Collusion and price fixing

Collusion in the Cournot model

In the earlier part of this chapter we showed how legal rules may provide firms with significant cost incentives to merge. But there may be other reasons for firms to merge. For example, firms may wish to collude in order to increase profits by raising their prices. One question that immediately arises is whether collusion is stable in the Cournot model. In this discussion, when we say collusion we mean an implicit or explicit agreement by the firms to restrict total market output to the monopoly level.

Consider the following simple example. Suppose that the demand curve is Q = a-P, and that there are two firms with identical marginal costs of c. Suppose that the two firms sign an agreement which stipulates that each of them will produce half of the monopoly level of output. In other words, suppose that they both agree to produce:

This agreement maximises the joint industry profits, but is it strategically stable? The answer, in general is no. In other words, firm 1 will want to cheat on the collusive agreement (and so will firm 2). Therefore, such collusive agreements are inherently unstable. This conclusion makes the analysis and punishment of collusive activity somewhat problematic - standard economic theory suggests that collusive agreements will, as a general rule, be very difficult to sustain.

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