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 that cartels 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 that
might 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.
International commodity agreements covering products such as coffee, 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.

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 highly
concentrated 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 through
competition, 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

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 pricecutting 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.

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 from
each others behaviour. 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.

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 the
rays 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.

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 the
rewards 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 between Unilever and Procter & 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)