Collusion. Collusion occurs when large firms in an oligopoly form a cartel to act as a monopoly to restrict output and raise prices.
An oligopoly allows firms the chance to compete through collusion, that is, making an agreement with each other to price-fix and set high prices.
Assume a duopoly where only two firms A and B dominate the market. A and B’s dominant strategy is Low Price, it is the best Price, it is the best option a player has no matter what the other player chooses. If B prices high, A earns the most profit by pricing low. If B prices low, A earns the most profit by pricing low. So Low Price is A’s dominant strategy. If A prices high, B earns the most profit by pricing low. If A prices low, B earns the most profit by pricing low. So Low Price is B’s dominant strategy. Low price is also a Nash equilibrium, A’s choice is optimal given B’s choice and vice versa. At Low Price, A and B do not change their behaviour. But A and B’s dominant strategy makes them both worse off because they can earn higher profits if they both charge a high price.
Alternatively then, A and B could collude to restrict output and raise prices, both charge a high price and earn more profit than at the Nash equilibrium. A and B must ensure that neither one cheats on their collusive agreement. If A (B) prices high, B (A) has the incentive of cheating and pricing low to take most of A’s (B’s) consumers and earn higher profits than colluding. A and B cannot draw up a contract to prevent cheating because contracts are illegal. Instead, A and B could use credible threats to deter cheating. A credible threat is one that is in the best interest of a punisher to act out, so players believe it will happen. A could use the credible threat of pricing low forever if B cheats on a collusive agreement and vice versa.
Overt collusion occurs when there is a formal agreement (written or verbal) amongst firms to control the market. Basically the price-fixing agreement is open. A and B could openly collude if there are no competition authorities/laws. An example is OPEC, there is no international law to stop oil rich Arab countries colluding. A and B cannot openly collude in countries like the UK, US and in the Eurozone because collusion is illegal so A and B cannot draw up legally binding contracts. Alternatively, A and B could verbally agree to price fix and threaten each other with a credible threat to deter cheating.
Tacit collusion occurs when there is an informal or implicit agreement amongst firms to control the market. For example, price leadership, where the price leader sets a high price and then rivals follow suit.