3 Collusion and horizontal agreements

• Different forms of collusive agreements:

— price fixing
— allocation of production quotas
— market sharing

• Two types of collusion:

— Explicit collusion, where firms communicate and enter into ex-

plicit collusive agreements (e.g., cartels)
— Tacit collusion, where firms do not communicate but reach an
"implicit understanding" that implies less competition
∗ Coordination problem!

• Any collusive agreement — tacit or explicit — always brings with it the

temptation to deviate from it.

• The temptation to deviate implies that two factors are essential for
collusion to arise:

— Detection of deviation
— Punishment of deviation

• A firm might not deviate from a collusive agreement if it knows that a

deviation will be quickly detected and punished.

• Fundamental trade-off facing each firm that enters into a collusive

agreement:

— The instantaneous profit gain of deviating from the collusive agree-

ment must be weighed against the future expected profit loss once
the punishment starts.

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 — In general: the less firms discount future profits, the easier it is to
sustain a collusive agreement.

3.1 Factors that facilitate collusion

• Market concentration:

— Collusion is more likely the smaller the number of firms in the

industry
∗ The more firms, the larger the benefits of deviating
∗ Fewer firms make coordination easier

• Entry:

— The easier it is for new firms to enter the industry, the harder it
is to sustain a collusive agreement
∗ Collusive (high) prices make entry more attractive

• Cross-ownership:

— Coordination is easier
— Lower incentives to compete

• Regularity and frequency of orders

— The absence of extraordinary orders reduces the temptation to

deviate
— High frequency of orders facilitates quick punishment in case of
deviation

• Demand stability

— Increases the degree of observability in the market

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 ∗ Easier to determine whether a drop in sales is due to demand
fluctuations or price-undercutting by rivals

• Symmetry:

— With symmetric players, it might be easier to coordinate on a

collusive agreement that benefits all firms

• Price transparency:

— Exchange of price/quantity information

3.2 Analysis of collusion in a supergame

3.2.1 A general model

• Consider an industry where n firms play an infinite horizon game

• If all firms choose a collusive action:

— π ci is current profits for firm i

— Vic is the (discounted) present value of all future profits

• If firm i deviates from the collusive agreement:

— π di is the current profit in the deviation period (before detection)

— Vip is the (discounted) present value of all future profits (after
detection)

• Assume that firms discount the future by a factor δ ∈ (0, 1)

— We can define the discount factor as

1
δ= ,
1+r

where r is the interest rate between two periods.

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 — Alternative interpretation of δ :
∗ δ can represent the uncertainty about when the game ends
∗ More precisely: δ can be represent the (constant) probability
that the game will continue for one more period.

• Collusion is a Nash equilibrium only if each firm prefers to play the

collusive action rather than to deviate from it

— Firm i has no incentive to deviate from the collusive action if

π ci + δVic ≥ π di + δVip ,

or
π di − π ci ≤ δ (Vic − Vip ) .

— The current profit gain from deviation must be lower than the
discounted future losses resulting from the punishment.
— This condition holds if the discount factor is sufficiently high:

π di − π ci
δ ≥ δ i := ,
Vic − Vip

and the condition must hold for all i = 1, ..., n.

— In other words: sustaining collusion is possible only if the players
are sufficiently patient

3.2.2 A specific model

• Consider an industry where n identical firms play an infinitely repeated

game.

• The firms produce the same homogeneous good at the same unit cost
c.

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• Bertrand competition: In each period t, firms set prices simultaneously
and non-cooperatively.

• All firms have the same discount factor δ

• If all firms set the same price p, then they share demand such that

D (p)
Di (p) =
n

and
π (p)
π i (p) =
,
n
where π (p) denotes aggregate profits when all firms set the price p.

• Any firm can capture all demand (and all industry profits) by charging
a (slightly) lower price than the other firms.

• Consider the following trigger strategies:

— At t = 0, each firm sets the collusive price pm that maximises joint

profits
— At each point in time t > 0, each firm sets the price pm if all firms
have set the price pm in all previous periods. Otherwise, each firm
sets p = c forever.

• These trigger strategies will constitute a Nash equilibrium with a col-

lusive outcome pi = pm in each period if

π (pm )


1 + δ + δ 2 + δ 3 + ... ≥ π (pm ) + 0 δ + δ 2 + δ 3 + ...
n
∞
• Since t=0 δt = 1
1−δ
, the above inequality can be written as

1
δ ≥ δ := 1 − .
n

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