How can collusion between firms distort the price mechanism?

Collusion between firms can distort the price mechanism by artificially inflating prices and reducing competition.

When firms collude, they agree to act together instead of competing against each other. This can take the form of price fixing, where firms agree to set prices at a certain level, or output restrictions, where firms agree to limit the amount of goods or services they produce. Both of these actions can distort the price mechanism, which relies on competition to set prices at a level where supply equals demand.

In a competitive market, prices are determined by the forces of supply and demand. If a firm tries to set its prices too high, consumers will buy from a competitor instead, forcing the firm to lower its prices. However, if firms collude to set prices, they can avoid this competitive pressure. Instead of lowering prices to attract customers, they can keep prices artificially high, knowing that consumers have no cheaper alternatives. This can lead to higher profits for the firms, but it also means that consumers are paying more than they would in a competitive market.

Similarly, if firms collude to restrict output, they can create artificial scarcity. By limiting the amount of goods or services available, they can drive up prices, again leading to higher profits. However, this also means that consumers may not be able to buy as much as they want at the current price, leading to a shortage.

Collusion can also lead to inefficiencies in the market. In a competitive market, firms have an incentive to be as efficient as possible in order to lower their costs and offer lower prices. However, if firms are colluding to set prices or restrict output, they may not have as much incentive to be efficient. This can lead to higher costs and lower quality goods or services.

In conclusion, collusion between firms can distort the price mechanism by artificially inflating prices and reducing competition. This can lead to higher prices and shortages for consumers, as well as inefficiencies in the market. It's important to note that collusion is generally illegal in many jurisdictions due to these negative effects on the market and consumers.