Collusion | A-Level Economics Model Paragraph
The supermarket sector could be damaging to consumers due to the risk of collusion. Extract F Line 1 mentions that economists have been worried about the lack of competition in the industry. Despite collusion being illegal in the UK, there is always a risk of tacit collusion taking place as it is informal and harder to spot. Collusive oligopolies can form if firms with a high market share secretly agree to limit quantity and set high prices. Game theory allows us to understand the benefits and the risks of different pricing strategies. Prisoner's Dilemma explains how firms that are interdependent may approach pricing. Firms know that they cannot set a high price unless they collude. This is because there is a huge risk a competitor would undercut them and steal all the profits. Therefore, the Nash equilibrium is for both firms to set lower prices. However, firms know that they could both set a high price if there is trust between them. If they can form an agreement not to undercut each other, firms can set a higher price and maximise profits. The first diagram shows this in terms of prisoners who may both choose to deny a crime assuming they have full trust that the other prisoner does not confess. The second diagram shows that these oligopolistic firms could then benefit from colluding by exploiting their price-making power and profit maximising. This leads to a high price and a low output of p1 and q1. This outcome is allocatively inefficient as AR does not equal to MC, which means that consumer surplus is nowhere near maximised. Extract F described that the second and third largest supermarkets attempted a merger, which would have given them signficant monopoly power, alongside Tesco, compared to any other supermarket.
However, even if firms could collude, there is arguably the benefit that they could use the high profits for re-investment and this would lead to innovations and quality products in the long run. This is called dynamic efficiency and this would benefit consumers over time. For example, pharmaceutical companies make a lot of profit but this also enabled them to quickly create innovative products, including the Covid vaccine at a very fast rate. We might also see supermarkets often re-investing in their recipes and their bakeries to create the best products for consumers.
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