Collusion occurs when firms in a market chose an optimal level of output for that market in order to maximize total industry profits (Baye, 2006). Collusion typically occurs in the oligopoly market model when the number of firms are few as opposed to many. This can simply be explained by the fact that when firms are working together, the more firms that have to work together the harder it is to make everyone happy.

See Wiki page about oligopoly for further information:
See Wiki page about monopolistic competition to see why collusion is more difficult with many firms:

Monitoring the agreement
This can be seen in that firms must monitor one another such that their collusion agreement is kept. This can be accomplished by monitoring the other firms in the collusion agreement. There comes a point at which because there are so many firms in the agreement that the costs of monitoring the other firms outweighs the benefits from the collusion agreement. This monitoring can be seen by the formula n*(n-1) where n is the number of firms in the agreement. If there are six firms in agreement there must be 30 (6*(6-1)=30) monitors to keep everyone aware that all the firms in the agreement are holding to the terms. As the number of firms increase in the market the number of monitors increases dramatically.

How collusion occurs
The first way collusion occurs is that firms will meet and agree not to steal each others customers, and if one firm tries to steal anothers customers there will be retaliation. This form of collusion is called explicit collusion. Another way firms collude may not involve physically meeting or talking at all. Overtime firms may reach a nonverbal understanding that they will leave each other alone, but if one firms tries to steal customers there are consequences. The second form of collusion just discussed is called tacit collusion. Tacit collusion occurs when the behaviors of the players in the market are learned. If you try to steal customers and get attacked back, eventually your firm will probably stop trying to steal customers. On the other hand if you lower prices in order to steal customers and there is no retaliation, or the retaliation is not effective, tacit collusion will not occur.

Collusion is considered illegal within the United States, European Union, and Canada. Collusion falls within the category of antitrust laws/competition laws. These are laws that prohibit anti-competitive behavior and unfair business practices. These laws make certain practices illegal because they hurt the businesses, consumers, or both, typically violating standards of ethical behavior (wikipedia-antitrust, 2006). Tacit collusion because of the fact that it is the learned behaviors of the players in the market is much more difficult to enforce, because specifically there has been no formal agreement, because of this tacit collusion can and does occur today.

Which is not a form of collusion?
A.) The behaviors of a competing firm in the same market of a second firm are learned.
B.) Two firms meet and agree not to steal one another's customers.
C.) If an agreement has been reached to not steal one another's customer has been breached, retaliation will occur.
D.) One firm lowers prices to compete against another when there was no agreement against it.
Answer: D.) This is just the normal game of business that occurs every day. There is no collusion because one firm is lowering a price without specific knowledge or an understanding that there will be repercussions or action taken or not taken because of this action.

In a finite number of games collusion will be more likely to occur:
A.) On the second to last turn.
B.) From the beginning.
C.) Once a tacit understanding of business practices has been reached.
D.) Will not occur because there is no effective punishment method that can be used.

Answer: D.) Will not occur because there is no effective punishment method that can be used. This is because of the ending nature of the finite number of games to be played. Each period the players in the game know what the last period will hold, and because they know the last periods outcome, the second to last game is the last game. It is because the second to last game is now the last game that once again the players know how each member of the collusion will act because there is no punishment that can be effective. This continues on until the first game being played, and each member of the collusion knows that each member will cheat, so collusion will not occur.

Sustained collusion is more likely to occur when firms know:
A.) their rivals.
B.) who their rivals customers are.
C.) when their rivals deviate from the agreement.
D.) All the above.

Answer: D.) All the above. This are all reasons why a sustained collusion is more likely to occur. The last reason not listed is that firms must be able to successfully punish rivals for deviating from the agreement.

A small firm with 1 outlet and a large firm with 10 outlets decide to collude, the small firm:
A.) is at an advantage because they only have to focus on the big competitor.
B.) is at an advantage because they are now "safe" from the big competitor.
C.) is at a disadvantage because they have to monitor more locations then the larger firm does.
D.) is at a disadvantage because they have less bargaining power when the "contract" needs to be renegotiated.

Answer: C.) is at a disadvantage because they have to monitor more locations then the larger firm does. This is because economies of scale exist within the monitoring act. The larger firm only has to monitor the one outlet of its collusive partner. The smaller firm has to monitor the larger firms 10 outlets, which most likely will cost more and be a larger percentage of the "savings" associated with the collusive agreement.

Several recent examples of collusion in the United States include:
  • Price fixing was engaged in the market division and among manufacturers of heavy electrical equipment during the 1960s.
  • An attempt by Major League Baseball owners to restrict players' salaries in the mid-1980s.
  • Price fixing within food manufacturers, this happened by providing cafeteria food to schools and the military in 1993.
  • Market division and output determination of livestock feed additive by companies in the US, Japan and South Korea in 1996. (Collusion, 2007)
  • School milk contracts in Florida and Texas during the 1980s. In both states firms were convicted of bid-rigging.
  • Construction Association, an illegal cartel that conspired to set the price of soil needed for reclamation. This collusive action allegedly produced a skimmed profit in the neighborhood of ¥5 billion, a portion of which supposedly went to influential politicians.

  1. Baye, Michael, Managerial Economics and Business Strategy (2006).
  2. Anonymous. Antitrust. February 16, 2007. Accessed February 20, 2007. <>.
  3. Anonymous. Collusion. January 24, 2007. Accessed February 20, 2007. <>.