Why would firms collude Flashcards
(5 cards)
- Draw a payoff matrix which would incentive firms to pick low prices as the Nash Equilibrium but show the improved payoff if they both pick high prices
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KAA1
One reason could be due to avoid price rigidity and price wars
We can use game theory to show why some firms engage in collusive behaviour. If we take the example of (I would say Coca Cola and Pepsi), game theory shows us why it is in the interests of the firms to collude
From the payoff matrix, we can see that if both firms have a high price for their good, then they can both receive ( insert value from payoff matrix) . Therefore, they are likely to collude because when they work together they can achieve a better outcome than if they were working as independent agents.
If they were working independently, without collusion, they would keep undercutting each other’s prices to gain market share and revenue until all supernormal profits are eroded. This scenario is shown in the bottom right hand box ( insert value from payoff matrix)
Therfore it is in the interests of both Coca Cola and Pepsi to collude as this means that they will make higher profits than if they were working alone. In effect by colluding, firms are recognising their interdependence and acting as a monopoly
Application:
The extra SNP could be reinvested back into research and development which could increase dynamic efficiency. For Pepsi and Coca Cola, they could work on new flavours or healthier alternatives
Eval 1
Not all firms engage in collusive behaviour. Firms actually have the incentive to cheat others by either increasing their share of the (restricted output) or by lowering the price below the fixed price.
In either of these 2 methods, the “cheating members should see an increase in sales, revenue and SNP.
From the payoff matrix, we can see that the top right and bottom left boxes give the potential payoffs if one firm breaks the collusive agreement on the price products will be sold at.
This means one firm is getting richer but at the expense of the other firms being much worse off. The fact that the incentive to cheat is so great means that cartels are inherently unstable
Application:
Due to the oligopolistic nature of the soft drinks market and price setting power of both Coca Cola and Pepsi, they are easily able to undercut the other firm
KAA2
Another reason why firms engage in collusive behaviour, might be to act as a barrier to entry to new firms or try to drive out existing smaller firms. For example, Coca Cola and Pepsi could engage in limit and predatory pricing, where large firms in the market get together to fix a low price such that they only make normal profits in the short run, so that smaller competitors are driven out of the market and there is little incentive for new firms to enter.
This will lead to PED becoming more price inelastic, allowing Coca Cola and Pepsi to raise their prices which could lead to an increase in revenue and SNP also
Application:
For example, Coca Cola and Pepsi colluding in the soft drinks industry to fix the price of drinks at their AVC, which will be much lower than most other firms due to significant marketing and technical economies of scale (give examples), will drive smaller competitors such as 7up out of the market. As a result, in the long run, the colluding firms will have less competition and can therefore raise the price of their drinks since consumers will have many alternatives (INELASTIC PEDDDDDD)
Eval 2
If coca cola and Pepsi wish to add more firms to their cartel like Dr Pepper, they may find it difficult to collude when there are too many firms.
In addition, there may be a difficulty in communication without getting caught by the competition authorities.
Potential Punishments: Regulations and Fines
Application:
CMA
