Different forms of collusion exist in an economy, especially in oligopolistic markets. One form in particular is called tacit collusion, and we see this on a regular basis. Recall the last time you drove through an intersection where one gas station was across the street from another. It's likely the gas prices were the same at each establishment. This is a situation where you saw tacit collusion at play. Keep reading to see examples, understand its advantages and disadvantages, and learn about the obstacles to collusion.
Tacit Collusion Definition
Let's take a look at the definition of tacit collusion! In an oligopoly, firms participate in some form of collusion in order to maintain control of their share of the market or the industry as a whole. There is formal collusion, where firms make an official agreement or contract to keep high prices, and there is implied collusion, or tacit collusion, in which firms agree upon a certain price for their product, but do so without any formal agreement.
Tacit collusion occurs when competitors reach an unspoken agreement to share control of the market and set high prices, minimizing the likelihood of subverting another firm.
If two firms in a certain industry were to sign an enforceable contract with one another, stating that each firm may produce no more than X amount per year, then they would benefit from this agreement. This takes away the threat of one firm producing more than it promised and undercutting the other firm. However, we know that this type of agreement is illegal and unenforceable due to antitrust laws.
Dive deeper into this topic in our article - Antitrust Law!
Tacit Collusion Examples
Let's take a closer look at the two gas stations across the street from each other, and find out why they have the same gas prices and why they may be an example of tacit collusion.
Whether you live in a large city or a small town, there are several gas stations to choose from when you want to fill up your tank. And depending on the station, the price of gas will vary. Some gas stations might have higher prices than others because of the quality of oil or a more convenient location. However, we see that some gas stations are located within close proximity of a competitor, and this can affect the prices of the product. What we don't see is exactly how the price is determined.
Tit for Tat Strategy vs Always Cheating
Fig. 1 - Gas station
Tacit collusion in oligopoly
Tacit collusion in oligopoly is a form of strategic behavior. Oligopolistic firms engage in strategic behavior by not only considering their own success in the short term, but also by speculating the effect on their competitors in the long term. In order to stay in business for a long time, firms have to be very competitive to be successful. As firms climb to the top of their industry, they tend to have fewer options of strategic behavior. It comes down to cheating or colluding.
Imagine two companies in the same industry: Firm A and Firm B. Think of these two firms as long-term players in the industry. Both of them have goals of doing business for a very long time. Eventually, Firm A and Firm B will be considering whether to cheat or collude with the other player.
Instead of cheating, where a firm sells more products than agreed upon, an oligopolist may play tit for tat. This strategy affects the future decisions of other competitors, and it involves playing cooperatively at first. Then, it turns into one competitor mimicking the action of what the other competitor did previously. In other words, this strategy rewards good behavior and punishes bad behavior.
Consider the following example of two imaginary soft drink companies Fizzle and Snap. In the Figure 1 below, we see different possibilities of what happens when one firm uses a tit for tat strategy or always cheats. Let's suppose:
- If one firm plays “tit for tat” and the second firm follows, then both will make a profit of $200 million each year.
- If one firm plays “always cheat”, but the second firm plays “tit for tat,” one makes a profit of $250 million the first year but only $150 million per year afterwards.
- If one firm plays “tit for tat” but the second firm plays “always cheat,” one makes a profit of only $130 million in the first year but $150 million per year afterwards.
- If one firm plays “always cheat” and the other does the same, both firms will make a profit of $150 million each year.
Fig. 2 - Tit for Tat Strategy vs. Always Cheating
We see that firms, depending on how its rival behaves, can evaluate the advantages and disadvantages of playing "tit for tat" or "always cheating" strategy.
Tit for tat is a strategy that affects the future decisions of other competitors, and it involves playing cooperatively at first. Then, it turns into one competitor mimicking the action of what the other competitor did previously.
If you are not already familiar, look into the Prisoners' Dilemma. It further illustrates the logic behind tacit collusion.
Causes Tacit Collusion
The main reason that causes the firms to be attracted towards the idea of tacit collusion is their interaction with one another on a repeated basis. After some time of being competitors in the same industry, firms who interact repeatedly may agree to work together in order to maintain high prices in their industry to benefit each firm.
Advantages and Disadvantages of Tacit Collusion
There are advantages as well as disadvantages of tacit collusion.
Let's take a look at some of the positive and negative factors of tacit collusion listed in Table 1. Note that these factors influence not only the firms that are colluding, but also other firms and consumers as well.
Advantages | Disadvantages |
| Price stability / Reduction of market instability | Lower incentive to innovate |
| Avoidance of direct competition | Barrier to entry for new firms |
| Higher profits | High prices for consumers |
Table 1. Advantages and Disadvantages of Tacit Collusion - StudySmarter
Advantages of tacit collusion benefit the firms involved, where they achieve high profits and stable markets and have little competition. It is easy for firms to put high prices on their products, as they have control over the industry. Therefore, it also makes the market more predictable because of the firm's knowledge about its products and how they affect the whole industry. In addition to these advantages, colluding firms also have very little, if any, competition so that only their products may sell in their specific industry.
Some disadvantages of collusion affect new firms who want to enter the industry but are not able to compete with its prices. Also, as a consumer who looks to buy a product from an industry where tacit collusion takes place, it is very difficult to purchase any good or service because the prices are so high. Lastly, a disadvantage to the firms themselves is the low incentive of innovating its products, which because of the lack of competition, may decrease in quality.
Product Differentiation and Price Leadership
Product differentiation and price leadership occurs in oligopolies where firms produce goods and services that consumers see as similar, though not the same. A small difference in price between two PC brands may not sway the consumer to go from one to the other. Firms acknowledge the power they get from consumers who see a product is different than another product in the same industry. In many industries, oligopolists construe the idea that their products are unique, when in reality, they are not all that different. This is called product differentiation. Another way to describe it is the endeavor of a firm to create a product that stands out from other products within the same industry.
Product differentiation often goes hand in hand with tacit collusion. The differentiation in goods and services become so small that the firms selling these products want to collude and set a high price for their products. When one firm marks the price of a product for the whole industry, and other firms adopt and follow, this is known as price leadership. For example, the electric car company Tesla, seeks to influence the electric automobile industry through innovation and sets prices on its cars while other auto companies follow the same model of pricing.
Product differentiation occurs when a firm creates a product that stands out from other products within the same industry.
Price leadership occurs when one firm sets the price of a product for the whole industry and other firms follow suit
Obstacles to Collusion
Let's take a look at some common obstacles to collusion. We often see tacit collusion at play in the world around us, but there are reasons why it is not even more prevalent. Listed below are obstacles that prevent industries from being overrun by monopolies, where a firm would have complete control of the market and set prices higher than any other market.
Obstacle | Explanation |
Large numbers of firms | The more firms there are in an oligopoly, the less incentive there is for any firm to collude. Firms speculate the impact of its actions on itself and on other firms. |
Different interests | Firms typically form different opinions about what they believe is fair in a market. Each entity's objectives and interests vary. |
Complex products and pricing | With firms that sell thousands of products, it is difficult to keep track of what firms produce and at what price. |
Bargaining power of buyers | Buyers, especially large buyers such as a nationwide chain store, have an advantage in a market to ask for lower prices. This pressures the sellers to meet these types of demands. |
Table 2. Obstacles to collusion - StudySmarter
Price war occurs when the collusion between firms breaks down causing prices to spiral
Because of these obstacles listed in Table 2, tacit collusion is hard to attain in many industries. And since tacit collusion is so hard to attain, most oligopolies set lower prices compared to those of monopolies, where collusion is legal and explicit. A monopolist would charge exorbitant prices for the same good that is sold in an oligopoly. Furthermore, tacit collusion can have the adverse effect of breaking down and causing prices to spiral, resulting in a price war.
Tacit Collusion - Key takeaways
- There is formal collusion, where firms make an official agreement or contract to keep high prices, and there is tacit collusion, in which firms agree upon a certain price for their product, but do so without any formal agreement.
- Tacit collusion occurs when competitors reach an unspoken agreement to share control of the market and set high prices, minimizing the likelihood of subverting another firm.
- Tit for tat is a strategy that affects the future decisions of other competitors, and it involves playing cooperatively at first. Then, it turns into one competitor mimicking the action of what the other competitor did previously.
- When one firm marks the price of a product for the whole industry, and other firms adopt and follow, this is known as price leadership.
- There are four factors that limit tacit collusion: (1) large numbers of firms in an industry, (2) different interests, (3) complex products and pricing, and (4) bargaining power of buyers.
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