Tacit Collusion, Free Entry and Welfare

Abstract

THE effect of collusion under free entry has a long history of analysis in economics, yet many of the central issues remain unresolved. Of particular interest is the interaction between the number of firms in the industry and the degree of collusion in the industry. There are two relationships that might reasonably exist between the number of firms and collusion. On one hand, collusion is made easier if the number of firms is small, but on the other hand, an industry that successfully colludes will earn short run above normal profits and attract new entry until profits are driven to zero. In this paper we model the interaction between these two forces and present, in a simple diagram, an illustration of the determination of equilibrium entry and collusion. We are also concerned with the implications of such a structure for public policy. In particular, direct anti-collusive policies and entry fees are examined. One preliminary point to address is why collusion should occur at all if profits are going to be driven to zero in any case.1 First of all, it is only marginal firms that must earn zero profits, so if there are asymmetries between firms, inframarginal firms might hope to gain from collusion even in the long run. Our analysis, however, focusses on the case of symmetric firms: all firms earn zero profits in the long run. Even in this case the profit that can be earned in the short run implies that the present discounted value of an increase in the degree of collusion is positive. Furthermore, once a collusive zero profit equilibrium is reached, industry participants will want to maintain collusion so as to avoid the short run losses that would result from a breakdown in collusive arrangements. (This is similar to the transitional gains trap described in Tullock ['9751). Certainly a fairly large class of industries seem to be characterized by partial collusion and free entry. Providers of professional services are an important example. There is a wide variation in the ability and income of different providers of the same professional services; nevertheless, in most professions there are individuals at the margin earning zero economic profit. Moreover in many countries professionals such as lawyers and dentists are