KBY1 Economics of Cartels
This assignment asks you to research examples of price fixing behaviour by businesses in
oligopolistic markets. It also invites you to build an evaluation about when collusion between
firms in monopolistic / oligopolistic markets can bring economic and social benefits. Collusion is
often deemed to be anti-competitive and against consumers’ interests - is this always the case?
1. What is meant by a cartel?
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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.
This can be harmful if it occurs within an industry that provides a merit good. One example of
this involved several leading public schools - including Winchester, Harrow and Eton College
- sharing information about future fees with a view to controlling prices. After a two year
investigation in 2005, many were fined up to £10m for their roles in the scheme.
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 pricefixing 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.