CHAPTER 7

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

leadership, product differentiation, and flexibility
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 and effectiveness in meeting customer needs
These profits are “efficiency” profits

Collusion’s profits come from reducing competition

These profits are “collusion” 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.

Just like how efficiency oriented strategies generate efficiency profits, collusion
produces collusion profits.

Collusion exists when firms in an industry or market cooperate to reduce

competition.

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. 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. Tacit collusion can be legal (not always illegal).

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.
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).
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.

THE VALUE OF COLLUSION

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

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 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).
COLLUSION AND SUSTAINED COMPETITIVE ADVANTAGE
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.

Case 1:
Consider the following scenario.
You own and operate a gas station on a busy street corner in your town, there
are another gas stations in your city, but they are located over ten miles away.
You sell a well-respected brand of gasoline, one that is supported by a national
advertising campaign. While you charge a premium for your gas (compared to
the other stations in town), your property is clean and well maintained, your self-
serve pumps are state of the art, and you run a clean and well-stocked
convenience store at your station. The store sells drinks, snack foods, and few
auto supply items, and does so very profitably. According to a recent national
survey, your store sells 95% of the top 100 selling items in gas station
convenience stores. Even more important, some people say you sell the best hot
coffee in town. Two years ago, you added a car washing station behind the store.
It too has done well. And you’ve been the only gas station on this busy corner
since you built it five years ago. Until now.
It began with a rumor that another gas station was going to be built kitty-
corner from yours. When the construction began, it was obvious that this rumor
was true. About the same size as your station, it was going to sell a different
brand of nationally advertised gasoline. The convenience store that was being
built was slightly smaller than yours, but as it was stocked, it become clear that it
would sell about the same items that your store sold. The new station even had
an automatic car wash similar to yours, although a different brand. As the new
station got close to opening, you got to know the new owner. She had a great
reputation in town as a business person, and was widely liked and respected. You
had every reason to believe that she would run her business very effectively.
Three weeks after her grand opening, something happened that surprised
you. Initially, the price of her gasoline—advertised like yours on a sign in front of
her station—was the same as yours. You had dropped your price a bit before her
grand opening—still higher than the other gas stations in towns, but a few cents
lower that what it had been—and she matched that price. Until today. Today, she
raised the price of her gasoline by five cents per gallon. There was no indication
that the wholesale price of gasoline—either yours or hers—had gone up.
How should you respond?

Case 2:
► 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 met together to decide on a common
price strategy. The court ruled it as collusion and decided in favor of Amazon.
(United States Court of Appeals for the Second Circuit, August 2014)