Harrington - The theory of collusion and competition policy

Collusion is when firms in a market coordinate their behavior for the purpose of producing a supracompetitive outcome. A supracompetitive outcome is one in which price exceeds the price that would have occurred without the coordination among firms. In the economic theory of collusion, coordination is with respect to the strategies that firms use. A firms strategy prescribes its behavior (e.g., what price to set, how much to produce), and that behavior can be contingent on what has transpired in the market (e.g., the prices that firms recently charged) as well as on current market conditions (e.g., a firms cost and the strength of market demand). In laymens terms, the definition of collusion put forth by economic theory is:

Collusion is when firms use history-dependent strategies to sustain supracompetitive outcomes through a reward-punishment scheme that rewards a firm for abiding by the supracompetitive outcome and punishes it for departing from it.

If a firm abides by the collusive outcomewhich could involve high prices, exclusive territories, customer allocation, and so forththen it is rewarded in the future by rival firms continuing to abide by the collusive outcome (e.g., persisting with high prices); while if it departs from the collusive outcome (e.g., setting a low price, selling above its quota, serving another firms customers) then it is punished in the future by rival firms acting aggressively to reduce the deviating firms profits (e.g., lowering prices, selling to the deviating firms customers). Collusion involves an implicit or explicit understanding among firms that ties future rewards and punishments to current behavior and, by doing so, is able to induce compliance with regard to the supracompetitive outcome. This understanding can be viewed as contractual, though the penalties for acting contrary to the terms of the contract take the form of rival firms future (disciplining) behavior. For this arrangement to be effective, it must be self-enforcing, which means that each firm finds it in its best interest to abide by the arrangement as long as all other firms are expected to do so.

A collusive strategy comprises three fundamental elements. First, it describes the collusive outcome, such as what common price is to be charged or which firm is to serve which geographic area (when the scheme involves exclusive territories). Second, it describes the monitoring protocol; that is, how firms will monitor one another for compliance with the collusive outcome. If prices are observable and the collusive outcome is to set a common high price, then monitoring could be in terms of past prices. However, if the firms supply an intermediate good to industrial buyers (e.g., cement suppliers selling to construction companies) where price can be privately negotiated between a seller and a buyer, then price monitoring will not work. In that case, the supracompetitive outcome could involve an allocation of sales quotas (along with a common price to be set), with monitoring taking the form of comparing realized sales to those sales quotas. Third, the collusive strategy describes the punishment that occurs when there is evidence of noncompliance. Among other possibilities, the punishment could be a temporary or permanent reversion to pricing competitively, or it could be a focused price war that has firms charge low prices for the customers of the firm that apparently deviated.

Let us now state more formally, in the jargon of game theory, the meaning of firms in a market coordinate their behavior for the purpose of producing a supracompetitive outcome. As the competitive benchmark is typically defined to be a Nash equilibrium outcome for some static oligopoly game, a supracompetitive outcome involves higher prices than for a static Nash equilibrium. Coordination on a collusive strategy in a game-theoretic framework is taken to be a subgame perfect (or sequential) equilibrium in a repeated game (where the stage game is the original static oligopoly game), which produces supracompetitive outcomes through the use of history-dependent strategies. More specifically, an outcome with higher prices and profits is sustained by the threat that noncompliance with that outcome (or evidence consistent with noncompliance) is punished with a low continuation payoff, such as a temporary or permanent reversion to a stage game Nash equilibrium, or a finite number of periods with low prices and subsequent return to prices exceeding static Nash equilibrium prices.