Collusion occurs when two or more firms informally agree not to compete with each other or to limit the introduction of new competitors into the market. These agreements are informal, not contractual and they are used to get around legislation that is designed to ensure fair competition in a market called anti-trust legislation. When firms collude, they typically agree to raise prices, restrict supply or share information that would normally be used to gain an advantage over the other firm(s).
For collusion to take place there has to be anti-trust legislation that prohibits the formation of these agreements. The existence of anti-trust legislation forces agreements to be informal and secret. Sometimes there is no communication between firms but a group of firms will all sell for the same price to achieve the same effect. Firms might also deliberately avoid undercutting a competitor to achieve the same effect without making an agreement, this is called tacit collusion.
Collusion is the central idea behind an oligopoly or oligopsony. Three firms in competition sell the same good for three different prices, each is slightly lower than the other, if they agree to collude then all three firms can raise their price to the highest level. The firms can raise prices because they do not have to worry about another firm undercutting their good by selling it at a lower price. This can also be used to prevent new competition from entering the market, the three firms could also drop their prices to keep firms with higher production costs out of the market as they would have to sell at a higher price. The aim of a collusion syndicate or cartel is to gain the market power meaning the firms can influence the price or quantity supplied in the market.
In an oligopoly the restraint placed on either the price or supply means that the market is kept from achieving an efficient equilibrium. This creates an inefficiency in the market and a deadweight loss.
The Organization of petroleum exporting countries (OPEC) is an example of firms and governments colluding to gain control of the market for crude oil and create a higher, more stable price. In the 1980s, Major League Baseball teams colluded to limit the amount of salary that would be offered to players. This saved teams money and limited the amount of competition in the market for payers because teams can incentivize better players with higher salaries