Using Google Docs - A2 Applied Micro on Collusion

One of my Year 13 groups was this week assigned a Google Doc exercise on the economics of collusion within an oligopoly. And their draft findings can be found in a pdf document at the bottom of this blog.

1. What is meant by a cartel?

* A cartel is a form of formal collusive behaviour by firms usually in an oligopolistic market where there are only handful of businesses which sell a homogenous or standardised product. It is a collaborative agreement where firms agree to control market supply and prices in order to jointly maximise profits.

* Cartels also agree to market sharing. They often do this by dividing up different regions to different firms within the cartel meaning that the firm has complete market share in the region an so there is no competition. Cartels also allocate different customers to different firms within the cartel to reduce competition

For a cartel to work, members involved in the agreement must monitor other firms levels of output. With firms not operating at their individual profit-maximising output, there is a tendency to employ game-theoretical strategies within the cartel. If one or more firms produce more than the agreed output in order to maximise their individual profits - which can be done by increasing their output to where marginal cost is equal to marginal revenue - the cartel is likely to break down, hence the almost inherent stability of these ventures.

2. What are the major reasons why firms in an oligopoly might enter into collusive behaviour?

If firms within an industry are in an oligopoly and enter into collusive behaviour they act as a monopoly. Acting as a cartel can also stop revenue and prices from being unstable in that industry.

Often firms in an oligopoly benefit from being in a cartel because it limits competitive responses that might reduce profits such as a price-war or attacking each other's market share. When firms are colluding it would be beneficial to any individual firm to expand output and undercut others in the cartel. This however would result in all firms following suit; supply would rise flooding the market and price would plummet bringing a negative result for all of the firms within the cartel. From this we can see that collusion can often be explained by a desire to achieve joint-profit maximisation or to try an stabilise the revenue or price in a market.

As John Nash noticed, each individual acting solely in his/her own interests does not, as Adam Smith suggested, necessarily produce the maximum benefit. In the case of a cartel, it would serve one firm to increase production, but, in the long-run, the break-down of trust between the cartel-members would have a negative effect on the industry profits as a whole. Essentially, working as a group guarantees long-term higher profits for all.

Interdependence and the incentive to form a cartel

As interdependence between firms is essential in an oligopoly, the field of game theory is relevant. In fact, the firms' pricing strategies, when simplified, can be modelled as the game of prisoners' dilemma.

Let us look at the possible pricing strategies of two firms and let us assume that there are two prices which the firms can charge for their product.

1. If both charge the high price, each will get equal market share, but a relatively high revenue due to the high price.
2. In contrast, if both charge the low price, each will get the same market share, but a lower revenue due to the low price.
3. If one charges the high price while the other charges the low price, the latter will gain sufficient market share from the former, which is likely to generate the highest revenue from all possible situations.:

As can be seen, charging the low price is the dominant strategy, as it is always preferable to charging the high price, regardless of what the rival firm charges. However, due to the symmetry of the game, the Nash equilibrium becomes the (low; low) outcome, which is collectively worst than if both firms adopt the dominated strategy in order to reach a (high; high) outcome.

Hence, just like how Thomas Hobbes argued that a strong state was needed to ensure cooperation within the state of nature, a cartel is formed in order to ensure cooperation and enforce punishment on those that will deviate from the 'high price' option. Of course, if this is successful, those that will be likely to lose out are the consumers.

3. Build the argument that price fixing is against the interests of consumers

Price fixing results in a situation where output is low to keep the price artificially high. This results in a dead-weight loss of welfare for consumers because monopolies lose out on the higher demand that exists at the lower price and consumers lose out due to the higher price. Because of this, UK and European law is designed to prevent formal collusion. Price fixing can be inequitable in particular for low income consumers as they may not be able to afford these higher prices forcing them to leave the market.

It is possible however that there are some benefits for consumers. If firms have fixed the price artificially high then it is likely they will see higher profits which could then be reinvested in the form of R&D. This is especially likely if firms cannot compete within a market in the form of price and as such will have to compete in other areas such as quality.

Having said this price fixing does remove, to a large extent, the incentive to lower costs in order to remain profitable. Without price competition firms do not have to keep costs low and it is likely that some of the extra profit that could b directed towards R&D will in fact be wasted away by the lack of cost incentive. Shareholders will benefit from the higher profits gained from price-fixing as these profits may be passed on to them in the form of dividends giving them a higher disposable income and more ability to consume.

4. Find some good recent examples of where cartels have been exposed and broken up by the competition authorities in the UK and Europe

Beer cartel: In 2007, Heineken, Grolsch and Bavaria were fined 273m Euros for operating a cartel in the Netherlands. The European Competition Commission stated that the brewers had exchanged ideas and 'illegal agreements' artificially driving up prices for distributors of the products, e.g. pubs, supermarkets and restaurants.

Air Cargo Cartel: Last week, following a three year investigation, British Airways was found guilty of participating in an air cargo cartel. In consequence, the airline was fined £90 million by the European Commission. The UK signature airline was found to have rigged fuel surcharges before extending its “co-operation by introducing a security surcharge". British Airways was one of eleven airlines attracting charges amounting to €799 million. Alistair Osbourne, business editor of The Telegraph, writes of Joaquin Almunia, the European Commission's vice-president for competition, who comments that “it is deplorable that so many major airlines co-ordinated their pricing to the detriment of European businesses and European consumers".

Recruitment Agency Fee Fixing: In September 2009, the Office of Fair Trading for price-fixing in the construction industry fined six recruitment agencies a total of £39.3 million. The cartel was exposed by two firms offered immunity in return. The recruiting agencies involved included the likes of A Warwick Associates, Hays Specialist Recruitment (fined over £30 million) and CDI AndersElite. Hays complained its fine was “disproportionate" but its grounds for appeal were unfavourable. The cartel was known as the Construction Recruitment Forum and met five times between 2004 and 2006. The BBC adds that the Office of Fair Trading “fined 103 building companies a total of £129.5m for colluding with competitors on building contracts".

Banking collusion: RBS was fined £28.6m earlier this year for revealing its loan pricing plans to one of its biggest rivals, Barclays. Regulators suggested that Barclays used the information to price its own loans, acting against the interests of consumers.

Beyond Europe
In Tokyo, four electric cable companies were fined 10.84 billion yen for working as a cartel and fixing their prices breaching the antimonopoly law. Cartels are illegal and serious fines are common for collusive behavior in Japan. However there were five firms within this cable cartel but the fifth firm was made exempt from a fine as i was the first of the companies to voluntarily report its cartel activities. It has been shown that the five firms dominated the market for cables in Japan and had been fixing the price between 2005 and 2009.

Pioneer foods in South Africa was a firm fined for participating in cartel activities. The firm was fined 1 billion rand for fixing the price of bread, flour and poultry products

5. Are there circumstances in which collusion between businesses brings economic and social benefits? Support your answer with real world examples.

There is a case for saying that a collusive oligopoly can bring about economic benefits to consumers. Firstly, cartels results in a uniform market structure with one price and one level of output produced. The result is greater consumer or business confidence, as expenditure can be more easily planned. One example of where prices were maintained relatively constant would be oil in the 1990s; where OPEC aimed to charge between $25 and $35 per barrel of oil. In doing so, businesses requiring oil as a raw material had the confidence to make long-term cost predictions. The ability to make such predictions often gives producers the confidence to invest and boost the long-term profitability of the firm.

Cartels may also provide social benefits in markets for demerit goods. In the cigarette market for example, if firms were to collude on higher prices for tobacco, fewer cigarettes would be 'consumed' and welfare would be improved. The following article talks of a price collusion effort between supermarkets and tobacco producers for which a £225m fine was charged. Is it possible, however, that such collusion may actually have benefited society and saved the government money in the long-term?

There is also no need for oligopolies to spend large amounts on publicity and advertising, since each firm is operating in the same way under a cartel. The result of these higher profits mean there are more spare funds for investment and innovation, which would ultimately benefit consumers in the long run. Economist Baumol argued that oligopolies can improve their dynamic efficiency more than other market structures.

The interdependency of oligopolies under a cartel also allows for the cooperation of research and development. There can also be joint investment in capital and labour. The resulting decreased production costs provide spare funds for product development.

Google Doc as a pdf
Collusion_Oligopoly.pdf