Tacit Collusion

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.

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.

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.

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.

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.

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.

Table 2. Obstacles to collusion - StudySmarter

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.