Question

The Australian Government monitors the behaviour of oligopolies to ensure firms are not behaving anti-competitively. One behaviour they are concerned about is collusion. Design and analyse a payoff matrix to explain collusion. Do you think rational firms would collude? Why or why not? Explain the Nash equilibrium and resulting payoffs. Can the firms do better? Does behaviour in real-life differ from the theoretical prediction? What can be used to sustain collusion in the real world?

Feel free to copy/paste the below and fill in the blanks with example numbers:

Firm 1	Firm 2
		Collude	Compete
	Collude	( , )	( , )
	Compete	( , )	( , )

Answer 1

Collusion is any explicit or tacit agreement between suppliers in a market to avoid competition either by price fixing or market sharing.

The main aim is to achieve joint profits or reduce the losses.

Sometimes firms decide to act in mutual interest and collude to fix supply and price points, assuming that they could form an oligopoly and control the market together. This works like the case of two prisoners communicating in secret to both remain silent for mutual benefit. Firms can collude to charge high price and lower output. However collusion is unstable because the most efficient firms will be tempted to break ranks by cutting prices in order to increase market share.

With reference to the payoff matrix, The Nash equilibrium is to collude, collude. The best response of firm 1 is to collude given firm 2 colludes and given firm 2 competes it's best response is to also compete. Similarly, best response of firm 2 is to collude given firm 1 colludes or competes.

The Nash equilibrium will provide higher profits by lowered output and higher prices. However, each firm will have the tendence to break away from the collusive deal for greater individual interest shown by higher payoff at (compete,compete).

collusion can be enforced through timely detection of deviation and formulationg a credible mechanism towards punishment in case of deviation.