Oligopoly in business can be described as when few firms between them share a large proportion of the industry. In the essay I will examine the economics literature on tacit collusion in oligopoly and why firms are tempted to collude. I will provide benefit of collusion and legal literature regarding collusion. Some of the best know companies are oligopolists, including Coca-Cola, Pepsi, British Airways, and Virgin Atlantic Airways. There are however, significant difference in the structure of industries under oligopoly, and similar significant difference in the behaviour of firms. The firms may also produce a virtually identical product. Most oligopolists produce differentiated products such as (e.g. cars, drinks). Much of the competition between such oligopolists is in term of the marketing of their particular brands (Sloman, Hinde, Garratt: 2010). Despite the difference between oligopolies, there are two crucial features that distinguish oligopoly from other market structures. There are various barriers to the entry of new firms because it requires a lot of capital to start, however entry barriers vary from industry to industry. Also, because there are only few firms under oligopoly, each firm will have to take into account of the others; this means that they are mutually dependent. Oligopolies do not compete on prices. Price wars tend to lead to lower profits, leaving a little change to market shares. Furthermore, Oligopolies firms tend to charge reasonably premium prices but they compete through advertising and other promotional means. It keeps the existing companies safe from new companies entering the market because barriers to entry to the market are high. For example, if products are heavily promoted and a producer has many existing successful brands, it will be very costly and difficult for new firms to establish their own new brand in an oligopoly market.

Similarly, collusion in oligopoly is when firms engage in colluding, they may agree on process, market share, advertising expenditure, etc. Such collusion reduces the uncertainty they face. It reduces the fear of engaging in competitive price cutting which could reduce total industry profits. The cartel maximises profits if it acts like a monopoly. This simply means all members behave as if they are just a single firm, an example of that is the organization of petroleum-exporting countries (OPEC) is the best-known example of an international cartel; OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to produce. Collusion can arise when firms interact repeatedly. They may then be able to maintain higher prices by tacitly agreeing that any deviation from the collusive path would trigger some retaliation. For being sustainable, retaliation must be sufficiently likely and costly to outweigh the short-term benefits from “cheating” on the collusive path. These short-term benefits, as well as the magnitude and likelihood of retaliation, depend in turn on the characteristics of the industry.

In addition, tacit collusion is a form of collusion where firms keep to the price that is set by an established leader. Price leadership can be defined as a situation where prices and price changes established by a dominant firm, or a firm are usually accepted by others and which other firm in the industry adopts and follow. When price leadership is adopted to facilitate tacit (or silent) collusion, the price leader will generally tend to set a price high enough that the least cost-efficient firm in the market may earn some return above the competitive level. An example of that is and petrol retailers where many suppliers follow the pricing strategies of leading firms. If most firms in a market are moving prices in the same direction, it can take some time for relative price differences to emerge which might cause consumers to switch their demand. Firms who market to consumers that they are “never knowingly undersold” or who claim to be monitoring and matching the cheapest price in a given geographical area are essentially engaged in tacit collusion. However, tacit collusion occurs where firms undertake actions that are likely to minimise a competitive response, e.g. avoiding price cutting or not attacking each other’s market It is often observed that when a market is dominated by a few large firms, there is always the potential for businesses to seek to reduce uncertainty and engage in some form of collusive behaviour. When this happens the existing firms engage in price fixing cartels.

However, this behaviour is deemed illegal by UK and European competition law. But it is hard to prove that a group of firms have deliberately joined together to raise prices. The antitrust law is not on the outcome nor the strategies that sustain an outcome but rather the means by which a collusive arrangement is achieved. The illegality comes from firms having an agreement to coordinate their behaviour. Antitrust law clarified that the idea of an agreement describes a process that firms engage in, not merely the outcome that they reach. Not every parallel pricing outcome constitutes an agreement because not every such outcome was reached through the process to which the law objects: a negotiation that concludes when the firms convey mutual assurances that the understanding they reached will be carried out. Mutual understanding is significant and is acquired through express communication. Explicit collusion is illegal.
Furthermore, Game theory is the study of alternative strategies that oligopolists may choose to adopt, depending on their assumptions about their rival’s behaviour. It is mainly concerned with predicting the outcome of games of strategy in which the participants (for example two or more businesses competing in a market) have incomplete information about the others' intentions. The theory analysis directly relates to the study of the conduct and behaviour of firms in oligopolistic markets – for example the decisions that firms must take over pricing and levels of production, and also how much money to invest in research and development spending. An example of a game theory is the prisoner’s dilemma, a situation where two prisoners are being questioned over their guilt or innocence of a crime. They both have a simple choice, either to the crime (thereby implicating their accomplice) and accept the consequences, or to deny all involvement and hope that their partners does likewise. Confess or keep quite? The prisoner’s dilemma is a classic example of basic game theory action. The “pay-off” is measured in terms of years in prison arising from their choice. No communication is permitted between the two suspects – in other words, each must make an independent decision, but clearly they will take into account the likely behaviour of the other when under-interrogation.
On the other hand, dominant strategies have a predictable outcome, no matter what assumptions each firms makes about its rivals behaviour. In many situations, firms will have a number of different options open to them and a number of possible reactions by rivals. In such scenario, the choice facing firms may be many; they may opt for a compromise strategy between maximas and maximin. An example is when the Whisky, Brandy and John walker etc. agreed not to advertise on television until recently, it was a cooperative equilibrium because they came together and agreed not to do any advertisement on television because they recognised the benefits of how much they could save by not doing any advertisement on television. But that broke down and they have moved to none cooperative equilibrium, where they all lose money by having adverts on television. Firms colluding with each other help them to maximize profit. They are always tempted to collude because when there is collusion they can control the market like a monopolistic market.
In conclusion, it can be suggested that there is some correlation between the policies in which oligopolies compete at, and the contestability of the industry in which they operate in. A highly contestable market in which barriers to entry are low, pressurises firms to compete more aggressively, whereas if incumbent firms have successfully erected high barriers to entry, whether natural or man-made barriers; the industry becomes less contestable, providing incentives to collude to maintain market share. There is a high probability that the formation of cartels will inevitably lead to the breakdown of the cartel, for reasons of cheating. Price fixing or other forms of agreement never maximises each firms benefit. However, this statement only relates to the short term, but an agreement with other firms does reduce uncertainty, therefore benefiting firms in the long run to maintain supernormal profits. Member firms must find ways to restrict other members from cheating on the cartel price. Therefore the profit loss incurred by deviating from the cartel should exceed the profit loss by remaining in the cartel. Theoretically, it is easy to form a cartel when approached via the text-book assumptions. However in the real world, it is difficult without perfect information being available. Research suggests that, differences in product life cycles and fluctuations in demand create instability among agreements, which naturally fractures the cartel (Haltiwanger and Harrington (1991). Collusion to mimic operations as a monopoly allows investment in research and development to be funded collectively via joint profit maximisation, benefiting consumers in the long run. In essence, firms who compete without any form of collusion or agreements, have greater scope to maximise personal utility, by developing brand loyalty among consumers, thus being able to successfully increase market share. This would be the best policy to approach benefiting both the firms and the consumer, yet avoiding any government intervention.

Reference:

The distinction between the economic and legal approaches to collusion is presented by Kaplow and Shapiro (2007); also, see Kaplow (2011a, 2011b, 2011c).

Sloman, J., Hinde, K., Garratt, D. (2010). Economics for Business. 5th ed. England: Prentice Hall. P239-254.

Haltiwanger, J. and J. Harrington (1991), "The impact of cyclical demand movements on collusive behaviour," Rand Journal of Economics, 22:89- 106.