Strategic Audit Report

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Strategic Management Week 11 – Chapter 7

Collusion

Ch. 7 Learning Objectives

• Define explicit and tacit collusion and explain why collusion is typically inconsistent with social welfare in an economy.

• Describe how collusion can create economic profits. • Describe different ways that collusive agreements can fall apart, and how it

is possible to use the attributes of an industry to anticipate how sustainable these agreements are likely to be.

• Describe two unique challenges associated with organizing to implement a collusion strategy.

Where Are We in the SM Process?

Defining Collusion

Collusion exists when firms in an industry or market cooperate to reduce competition.

We’ll discuss two types with differing behavior and implications: Explicit collusion exists when firms in an industry directly negotiate agreements about how to reduce competition.

Tacit collusion exists when firms cooperate in reducing competition, but engage in no face-to-face negotiations to do so.

Ethics & Strategy

• Perfectly competitive markets are consistent with social welfare.

• But social welfare is reduced when firms with homogeneous resources and capabilities cooperate to reduce competition below a perfect competition level.

• This reduction in social welfare is called a “dead weight loss.”

Generic Business Strategies and Collusion

• Cost leadership, product differentiation, and flexibility – Generate economic profits via efficiency and effectiveness

in meeting customer needs – These profits are “efficiency” profits

• Collusion’s profits come from reducing competition – These profits are “collusion” profits

Amazon and the E-Books Controversy

• “Big Six” book publishers threatened by Amazon’s $9.99 e- Book pricing model

• Believed that this would erode the value of a $25–30-priced hardcover book

• Used Apple’s planned entry (via iPad) to e-Books business to collude

• Met in New York restaurant to collectively offer better terms to Apple

• Court deemed this as collusion

Collusion and the S-C-P Model

• Collusive strategies can impact any of the threats associated with: – New competitors – Existing competitors – Substitute products – Supplier leverage – Buyer influence

– … i.e., any aspect of the S-C-P framework

The Value of Collusion

• Colluding to reduce threat of new competitors – Building up scale – Developing common technology standards – Lowering emphasis on product differentiation (“Made in the

USA”) Lobbying to increase cost of entry • Colluding to reduce threat of current competitors

– Cost side efforts – Revenue side efforts

• Colluding to reduce other competitive threats – Reducing supplier and buyer power – Substitutes?

Table 7.2 Cheating in Collusion

Table 7.2 Describes: Ways Firms Can Cheat on Collusive Agreements, Decision Variables, Behavioral Assumptions, and Equilibrium Performance Implications for Firms in a Duopoly without Product Differentiation

Table 7.2 Cheating in Collusion

Strategy Decision Variables

Behavioral Assumptions Performance Implications

Cooperation Price/quantity Both firms maintain agreements Share monopoly profits

Price taking Price/quantity Both firms ignore all interdependence

Normal profits

Bertrand cheating

Price One firm assumes that the other firm will maintain price from previous period; no learning across periods

Normal profits

Cournot cheating

Quantity One firm assumes that the other firm will maintain quantity from previous period; no learning across periods

Profits fall between shared monopoly and normal profits

Bertrand Cheating

Assuming little or no product differentiation among a small number of firms, if one firm decides to cheat on a collusive agreement by reducing its prices, others will as well and, in the long run, firms in this industry will earn no economic profits Key Assumption: each time cheating firms adjust their prices, other firms in the industry will continue cooperating

Cournot Cheating

• Looked at performance consequences if colluding firms cheat by adjusting the quantity of their output and letting market forces determine prices.

• Cheating firms can still earn some economic profits – Between shared monopoly and normal profits

Collusion and Cheating—Key Takeaway:

Generally, long-run profits for firms that cheat on purely collusive agreements (via pricing or capacity management) fall somewhere between the perfect competition, zero-economic- profit solution and the perfect cooperation, shared-monopoly- profit solution.

Types of Signals in Collusion

• Tough Signal – If parties cheat on collusive agreements, signal sender will

decrease prices more or increase output more than would have otherwise been the case

• Soft Signal – If parties cheat on collusive agreements, signal sender will

decrease prices less or increase output less than would have otherwise been the case

Signaling Strategies

• “Puppy-Dog Ploy” – Example: Ben & Jerry’s frozen yogurt

• “Fat-Cat Effect” – IKEA and upholstered furniture

• “Top-Dog Strategy” • “Lean-and-Hungry Look”

– H-P’s electronic instruments

Table 7.6 Industry Attributes That Facilitate the Development and Maintenance of Tacit Collusion

Small number of firms Product homogeneity Cost homogeneity Price leaders Industry social structure High-order frequency and small-order size Large inventories and order backlogs Entry barriers

VRIO’s “R” and “I” in Collusion

• VRIO’s rarity requirement – Met by the small-numbers industry attribute

• VRIO’s costly-to-imitate requirement – Met by the barrier-to-entry industry attribute

Organizational Requirements to Implement Tacit Collusion

1. Maintaining organizational efficiency 2. Organizational self-discipline