Tacit collusion

Tacit collusion occurs when cartels are illegal or overt collusion is absent. Put another way, two firms agree to play a certain strategy "without explicitly saying so". This is also known as price leadership, as firms may stay within the law but still tacitly collude by monitoring each other's prices and keeping them the same. Usually, this occurs when a firm emerges to set the general industry price and other firms follow suit. Oligopolists usually try not to engage in price cutting, excessive advertising or other forms of competition. Thus, there may be unwritten rules of collusive behavior such as price leadership (tacit collusion). A price leader will then emerge and sets the general industry price, with other firms following suit. For example see the case of British Salt Vs Salt Union (Competition Commission report which concludes price leadership and a lasting collusive agreement between the two firms).

Tacit collusion is best understood in the context of a duopoly and the concept of Game Theory (namely, Nash Equilibrium). Let's take an example of two firms A and B, who both play an advertising game over an indefinite number of periods (effectively saying 'infinitely many'). Both of the firms' payoffs are contingent upon their own action, but more importantly the action of their competitor. They can choose to stay at the current level of advertising or choose a more aggressive advertising strategy. If either firm chooses low advertising while the other chooses high, then the low-advertising firm will suffer a great loss in market share while the other experiences a boost. However if they both choose high advertising, then neither firms' market share will increase but their advertising costs will increase, thus lowering their profits. If they both choose to stay at the normal level of advertising, then sales will remain constant without the added advertising expense. Thus, both firms will experience a greater payoff if they both choose normal advertising (however this set of actions is unstable, as both are tempted to defect to higher advertising to increase payoffs). A payoff matrix is presented with numbers given:

Notice that Nash's Equilibrium is set at both firms choosing an aggressive advertising strategy. This is to protect themselves against lost sales.

In general, if the payoffs for colluding (normal, normal) are greater than the payoffs for cheating (aggressive, aggressive), then the two firms will choose to collude (tacitly). The payoffs can be calculated by taking into account the interest rate and, from this, obtaining the discount factor. Taking the sum of the payoffs and discount factor along with the indefinite number of periods will give you the sum of the discounted payoffs. The calculation of a firm's total payoffs can be obtained through the concept of discounted payoffs.

Forms

Price leadership is an observation made of oligopic business behavior in which one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following. In the long run price leadership could have a negative impact on the dominant firm. Over time, as the supply from the fringe (smaller) competitors in the market increases the residual demand of the dominant firm decreases. In such a scenario, if the dominant firm intends to continue as the price leader in the market, it can do so only at the cost of decreasing its supply to the market, consequently sacrificing its market share. Unheeded to, the gradual loss in market share could see the once dominant player lose its position of dominance in the market.

Classical economic theory holds that price stability is ideally attained at a price equal to the incremental cost of producing additional units. Monopolies are able to extract optimum revenue by offering fewer units at a higher cost.

An oligopoly where each firm acts independently tends toward equilibrium at the ideal, but such covert cooperation as price leadership tends toward higher profitability for all, though it is an unstable arrangement.

In dominant firm price leadership, follower firms set the same price as an established leader. The price leader may be the largest firm that dominates the industry.

In barometric firm price leadership, the most reliable firm emerges as the best barometer of market conditions, or the firm could be the one with the lowest costs of production, leading other firms to follow suit. Although this firm might not be dominating the industry, its prices are believed to reflect market conditions which are the most satisfactory, as the firm would most likely be a good forecaster of economic changes.

See also

* Cournot competition