Abstract
We explore the response of collusive prices to changing demand conditions when firms operate under capacity constraints in the presence of demand uncertainty. We find support for the conventional view that periods of low demand lead, through the emergence of excess capacity, to a breakdown of collusive pricing. We also find that the nature of price wars depends on the degree of excess capacity in the industry; while small amounts of excess capacity can lead firms to engage in mild price wars, characterized by uniform price reductions and market share stability, more severe price wars, characterized by price undercutting and market share instability, can emerge if excess capacity is sufficiently great. Finally, our results lend support to the view that market share instability is a symptom of ineffective collusion.
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