Collusion

Troy Deppert


As many drivers of cars notice when the gas gauge is low, the prices for gas at the gas stations seem strangely similar, particularly if the proximity of the gas stations is on the same street corner. There is usually only $.01 to $.02 variation in price. More remarkable, is when the gas price jumps or lowers at a station, the other stations in close proximity seem to respond by matching these changes. Often times this will lead to speculation that there is a set price for the day with slight variation, thus making the local gas markets the target for accusations of collusion on pricing by the casual observer. In fact, the gas stations are exhibiting a form of Game Theory (see Game Theory) by matching or somewhat lowering prices as a response to a competitor.




Definition


Collusion is defined as "A secret agreement between two or more parties for a fraudulent, illegal, or deceitful purpose."1. But in Economics, Collusion is used to describe rival companies that agree to a market price or maket output that is mutually beneficial to all parties. This practice is largely illegal in U.S., Canada and some EU countries. Collusion tends to happen in industries that are part of an oligopoly market, such as oil companies and automakers (see Oligopoly), since monitoring competitors output and prices becomes too cost prohibitive if there are several firms in the industry. This is explained in more detail in the Factors Affecting Collusion in Price Cheating section below. When Collusion occurs in a Cournot duopoly (one form of an oligopoly see Cournot), the output from the colluding firms is the same output as a monopoly. Therefore the market prices will be above the individual company's marginal cost and the output will be carrying deadweight loss.



Examples and Current Concerns


A main example of Collusion would be a cartel. A primary example of a world-wide cartel is the Organization of Petroleum Exporting Companies. OPEC was formed in 1960 to control oil production output and the price. Their prime example of collusion was the oil crises of 1973 by OPEC nations against the U.S. and Western Europe in response to their support of Israel in the Yom Kippur war. This response opened the Western countries to purchasing oil from Russian and start drilling in Mexico and the North Sea. While these new initiatives did not immediately lessen OPEC control, it did reduce their ability to fully influence the market in current times.

A more recent example of suspected collusion was for the New York City Medallions for Taxi drivers and Limousine service. In 2006, one broker was able to advise several bidders and bid for himself for 20 of the 124 medallions up for auction. The broker and his clients won all of their auctions. In a previous month, the same broker with 2 business associates won an auction for 54 medallions. In the past, this broker won similar bids back in 2004 which prompted the Department of Investigation in New York to look into the auctions. While the Department found nothing illegal, it advised the Taxi and Limousine Commission on three collusion loopholes in their rules. The Commission is looking into changing the rules.2

Another concern for collusion has been raised with the advent of B2B web portals sharing information which could lead to collusion. The Internet has been hailed as opening information which is an asset to an open market system. But, there have been more recent concerns for the openesss of these business-to-business systems. An example is a new system to help automobile manufacturers check prices from different suppliers. The system is called Covisint and while it is hailed by many auto manufacturers of Ford, General Motors, DaimlerChrysler, Nissan and Renault as a major source of savings in a $240 billion business, anti-trust groups are worried that the suppliers could use the system to set beneficial manufacturing prices. A similar system has been setup in EU for aerospace suppliers. These systems share a similarity with the 1994 airline lawsuit when six large airlines where cited for colluding when prices were available in a computerized booking system. Orbitz, a pricing system used currently for five airlines, is also facing anti-trust scrutiny.3



Factors Affecting Collusion in Price Cheating


Companies that are most concerned about price or production changes have factors to consider when needing to monitor rivals. These have lead to factors affecting collusion in price cheating. The factors are: the number of firms to monitor; the size of the firms; the history of the market; and the mechanisms to punish a "cheater" in a collusive deal.

Number of Firms

The first factor in collusion pricing is the number of firms in the industry. Simply put, the lower the number of firms to monitor, the easier they are to monitor. When there are two firms, each firm watches the other, but when more firms are added into the industry, the monitoring costs increase marginally. The formula for calculating the monitors is n x (n - 1), so if there are 4 firms in the industry, 12 monitors will be needed in the market. Once the number becomes too large, monitoring will not be feasible as an enforcement against cheating in a collusion.

Firm Size

Larger firms will have lower costs in monitoring smaller firms for price "cheating". A firm with one store competing against a large chain would have a harder time keeping track of prices than the chain store. Only one person would need to check the individual store for price changes.

History of the Market

Sometimes a meeting of the rival companies is not needed for colluding. If a company "cheats" by stealing customers, the other company may lower prices or increase output to put pressure on the "cheater". After a time of this tit-for-tat, the companies will come to a "tacit collusion". This type of collusion occurs without an overt agreement between the companies. In other words, enough time in the market has trained the companies behavior through interacting with each other and their customers. But, if one company is unable to retaliate, the rival company will endeavor to continue its "cheating ways".

Punishment Mechanisms

If a company charges one price to all customers, the cost of retaliating to a "cheater" is higher than a company that charges each customer individually. Simply put, if the company only has one price to all customers and is forced to lower that price, this will reduce revenues. Companies that can tailor their prices to varying customers have more leverage on "cheaters" by only offering the lower prices to stolen or potential customers.



Quiz


Question 1:
Collusion is more common in the following type of industry
a. Monopoly.
b. Monopolistic Competition.
c. Oligopoly.
d. Perfect Competition.

Answer: c. Oligopolies are the most likely market for Collusion

Question 2:
All of the following are true of Collusion except:
a. Companies can charge monopolistic prices.
b. Collusion is legal in most Western Countries.
c. Oligopolies are the primary market for Collusions.
d. Companies have been successfully sued for Collusion.

Answer: b. Collusion is mostly illegal in the U.S., most of the European Union and Canada.

Question 3:
The following is not true of OPEC:
a. It was formed in 1960.
b. It issued an embargo against the U.S. and other Western countries in 1973.
c. It is a cartel that is openly colluding.
d. It is more powerful today than in the past.

Answer: d. OPEC's power and market share has diminished thus reducing its influence on the market.

Question 4:
The following are recent concerns for possible Collusion except:
a. Taxi drivers without legal medallions.
b. B2B system between auto makers and suppliers.
c. B2B system between aerospace companies and suppliers.
d. Orbitz system for five airlines.

Answer: a. It was the bidding on the medallions in 2004 and 2006 that was of concern, not the drivers without one.

Question 5:
All of the following are factors affecting collusion in price cheating except:
a. History of the Market
b. Size of the Firms involved.
c. Number of Firms in the Market.
d. Reward Mechanisms

Answer: d. The fourth one is Punishment Mechanisms not Reward Mechanisms.



References


Bayer, Michael R. "Managerial Economics and Business Strategy". 5th ed. McGraw-Hill Irwin. pp. 331, 369-371. ISBN 0-07-298389-2.

"Collusion." Retrieved on 10/18/2007 from http://en.wikipedia.org/wiki/Collusion.

"collusion." The American Heritage® Dictionary of the English Language, 4th Edition. Houghton Mifflin Company, 2004. 23 Oct. 2007. <Dictionary.com http://dictionary.reference.com/browse/collusion>.

Labaton, Stephen. "As Competition Heats Up, So Does the Threat of Collusion." NY Times. 25 Oct. 2000. Retrieved on 10/20/2007 from http://partners.nytimes.com/library/tech/00/10/biztech/technology/25laba.html.

Rivera, Ray., "City to Change Taxi Rules After Inquiry Into Bidding." NY Times. 5 May 2007. Retrieved on 10/19/2007 from http://www.lexisnexis.com.proxy.bsu.edu/us/lnacademic/auth/checkbrowser.do?ipcounter=1&cookieState=0&rand=0.9842338127961884&bhcp=1 .

Ross, Don. "Game Theory". Stanford Encyclopedia of Philosophy. Revised 10 Mar. 2006. Retrieved on 10/18/2007 from http://plato.stanford.edu/entries/game-theory/.