Definitions

drug cartel

Cartel

[kahr-tel]

A cartel is a formal (explicit) agreement among firms. Cartels usually occur in an oligopolistic industry, where there is a small number of sellers and usually involve homogeneous products. Cartel members may agree on such matters as price fixing, total industry output, market shares, allocation of customers, allocation of territories, bid rigging, establishment of common sales agencies, and the division of profits or combination of these. The aim of such collusion is to increase individual member's profits by reducing competition. Competition laws forbid cartels. Identifying and breaking up cartels is an important part of the competition policy in most countries, although proving the existence of a cartel is rarely easy, as firms are usually not so careless as to put agreements to collude on paper.

Several economic studies and legal decisions of antitrust authorities have found that the median price increase achieved by cartels in the last 200 years is around 25%. Private international cartels (those with participants from two or more nations) had an average price increase of 28%, whereas domestic cartels averaged 18%. Less than 10% of all cartels in the sample failed to raise market prices.

Private vs public cartel

A distinction needs to be 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. Export cartels and shipping conferences are examples of public cartels. In many countries, depression cartels have been permitted in industries deemed to be requiring price and production stability and/or to permit rationalization of industry structure and excess capacity. In Japan for example, such arrangements have been permitted in the steel, aluminum smelting, ship building and various chemical industries. Public cartels were also permitted in the United States during the Great Depression in the 1930s and continued to exist for some time after World War II in industries such as coal mining and oil production. Cartels have also played an extensive role in the German economy during the inter-war period. International commodity agreements covering products such as coffee, sugar, tin and more recently oil (OPEC) are examples of international cartels which have publicly entailed agreements between different national governments. Crisis cartels have also been organized by governments for various industries or products in different countries in order to fix prices and ration production and distribution in periods of acute shortages.

In contrast, private cartels entail an agreement on terms and conditions from which the members derive mutual advantage but which are not known or likely to be detected by outside parties. Private cartels in most jurisdictions are viewed as being illegal and in violation of antitrust laws.

Long-term unsustainability of cartels

The reason why cartels are not sustainable is well-explained by the prisoner's dilemma:
Two suspects, A and B, are arrested by the police. The police have insufficient evidence for a conviction, and, having separated both prisoners, visit each of them to offer the same deal: if one testifies for the prosecution against the other and the other remains silent, the betrayer goes free and the silent accomplice receives the full 10-year sentence. If both stay silent, both prisoners are sentenced to only six months in jail for a minor charge. If each betrays the other, each receives a five-year sentence. Each prisoner must make the choice of whether to betray the other or to remain silent. However, neither prisoner knows for sure what choice the other prisoner will make. So this dilemma poses the question: How should the prisoners act?

The dilemma can be summarized thus:

Prisoner B Stays Silent Prisoner B Betrays
Prisoner A Stays Silent Each serves six months Prisoner A serves ten years
Prisoner B goes free
Prisoner A Betrays Prisoner A goes free
Prisoner B serves ten years
Each serves five years

As can be seen, by staying silent (cooperating) both prisoners are better off than in the case where both decide to betray (deviate from the agreement, that is, competing). Nevertheless, if only one of the two prisoners betray while the other stays silent, the former would be free, which is still more desirable for him than having to stay in prison for six months.

Exactly the same occurs in a cartel: while their members are better-off being part to the agreement than competing, deviating (for example by reducing one's price) could imply capturing a big amount of the market demand and making big profits. In other words, the members of a cartel always have an incentive to deviate from their agreement which explains why cartels are generally difficult to sustain in the long run. Empirical studies of 20th century cartels have determined that the mean duration of discovered cartels is from 5 to 8 years. However, once a cartel is broken, the incentives to form the cartel return and the cartel may be re-formed.

Whether the members of a cartel will choose to cheat on the agreement will depend on whether the short term returns to cheating outweigh the medium and long term losses which result from the possible breakdown of the cartel (this is why, also in the Prisoner's dilemma game, the equilibrium varies if the game is played once or if it is, instead, a repeated game). The relative size of these two factors depend in part on how difficult it is for firms to monitor whether the agreement is being adhered to and on the importance of short-run gains relative to the long-run gain. The longer the time firms in the cartel can cheat without detection, the greater the gains from doing so. Therefore, if monitoring is difficult, the higher the probability that some part to the agreement will cheat and the more unsustainable the cartel will be.

There are several factors that will affect the firms' ability to monitor a cartel:

  1. Number of firms in the industry.
  2. Characteristics of the products sold by the firms.
  3. Production costs of each member.
  4. Behaviour of demand.
  5. Frequency of sales and their characteristics.

Number of firms in industry

The lower the number of firms in the industry, the easier for the members of the cartel to monitor the behaviour of other members. Given that detecting a price cut becomes harder as the number of firms increases, the bigger are the gains from price cutting.

The larger the number of firms the more probable one of those firms being a maverick firm, that is, a firm known for pursuing aggressive and independent pricing strategy. Even in the case of a concentrated market, with few firms, the existence of such a firm may undermine the collusive behaviour of the cartel.

Characteristics of products sold

Whether the products sold by cartels are homogeneous or differentiated also will affect the ability of monitoring and therefore the long-term sustainability of the cartel. Not only do homogeneous products make agreement on prices and/or quantities easier but also they facilitate monitoring. If goods are homogeneous, firms know that a change in their market share is more likely due to a price cut (or quantity increase) by another member. Instead, if products are differentiated, changes in quantity sold by a member may be due to changes in consumer preferences or demand. In the first case, change in one firm's demand is clearly due to cheating by another member, whereas in the second case members may well not be cheating and still demand patterns change.

Production costs

Similar cost structures by the firms in a cartel make it easier to co-ordinate given that the firms will have similar maximizing behaviour as regards prices and output. Instead, if firms have different cost structures then each will have different maximizing behaviour and therefore will have an incentive to price or produce a different quantity. Changes in cost structure (for example when a firm introduces a new technology) also gives a cost advantage over rivals, making co-ordination and sustainability more difficult.

Behaviour of demand

If an industry is characterised by a varying demand (that is, a demand with cyclical fluctuations) this makes it more difficult for the firms in the cartel to detect whether such changes are due to demand fluctuations or to cheating by another member of the cartel. Therefore, in a market with demand fluctuations, monitoring is more difficult.

Characteristics of sales

As said, short-term gains from cheating (relative to long-term gains from collusion) make it more likely that a member will cheat. These short-term gains will partly depend on the frequency and amount of sales. If sales are not frequent (for example in some bidding markets where firms may have ten selling contracts) then the firms in a cartel may have an incentive to undercut the price of other sellers and win the contract (given that overall they know they will be few possible contracts). Moreover, the higher the amount of output to sell the higher the incentive for the firm to cheat. Therefore, low frequency of sales coupled with huge amounts of output in each of these sales make cartels less sustainable.

Antitrust law on cartels

General view

International competition authorities forbid cartels, but the effectiveness of cartel regulation and antitrust law in general is disputed by economic libertarians.

United States

The Sherman Antitrust Act of 1890 outlawed all contracts, combinations and conspiracies that unreasonably restrain interstate and foreign trade. This includes cartel violations, such as price fixing, bid rigging and customer allocation. Sherman Act violations involving agreements between competitors are usually punishable as criminal felonies.

European Union

The EU's competition law explicitly forbids cartels and related practices in its article 81 of the Treaty of Rome. The article reads:
1. The following shall be prohibited as incompatible with the common market: all agreements between undertakings, decisions by associations of undertakings and concerted practices which may affect trade between Member States and which have as their object or effect the prevention, restriction or distortion of competition within the common market, and in particular those which:
(a) directly or indirectly fix purchase or selling prices or any other trading conditions;
(b) limit or control production, markets, technical development, or investment;
(c) share markets or sources of supply;
(d) apply dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage;
(e) make the conclusion of contracts subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts.
2. Any agreements or decisions prohibited pursuant to this article shall be automatically void.
3. The provisions of paragraph 1 may, however, be declared inapplicable in the case of:
- any agreement or category of agreements between undertakings,
- any decision or category of decisions by associations of undertakings,
- any concerted practice or category of concerted practices,
which contributes to improving the production or distribution of goods or to promoting technical or economic progress, while allowing consumers a fair share of the resulting benefit, and which does not:
(a) impose on the undertakings concerned restrictions which are not indispensable to the attainment of these objectives;
(b) afford such undertakings the possibility of eliminating competition in respect of a substantial part of the products in question.

Article 81 explicitly forbids price fixing and limitation/control of production, the two more frequent cartel-types of collusion. The EU competition law also has regulations on the amount of fines for each type of cartel and a leniency policy by which if a firm in a cartel is the first to denounce the collusion agreement it is free of any responsibility. This mechanism has helped a lot in detecting cartel agreements in the EU.

Examples

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.
Adam Smith, The Wealth of Nations, 1776
An example of a new international cartel is the one created by the members of the Asian Racing Federation and documented in the Good Neighbor Policy signed on September 1, 2003. Other well-known examples include:

  • OPEC: As its name suggests, OPEC is organized by sovereign states. It cannot be held to antitrust enforcement in other jurisdictions by virtue of the doctrine of state immunity under public international law. However, members of the group do frequently break rank to increase production quotas.
  • De Beers is a cartel of companies that trade in rough diamond exploration.
  • Many trade organizations, especially in industries dominated by only a few major companies, have been accused of being fronts for cartels:
  • Although cartels are usually thought of as a group of corporations, some consider labor unions to be cartels, as they seek to raise the price of labor (wages) by preventing competition.
  • The United States Federal Reserve is a quasi-government entity of private banks that meets most--if not all--of the definitions of a cartel.

See also

External links

References

Bibliography

  • Bishop, Simon and Mike Walker (1999): The Economics of EC Competition Law. Sweet and Maxwell.
  • Connor, John M. (2001): Global Price Fixing: Our Customers Are the Enemy. Studies in Industrial Organization No. 24. Boston: Kluwer Academic (2001).
  • Levenstein, Margaret C. and Valerie Y. Suslow. What Determines Cartel Success? Journal of Economic Literature 64 (March 2006): 43-95.
  • Stocking, George W. and Myron W. Watkins. Cartels in Action. New York: Twentieth Century Fund (1946).
  • Tirole, Jean (1988): The Theory of Industrial Organization. The MIT Press, Cambridge, Massachusetts.

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