4) More Collusion: In practice collusion breaks down as suggested by price cycle

Question

4) More Collusion:
In practice collusion breaks down as suggested by price cycles.
a) In the US, when shipping firms were forced to announce all prices, prices actually increased suggesting that collusion was easier to sustain. Suggest a reason why.

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b) Suppose that firms play a modified tit for tat strategy whereby if another firm cheats, each other firm prices at marginal cost for T periods. Suppose that the discount factor is sufficient to ensure that firms do not cheat on collusion. Suppose also that you observe that price wars still happen but only in situations of unexpected demand shocks. Provide a hypothesis to explain your observation.

c) In 2005, the two biggest Canadian Airline producers Air Canada and West Jet, faced competition from a new entrant, Jetsgo. By Christmas time of 2005, prices were remarkably low and Jetso was finally driven out of the industry leaving many travellers stranded and unable to get their money back. Low prices might be explained due to the breakdown of collusion. Provide two possible explanations.

d) Is collusion legal? Is it always bad for society? (hint: allocative vs. dynamic efficiency)
e) Explain how most favoured customer clauses or price matching can serve as a commitment vehicle whereby firms commit to colluding.

Explanation / Answer

a) When shipping firms started announcing prices, then information which was earlier obscure became easily available, and that resulted in tacit collusions. Before this, the firms lowered their prices suspecting that their competitors might be doing so.

b) In the case of unexpected demand shocks, discount factor that is otherwise sufficient to ensure collusion become insufficient, thereby making it rational for a firm to default. Therefore, firms cheat on collusion in situations of unexpected demand shocks.

c)

The new firm came in with low prices, this caused price competition leading to breakdown of collusion.

Tacit collusions are difficult to sustain when there occurs an increase in the number of firms.

d) Some types of collusion are legal and some aren’t. As per Sherman act, some types of collusion, such as coming into an agreement with other firms to fix a price at a certain level, are illegal per se. In case a type of collusion is not illegal per se, then it is considered illegal only if the plaintiff proves that the collusion is detrimental to the economy.

Collusion is not necessarily bad for society. Without collusion there is allocative efficiency in the economy when the surplus is maximized. But since firms earn almost zero economic profits, very little can be invested in research and innovation. Therefore, technological advancement may not come about without collusion. Collusion may bring about dynamic efficiency (technological progress) in an industry.

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