Tacit collusion in the presence of cyclical demand and endogenous capacity levels

We analyze tacit collusion in an industry characterized by cyclical demand and long-run scale decisions; firms face deterministic demand cycles and choose capacity levels prior to competing in prices. Our focus is on the nature of prices. We find that two types of price wars may exist. In one, collusion can involve periods of mixed-strategy price wars. in the other, consistent with the Rotemberg and Saloner (1986) definition of price wars, we show that collusive prices can also become counter-cyclical. We also establish pricing patterns with respect to the relative prices in booms and recessions. If the marginal cost of capacity is high enough, holding current demand constant, prices in the boom are generally lower than the prices in the recession: this reverses the results of Haltiwanger and Harrington (1991). In contrast, if the marginal cost of capacity is low enough, then prices in the boom are generally higher than the prices in the recession. For costs in an intermediate range, numerical examples are calculated to show specific pricing patterns. (C) 2009 Elsevier B.V. All rights reserved.