Strategic Management and Competitive

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 7
Collusion

INTRODUCTION

Chapters 4, 5, and 6 introduced the three generic strategies of cost leadership,

product differentiation, and flexibility, respectively. The key to these strategies is
implementing the chosen position efficiently and effectively. In other words, these three
positioning strategies generate economic profits via efficiency – efficiency profits.

In this chapter, the focus is on firms working together with other firms to reduce
competition so as to generate profits. This strategy, called collusion, may lead to moves
such as:
 Reducing industry supply below demand (so as to drive up prices)
 Arranging to hold prices at a certain level so that industry profits can be protected
even when demand slows down

Slide 7-3
This slide introduces collusion by contrasting it with efficiency profits generated by the
generic strategies of cost leadership, product differentiation, and flexibility.

Just like how efficiency oriented strategies generate efficiency profits, collusion produces
collusion profits. The objective of this chapter is to show that there are a host of issues—
economic, strategic, legal, and ethical—associated with the decision to collude.

► Example: eBooks and Amazon

In the world of book publishing (fiction and non-fiction), six firms dominate
the market – Hachete, Harpercollins, Macmillan, Penguin, Simon & Schuster,
and Random House. Their business model called for selling hardcover titles
with a 30 percent commission to retailers. All this changed with the advent
of e-books and the entry of Amazon into this area. Amazon argued that it
should be allowed to set the final retail price of an e-book, even allowing it to
sell below cost (as a loss leader). Clearly, threatened by Amazon’s bargaining
power over them, the publishers had to act to protect their business.
According to a lawsuit filed by Amazon, the heads of these six publishers
brazenly met together to decide on a common price strategy. The court

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 Chapter 7: Collusion 149

ruled it as collusion and decided in favor of Amazon. (United States Court of

Appeals for the Second Circuit, August 2014)

Slide 7-4
Use this slide to summarize the e-book collusion vignette described above. It has some
additional details.

WHAT IS COLLUSION?
Learning Define Explicit and Tacit Collusion and Explain Why Collusion is Typically Inconsistent With Social
Objective Welfare in an Economy
7.1
Start with the examples of Coca-Cola, GE, and OPEC to illustrate collusion. Once these
examples are understood, it makes sense to provide a formal definition of the term.
Collusion exists when firms in an industry or market cooperate to reduce competition. In the
examples cited, the end result is the same: competition decreases, prices rise, and the
colluding firms gain economic profits.

Before getting into forms of illusion, it is important for students to know that not all
cooperation among firms is collusive. Firms, for example, engage in strategic alliances, not to
benefit from collusion, but from various kinds of economies.

Slide 7-5
Use this slide to reinforce the formal definition of collusion.

There are two types of collusion:

 Explicit collusion
 Tacit collusion

Explicit collusion happens when firms in an industry sit across from each other and directly
negotiate agreements to reduce competition. OPEC members met in a highly publicized
meeting in 1973 and negotiated a production level agreement. Explicit collusion is illegal in
most developed countries (such as the U.S.).

Tacit collusion results in a cooperation agreement without direct or face-to-face negotiations

among the members. Although the heads of the six publishing companies met face-to-face
(in a New York restaurant!), it is still tacit because it was not a public and publicized meeting.
Tacit collusion can be legal. However, both tacit and explicit collusion face fundamental
ethical challenges.

Slide 7-6
This slide identifies and explains both explicit and tacit collusion.

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150 Chapter 7: Collusion

Slide 7-7
This slide looks at the ethics of collusion. It defines the term “dead weight loss” and its
impact on social welfare.

For tacit collusion to work, firms have to signal their intentions. The intention may be to
hold prices or increase production capacity. Whatever the intention is, sometimes signals are
lost in translation. When this happens, firms who stand to gain from cooperation may not
be able to realize these gains.

In the classic prisoner’s dilemma scenario (described in detail in Chapter 11), there is a huge
payoff to not cooperating (and the other prisoner is found guilty), but the risks are high.
Cooperation is the safer bet but it involves signaling and interpreting the signal!

In spite of the challenges involved in sending and receiving signals, there are examples of
both tacit and explicit collusion. Major League Baseball owners were found guilty of
colluding to depress the market for free agents in 1990. There are non-U.S. examples, too
(OPEC in 1973)

 Important Point: Students must understand clearly that in the U.S. (and most
developed countries), explicit collusion is illegal. While tacit collusion is not always illegal,
there are ethical issues associated with any kind of illusion.

 Teaching Points

• Use the examples given above to demonstrate that there are recognizable
examples both explicit and tacit collusion.
• Briefly explain that while explicit collusion is always illegal (in developing
countries), not all tacit collusion is deemed illegal.
• Stress the importance of signaling and interpreting signals in tacit collusion.
• Point out that ethical issues are associated with collusion, particularly the
concept of “dead weight loss.”

THE VALUE OF COLLUSION

Strategic actions are aimed at creating value for the organization. Therefore, it is important
to look at the value creation rationale of collusion.

Describe How Collusion Can Create Economic Profits Learning

Objective
Per the S-C-P model in Chapter 2, there are five threats to profits of firms in an industry: 7.2
new competitors, existing competitors, substitute products, supplier leverage, and buyer
influence. Collusive behavior can aim at any of these forces.

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 Chapter 7: Collusion 151

Slide 7-8
This slide shows that collusion can be aimed at any one of the five forces per the S-C-P
model

Colluding to Reduce the Threat of New Competitors

Colluding firms can cooperate to create entry barriers that would discourage or prevent new
entrants from entering the industry. Incumbents firms, for example, can increase the scale
of production that has an adverse effect on the newcomer’s pricing ability. Firms can
collude to develop and adopt common technology standards. This is an example of
increasing costs for new entrants that is scale independent. Promoting standardized industry-
wide product differentiation (“Made in the USA”) simply makes it difficult for new entrants
to succeed via their own product differentiation. Finally, incumbent firms can jointly lobby
to increase the cost of entry.

Colluding to Reduce the Threat of Current Competitors

Colluding firms can cooperate to reduce the rivalry among themselves; the resulting reduced
rivalry can have a positive impact on profits. From a cost reduction perspective, incumbents
can agree to avoid (say) costly and periodic product upgrades and decide to reduce their
marketing spend. On the revenue side, firms can agree to raise prices without the fear of
one undercutting the other.

Colluding to Reduce Other Competitive Threats

Colluding firms can cooperate to increase their profits by paying less for various inputs (thus
negating supplier threat) and/or by agreeing to sell only limited quantities to buyers (thus
negating buyer threat). It is important for students to understand that collusion cannot
address the threat of substitutes. Collusive action may actually increase the attractiveness of
substitutes (OPEC’s collusion led to the growth of alternative fuels).

Slide 7-9
Use this slide to summarize how collusion specifically addresses the forces in an industry.

COLLUSION AND SUSTAINED COMPETITIVE ADVANTAGE

Describe Different Ways That Collusive Agreements Can Fall Apart, and How it is Possible to Use the Learning
Attributes of an Industry to Anticipate How Sustainable These Agreements are Likely to Be Objective
7.3
Collusion is difficult to maintain over time. The reason is this: while parties to a collusive
agreement have strong incentives to cooperate (the profits that come from collaboration),
they also have strong incentives to cheat. In the prisoner’s dilemma example (Chapter 11),
the payoff is higher if the prisoner doesn’t cooperate and the other is found guilty. This is a
good segue to use to move to the topic of cheating.

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152 Chapter 7: Collusion

There are two most important forms of cheating in collusive agreements:

 Bertrand cheating
 Cournot cheating

Slide 7-10
This slide reproduces Table 7.1 that looks at ways firms cheat, and the assumptions and
performance implications of each. This is a good overview of cheating in collusion and
helps to understand the leading methods described below.

Per Joseph Bertrand, assuming little or no product differentiation among a small number of
firms, if one firm decides to cheat on a collusive agreement by reducing its prices, others will
as well and, in the long run, firms in this industry will earn no economic profits. In other
words, Bertrand’s conclusion is that, in the long run, collusion will lead to normal profits.
Bertrand made the key (and unrealistic) assumption that each time cheating firms adjust their
prices, they assume that other firms in the industry will continue cooperating.

Slide 7-11
This slide summarizes Bertrand cheating. While parts of it are covered in the previous slide,
this slide highlights the key aspects of Bertrand’s thesis.

While Bertrand focused on price fixing in collusions, Antoine-Augustin Cournot looked at

collusion from the perspective of quantity manipulation. He examined the performance
consequences if colluding firms cheat by adjusting the quantity of their output and let market
forces (of supply and demand) determine prices. His conclusion differs from that of
Bertrand’s in that per Cournot’s thesis, cheating firms can still earn some economic profits,
although the profits from cheating would not be as large as those from cooperation.

Slide 7-12
This slide summarizes Cournot cheating by describing the key aspects of his thesis.

Two other researchers who worked on cheating are:

 Edgeworth (who combined Bertrand’s focus on price with capacity)

 Stackelberg (who used Cournot’s thesis and built on it)

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 Chapter 7: Collusion 153

Slide 7-13
Use this slide to offer a succinct conclusion—takeaway—on collusion and cheating.

Explicit and Tacit Collusion

The discussion on cheating will enable students to understand that, to benefit from tacit
collusion, firms have to signal their intentions and others have to correctly interpret them.
Sometimes, signals of intent to collude are very ambiguous. This brings us to the idea of
“tough” and “soft” signals.

A tough signal indicates that the firm in question will aggressively respond to cheating. In
contrast, a soft signal indicates that the firm in question will not aggressively respond to
cheating. Before the instructor gets deep into these two kinds of signals, it is important to
reiterate the concept of conscious parallelism. This suggests that when firms consciously
make price and output decisions in order to reduce competition, the courts may regard this
as tacit collusion, even if they do not explicitly collude.

 Important Point: The concept of signaling is very important to understanding

tacit collusion. Because firms involved in tacit collusion do not meet face-to-face and
negotiate the terms of their collusive agreement, they somehow have to communicate their
intentions to each other.

Slide 7-14
Use this slide to define both tough and soft signals. This will help in understanding the
various strategies identified in the “Research Made Relevant” box.

The intent of a tough signal is this: that if parties cheat on collusive agreements, the firm
sending the signal will decrease prices more or increase output more than would have
otherwise been the case. In other words, such a signal indicates punitive intent.

In contrast, a soft signal has a different intent: that if parties cheat on collusive agreements,
the firm sending the signal will decrease its prices less or increase its output less than would
have otherwise been the case. In short, the message is that the signaling firm will back off.

Tough and soft signals led to the following strategies:

 The “puppy-dog ploy” – avoiding tough signals when price is a major basis
of competition.
 The “fat-cat effect” – proactively using soft signals when price is key in
industry (may be the better strategy than “puppy-dog ploy.”
 The “top-dog strategy” – tough signals when capacity is key in industry.
 The “lean-and-hungry look” – preferred option for some firms in industries
where capacity is important.

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154 Chapter 7: Collusion

Slide 7-15
Use this slide to go over the four types of strategies associated with signaling.

Industry Attributes and the Threat of Cheating

Industry attributes play a key role in estimating the probability of cheating on collusive
agreements. These attributes are listed in Table 7.5.

Slide 7-16
Use this slide to go over the industry attributes that facilitate the development and
maintenance of tacit collusion. This slide reproduces Table 7.5.

Tacit collusion is more likely to be successful if there are a small number of firms in an
industry (or at least one in which a small number of firms dominate). Take the example of
book publishers confronting the threat of Amazon in e-books. The fact that the six firms
dominated the industry enabled them to send and interpret signals easily (of course, the
“cloak-and-dagger’ meetings in a New York restaurant didn’t hurt!). This would have been
much more difficult if a large number of firms were involved.

Tacit collusion is also more likely when firms produce and sell similar products or services,
i.e., when product homogeneity is high. This is because price changes (as signals) are easier
to send and interpret than product attribute changes.

Homogeneity of economic costs increases the opportunities to implement tacit collusion.

This is because costs are related to output and product range. When cooperating firms have
similar economic costs, it may be relatively easy for them to discover an output level that is
mutually satisfactory; this, in turn, facilitates tacit collusion.

A price leader is a firm that sets “acceptable” industry prices or “acceptable” profit margins
in an industry. In essence, price leaders (typically firms with the largest market share in the
industry) “police” the industry and ensure that there is order and discipline. The presence of
price leaders facilitates tacit collusion.

Industry social structure refers to accepted norms of behavior and competition that evolve
in industries (the “do’s” and “don’ts”). As the Major League Baseball collusion example
points out, industry social structure facilitates collusion. While each franchise is
independently owned, baseball owners cooperate to set schedules, rules of the game, and
other operating standards. It simply makes it easy in such a situation for owners to collude
on how much to pay for free agents.

When maintaining a collusive agreement precludes a firm from doing something else
(opportunity costs), the incentive to cheat is high. Industries characterized by infrequent and
large orders are more prone to cheating in collusive agreements.

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 Chapter 7: Collusion 155

In the same spirit, the ability of firms to produce for inventory and to create order backlogs
helps facilitate tacit collusion. Inventory buffers help firms maintain consistency in output
and prices, resulting in creating conditions for tacit collusion.

Of all the factors, though, the most important industry characteristic facilitating tacit
collusion is the presence of entry barriers. Low entry barriers mean a constant flow of new
entrants that makes it difficult to signal and facilitate tacit collusion.

 Important Point: Industry factors play an important role in not only enabling
tacit collusion but also in maintaining it. The key factor, though, is the presence of entry
barriers.

Rarity and Costly to Imitate Collusion Strategies

Rarity implies selectivity or exclusivity. This runs counter to the concept of collusion which
requires a number of firms to agree to something. Rarity in this context refers to the small
numbers issue discussed as one of the industry characteristic that facilitates collusion. By the
same token, the idea of imitation also seems to run counter to cooperation. What is
important here though, is this: imitation here has to be looked as equivalent to entry barriers
for the industry.
 Important Point: The small-numbers industry attribute is equivalent to the
rarity requirement; the barrier-to-entry industry attribute is equal to the costly-to-duplicate
requirement.

Slide 7-17
This slide reiterates the important point described above, that rarity and costly-to-duplicate
concepts have to be looked at in terms of industry factors when it comes to collusion.

ORGANIZING TO IMPLEMENT TACIT COLLUSION

Learning Describe Two Unique Challenges Associated With Organizing to Implement a Collusion Strategy
Objective
7.4 There are two unique organizational issues that are critical to successfully implementing tacit
collusion strategies: maintaining organizational efficiency and organizational self-discipline.
Typically, competition forces a firm to be efficient. For example, if UPS has to
successfully compete in the package delivery business, it has to focus on efficiency, lest its
costs rise and its margins are threatened. The problem is tacit collusion runs counter to this.
If a firm is engaged in tacit collusion along with others, it is encouraged not to drive its costs
down or increase its product differentiation. This means that, as long as a firm is involved in
tacit collusion, it shouldn’t focus on efficiency. But what happens when the collusion falls
apart? Given the fragility of tacit collusion, it behooves a firm to maintaining its efficiency
even if it is a challenge.

In the same vein, organizational self-discipline become an issue when a firm is engaged in
collusion. Because tacitly colluding firms will almost certainly be tested in their resolve to

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156 Chapter 7: Collusion

maintain price and output stability, the ability to implement this strategy successfully
depends on an unusual level of organizational self-discipline.

Slide 7-18
This slide lists the two unique organizational requirements necessary to implement and
maintain a strategy of tacit collusion.

 Teaching Points

• Ensure that students understand the unique requirements that an

organization must have to be involved in tacit collusion.
• Reiterate that these are in addition to the typical organizational factors
necessary for strategy implementation.

SUMMARY OF COLLUSION

Slide 7-19
This slide can be used to summarize the key points in this chapter.

This chapter runs counter to the ideas described in the other chapters in the book,
particularly Chapters 4, 5, and 6, all of which talk about strategies to effectively compete
against other firms in the industry. In this chapter, an alternative notion is introduced – one
that involves colluding with and not competing against other firms in the industry.

To understand collusion, it is important to understand two key concepts: the idea of

cheating and the notion of using signals to convey one’s intention. Cheating breaks up a
collusion agreement and so firms that want to enter into collusive agreements need to know
why firms cheat and what factors are conducive to cheating. In addition, firms also need to
know the kinds of signals in collusion and what each one conveys.

CHALLENGE QUESTIONS

7.1. Firms that engage in Cournot cheating will achieve higher levels of performance than
will firms that engage in Bertrand cheating. Why, then, would firms ever engage in
Bertrand cheating?

Cournot cheating relates to capacity and capacity planning while Bertrand

cheating has to do with prices. In addition, Bertrand cheating suggests a race
to the bottom in the long run. Firms may collude on prices to keep away a
powerful new entrant, but one of the cheaters may resort to Bertrand
cheating if it feels that the powerful new entrant needs a nudge to exit the
industry and so its lower prices (lower than what the colluders may have
agreed on) may be that nudge. Of course, the cheater cannot let the race

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 Chapter 7: Collusion 157

reach unprofitable levels, but it can cheat up until it is able to generate a

profit.

7.2. Both cost homogeneity and product homogeneity enhance the ability of firms in an
industry to implement tacit collusion strategies. Under what conditions, if any,
would a firm be able to pursue a cost leadership strategy or product differentiation
strategy while simultaneously trying to implement a tacit collusion strategy? Are
these strategies mutually exclusive?

In a way, the strategy of cost leadership and product differentiation are

strategies of avoidance, because these firms want to stand out from the
competition either via prices or via differentiating factors. Collusion is the
opposite because you are doing the same thing as the other colluders. Tacit
collusion and the generic strategies of cost leadership and product
differentiation are mutually exclusive.

7.3. At one level, the requirement that all firms in an industry be involved in a tacit
collusion strategy in order for that strategy to be viable seems to contradict the
rareness and imitability requirements for sustained competitive advantage, first
discussed in Chapter 5. Is it possible to rationalize this apparent contradiction? If
yes, how? If no, why not?

The rareness part comes from the small numbers requirement. Collusion
passes the rareness test if an industry has a small number of firms that
facilitates collusion. The costly-to-imitate requirement cannot be
rationalized, though, simply by looking at incumbents. If it is very costly for
non-colluding firms to begin colluding, then collusion will break down.
Therefore, this test has to be looked at by also including potential entrants.
Collusion creates entry barriers for potential entrants because it is costly for
them to duplicate the colluders’ resources.

7.4. Some have argued that the implementation of a tacit collusion strategy will lead a
firm to be relatively inefficient. Others have argued that the implementation of a
tacit collusion strategy requires firms to be very efficient at implementing this
strategy. Which is it? Do firms implementing a tacit collusion strategy become less
efficient or more efficient? Justify your answer.

Collusion takes away competition because the colluding firms are essentially
competing the same way. Because competitive intensity is lacking, if
collusion continues for a long time, it will make the colluders less efficient.
However, the exception to this is if collectively, the cheaters decide to
become more efficient, perhaps because of the possibility of a powerful new
entrant entering the industry, then all the colluding firms become more
efficient.

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158 Chapter 7: Collusion

Problem Set

7.5 The opening case of this chapter poses a specific strategic question. If you owned the
established gas station, would you raise your gasoline prices or not? Why?

Answer 7.5

Answer 1: Match prices.

Rationale:
1. This type of collusion would simply be tacit collusion, which is legal and often
profitable, although difficult to maintain. Pepsi and Coke are an example of this
collusion being successful, where they have two very similar products, but enjoy
higher margins by not fighting each other on price.
2. The raised price is, in essence, a signal. By responding to and cooperating with this
signal, I would leave the door open for future signals and cooperation. If I ignore the
signal (keep the price the same) or respond competitively (lower prices even more), I
reduce the option for tacit cooperation in the future. However, by responding
positively to the signal, I maintain the ability to cooperate OR compete in the future,
as is prudent.
3. In the scenario, there is little to no threat of substitutes, buyers, or suppliers. I have
already attempted to lower the threat of new entrants by lowering my prices, but this
was not effective. My current threat is a threat of rivals. Tacit collusion would
significantly reduce the threat of rivals, although it might increase the threat of new
entrants. However, there are few, if any, options to prevent new entrants and a very
clear path to reducing rivalry.
4. The situation is generally conducive to tacit collusion. There are only two firms,
selling similar products with similar costs. Further, the competitor has stepped
forward as a price leader (or Stackelberg leader, in this case), and following this
leader will be more profitable than triggering Bertrand competition (at which point,
we would eventually compete away all the rents from gasoline. The industry social
structure is also conducive to tacit collusion, as the norm is to post prices publicly
and consumers are used to competing stores having similar, if not identical prices.
There are only two gas stations in the geographic area, so the price is easy to
maintain without explicit cooperation. Further, a gas station has high order
frequency, and small order size, so little can be gained by a sudden change in pricing
(at most, a day’s worth of competitive advantage; at worst, a few hours). Gas stations
are subject to changes in supply pricing, but those changes are likely to be similar,
given the similarity of the products being sold and high correlation to commodity oil
pricing. However, there remains a drawback in barriers to entry, as this collusion is
not protected by any. In short, it will be a good strategy for the immediate future, but
may be undercut by the entrance of a third gas station.

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 Chapter 7: Collusion 159

5. There are only weak incentives to defect from this collusion. Defection would only
yield short-term advantage and trigger Bertand competition, which would drive
prices down unnecessarily.
6. The increase is relatively small, and likely within the normal range. As long as the
price does not become excessive, such that it would drive consumers away, following
the signal would be profitable and harmless. However, if the other manager begins
raising the price excessively, refusal to follow future signals will signal to the other
manager that the price is too high. However, flat refusal to follow the signal now will
indicate a lack of cooperation or misunderstanding of the signals. Thus, following
the signal now enables communication in the future.
7. I can still compete on the prices of convenience store goods. These are much more
difficult to cooperate on and allow for differentiation without reducing gasoline
revenues.
8. There’s always time to compete on price later, but triggering competition now will be
difficult to undo without.

Answer 2: Keep the price the same.

Rationale:
1. Rather than allowing the other manager to be the price setter, I remain the price
setter by refusing to respond to the other manager’s signals. This allows me to set the
best price for me, and puts the burden of collusion on the other manager.
2. I really hate the idea of “collusion” so I’m going to gently compete rather than
cooperating.

Answer 3: Lower prices

Rationale:
1. I’m a monster who doesn’t understand what I’m doing.
2. By triggering a pricing war, I discourage new entrants. If I deem this to be my most
credible threat, then this strategy might make sense.

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