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Chapter 5: Cartels (Collusion)

Why Cartels Form
Cartels are formed to increase individual profit for the firm. This is accomplished by using the monopoly strategy of decreasing output and increasing price. However, there is a free rider problem that can be overcome with a cartel. Any individual firm can decrease output independently in an oligopoly and see prices and profits increase for all firms in the industry – with the larger gains going to the firms that did not change their output.

A cartel therefore becomes
1. An enforcement mechanism to overcome free-riding
2. An enforcement mechanism to punish cheating
3. An agency to determine output levels, and
4. An agency to divide the gains of the cartel.

Difficulties:
1. Coordinating collusion is a problem, despite the fact that is maximizes industry profit 2. Overt or explicit collusion is illegal in the U.S.
3. Most efforts to fix prices are tacit (conscious parallelism) 4. The trick is to influence rivals behavior by signaling and threatening to punish defection 5. Need cooperation-inducing strategy as a “focal point” – a strategy so compelling that a firm would expect all other firms to adopt it

Need repeated competition over a number of periods to establish a focal point or reputation.

The development of repeated, multi-period games in Game Theory was an important development for IO, allowing for more complex and realistic interactions between firms.

Why is cooperation so difficult for finite games (where the last period is known for certain)?

Factors Necessary to Establish a Cartel

1. Must be able to raise price w/o inducing competition from outside the cartel

2. Expected punishment for forming the cartel must be low relative to the gains (Note: most cartels are international)

3. Cost for establishing and enforcing the cartel must be less than the gains

Facilitating Practices for Cooperative Pricing:
1. Price leadership
2. Advanced announcement of price changes
3. Most favored customer clause
4. Uniform delivered pricing
5. Meet the competition clauses

Repeated competition allows firms to create and maintain a reputation for cooperation. Pricing rivalry then is a repeated or dynamic process.

Strategies for Maintaining Effective Collusion

1. Detect Cheating
2. Punish Cheating

Grim Trigger Price Strategy:
The firm
1) sets a high price in the first period,
2) sets a high price in every succeeding period, provided the other firm does likewise, and 3) sets low prices forever after, if the other firm ever charges a low price

Any defection from the cooperative high-price outcome is penalized by immediate and perpetual movement to low prices.

The grim trigger strategy can be highly provocative and unforgiving, but it is difficult to communicate to other competitors that this is the game being played. Furthermore, the perpetual nature of the punishment lacks credibility.

The difficulty with the grim trigger is that it is unforgiving. In addition, there is the possibility for a defector to profit with a grim trigger strategy. Consider the following:

PVcollusion = Σ∞t=0 (High price profit) / (1 + i)t

PVdefection = Big Profit (1st period only) + Σ∞t=1 (Low price profit) / (1 + i)t

Defect ifPVdefection > PVcollusion

Folk Theorem: If the discount rate, i, is not too large the cooperative outcome is sustainable.

An alternative strategy that is more compelling is the tit-for-tat pricing strategy.

Tit-For-Tat Price Strategy:
The firm
1) sets a high price in the first period, and
2) in each succeeding period, echoes (imitates) the competitor’s previous price

The tit-for-tat pricing strategy is more compelling than alternative strategies for collusion because it is 1. Nice. The firm is not the 1st to defect
2. Provocative. Punishment is immediate
3. Forgiving. If the rival...
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