South-Western College Publishing - Economics  
Just How Easy is it to Collude?
Topic Oligopoly
Key Words collusion, cartel, mergers, game theory, prisoner's dilemma
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Reference ID: A161191756

News Story Sony and Bertelsman, two of the largest record companies in the world, merged together in 2004, creating Sony BMG. That merger reduced the number of major players in the market from five to four - owning about 80% of market sales. Is that enough to induce collusive behavior, if only tacitly?

Economics textbooks suggest that collusion is very difficult because of the incentive to cheat on the collusive agreement. Since collusion is illegal in most countries, punishing cheaters is very difficult, since punishing exposes everyone in a collusive situation.

But is it possible to tacitly collude? Such actions are difficult, because it requires coordination of prices without discussion or explicit understandings. Evidence is scant, but mergers create greater potential for tacit collusion; when Sony BMG was created, and five major firms became four major firms, the ability to tacitly collude increased. The four remaining firms are relatively similar in size, increasing the gains from coordination. All firms will have a similar notion of what the "best price" is in the market.

What's more, the gains from cheating on a collusive agreement fall, because at least in the record industry, punishing cheaters is much easier. One company could quickly come out with "promotional pricing" in retaliation for another's cheating. Such is the nature of the record industry. Wholesale prices are well-known, and there are so many sales, that short-term gains from cheating are relatively small.

In an industry with differentiated products - think of a Deep Purple live CD vs Artist-Formerly-Known-As-Prince Live CD - is it really possible to know whether a company's sales slump is a result of a promotional price or another company's illicit behavior? Justice Departments have the difficult job of trying to distinguish between the two.

Questions
Discussion Questions:
1. Why is it so difficult for firms to hold to a collusive agreement?
2. Why does the presence of differentiated products make cheating and punishment difficult?
3. Consider the following payoff matrix for two firms in the music industry who are considering whether to coordinate prices on compact discs, or to cheat and price independently. Payoff values are profits, in millions, for Firm A and Firm B, respectively. What is the outcome of this game? Why is it a prisoner's dilemma solution?
Firm A/Firm B Coordinate Price Cheat
Coordinate Price 50,50 20,60
Cheat 60,20 27,27
Multiple Choice/True False Questions:
1. Under tacit collusion,
  1. Firms agree to set prices.
  2. Firms act as if they set prices together.
  3. Firms engage in nonprice competition.
  4. Firms attempt to gain market share by reducing price.
2. The greater the concentration of firms in a given industry,
  1. The less the incentive to collude.
  2. The greater the incentive to collude.
  3. The incentive to collude remains the same.
  4. Collusion always takes place.
3. In a prisoner's dilemma-type game,
  1. Players end up at a non-optimal solution.
  2. Players end up at an optimal solution.
  3. There is no outcome to be found.
  4. All strategies are outcomes.
Source "Silent Orchestration," The Economist. May 3, 2007.
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