Lecture 2

• Strategic Commitment

• Explicit Collusion and Tacit Collusion

• Infinitely Repeated Games

• Dynamic Price Competition

• Factors that Facilitate Collusion

Strategic commitments are decisions that have long run impact and are hard to reverse

• Example: Installation of additional production capacity

These differ from tactical moves which are easy to reverse and have only a short run impact

• Example: A store cutting the price on certain items

To be successful a strategic commitment should be

• Visible

  • You must be sure that your competitors see it.

• Understandable

  • Everybody understands it.

• Credible

  • To be credible, the commitment should be irreversible

Reversible moves are more likely to be matched by rivals than irreversible moves

• It is easier for a firm to follow a price cut from a rival (reversible) than invest in developing a new product or building a new plant (irreversible due to sunk costs).

Explicit Cartel (illegal):

• Cartel members eliminate competition by reducing joint output or by increasing prices.

• In many markets, not all participants on the seller side collude, but only a subset of firms may form a cartel.

• Collusive behavior also benefits firms outside the cartel.

• Firms tend to free-ride on the cartels formed by other firms, making cartels highly unstable.

Tacit Collusion:

• Collusion emerges as the noncooperative equilibrium of a situation of repeated competition (repeated game)

• Firms adopt strategies, in a non-cooperative way, that lead to a coordinated outcome

• Main issue: sustainability

• Explicit vs. Implicit: Cartels involve explicit agreements, while tacit collusion is implicit and based on understanding or signaling.

• Legal Status: Cartels are clearly illegal under most competition laws, whereas tacit collusion exists in a grey area and is difficult to regulate and prosecute.

• Organization: Cartels have a more organized structure with clear agreements, whereas tacit collusion is more about unspoken and informal coordination.

Both cartels and tacit collusion can lead to higher prices, reduced output, less innovation, and generally poorer outcomes for consumers and market efficiency. However, the explicit nature of cartels makes them a more direct target for antitrust enforcement compared to the elusive and subtle nature of tacit collusion.

• In an infinite repeated game a collusive outcome can emerge as the equilibrium in an oligopoly.

• In order to achieve this outcome firms must solve a coordination problem.

• However, coordination without explicit agreements or communication is very difficult.

Solution for the Coordination Problem:

In order to have a collusive outcome we must have a strategy (like the grim strategy) that works as a Focal Point:

• each firm expects that all rivals will follow that strategy.

• Collusive pricing is more likely to be an equilibrium the greater the frequency with which firms interact and the greater the probability of continuation and growth of industry.

• Collusion is normally easier to maintain among few and similar firms.

• Collusion is usually easier to maintain when firms compete in more than one market.

• Collusion is easier when punishment mechanisms are in place.

Price Leadership

• The price leader in the industry announces price changes ahead of others and others match the leader’s price

• The system of price leadership can break down if the leader does not retaliate if one of the follower firms defects

Most Favored Customer Clauses

• Most favored customer clause allows the buyer to pay the lowest price charged by the seller

• While this clause appears to benefit the buyer (a price cut to any one customer lowers the price for the most favored customer) it also inhibits price competition

Tacit collusion or competitive pressure?

For a regulator, it is challenging to distinguish tacit collusion from competitive pressure.

• Price-matching: promise not to be undersold and match competitor’s lower price

• Price-beating: promise to have the lowest price in the market

A study from 2006 concluded that prices tend to be higher under ‘price-matching’ guarantees → it is a form of tacit collusion to keep prices high.*