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In the late 1990s federal regulators noticed something unusual. Retailers no longer offered meaningful discounts on music. No matter what store sold them, compact discs always cost the same; usually $14.95 or $19.95 per album.

The Federal Trade Commission investigated and discovered one of the largest price fixing cartels to that time, a collaboration between five labels to keep the price of music artificially high. The FTC found concrete evidence that the largest music companies in the U.S. had systematically broken the law. In a sign of things to come, it then settled the case for zero dollars in fines and an agreement that the industry would stop.

More recently, 44 U.S. state attorneys general have banded together in a lawsuit that alleges price fixing in the generic drug market. What are they arguing, and why does it matter?

Here's what you need to know.

What Is Price Fixing?

Price fixing is when participants in a market band together to artificially set the price, supply or other market value of some good or service. The most common form is when companies agree not to sell their product for less than a specific amount. This, for example, is what the plaintiffs have alleged in their generic drug lawsuit. According to the complaint, approximately 20 manufacturers have agreed to collectively raise the prices on certain generic drugs and not to undercut each other.

As long as no company breaks ranks, consumers have no choice but to accept the higher prices. This is a form of monopolistic behavior.

Price fixing can also happen on the demand side of a market. In this case, participants agree not to buy something for more than a certain amount. For example, suppose every car company were to agree not to buy steel for more than 15 cents a pound. With their market dominance they could try to force steel mills to accept this very low offer.

As with supply-side price fixing, as long as no company breaks ranks, suppliers would have no choice but to accept these lower prices if they want to continue selling their product. This is a form of what's called "monopsonistic" behavior.

Despite its name, price fixing does not have to deal strictly with prices. Any form of agreed-upon, anticompetitive market control is considered price fixing. This can include agreements among competitors on consumer identity, promotions, shipping and even future development plans.

What Are the Types of Price Fixing?

There are two formal categories of price fixing:

Horizontal Price Fixing

This occurs when competitors across a market agree not to compete over a given product. For example, when every music label agreed not to reduce their prices on compact discs in the 1990s, this was a form of horizontal price fixing.

Horizontal price fixing can apply to any terms of a product, not just prices, as long as all of the participants agree not to compete with each other. For example, if a group of online retailers agreed not to offer free shipping, this would be considered a form of horizontal price fixing.

Vertical Price Fixing

This occurs when all of the participants in a supply chain make an agreement to fix the terms of a given product. Typically, it occurs between a manufacturer and the retailer who sells its products. A company that makes widgets, then reaches an agreement with the store to set the price of those widgets, would engage in vertical price fixing.

Or suppose a regional landlord reached an agreement with a real estate developer not to build any new apartments. This would be illegal vertical price fixing, as the landlord would be hoping to keep the supply of apartments low and its rents (therefore) high.

Companies can publish suggested prices, such as the list price printed on each book you purchase, but they cannot reach an agreement with a retailer to set those prices. This is why an increasing number of manufacturers have begun launching their own proprietary retail chains, such as Apple (AAPL - Get Report) Stores, as this avoids the restraints of vertical price fixing.

That said, while companies cannot reach an explicit price agreement with a retailer, they can legally refuse to do business with retailers which sell on terms with which the company is unhappy. This often makes vertical price fixing more of a paper tiger than anything else.

There are many informal categories of price fixing. You will not find these listed in legal resources, but they are helpful for considering the subject.

Monopolistic

An agreement to control a market by anticompetitively limiting the supply of goods or services.

Monopsonistic

An agreement to control a market by anticompetitively limiting the demand for goods or services.

Increased Prices

An agreement to raise prices or to set minimum prices. This can be done either among competitors (horizontally) or among members of a supply chain (vertically).

Reduced Prices

An agreement to lower prices or keep them from rising. This is typically done by companies looking to lower their costs, and can be done either among competitors (horizontally) or among members of a supply chain (vertically).

Output Reduction

An agreement to reduce or restrict how much of a product reaches the market. This can be done by manufacturers choosing to produce less altogether, distributors choosing to let only a given amount reach the market, or retailers choosing to only sell in a limited supply.

How Does Price Fixing Happen?

Price fixing happens when market actors who should compete with each other over some aspect of the marketplace reach an agreement not to do so. It's an attempt to control the market by creating a cartel, or an effective monopoly. While this must happen by agreement, that can either be express or implied.

Express Agreement

In this scenario, competitors explicitly state and understand their terms. For example, in 2016 Apple was sued for conspiring with five publishing houses to fix the price of eBooks. Under this scheme, the publishers collectively raised the prices of their books to push back against the low prices charged by Amazon.com.

This was a specific, known agreement among all parties. The fact that the publishers did it to push back against the arguably monopolistic behavior of Amazon (AMZN - Get Report) (which uses its market dominance to force them to accept lower prices) did not matter.

Implied Agreement

This is a more difficult scenario. Under an implied agreement, the parties don't reach specific terms. It is the proverbial "wink and nod" situation, in which they collectively decide to work together without reaching a provable, formal agreement.

Parties can reach an implied agreement in many situations. For example, retailers in a marketplace might agree that prices have gotten too low, leaving the solution ambiguous. Or a group of companies might decide not to compete, understanding that if one company enters a region the others will leave it alone. As often as not, an implied agreement can mean that investigators lack the proof of an explicit arrangement and are working instead from circumstantial evidence. That makes the behavior no less illegal.

No Agreement

It is important to understand that not all similar behavior implies coordination.

In a perfectly rational market companies in the same industry will behave similarly. When they have the same access to supply lines, consumers and information, regulators expect companies to produce comparable prices. Ideally this means competing down to the lowest rate that the market will bear.

This is not illegal. Similar, even identical, behavior that results from companies operating independently is not an example of price fixing.

Why Is Price Fixing Illegal?

Price fixing is illegal because it is an anticompetitive behavior that allows companies to artificially stifle competition and raise prices on consumers. A healthy capitalist economy depends on active competition among participants, and that can quickly break down when companies begin to collude against consumers.

For example, when companies collectively raise prices they are charging what economists call "rents." A rent is an amount of money that someone can charge not because of any value that they have added, but simply because they control access to a specific good or service.

This allows the participating companies to extract money beyond any value that they've created. In a well-functioning economy this would be no problem. A company trying to charge more than its product is worth would quickly lose customers. However under a price-fixing scheme, those customers have no alternative and nowhere else to go. The market is stifled and consumers get ripped off.

Or, consider companies that collude to freeze access to the market. A group of manufacturers could use their market leverage to threaten retailers across the country, pulling their products from the shelves of any store that stocks a competitor. This would effectively make sure that no one else can enter the market, preventing anyone from offering consumers a better deal.

The examples could go on. Ultimately, price fixing is illegal because it is bad for consumers. It lets companies dominate markets not by creating value but by stifling competition.