A Free-Market Approach to Eliminating Price Collusion
Tuesday, November 14, 2023
Have you noticed that goods are becoming more expensive?
Prices are rising, and we, as customers, are suffering.
Vendors are quick to explain that it isn't their fault. They have to raise prices, because their own costs have increased. Of course, they would say that. It's the exact rationale I recommended more than five years ago in my guide to price increase letters.
While it might be true that some price increases can be attributed to increased costs, the sweeping breadth and magnitude of price increases suggest that something else is going on: opportunism. In other words, companies are raising prices because they no longer fear a customer revolt.
Price collusion makes it easy for vendors to raise prices
In commoditized markets, producers sell very similar products and are afraid to raise their prices. Even a small increase in price will cause customers to take their business elsewhere.
Basic economics states that this fact is all that is required to ensure the existence of reasonable prices. Who in his right mind would dare to raise prices if doing so would ensure the destruction of his business?
Nevertheless, the marketplace doesn't always work the way textbooks would suggest.
Sometimes vendors don't act independently. Instead, either tacitly or explicitly, sellers decide to match each other's price increases as soon as they arrive.
When many vendors increase prices in quick succession, buyers are faced with a decision: they can either accept the price increases or they can do without.
Can governments stop price collusion?
Politicians lack the proper tools for addressing price collusion in a meaningful way. Regulation, investigation, and litigation only service to complicate the marketplace and add unneeded costs to free enterprise. Their actions do little to address the incentives that drive vendors to collude with one another in the first place.
What if we could eliminate the incentive for price collusion once and for all?
Traditional economics assumes that consumers are rational, and, all things being equal, they prefer to purchase goods at the lowest available price. If each vendor selects the exact same pricing, customers would have no reason to favor one vendor over another. Buyers would just spread their orders across all vendors. The implication of this theory is important: it means that the benefits of price collusion are shared when vendors match each other's prices.
What would happen if this theory didn't apply? In other words, what would happen if buyers still exercised a preference, even when no difference in price exists?
My easy-peasy method for eliminating price collusion
I have devised an effective method to fight against price collusion and drive down prices.
It requires no government interference and costs zero dollars to implement.
Best of all, it can be taught in just two sentences.
Here's how it works:
- If one supplier has the lowest price, buyers should purchase goods from him.
- In all other cases, buyers should purchase goods from the vendor who is tied for the lowest price and whose name comes first alphabetically.
Assuming that buyers are willing to follow this simple strategy, they will put immense downward pressure on pricing and destroy most cases of price collusion in short order.
So how does this anti-price collusion system work?
Consider the following scenario:
There are three gas stations in an isolated town, each named after its owner: Adam, Bob, and Charlie. The station owners have followed a tacit agreement for many years to charge exactly $10 per gallon of gas.
- The townsfolk, upset about the high price of gas, decide to try my method to end the price collusion between Adam, Bob and Charlie.
- Since each station owner charges the same $10 per gallon, everyone in the town decides to purchase gas only at Adam's station. This is because Adam's name comes first alphabetically.
- Buyers are still spending just as much as before, but now Adam is earning all the profit. Bob and Charlie, however, suddenly discover that they're heading to bankruptcy. No one is buying their gas!
- Bob and Charlie realize that since gas is a commodity, the most obvious means to get their customers back is to implement price reductions. They quickly lower their prices to $9.50 per gallon.
- The townsfolk cheer! Their strategy is working. With the new pricing landscape, customers abandon Adam's gas station and head to Bob's where the gas only costs $9.50. This works out great for Bob, as the discount has enabled him to capture the entire market.
- Now Adam and Charlie are looking at Bob's market share and are getting worried. They need customers too. So they decide to start charging $9 per gallon.
- This cycle of cost reductions continues until prices drop low enough that shoppers become content with the pricing. They take a break from implementing the anti-collusion strategy and divide their orders between the three service stations at random.
- At this point, the three station owners have learned a very harsh lesson and will be hesitant to raise prices in the future. Their customers have demonstrated their ability and willingness to punish business for increasing prices.
The fine print
Like all economic models, this method sounds wonderful - in theory. The strategy is simple and has great potential for decreasing costs around the world.
Let's explore a few of the reasons why it might not work perfectly in the real world:
- Requires price transparency - It's often difficult to figure out the final price of a product before purchasing it. The case of gasoline is simple because prices are highly visible. The price of other offerings, like cable television and airfare, can be difficult to assess prior to purchase.
- Requires some degree of commoditization - The less similar the offerings, the more difficult it will be for consumers to agree on which has the lowest price. Differences in quality, vendor reputation, speed of delivery, package sizing, and pricing terms may complicate analyses or prevent buyers from coming to a consensus.
- Requires coordination of buyers - The approach outlined above is simple enough that any buyer could master it quickly. Unfortunately, a considerable portion of buyers would have to utilize this strategy to influence a given market.
Many economists underestimate the ability of buyers to fight price collusion. They think shoppers have only two choices when faced with price collusion: take it or leave it.
This model shows that buyers can force prices down, even in the face of extreme price collusion.
Of course, if you happen to be a vendor, and this strategy has given you cold sweats, don't worry. There is a means of protection.
You can learn all about it in my book Premium. It will show you how to create offerings that can stand against price-based competition.