Blog Paul de Bijl: Misconceptions about tacit collusion

Background

The Netherlands Authority for Consumers and Markets (ACM) recently published the final version of its study into the Dutch savings market, following a draft version for public consultation. The three major Dutch banks responded firmly: the savings market is competitive, there is no oligopoly, and there is no tacit collusion.

In my previous blog (June 5), I gave an initial explanation of the concept of tacit collusion complementary to the draft report on the savings market, where three players have strong market positions (an oligopoly), and, moreover, savers experience switching costs. In this blog, I will make the notion of tacit collusion more concrete, and address common misconceptions about it.

Concrete example

Economic theory and game theory view tacit collusion as an equilibrium that can emerge through indefinitely repeated interactions between firms. In such an equilibrium, businesses implicitly coordinate their behavior – without an agreement or communication – as a result of which competition is reduced, leaving buyers worse off.

How does this work? Imagine two ice cream sellers on a beach. Every morning, each of them sets, independent from the other one, the price for a scoop of ice cream:

• If competition is effective, consumers pay the lowest price and the sellers are able to earn reasonable profits.
• If both sellers charge higher prices, scoops are more expensive and profits are higher ('supra-normal') compared to the previous situation.
• By undercutting its rival's price, a seller can capture customers from the other one and boost its profits on that day. Since the rival observes this, there is a risk that he reduces his price the next day as well. In that case, the profit advantage will quickly evaporate.

The ice cream sellers (who observe each other doing business every day) thus not only take into account each other's price, but also think through how the rival seller will respond to a price change. If they take the risk of reverting to fierce competition seriously, they will think twice about putting their excess or supra-normal profits on the line by reducing the price of a scoop. In that way, prices above the competitive level can occur in a stable equilibrium outcome.

This theory assumes a repeated game with an indefinite time horizon, where, in each period, the incumbents set their prices, then observe each other’s prices, set their prices for the next round, etcetera. The implicit threat of future price reductions keeps competitors in check without them actually having to threaten each other with retaliations.

How can such an equilibrium emerge? It may occur, for example, when, after a while, the ice cream sellers figure out how the other one reacts, and understand that both benefit from higher prices. But how high, if they do not communicate about the price? Through their daily interactions, the ice cream sellers gradually get a better understanding of the impact of their prices on their daily profits, which allows them to repeatedly implement small price adjustments. The joint best price can thus be formed through an iterative learning process. Alternatively, there may be a natural reference point ('focal point'), such as a suggested retail price from their ice manufacturer, a price change by a big ice cream parlor along the boulevard seen as the market leader, or a public announcement by one of them about the need for an ‘inflation correction’.

The conditions for tacit collusion are thus more favorable as providers prefer future (excess) profits above an even higher yet one-off profit gain, can more quickly observe each others' prices, and are able to respond directly to price changes. Barriers to entry and a small number of competitors keep the market orderly and are also favorable conditions.

Misconceptions

The concept of tacit collusion easily gives rise to misconceptions:

1. 'Tacit collusion involves collusion.' The term is confusing indeed, because the collusion is implicit, that is, without an agreement or communication. Just like a tacit agreement is an agreement that has not been communicated nor written down.
2. 'Tacit collusion is illegal.' EU competition rules and the Dutch Competition Act prohibit businesses from restricting competition through agreements or concerted practices, but establishing a violation requires evidence of an agreement or communication, which, in this case, do not occur. Despite the fact that the reduction in competition has similar effects as does a cartel, including the harm suffered by buyers, there is no violation of competition rules.
3. 'Tacit collusion requires an intention to coordinate.' On the contrary, it can occur organically because businesses observe and respond to each other’s behavior. Without having to say it out loud, competitors understand that everyone will benefit from higher prices (and thus higher profits).
4. Tacit collusion is easy to spot.' By definition, there is no smoking gun such as a written cartel agreement (which we still come across sometimes!) or a secret recording of a conversation. However, one can possibly make a case that it is plausible, for example, by observing market behavior, assessing market conditions, or estimating the statistical likelihood.

By definition there is no proof but sometimes it's plausible'

Tacit collusion is a stable market outcome where competitors, without agreement or communication, stay out of each other’s way: an unspoken understanding not to make each others' lives difficult. Market conditions can facilitate such an outcome regardless of actual intentions, for example in an orderly oligopoly, dominated by a few, big competitors. Legally, it cannot be proven, because, by definition, there is no hard evidence of an agreement or communication between competitors. In some cases however, it can be a plausible explanation for an unusually high price level – possibly besides other causes, such as consumer switching costs or contractual provisions.

Paul de Bijl, Chief Economist of the Netherlands Authority for Consumers and Markets