Why Firms Engage in Collusive Behaviour (Worked Answer to Edexcel Q8 Paper 1 2019)
Last updated 5 Jan 2020
Here is an example answer to a 25 mark essay question for Edexcel A-Level Economics on why firms engage in collusive behaviour.
[Note: Examiner Commentary is provided in square brackets / bold / italics]
In December 2016, a group of UK model agencies were found guilty of price-fixing. The UK competition regulator, the CMA, fined FM Models, Models 1, Premier, Storm and Viva, along with industry trade body the Association of Model Agents (AMA), for price-fixing modelling services for at least two years from March 2013. The total fines added up to £1.5m
[It is clear up-front that the candidate has responded to the demands of the question in terms of referring to an industry of their choice.]
The CMA alleged that the agencies “systematically exchanged information and discussed prices” and - in some cases - actually fixed minimum prices or agreed a common approach to pricing. Modelling assignments can range from fashion magazine shoots offering models fees of a few hundred pounds to ad campaigns offering more than £10,000. The CMA said that the collusion extended across all types of assignment and that it was not limited to the very top models. The great benefit of such collusion is that the consumers (which, in this case, are high street chains and online fashion retailers) spend on using models to advertise their products and appear in ad campaigns. Because all the agencies are charging the same price, the consumer have nowhere else to go and so the modelling agencies, consequently, see increased sales revenue and profit.
Not all firms engage in collusive behaviour though. Firms actually have an incentive to cheat others by either increasing their share of the (restricted) output or by lowering the price below the fixed price. In either of these two methods, the ‘cheating’ members should see an increase in sales, revenue and abnormal profit. This means that the industry is no longer at the profit-maximising point and so industry profits – as a whole – go down. This means one firm is getting richer but at the expense of the other firms being much worse off. The fact that the incentive to cheat is so great means that cartels are inherently unstable. This could be illustrated using a Prisoners Dilemma payoff matrix.
However, it is easy to see why modelling agency were keen to collude in 2013 when seen in the context of the market structure in 2013. In the US, the concentration ratio has been falling since the start of the 21st century. In addition, the rise of digital/social media means that barriers are coming down all of the time. Ultimately, the service of providing a model for an assignment is fairly homogeneous but there are so many ways to differentiate the service (through customer service all the way through to the model him/herself) it is likely to be considered by most as a heterogeneous good with low barriers to entry. As a result, collusion have been the last chance for the main players to hold on to the market power and make supernormal profit. Monopolistically competitive markets only make normal profit in the long run.
[Consideration of the context in which certain actions took place is a great way to embed theory with practice]
Of course, new entrants in the markets are intent on disruption. They try to break the dominance of main players and to undercut their prices. Therefore, it is fair to say that not all firms engage in collusive behaviour; some consider the collusive behaviour of others to be a source of inefficiency that they can disrupt. A similar thing has happened with Uber in the taxi and private hire car market; Uber has offered a rival product at a much lower price, thereby undercutting the established players. Cheap prices can be a huge source of competitiveness.
[This shows a good, practical understanding of how firms interact in competitive markets.]
In conclusion, it is easy to see why modelling agencies in the UK colluded: it will have led to larger revenues and profit, reduced the risk of costly of price wars and may well have been the last chance to exert market dominance before the market was disrupted. That said, non-collusive behaviour is probably more profitable if you can ‘reduce’ your prices below your competitors and sustain that price fall for a long time. In fact, undercutting the market price can actually be a long-term growth strategy for new-entrants.
Essential Revision Resources for Edexcel A-Level Economics