartel is OPEC – an organisation concerned with setting prices for oil.
- Tacit collusion – where firms make informal agreements or collude without actually speaking to their rivals. This maybe to avoid detection by government regulators.
- Price leadership. It is possible firms may try to unofficially collude by following the prices set by a market leader. This enables them to keep prices high, without ever meeting with rival firms. This kind of collusion is hard to prove whether it is unfair competition or just the natural operation of markets.
Problems of collusion
Collusion is seen as bad for consumers and economic welfare, and therefore collusion is mostly regulated by governments. Collusion can lead to:
- High prices for consumers. This leads to a decline in consumer surplus and allocative inefficiency (Price pushed up above marginal cost)
- New firms can be discouraged from entering the market by types of collusion which act as a barrier to entry.
- Easy profits from collusion can make firms lazy and avoid innovation and efforts to increase productivity.
- Industry gets the disadvantages of monopoly (higher price) but none of the advantages (e.g. economies of scale)
Justification for collusion
- In times of unprofitable conditions, collusion may be a way to try and save the industry and prevent firms going out of business, which wouldn’t be in the long-term consumer interest. Dairy suppliers tried to use this justification in 2002/03 after problems from foot and mouth disease on farm incomes.
- Research and development. Profits from collusion could, in theory, be used to invest in research and development.
Examples of collusion
Milk price by supermarkets 2002-03
After a period of low milk, butter and cheese prices, supermarkets such as Asda and Sainsbury’s colluded with Dairy suppliers, Dairy Crest and Wiseman Dairies to increase the price of milk, cheese and other dairy products in supermarkets. After an OFT investigation, supermarkets and suppliers were fined a total of £116m.
The OFT found prices set by supermarkets went up by three pence per pint of milk, but the income received by farmers did not go up. Milk collusion at BBC
Bank loans collusion – RBS and Barclays 2008-2010
In 2010 the OFT found RBS and Barclays guilty of collusion in sharing price arrangements for loans to professionals, such as lawyers and accountants. Sharing price information is a way to avoid price competition and keep prices high. RBS was fined £28.59m. (Independent)
Recruitment agencies forum cartel 2004-06
Between 2004 and 2006 six recruitment companies formed a cartel called the “Construction Recruitment Forum” which met to fix prices for supplying labour to intermediaries and construction companies. They also excluded a new firm Parc from any dealings. Hays was fined £30.4 million for a ‘Serious breach of competition law.’ BBC link
Collusion in construction industry – collusion on tender price
In bidding for public sector construction work, construction firms would collude in setting artificially high prices. Firms would decide which contracts they wanted, and rivals would bid purposefully high price. This is a practice known as “Cover pricing”. Successful companies would often reward rivals with a secret payment for avoiding competition.
During the investigation, the OFT found 199 offences where the 103 companies artificially inflated £200m worth of work. Companies were fined a total of £129.5m by the OFT. Guardian link.
Price fixing in air travel – British Airways and Virgin 2004-06
In 2007, British Airways was fined £270m for illegal price fixing arrangements with Virgin on long haul flights. The two companies met to agree and collude on the extra price of fuel surcharges in response to rising oil prices. Between 2004 and 2006, surcharges on air tickets rose from £5 to £60 per ticket. The £270m fine compares to an annual profit of £611m for BA. BBC link on collusion.
Regulation for collusion
In the UK, the Competition Act of 1998, states the OFT has the power to impose penalties on companies of up to 10 percent of their worldwide turnover for breaches of competition law.
Firms which act as whistleblowers can gain immunity from penalties. Therefore, if two firms are colluding there is an incentive to be the first to blow the whistle and give information to the OFT.
Game theory and collusion
Collusion enables both firms to make £8m – compared to the competitive equilibrium of £3m.
- If a market is competitive, firms will end up with low prices and low profits.
- Collusion is a way for firms to benefit from higher prices and high profits.
- However, collusion is an unstable equilibrium. When prices are high, a firm in a cartel has an incentive to ‘cheat’ – exceed its quotas and try to benefit from both high prices and higher output. But, if a firm exceeds its quotes, the collusion is likely to break down as other firms follow suit.
- Another factor that makes collusion unstable is the law. If a firm reports the collusion to the regulator, then the firm is immune from being fined; it is the other firm which will suffer. Therefore, in collusion, there is a strong incentive to be first to confess. It is a very risky strategy to continue with the collusion, hoping the other firm won’t run to the regulator.
- This is why the law is designed as it is – with a strong incentive to be the one to confess. The downside is that firms who collude for a long-time can be immune from prosecution and being fined.