The Inherent Weakness of Price Collusion
JANUARY 01, 1970 by D. T. ARMENTANO
Dr. Armentano is Assistant Professor of Economics at the University of Hartford in Connecticut.
The following article is a brief explanation of some of the economic factors that appear to make price-fixing agreements between firms difficult to sustain, even in the absence of direct legal prohibition. The widely-held presumption among economists for some time has been that price conspiracies would be common in the American business system without antitrust legislation. The intent of the following discussion is to challenge such a presumption and suggest, instead, that there are diverse economic factors which would tend at all times to limit the success, and hence the significance, of price-fixing agreements in a free market. It is to be assumed that the firms under discussion here want to fix prices at more than competitive rates; what is being challenged is their collective ability to effectuate such a situation.
The responsiveness of buyers to price changes is of crucial importance when considering the potential effectiveness of price-fixing agreements. If, for example, the commodity to be price-fixed has few good substitutes, an increase in its price may increase total revenues of the conspiracy and make price collusion financially rewarding, at least in the short run. But if, as more often is the case, there is a plentiful array of goods that might be substituted for the commodity that is being price-fixed, the higher fixed price may push marginal buyers to the cheaper substitutes, and thus lower total conspiracy revenues.
This consequence encourages firms to break the agreement to maintain a uniform price since the agreement does not, apparently, work in their interests. Certainly some firms will be relatively worse off with regards to substitute competition than others, and would be the first to feel the pinch of a revenue squeeze, and the first to consider a policy of selective price reductions. Thus, the threat of substitute competition may make price conspiracy difficult to form in the first place or lead to competitive price reductions that break the conspiracy apart.
Changes in Demand
A slight, even temporary reduction in demand for the price-fixed commodity may break apart the price agreement; recession is the natural enemy of successful price collusion. A decrease in demand at fixed prices will curb sales, and the temptation to ease the decline with a price reduction will be strong, especially for any low-profit firm involved. Since all firms differ in financial strength, and in their willingness to "ride out" a demand decline, there must be such temptations and such producers. When the relatively weaker firms cut price in an attempt to increase or maintain sales, the formal price-fixing agreements tumble.
Firms that agree to fix prices also agree to some marketing arrangement. Somehow, particular firms must be selected to "get" particular "jobs," or a particular percentage of industry output.
This part of the conspiracy is crucial since it must produce proper revenues to all firms involved else one or more of the conspirators will "chisel" price to steal orders. But these market-share arrangements are all but impossible to sustain for any extended period of time. Will the present market shares be maintained and for how long? What arrangements will exist for altering the status quo? Will a smaller firm attempt to cut the fixed price when it feels that its allotted share or territory is too restrictive, and no operational procedures for change exist? And what about new firms attracted to the market by the higher than competitive prices? By definition, they have no allotted outputs or selling instructions; will they be content to just take a slice of the existing action? But which of the existing sellers will give up sales to make room for the newcomer? The tendency of output restrictions is to frustrate all aggressive sellers and attract new producers, and thus to weaken and eventually break apart price-fixing agreements.
Assume a (manufacturing) firm A whose production and selling costs—on the average—decline as output increases. As almost every businessman realizes, there are "economies" associated with larger outputs; "spreading the overhead" and purchasing supplies in larger quantities tend to lower average costs per unit of output, and make larger outputs cheaper to produce and sell than smaller outputs. The significant point for this discussion is that firms that restrict outputs as part of a price conspiracy invariably raise their average costs per unit. Hence, profits will decline unless the extra revenue associated with the conspiracy exceeds the extra costs associated with the output restriction.
This important factor must surely make firms hesitant to join such restrictive agreements. Smaller firms especially, will be anxious to increase—not decrease—output, in order to enjoy the economies associated with larger scale enterprise. To compete with larger, more efficient firms in the future may make this output expansion mandatory. In conclusion, price-fixing and output agreements are difficult to conclude when firms find it advantageous to increase, not decrease, their sales.
As long as international markets are free (and it is within our power to lower our duties and tariffs to zero on all goods), a domestic price-fixing conspiracy appears limited by foreign competition. When foreign goods are price competitive, domestic price-fixing agreements are inherently unstable. A world-wide conspiracy is possible, but such arrangements have only existed and functioned successfully in the past with active governmental support.
Honesty and Trust
Of course, honesty and trust between the firms to a price conspiracy is absolutely crucial to its successful operation. If one of the conspirators thinks, or is lead to think, that anyone else is not living up to the price-output agreements (and they will have to police their own agreements), then price cutting is likely. And since it is hard to turn down old customers and their price requests, and difficult not to discount from book price when demand lags, and since all firms know this, the suspicion of price cutting will always be strong. Since firms don’t trust each other in open competition, it is difficult to understand why they should suddenly trust each other in price conspiracy.
As a final point, some assumption concerning the market power of the buyers is necessary to understand price collusion. The buyers must, obviously, have a relatively weak bargaining position compared to that of the selling conspiracy. If buyers are large firms that can threaten to make the price-fixed item or import it, or can use reciprocal agreements to the detriment of the price conspirators, then successful price conspiracy certainly becomes more difficult. It is hard to imagine Sears, DuPont, American Can, or any of America’s industrial giants being the victim of price conspiracy in their purchasing markets.
Summary and Conclusions
In summation, price-fixing agreements appear unstable or unworkable when substitute competition is important, demand is falling, large producers are not party to the conspiracy, production quotas are to be agreed upon, larger outputs are cheaper per unit than smaller outputs, imports are an important part of market competition, mutual distrust and suspicion abound, and where buyers are in a position to bargain. Any or all of these factors might be enough to prevent successful price-fixing. Since almost all free markets, at one time or another, display these conditions, it appears reasonable to conclude that successful price collusion would be of negligible proportions, even without antitrust legislation.
Finally, it might be important to note that the record of many price-fixing cases prosecuted under our Sherman Antitrust Act has revealed a conspicuous lack of price-fixing success. With few exceptions, the prices have not been really fixed and have not been uniform for any substantial period of time; the evidence indicates that the agreements have broken down with almost monotonous regularity. Firms have been convicted for having a price-fixing agreement or "tampering with price structures" or agreeing to charge the same price, but rarely, if ever, for having accomplished successful price collusion. Thus, much of the factual and empirical evidence concerning price collusion appears to bear out the general correctness of the theories examined in this paper.