In Defense of Allowing Collusion

In modern liberal society if a seller of some output – say, yo-yos – retires or switches his commercial efforts from the selling of yo-yos to the selling of yogurt, no one regards this businessperson as having committed a moral or legal offense. Yet if this same businessperson were instead to collude with other yo-yo sellers to restrict output and (hence) to raise the price of yo-yos, he would be regarded by nearly everyone in modern liberal society as being not only unethical, but a criminal. Indeed, in the United States, a conviction for such collusion can be punished by imprisonment.

This harsh treatment of collusion is odd. After all, sellers who collude only restrict the quantities of output they make available for sale, while sellers who quit the industry stop producing those outputs altogether. Why punish the former action while thinking nothing of the latter?

Every mainstream economist would answer the above question with a recitation of the textbook demonstration that the gains reaped by colluders are less than is the cost of collusion borne by consumers. Upon completing this recitation – one that would likely include a nicely drawn “deadweight-loss triangle” – the mainstream economist would be confident that he has proven far beyond a reasonable doubt that the prohibition of collusion well and truly serves the public interest.

But if you press the mainstream economist to explain why, if collusion is so terrible, a seller’s quitting the industry is perfectly acceptable, that economist will stumble. He won’t know what to say because he almost certainly hasn’t even thought to compare collusion with quitting the industry altogether.

And thus we encounter one of the great inconsistencies of mainstream economics. An economist working in this venerable tradition (and, for the most part, it is truly venerable) understands that a seller who dies or retires or otherwise exits the industry does no harm to consumers because other suppliers will quickly fill the output left by the seller’s exit. More specifically, this economist will quite correctly explain that if the outputs that the departed seller is no longer supplying are valuable enough to consumers to justify their continued production, other sellers will expand their production or new sellers will enter the industry to replace the now-departed seller. Easy-peasy.

But this economist mysteriously fails to apply this same understanding to collusion. Assuming that there are no government-erected barriers to entry into the yo-yo industry, if two or more yo-yo sellers collude to raise prices, these higher prices will prompt yo-yo sellers who aren’t party to the collusion to expand their yo-yo outputs, or they will attract new producers into the yo-yo industry.

There is simply no good reason to worry that, in markets unprotected by government-erected barriers to entry, reduced output caused by collusion will create any more consumer harm than is created whenever producers voluntarily leave the industry.

But What About…?

The hostility to collusion is so ingrained that the mainstream economist will, at this point, search frantically for reasons to dismiss the above argument. The most plausible such reason goes like this: “Incumbent firms that collude with each other will protect themselves from new entry by threatening to lower their prices down to below-competitive levels whenever new firms attempt to enter. New entrants will thus be dissuaded from even attempting to enter.”

Although this mainstream rejoinder is the most plausible one possible, it is weak. In order to be able to credibly threaten to increase their outputs in attempts to scare off new entrants, the incumbent colluding firms must maintain the capacity to produce these extra outputs. But maintaining such capacity is costly. It’s a trivial economic exercise to demonstrate that such colluding incumbents will almost certainly, during their periods of collusion, operate ‘inefficiently’ – here meaning that they won’t minimize their costs of producing the units of output that they sell. This excess capacity, in turn, will constantly tempt each colluding firm to secretly expand its output and sales, thus making that collusion unstable.

In contrast, if the colluding firms do not maintain the excess capacity necessary for them to credibly threaten to under-price new firms who dare to enter the industry, then new entrants have nothing to fear by entering the industry and selling at prices lower than those agreed to by the colluders.

Either way, the collusive agreement is highly unstable, so it’s unsurprising that history provides very few actual examples of private firms that are unprotected by government-erected barriers to entry successfully colluding in ways that harm consumers.

The mainstream economist – at least one who is familiar with some economic history – won’t be too adamant in disputing the argument that collusive agreements are unstable. Nevertheless, he or she will insist that collusion should remain – as antitrust lawyers say – “per se illegal” because there is no upside to society from allowing such collusion.

Yet again, the mainstream economist is mistaken.

Many industries feature what economists call “high fixed costs.” These are industries in which, if any units of output at all are to be supplied at affordable prices, each producer must first incur huge upfront costs. The plan is to recover these costs by selling many units of output at prices slightly above the additional out-of-pocket (“variable”) costs of producing these outputs. In these industries, collusion to keep prices from falling can serve the public interest.

One such industry is commercial air transportation. To supply air travel at affordable prices, an airline must first acquire not only a fleet of airplanes, but also landing slots, hangars, and other pricey inputs. Once an airline has these inputs in place, it hopes to recover these costs by setting fares high enough not only to fully pay all “variable costs,” such as the aviation fuel that it burns on each flight, but also to make a contribution toward covering the already-incurred upfront costs.

Imagine a Delta Airlines jet about to fly from Atlanta to Boston. All seats but one are occupied. A would-be passenger approaches the gate attendant and offers to pay $10 for that last seat. Were Delta to say ‘yes,’ that entire $10 would go toward covering the upfront costs. Because the plane is going to fly regardless of whether that seat is occupied, by refusing the passenger’s offer of $10 Delta loses the opportunity to earn an extra $10 to help cover its large up-front costs – costs that it has incurred and must pay whether or not that seat is occupied.

In normal times, an airline can fill enough seats by charging ‘regular’ prices. The revenues earned on these sales enable the airline to cover all of its “variable” costs (such as for the fuel that it burns on each flight) plus cover an adequate portion of its “fixed” costs (such as the price of a jetliner). The airline operates profitably.

But suppose there’s an economic downturn. One result would be a fall in the demand for air travel. Each airline would find itself with plenty of unfilled seats. To fill these seats, competition among airlines could get so intense that airfares are bid down so low that the airlines would earn no revenues to help cover their high upfront costs. If the downturn lasts long enough, the airlines would go bankrupt.

Because entrepreneurs and investors realize that economic downturns occur from time to time, fear of the inability to charge airfares high enough during recessions to help cover their upfront costs reduces the attractiveness of investing in, and operating, airlines. Even during boom times, therefore, fewer airplanes fly than would do so if airline investors weren’t worried that temporary decreases in demand for air travel would result in prices too low to help cover upfront costs.

One way to avoid this outcome would be to allow airlines to collude. By agreeing not to cut fares so low that they make no contribution to covering upfront costs, airlines could better weather temporary declines in the demand for air travel. In turn, the attractiveness of investing in airlines would rise, thus resulting over time in a greater supply of commercial air travel – and lower average airfares overall.

Of course, colluding airlines would still have to find ways to avoid cheating on the agreement to keep fares from falling below agreed-upon levels. Doing so would be a challenge, but one made easier by the fact that fares kept high by collusion when demand for air travel is temporarily unduly low would not attract new entrants into the industry. Entrepreneurs and investors would understand that these ‘collusively high’ fares simply allow each airline to earn some money toward covering their upfront costs. These fares would not be true monopoly prices that result in true monopoly profits.

If airlines did collude to set fares at levels that are truly monopolistic, then new entrants would indeed be attracted into the industry – new entrants who would push airfares down to competitive levels.

The Importance of Humility

It’s tempting to dismiss the above analysis as ivory-tower speculation. But the real ivory-tower speculators are those who insist that all collusion among competitors should be prohibited by law. It is these persons who pretend to know in the abstract that a particular voluntary method of setting prices is always so certain to have no potential upsides that it should be outlawed. In contrast, those relatively few of us who advocate allowing market participants to make whatever peaceful, voluntary agreements they wish – including agreements to fix prices – are not confident that we can know in the abstract just what are, and what aren’t, in each of countless particular cases the best methods of serving consumers. We understand that if markets are to serve consumers as well as possible, entrepreneurs and investors must enjoy wide freedom to experiment with different organizational and contractual arrangements. They won’t always get it right, but because they spend their own money – and because they can’t force anyone to do business with them – over time the results of free competition and open market experimentation will serve consumers far better than will politicians, bureaucrats, and courts who arrogantly presume to know better than actual market entrepreneurs, investors, and managers how to survive and thrive in competitive markets.

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This article, In Defense of Allowing Collusion, was originally published by the American Institute for Economic Research and appears here with permission. Please support their efforts.

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