Title: Does Market Demand Volatility Facilitate Collusion?
Reference Number: 1179
Publication Date: November 2007
JEL Classifcation: G13; L13
Author(s):

Kit Pong Wong
The University of Hong Kong

Abstract:
This paper develops a real options model of a price-setting cartel under uncertainty to examine whether market demand volatility facilitates collusion or not. We show that there is a critical level of market demand (the optimal defection trigger) above which firms find it desirable to defect from the cartel. We show further that an increase in the underlying market demand uncertainty has two opposing effects on the optimal defection trigger. First, the increased market demand volatility gives rise to the usual positive effect on option value that lifts up the optimal defection trigger. Second, the increased market demand volatility calls for an upward adjustment of the discount rate and thus creates a negative effect on option value that pushes down the optimal defection trigger. We show that the negative effect dominates (is dominated by) the positive effect when the underlying market demand uncertainty is trivial (significant), thereby rendering a U-shaped pattern of the optimal defection trigger against the market demand volatility.

Key words: Cartel defections; Market demand volatility; Real options

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Last modified: 11/09/2007