collusion essay

8/10/2019 Collusion Essay

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3) Collusion

With reference to economic theory and empirical evidence, examine the conditions that are likely to

facilitate the formation and survival of successful cartels within industries. (2010)

Using economic theory and empirical evidence, discuss the main problems faced by cartels. What, if

anything, can the organisations who are attempting to run a cartel do about them? (2011)

Deterring cheating on a cartel agreement is the major problem thatcartels have to face. Critically

analyse and discuss this statement with reference to economic theory and empirical evidence. (2013)

Full Essay

Introduction

Cartels are associations of independent firms in the same industry that exist in order to impose some

form of restraint upon competition. To many observers, cartels are associated with actions taken by

small groups of firms determined to exploit their market power to the full.

Traditional microeconomic models can describe the higher profits resulting from the exercise of

near-monopoly power as the incentive to form a cartel. However, there is evidence suggesting that

firms join cartels mainly for reasons of self-protection, rather than to exploit their customers (Hunter,

1954). Agreements tend, on the whole, to impede entry or the development of new products thatmight threaten the profitability or survival of incumbent firms. Price-fixing seems only to be of

secondary importance, usually as a means to support the less efficient members. Other motives for

collusion in general, and for the formation of cartels specifically, include risk management and the

enhancement of security, exchange of information, and unsatisfactory financial performance on the

part of potential cartel members.

A distinction is sometimes drawn between public and private cartels. In the case of public cartels, the

government may establish and enforce the rules relating to prices, output and other such matters.

Internationalcommodity agreements covering products such ascoffee,sugar,tin and more recently

oil (OPEC)are examples of international cartels with publicly entailed agreements between different

national governments.

Conditions that facilitate formation of cartels:

Certain characteristics of industries will influence whether firms are likely to be able to succeed in

forming a cartel. These focus around the degree of seller concentration, firm similarity, and the

extent to which firms are vertically integrated.
http://en.wikipedia.org/wiki/Commodity_markethttp://en.wikipedia.org/wiki/Coffeehttp://en.wikipedia.org/wiki/Sugarhttp://en.wikipedia.org/wiki/Tinhttp://en.wikipedia.org/wiki/Oilhttp://en.wikipedia.org/wiki/OPEChttp://en.wikipedia.org/wiki/OPEChttp://en.wikipedia.org/wiki/Oilhttp://en.wikipedia.org/wiki/Tinhttp://en.wikipedia.org/wiki/Sugarhttp://en.wikipedia.org/wiki/Coffeehttp://en.wikipedia.org/wiki/Commodity_market


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1) The degree of seller concentration

Imperative to the success of a cartel is that the level of market concentration is high as this will help

the effective functioning of the group. Bain (1959)argued that this is the most important factor for

success as concentration is associated with duration, confirmed by Symeondiss (2003)finding of a

concave association between cartel prevalence and concentration. Markets that are highlyconcentrated allow the controlling firms a larger share of the market and thus their payoff from

setting a monopolistic price increases (Levenstein and Suslow, 2006). Furthermore, theories of group

and coalition behaviour suggest that, as firm numbers increase, the unanimity of goals diminishes

and therefore the costs of communication, monitoring and enforcement will rise. Firms are also more

likely to cheat as firm numbers increase, as they perceive a lower risk of detection. Finally,

communication and negotiation between firms is crucial to cartel stability, and this becomes

increasingly difficult with increasing numbers (Fraas and Greer, 1977).

2) Firm similarity

Firms with similar cost structures find it easier to collude than those with pronounced differences in

costs. A firm faced with an average cost function that decreases as output increases may be reluctant

to restrict its output as a condition of cartel membership. Similar products (or a lack of product

differentiation) may be another factor conducive to successful collusion (Compte et al., 2002). Firms

selling similar goods need only focus on a narrow range of pricing decisions. If product

characteristics are subject to change over time, perhaps due to technological progress or evolving

consumer tastes, a price agreement is more difficult to negotiate and sustain (Symeondis, 1999).

Firm size and market share is also important as MacGregor (1906)suggests; if most of the firms in

an industry are similar in size, the likelihood of successful collusion is enhanced. If market shares are

symmetric, it is possible that the large firms have already eliminated the smaller firms throughcompetition, however, asymmetric market shares are likely to be associated with a divergence of

views between the large and small firms.

3) Extent of vertical integration

A successful cartel requires member firms to be reassured that fellow members are abiding by the

terms of the agreement. Effective monitoring is important. If one member is vertically integrated

downstream, perhaps with ownership of retail outlets, it may be able to undercut the cartel price by

reducing its transfer price to its own retailers. Unless other cartel members are fully aware of the true

cost structure of the retail business, they may be unaware that the cartel agreement is being

undermined.

4) Demand Stability

A final and key aspect of success is that the industry in which the cartel operates is highly stable,

with relatively little fluctuation in demand. Reductions in total demand place strain on cartel

agreements as firms are more tempted to undercut one another to protect their sales volumes

(Lipczynski et al., 2013). This destabilising effect is exacerbated when firms operate in an industry

where fixed costs account for a large proportion of total cost. Falling demand tempts producers to cut

prices in an attempt to cover these fixed costs. At the other end of the scale, in times of rising

demand, monitoring and detection is more difficult as sales rise for all firms. This increases the


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opportunity to cheat without facing punishment, and thus demand stability is key to ensuring cartel

stability (Carlton and Perloff, 2000).

Problems Cartels Face

Oborne (1976) states that there is one external and four internal problems faced by cartels. The

external problem is to predict the production on non-members, and the internal problems are first, to

locate the contract surface; second, to choose a point on that surface (the sharing problem); third, to

detect, and fourth, to deter, cheating. Of these we are concerned with the problems of sharing the

output and deterring cheating. The most acute of which is sharing problem and detecting cheating

and by solving these, the cartel will be stable. Thus there are a number of conditions that help to

maintain the stability of cartels.

Conditions that facilitate the survival of cartels

1) Monitoring and Detection of Cheating

Stigler (1964)argues that collusion is successful when it is accompanied by efficient mechanisms for

monitoring compliance with the agreement. The most effective method for detecting secret price-

cutting might be to check transaction prices in the market. Stigler argues that evidence of cheating

can be inferred by observing unexpected changes in the market shares of individual firms. If a firm

discovers that it is systematically losing business, which it would normally expect to secure, it might

infer that another cartel member is guilty of price-cutting. The greater the degree of regular variation

in the cartel firms market shares, the greater the potential for secret price-cuts, since it is more

difficult for loyal firms to detect suspicious changes in their market shares.

Sealed bidding provides a useful mechanism for ensuring detection if a firm breaks a cartel

agreement. Sealed bid competition occurs when a buyer (frequently the government) requests bids

for a contract, and subsequently announces the result publicly. The firms submit their bids secretly.

The bidding firms might decide to meet in order to consider their bids, and perhaps decide which

firm will win the contract. If a firm should cheat by submitting a lower bid than has been agreed, it

will be detected when the winning bid is announced.

2) Sanctions

The ability of a cartel to impose effective sanctions if cheating does occur is another important

determinant of cartel stability. If additional profits can be realized through non-compliance, then

non-compliance probably will occur unless some policy of deterrence is adopted. It is surely one of

the axioms of human behaviour that all agreements whose violation would be profitable to the

violator must be enforced (Stigler, 1968). The ability of a cartel to discipline its own members for

breaches of agreement is essential, as the courts cannot be used to enforce an illegal contract. Certain

types of discipline or sanction include reducing demand for the non-compliant firms product,

increasing its costs, fining them or expulsion from the cartel. Rees (1993)finds that in the British salt

duopoly, any gain from cheating was outweighed by losses from credible short-term price cuts.


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A cartel may also use the services of third parties in an attempt to deter cheating. A joint sales

agency through which all output is channelled should prevent price-cutting, though problems of

allocating the proceeds between the cartel members might surface. Finally, the threat or use of

physical force might be an effective means of encouraging compliance. Kuhlman (1969)discusses

the role of organized crime in policing cartel agreements.

3) Entry threat

Osborne (1976) highlights that the key problems faced by cartels are the threat of non-member

production and the incentives for firms to cheat on the agreement. In the long run, the stability and

profitability of collusion depends on the ease or difficulty of entry. If a cartel shelters behind

effective entry barriers, it may enjoy the necessary time and space to prosper and resolve the

conflicting demands of its members. If entry barriers are low, the cartel faces competitive pressure

from potential entrants. If a cartel has agreed to fix the price above the competitive level, there is an

incentive for an entrant to move in and set a price just below the cartel price, encroaching on the

profits of group members.

Certain approaches are taken by cartel firms to deter non-member firm entry. The first two types of

deterrent are pricing strategies: limit pricing and predatory pricing. The third is strategic product

differentiation. The fourth, creating and signalling commitment, which involves an incumbent

demonstrating its willingness to fight a price war in the event that entry takes place, by deliberately

incurring sunk cost investment expenditure.

4) Repeated games

It is more likely that cooperative behaviour will evolve as the two sellers observe and learn fromeach othersbehaviour. In a repeated or multiple-period game, each firm may attempt to influence its

rivals behaviour by sending signals that promise to reward cooperative behaviour, and threaten to

punish non-cooperative behaviour. In the present context, experiments have shown the adoption of a

tit-for-tat strategy by one or both players is a highly effective method for ensuring adherence to

cooperative behaviour in repeated games with a prisoners dilemma structure. Usually, both players

rapidly learn it is best for them to adhere to the cooperative strategy on each occasion the game is

repeated.

Conditions under which these problems are overcome

Alongside these conditions which firstly facilitate the formation of cartel agreements, but also help to

maintain their stability, Osborne (1976)explains that the stability of the initial quota assignment is

crucial to cartel success.


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Osbornes Quota Rule

At any point on the line QMQM, the combined output of firms A and B equals the profit maximizing

output for a monopolist. Starting from any of points F, G and H, there is an incentive for either firm

to cheat by raising its output, if it believes the other firm will not retaliate. If firm A increases its

output while firm Bs output is unchanged (moving east from F, G or H), A increases its profit. A

decision by either firm to cheat would however invite retaliation, resulting in a diagonal shift up therays OX, OY or OZ, along which the market shares of both firms are the same as at points F, G and

H respectively.

An examination of the implications of diagonal shifts up the rays OX, OY and OZ demonstrates the

importance for cartel stability of the initial quota assignment. Beginning from G and moving up OY,

both firms experience a decrease in profits. Therefore if retaliation of the kind described above is

anticipated, neither firm has an incentive to cheat. If the quotas are assigned such that the firms

locate at G, the cartel is stable. However, beginning from either F or H, the cartel is unstable.

Beginning from F and moving up OX, As profit increases while Bs decreases, so A has an

incentive to cheat. Similarly, beginning from H and moving up OZ, Bs profit increases while As

profit decreases, so B has an incentive to cheat.

Measuring the Success of Cartels

One of the more widely used measures for cartel success is looking at the duration of the cartel. This

is the most simplistic approach and more often than not gives a good indication of cartel success,

however, it does have its limitations as supported by Mazurkeviciute (2012), cartel duration is the

most obvious, although not perfect, and easily measured evidence of cartel success. The duration of

a cartel ranges hugely from some, which last less than a year, to some, such as OPEC, which have

lasted decades and remain powerful to this day.


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Using duration as a measure bypasses the problems associated with calculating pricing and profit

levels, however, still has some issues. The duration of a cartel does not indicate the extent of

collusion and the degree to which prices have been raised above market equilibrium levels. It is also

possible for a cartel to be in effect for a significant period of time without actually reaping therewards of a successful cartel. Additionally, cartels often have a broken history in that they

frequently break down and reform. This diminishes the effectiveness that cartel duration can have as

a cartel success measurement. Moreover, it can be very difficult to formally agree when a cartel

officially began colluding, as by nature cartels are supposed to be informal agreements. Grossman

(2004)suggested that it may be useful to use other measures for cartel success alongside duration, to

give a better picture of the cartel itself. Another measure used is that whereby success is measured

against the ability to price at monopolistic levels for extended periods of time. Although this would

arguably be a better measure, it comes with significant issues in its calculation.

Tacit Collusion

Tacit collusion is a term often used to describe a collusive outcome that requires no formal

agreement, and where there is no direct communication between firms. NERA (2003)note that the

European Court outlined three conditions which can sustain tacit coordination. First, for tacit

collusion to operate there must be transparency, so that all firms are aware of each others behaviour.

Second, there must be an incentive for firms to stick to a common policy. In other words, any firm

that breaks the agreement is made worse off and not better off. Third, potential entry and buyer

reactions should not be seen by firms as potentially destabilizing threats.

Tacit collusion may develop through personal contacts, a group ethos, or live-and- let-live attitudes.

Personal and social contacts among competitors lessen rivalrous attitudes: perhaps one does not

undercut or poach customers from people with whom one socializes. Social groupings, whether by

social class, ethnic origin or even religion, may help stabilize an otherwise potentially unstable

collusive arrangement. This feeling of belonging can be strengthened by the existence of trade

associations, trade journals, conferences and social activities.

Non-Economic Influences On Cartel Stability

In a classification of influences on cartel stability, non-economic factors such as leadership, trust and

social background may also be relevant (Yamey, 1973).

Example

The most recent example of a cartel was betweenUnilever andProcter & Gamble who were found

guilty of price fixing washing powder in eight European countries. The case that was conducted by

the European Commission after a tip off from Germany company, Henkel. The resulting penalty was

a 315 million fine, split between Unilever (104m) and Procter & Gamble (211m)
http://en.wikipedia.org/wiki/Unileverhttp://en.wikipedia.org/wiki/Procter_%26_Gamblehttp://en.wikipedia.org/wiki/Procter_%26_Gamblehttp://en.wikipedia.org/wiki/Unilever

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