How can collusion between firms lead to market failure?

Collusion between firms can lead to market failure by reducing competition, leading to higher prices and lower output.

In a perfectly competitive market, firms compete with each other to offer the best prices and products to consumers. This competition drives innovation, efficiency, and fair pricing. However, when firms collude, they essentially agree to act as a single entity, setting prices and output levels to maximise their joint profits. This behaviour undermines the competitive market structure and can lead to market failure.

Collusion can take various forms, such as price fixing, market sharing, and bid rigging. Price fixing involves firms agreeing to sell their products at a certain price, usually higher than the competitive price. This leads to consumers paying more for goods and services than they would in a competitive market. Market sharing involves firms dividing the market among themselves, each agreeing not to compete in certain areas. This reduces consumer choice and can lead to higher prices. Bid rigging involves firms agreeing on who will win a bid, undermining the competitive bidding process.

When firms collude, they essentially form a monopoly or oligopoly, where a single firm or a small group of firms control the market. This market structure can lead to allocative inefficiency, where resources are not allocated in a way that maximises consumer and producer surplus. In a competitive market, the price of a good or service is determined by supply and demand, reflecting the marginal cost of production and the marginal benefit to consumers. However, in a collusive market, firms can set prices above the marginal cost, leading to a loss of consumer surplus and a deadweight loss to society.

Moreover, collusion can stifle innovation. In a competitive market, firms are incentivised to innovate to gain a competitive edge. However, when firms collude, this incentive is reduced as they are not competing with each other. This can lead to technological stagnation and a loss of dynamic efficiency.

In conclusion, collusion between firms can lead to market failure by reducing competition, leading to higher prices, lower output, allocative inefficiency, and a loss of dynamic efficiency. It is for these reasons that collusion is generally illegal under competition law. However, detecting and proving collusion can be challenging, making it a persistent issue in many markets.