Collusion "is an agreement among firms or individuals to divide a market, set prices, limit production or limit opportunities."
Under capitalism, it is possible that an industry could collude with its competitors to artificially set prices high so as to maximize profit. Is such an act immoral? Should it be illegal?
The question starts with an erroneous assumption about free markets and turns it into a moral issue:
Under capitalism, it is possible that an industry could collude with its competitors to artificially set prices high so as to maximize profit.
In a free market, producers have no way to force consumers to continue buying a product whose price is higher than consumers are able and willing to spend on it. There will always be some reduction in buyers as a result of higher prices, even if many other buyers are willing to keep paying the higher prices. As long as buyers are free to buy alternatives, as they would be in a free market, some number of them will do so in the course of seeking to maximize their own gains.
Furthermore, in a free market, producers have no way to force other producers not to enter the market for a particular product and compete with existing producers, if the price level is high enough to be profitable for the new entrants. The new producers would be able to offer the product at a slightly lower price to attract more buyers, and the existing producers could not do anything to stop it without lowering their own prices in response. The new entrants might range from very small newcomers to very large, established firms that hitherto found it insufficiently profitable to compete in the allegedly "colluded" market.
With a proper understanding of how a free market works, the alleged moral "problem of collusion" ceases to be a major issue. Note that what happens in a mixed economy is likely to be very different, with a mixed economy's pressure on producers to obtain favorable treatment from the government, and the government's power to impose altruistic goals onto free markets everywhere.
Note also that even if free markets did make collusion profitable without inducing new producers to enter the market, it would still be true that the product was created by someone, and the creator is morally entitled by his effort and initiative to charge whatever price he wants to charge, even if a higher price would actually mean loss of profits because of loss of buyers. It is a huge mistake to assume that higher prices automatically mean higher profits in a free market. It's more likely (though still far from certain) in a mixed economy, with freedom-infringing government mandates and prohibitions everywhere -- which is why controls breed more controls.
Update: The System of Individual Rights
The comments raise questions about the "classical economic view of perfect competition driving prices down to marginal cost...." Articles have been published in the literature of Objectivism rejecting this view. For example, the following can be found in the topic of "Competition" in The Ayn Rand Lexicon:
The competition which takes place under capitalism acts to regulate prices simply in accordance with the full costs of production and with the requirements of earning a rate of profit. It does not act to drive prices to the level of "marginal costs" or to the point where they reflect a "scarcity" of capacity.
This excerpt is from an article in the August 1968 issue of The Objectivist titled, "Platonic Competition," a concept which the article criticizes and rejects. In fact, it is precisely this view of "pure and perfect competition" that provides the economic "case" for anti-trust laws.
Objectivism views capitalism primarily as the system of individual rights, not primarily as the system of competition or the system of "private ownership of the means of production." Individual rights include property rights, including intellectual property rights, which means patents, copyrights, trademarks, and the like. Note that intellectual property rights do not extend into perpetuity; they last for a specific time, as a consequence and recognition of the individual thought and initiative that brought the "means of production" (and property of any kind) into existence in a form that could be of value to man's life. Intellectual property certainly does not invalidate capitalism, properly defined.
The same commenter also states: "Under perfect competition I could get a $400 billion dollar loan with which I could instantly build factories producing perfect replicas of the iPhone, which I could then legally sell under the name "iPhone" for $199." This example illustrates why free markets are not a system of so-called "perfect competition" (also aptly described as "Platonic competition"). Laissez-faire capitaism consistently upholds intellectual property rights (and individual rights of any kind); it does not abrogate them.
Update: Free-Market Price-Setting
One of the newest Objectivist books on economic issues that is almost at the top of my reading list at present is Free Market Revolution by Yaron Brook and Don Watkins. Although I haven't had time to read it yet (as I continue reading Dr. Peikoff's book on the DIM Hypothesis), I did run across the following passage specifically on collusion and competition in a free market (p. 146):
People often treat prices as if they could be set arbitrarily by producers. When gas prices go up, for instance, we accuse oil companies of greedily "gouging" us. But why, then, do gas prices ever fall? And why, when they do fall, don't we thank oil companies for their generosity? The truth is that businesses don't arbitrarily raise prices in order to exploit consumers, any more than they arbitrarily drop prices in order to altruistically benefit consumers at the expense of their own profits. On a free market, prices are the product of voluntary trade and reflect facts of supply and demand. Prices are at once a prouct of individuals pursuing their own self-interest and a means by which individuals coordinate their economic goals in concert with others.
I have attempted, perhaps inadequately, to concretize this perspective on free-market price-setting in my original answer. I hope that my answer, along with its updates and applicable comments, including the various references I have cited, will prove helpful to the readers of this website.
Update: Free-Market Economics
Free-market price-setting still seems to be a disputed topic in the comments. The basic principle, as I understand it, is supply and demand. I.e., the average price of something generally tends to rise or fall to the level that balances the available supply with the available monetary demand. Mathematically, P = D/S. This is actually a mathematical identity if D is the total monetary spending for a particular type of item, and S is the total quantity sold. If the price is set too high, some of the available supply remains unsold. If the price is set too low, the available supply becomes exhausted sooner than it could have been, with correspondingly lower total revenue and lower net profit. I must emphasize again that this is a description of a free market. Government intervention can impede the law of supply and demand and distort the operation of markets.
Here is how Yaron Brook and Don Watkins describe price setting in their book, Free Market Revolution, p. 153:
We've seen that market prices aren't arbitrary -- they are determined by the facts of supply and demand. But government edicts concerning what prices "should" be are arbitrary. Economists call these price controls, and they devastate economic coordination. When the government sets prices above the market price, supply exceeds demand and there is a glut of products no one wants to buy. When it sets prices below the market price, demand exceeds supply and shortages ensue.
A few pages later, in the Conclusion section of Chapter 10, the book explains (p. 159):
A capitalist economy is a free economy. When men are left free to pursue their self-interest, they divide up their labor, rendering it more productive; they use prices to coordinate their productive activities, they compete with one another for profits -- and they innovate their way to prosperity.
Ayn Rand provided a list of additional references at the end of her book, Capitalism: The Unknown Ideal. The economic references include Faustino Ballve, Frederic Bastiat, Eugen von Boehm-Bawerk, Henry Hazlitt, Isabel Paterson, Ludwig von Mises (8 reference works), and many others. My understanding is that Objectivism's endorsements are generally closer to the Austrian School of economics than to "classical economics" (refer to the Wikipedia entries on "Austrian school" and "Classical economics" for a rough indication of significant differences), but Objectivism does not fully endorse all the views of any of them, especially their philosophical views apart from their writings on economics. It must be remembered that there has never been a full moral defense of capitalism prior to Ayn Rand.
Update: Quantity Theory of Money
At least two comments from the same commenter express puzzlement over the equation, P = D/S. It is part of a segment of Austrian School economics known as the "quantity theory of money." D refers to aggregate demand, i.e., total monetary spending for a specific quantity (S) of goods and services within a specific time period. P refers to the average price per purchase. This equation can also be thought of as a definition of "average price." If n purchases occur in a time period t, and the prices of the purchases are denoted by P1, P2, P3, ... Pn, then the sum of all the Pi terms gives D, and S is simply the number of purchases involved in the analysis, namely, n in this example. One could also write: Pav = D/n.
There is also a second equation in the quantity theory of money: D = M x V, where D again refers to aggregate monetary demand, and M refers to the total number of monetary units (such as dollar units) involved in all the purchases for quantity S of goods and services within a specific time period. V is the average number of times each monetary unit is used in the purchases, also referred to as the "velocity of circulation." This equation, like the first one, can be viewed as a definition -- in this case, the definition of "average velocity of circulation," hence, the letter V.
More information about the quantity theory of money can be found in the Wikipedia article on "Quantity theory of money."
Since D is the same in both equations, the equations can be combined into the form, P x S = M x V, or P = M x V / S. The significance of this is that it highights the key factors that determine the overall average price level in the economy. Further historical analysis shows that P, the average level of prices, has increased by orders of magnitude over the decades, while V and S have changed far less than that. This leaves M, the quantity of money, as the most significant factor driving the average level of prices in the economy. M, in turn, is completely under the control of our government (for domestic economic activity).
Another comment also mentions:
If a cartel can agree to set prices higher for some subset of customers (which is equivalent to setting prices lower for the opposite subset) [?], then they can increase average prices without losing any buyers at all.
I don't quite follow what an "opposite subset" is, unless it is simply the entire population other than the targeted subset. I also don't follow why higher prices for some are "equivalent" to lower prices for all others. If the two subsets are consistently identifiable, then raising prices for one will result in fewer buyers from that subset, and lowering prices for the other subset will be likely to result in more buyers from the other subset. There would also be an economic incentive for buyers in the high-price group to shift over to the low-price group, to make their purchases at the lower price -- if they are free to do so. How this affects profits depends on which subset is larger and by how much.
This sounds like the same, or nearly the same, scenario as the original question. The answer, to repeat, is twofold. First, higher overall prices generally lead to fewer buyers, since even a cartel can't force buyers to buy the product, and the buyers may not be able to afford the product at the higher price even if they want more of it. Second, there will be competition for profits, as Yaron Brook points out in his book. If the prevailing price level is high enough to increase profitability, it will simultaneously create a financial incentive for new competitors to come into the market and compete for a share of the profits. A cartel can't prevent that in a free market. Large, long-established firms may find the prospect of higher profits particularly enticing, motivating them to enter markets that had hitherto remained less attractive from a profitability standpoint. Bear in mind, also, that the product offered by a competitor doesn't necessarily have to be identical to the product offered by the cartel. The competing product only needs to serve the same basic function for a user, to compete with the cartel's product.
This kind of cartel "collusion" has nothing to do with intellectual property, by the way, nor with property rights of any kind. Capitalism upholds property rights, as I pointed out before, and that is not what is normally meant by "collusion." If a dictionary definition includes protection of property rights as a form of "collusion to limit opportunities," it doesn't make sense. Property rights begin as an individual matter and are then subject to the possibility of trade among producers as well as trading with consumers (i.e., unrelated producers, since one needs to produce in order to be able to consume).