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Costly collusion in differentiated industries.

Article Excerpt
This paper demonstrates that increased product differentiation will make it more difficult to sustain collusion when it is costly to coordinate or maintain collusion. This result holds for a wide range of models, including all those commonly used to model competition between differentiated products. This contrasts with the previous theoretical literature, which shows that, in the absence of these costs, greater differentiation can help foster collusion under some common models of product differentiation but is consistent with the empirical literature, which suggests that collusion tends to occur most among homogeneous firms.

Key words: game theory; product differentiation; competition; collusion

History: This paper was received January 24, 2006, and was with the authors 2 months for 2 revisions; processed by Greg Shaffer.

1. Introduction

This paper demonstrates that under relatively unrestrictive assumptions, tacit collusion becomes more difficult to sustain as the level of product differentiation increases when there are high enough costs associated with collusion. This lack of ambiguity contrasts with the previous theoretical literature on tacit collusion and product differentiation, which finds that the direction of the relationship between product differentiation and collusive stability depends on the particular model of product differentiation that is used.

At the heart of this issue is a simple trade-off: While firms selling homogeneous products have the most to gain from tacit collusion, they also have the most to gain from cheating on the collusive agreement. The result is that the exact demand specification determines which effect dominates (Tyagi 1999). In contrast with the mixed results in the theoretical literature, (1) empirical studies consistently find that collusion occurs more frequently among firms selling homogeneous products. For example, Levenstein and Suslow (2006) examine the cartel literature and conclude that price fixing occurs more frequently in homogeneous product markets. (2) These observations match the general findings among empirical papers testing for collusion: Those looking at homogeneous firms generally find tacit collusion, while those examining heterogeneous firms generally cannot reject that firms are competing using static Nash outcomes. (3)

This paper proposes a general reason why it might be easiest to support tacit collusion among homogeneous firms--that there is a cost to maintaining or coordinating collusion. Costs of maintaining collusion could include monitoring costs, communication costs, or the continual potential of being caught and punished for illegally colluding. Costs of coordinating collusion could include costs of building collusion-specific infrastructure or the cost of negotiating the collusive outcome. We show that the presence of these costs increases the difficulty of sustaining collusion more for firms that are more differentiated.

To see the intuition behind this result, note that the ease of collusion is based upon the patience required to balance short-term gains from cheating with long-term benefits from colluding. Introducing costs of maintaining collusion increases the short-run gains from cheating (because the firm no longer has to incur the costs of colluding) and reduces the long-run benefits from colluding (by the amount of the costs of collusion), making collusion more difficult to support.

The degree to which collusion becomes more difficult is higher when the products are more differentiated because the sizes of both the short-run gain from cheating and the long-run benefit from collusion are smaller, so the percentage change of each effect from costs of collusion are larger. The effect of these costs is strong enough that collusion becomes monotonically harder to sustain as products grow more heterogeneous when these costs are large enough.

2. Costs of Collusion

The premise of this paper is that there are costs to coordinating and maintaining collusion. In this section, we discuss the sources of these costs along with empirical evidence of their existence. The costs that we focus on are costs of negotiating collusive outcomes, costs of building social and institutional structures needed to...

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