Collusion, profitability and welfare: Theory and evidence

Abstract

In a differentiated oligopoly model with free entry, the static welfare loss from collusion is larger the lower the entry cost, the larger the market size and the higher the degree of product differentiation. The cartel overcharge is larger the lower the entry cost and the larger the market size, and is independent of the degree of product differentiation. These theoretical results are consistent with evidence from a natural experiment of policy reform, the introduction of cartel law in the UK in the late 1950s. Price-cost margins declined after the breakdown of cartels in low-capital and larger-sized industries relative to capital-intensive and smaller-sized ones. There is weaker evidence of a fall in price-cost margins in consumer good and advertising-intensive relative to producer good and low-advertising industries. Crucially, these effects are not observed for industries that were not affected by the cartel law. A comparison of these findings with evidence on the incidence of collusion suggests that the welfare loss from collusive pricing may often be smaller in industries where cartels tend to form than in those where collusion is more difficult to sustain.