I recently interviewed for a Cambridge college as part of the undergrad admissions process and one of the questions I asked was as follows:

“We have a scenario where two shops (e.g. supermarkets) are selling the same product (e.g. chocolate bar) at the same price, does this necessarily mean that collusion is occurring? What other factors might the authority want information on?”

I find this to be an interesting question, as there isn’t a right or wrong answer and so it allowed applicants to discuss a wide range of economic phenomena, from market structure to pricing decisions and I wanted to elaborate upon a few of these points here. Before I get started, I should note that I didn’t make any assumptions other than what was stated above, letting the applicant make an assumption if this was convenient for their exposition.

The starting point in this question, for me at least, is to explain what collusion is and particularly to focus on the differences between overt and tacit collusion. Overt collusion occurs when firms talk to each other (or directly communicate in some way) to set prices or some other strategy to reduce competition (e.g. limiting innovation, reducing quality, not serving certain customers etc) with the intention of increasing firm profits. This practice is illegal and competition authorities spend considerable resources trying to detect such collusion to prevent the resulting reduction in consumer welfare. On the other hand, tacit collusion occurs when firms do not explicitly communicate to restrict competition but such an outcome still occurs. One such way this can happen is through price leadership. Here, one firm in an industry, usually the largest, sets a price and competing firms in the industry follow such a price. If any one firm deviates then there could be some form of retaliation, such as a grim-trigger strategy (if a firm deviates, all firms deviate and lose profit compared to the cartel situation). This tacit form of collusion is not illegal and is difficult to detect (are prices consistently going up due to changes in cost structure or due to tacit collusion? I will elaborate upon this point shortly). This launched a springboard for candidates to talk further about oligopolistic markets (where collusion is easier to sustain), the sustainability of cartels and game theoretic responses to such scenarios.

Returning to the original question, it is therefore clear that this pricing outcome could be consistent with either tacit or overt collusion. We might therefore want (in an ideal world) to see if we can find evidence of direct communications between competitors which would point to overt collusion. However, there is also another explanation: the described market could be one of perfect competition where firms are setting price at marginal cost, earning no supra-normal profit, and therefore consumer welfare is maximised. Such an outcome would look the same as above.

Such a situation might seem a bit confusing because a lot of A-Level economics discusses perfect competition in a world with many firms and homogeneous products, which is not exactly the situation described above. In reality though, even in an oligopolistic market we could see fierce competition between rivals, perhaps due to a maverick firm wishing to take market share from an incumbent, or due to a pricing war (maybe induced by a grim-trigger strategy / the breakdown of tacit collusion). In fact, this is a well observed phenomenon in retail, with many examples of pricing wars between supermarkets (one of my earliest posts, when I was an A-Level student, looked at the UK Supermarket Pricing Wars). To see whether perfect competition is occurring, we might want to get some information on costs to see whether price (roughly) equals costs, in which case we might be witnessing strong competition. In practice, it is often difficult to get data on marginal prices but that wasn’t a problem in my hypothetical world!

To sum up, we have discussed that a scenario of the same product being sold for the same price at two competing firms could either signal perfect competition or collusion; both of which are quite different scenarios and have different implications for consumer welfare (in the first case it is maximised and there is no need for government/regulatory intervention, in the second case it is diminished in favour of producer surplus/profit). In an ideal world of infinite data, we would want to look at information on costs, perhaps look at a time series of prices (have prices always been the same or do they usually differ between stores), look at the price similarities of other products sold by the competing firms, whether there exists collusive agreements between the firms, and finally some metrics on competition between the two firms (i.e. if they are located next door to each other then they may have a greater incentive to compete for customers than if they were monopolies in their localities).

There are of course many other interesting discussion points that this questions leads to, which makes it so interesting for an undergraduate interview setting! Outside of economics, the incentives for pricing, strategies employed by firms (such as Resale Price Maintenance or Recommended Retail Pricing), or marketing activity such as stock levels could be discussed in relation to this question. One point which was brought up and I thought was particularly interesting (maybe just because I hadn’t considered it!) is that it could be the case that the product in question is regulated by the government which results in the same price. I guess this is the flip-side of the manufacturer regulation the price through RPM or a similar agreement. Anyway, if you have any other thoughts on how to answer this question, leave them in the comments below!