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 explicit 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 agreement must be weighed against the future expected profit loss once the punishment starts. 34

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 easier it is to sustain a collusive agreement. 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 35 . the larger the benefits of deviating ∗ Fewer firms make coordination easier • Entry: — The easier it is for new firms to enter the industry.— In general: the less firms discount future profits.

2 3. 1+r where r is the interest rate between two periods.∗ Easier to determine whether a drop in sales is due to demand fluctuations or price-undercutting by rivals • Symmetry: — With symmetric players. 1) — We can define the discount factor as δ= 1 . it might be easier to coordinate on a collusive agreement that benefits all firms • Price transparency: — Exchange of price/quantity information 3.2. 36 .1 Analysis of collusion in a supergame A general model • Consider an industry where n firms play an infinite horizon game • If all firms choose a collusive action: — π c is current profits for firm i i — Vic is the (discounted) present value of all future profits • If firm i deviates from the collusive agreement: — π d is the current profit in the deviation period (before detection) i — Vip is the (discounted) present value of all future profits (after detection) • Assume that firms discount the future by a factor δ ∈ (0.

— This condition holds if the discount factor is sufficiently high: δ ≥ δ i := πd − πc i i ... i i or π d − π c ≤ δ (Vic − Vip ) . • 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 c + δVic ≥ π d + δVip . i i — The current profit gain from deviation must be lower than the discounted future losses resulting from the punishment. n. 37 .2 A specific model • Consider an industry where n identical firms play an infinitely repeated game.— 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. — In other words: sustaining collusion is possible only if the players are sufficiently patient 3. . c Vi − Vip and the condition must hold for all i = 1. • The firms produce the same homogeneous good at the same unit cost c.2..

n where π (p) denotes aggregate profits when all firms set the price p. Otherwise. 1−δ the above inequality can be written as δ ≥ δ := 1 − 38 1 . • All firms have the same discount factor δ • If all firms set the same price p. firms set prices simultaneously and non-cooperatively.. ≥ π (pm ) + 0 δ + δ 2 + δ 3 + ... n . n • Since ∞ t=0 δt = 1 . each firm sets p = c forever. each firm sets the collusive price pm that maximises joint profits — At each point in time t > 0. • Consider the following trigger strategies: — At t = 0. each firm sets the price pm if all firms have set the price pm in all previous periods.• Bertrand competition: In each period t.. • These trigger strategies will constitute a Nash equilibrium with a collusive outcome pi = pm in each period if π (pm ) 1 + δ + δ 2 + δ 3 + . π i (p) = • Any firm can capture all demand (and all industry profits) by charging a (slightly) lower price than the other firms. then they share demand such that Di (p) = and D (p) n π (p) .

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