Explicit collusion

A cartel is an organization of producers who

jointly decide how much to produce and
how the total production is to be allocated
between the different firms in the cartel.
The joint decision means that the cartel can
act like a monopoly
- if it comprises all the firms in the industry,
- and if it can prevent non-members from
entering the industry.
 Cartels and collusion
• In other words, if there are only a few
similar firms in an industry and if these
firms agree not to undercut one another,
they can all make a profit by restricting
output and charging a high price for their
product.
 Cartels and collusion
• One would then expect to come across many
instances of collusion (cooperative behavior).
• However, collusion is usually very difficult to
sustain.
• Three main reasons for cartel failures:
- Lack of control over firms who have not joined
the cartel
- The inherent problem of cheating faced by cartel
members.
- In many countries explicit cartels are illegal and
cartels must find ways of coordinating actions of
members that do not invite legal sanctions.
 Cartels
• When explicit cartels are illegal, we can
get to know about cartels only when they
are caught and penalised.
• Some examples follow
 DRAM Cartel
• In 2004, federal prosecutors announced that they had
cracked a global cartel that had illegally fixed prices of
memory chips in personal computers and servers for
three years
• One of the companies involved, Infineon Technologies,
had agreed to plead guilty to one criminal count and pay
a fine of $160 million
• The computer makers that were hurt by the collusion, the
government said, included Dell, Compaq, Hewlett-
Packard, Apple, I.B.M. and Gateway.
• In 2006, three executives of Samsung, the largest
supplier of computer memory for consumer electronics,
agreed to plead guilty and serve prison sentences in the
United States for their roles in the price-fixing conspiracy
 Vitamin cartel
• The Guardian reported on November 21, 2001, that
The European Union imposed record fines against
drug companies for colluding to fix the price of
vitamins.
• Eight companies were fined 855.2m euros (£529.5m).
Hoffman-La Roche of Switzerland received the largest
fine, 462m euros, for being the "prime mover and
main beneficiary" of the cartel.
• The second-largest fine - 296m euros - was levied
against Germany's BASF, the world's second-biggest
maker of vitamins.
• "The companies' collusive behaviour enabled them to
charge higher prices than if the full forces of
competition had been at play, damaging consumers
and allowing the companies to pocket illicit profits"
 Vitamin cartel
• EU investigators found the price fixing started in the
vitamin A and E market in the 1990s, then moved to
other categories in the European vitamin market. The
cartels were established in products covering vitamins A,
E, B1, B2, B5, B6, C, D3, Biotin (H), Folic acid (M), Beta
Carotene and carotinoids.

• The EU said La Roche and BASF formed a "common

front" to enlist Japanese rivals to their cartel. It said that
the involvement of La Roche's most senior executives
suggested "the arrangements were part of a strategic
plan conceived at the highest levels to control the world
market in vitamins by illegal means".
 Cartel formation and stability
• First let us consider the case where
cartel formation is not illegal.
• When firms within an industry form a
cartel they eliminate the competition
that was existing between them
• Joint output is reduced and price
increased
• This collusive behaviour also benefits
firms outside the cartel
 Cartel formation as a public good

• One can therefore anticipate that firms will

tend to free-ride on the cartels formed by
other firms, making cartels highly unstable
 Successful operation of a Cartel
Several steps are involved in the successful
operation of a cartel.
• Reaching an agreement between
members
• Implementation of the agreement which
involves :
Detecting cheating
Punishing cheating
 Reaching an agreement
1. Important to identify the issues on which
firms can agree
2. Next, a proposal for sharing the proceeds
of cooperation is needed
• Giving too little to one party invites
uncooperative behavior
• Question of fairness:
- trade-off between asking for more and risk
losing the entire agreement
 Reaching an agreement
1. The more heterogeneous the
industry and larger the number of
firms, the more difficult is it to reach
an agreement.
If, for example, cost conditions differ and
product differentiation exists to a
significant degree, different firms will
have different expectations and it will
not be easy to reach an agreement.
 An example
• “Saudi light” contains a higher fraction of
relatively valuable petrol, while “Nigerian
heavy sour crude” contains more low-value
sludge out of which asphalt is made
• Saudi light contains relatively little sulfur,
while Nigerian crude contains more sulfur
• What should be the price difference?
• Larger the difference, larger the number of
buyers who will switch to the Nigerian
crude
 Reaching an agreement
2. The larger the number of items on
which firms have to agree, the
greater the hurdles in the way of
concluding successful negotiations.
 Reaching an agreement
3. If conditions in the market are
uncertain, agreements must be
reached more often, thereby
increasing negotiation costs.

In addition, divergence of opinion about

future conditions becomes likely.
 Cheating in a cartel
• In practice, cartels find it difficult to survive because
members of the cartel have an incentive to cheat.
• Consider the following game.
Firm 2
Hi price Lo price
(cooperate) (cheat)
------------------------------------------------------
Hi price (2,2) (0,3)
Firm 1 ------------------------------------------------------
Lo price (3,0) (1.5,1.5)
-------------------------------------------------------
For both firms cheating is the dominant strategy and the
proposed cartel breaks down.
 Detection of Cheating
Other than spying on rival firms and trying to keep
track of market trends, firms can also adopt
innovative monitoring systems.
For example, a firm can adopt a meet-the-
competition (MCC) clause to detect cheating and
make the threat of future punishment more
credible.
- Under a MCC, the company promises to match
any rival bids. If another firm sells the same item
at a lower price, a customer has the incentive to
report it to the firm to get the benefit of the
lower price.
- This is a policing mechanism, in which the
customers do the policing in their own interest.
 Detection of Cheating
Environmental randomness
• The detection of cheating can also be a
signal-extraction problem
• The usual approach is to set a critical value
for some observable variable and respond
when that critical value is exceeded
- Trigger-price strategies
- Critical sales figure
 Punishment
• Cheating can be deterred through the
threat of future punishment in repeated
interactions
• Cheating by one player leads to the
breakdown of the agreement as soon as it
is detected and the other players can then
adopt a non-cooperative stance.
 Punishment
Suppose that the market demand in each
period is given by D(p). The cost functions
are C = cQ, where Q = D(p).
• First consider a non-cooperative
equilibrium in the market.
• All n firms in the market charge the
industry price p0 and share the industry
profit P0 equally, so that each earns P0/n.
 Punishment
• If a cartel is formed, the industry profit is
the monopoly profit Pm and each firm
earns Pm/n.
• The monopoly price pm will be greater
than p0 and Pm > P0.
 Punishment
• If a firm decides to cheat, then it lowers price to
p0 and captures entire industry profit P0; other
firms earn zero profit.
• Assume that P0 > Pm/n, so that there is an
incentive to cheat.
• The cheating is detected next period after which
all firms switch to non-cooperation and start
charging p0 thereafter; hence each firm earns
P0/n (grim trigger strategy)
 Punishment
• If a firm cheats, then the present
discounted value of its profit stream is
going to be:

P0 + P0/[n{(1 + i)}] + P0/[n{(1 + i)}2] +

P0/[n{(1 + i)}3]+ …….
= P0 + P0/[n{(1 + i)}{(1+i)/i}]
= P0 + P0/ni.
 Punishment
• If the firm does not cheat, it expects to
earn
Pm/n + Pm/n{(1 + i)} + Pm/n{(1 + i)}2 +
Pm/n{(1 + i)}3 + …….
= Pm/n+ Pm/n{(1 + i)}{(1+i)/i}
= Pm/n+ Pm/ni.
 Punishment
Therefore, the firm is better off not cheating
if
Pm/n+ Pm/ni > P0 + P0/ni.

This condition can be written as

[(Pm - P0)/n]/[P0 - Pm/n] > i.

 The benefit-cost ratio
[(Pm - P0)/n]/[P0 - Pm/n] > i

• The left-hand side is the benefit-cost ratio

associated with not cheating.
• The numerator captures the net future
benefit to cooperation compared with non-
cooperation while the denominator
captures the extra profit in current period
from cheating.
 The benefit-cost ratio
[(Pm - P0)/n]/[P0 - Pm/n] > i
If i is sufficiently close to zero, then there
will be no incentive to cheat.
• This is the Folk Theorem
• That is, if the future is not discounted too
heavily, then the prospect of future loss
from breakdown of cooperation will always
outweigh any temporary gains to
cheating.
 The benefit-cost ratio
How does the market structure affect the
incentive to cheat?
• Let X = [(Pm - P0)/n]/[P0 - Pm/n]
= (Pm - P0)/(nP0 - Pm).

• As n increases, X becomes smaller and it

becomes more likely that the incentive to
cheat will be stronger.
 Market structure and the incentive to
cheat
• As n increases, incentive to cheat becomes
stronger. Why?
In a more concentrated market,
• a typical firm has a larger market share, and
therefore captures a larger fraction of overall
benefit when price is moved from p0 to pm;
• a potential cheater who already has a larger
market share can hope to steal a smaller
amount of business by charging p0;
• with a smaller number of firms, it is easier to
move to a cooperative equilibrium.
 Firm asymmetries
Suppose firms face different cost conditions.

Then each firm would like to charge a

different price and there will be no
natural “focal point” which can be
agreed on.
 Firm asymmetries
- Larger firms have less incentives to punish
smaller players.
Suppose that a large firm is charging Rs. 100 and
selling Q = 100. Its marginal cost = Rs. 50.
A small firm undercuts this price by 5% and takes
away z% of volume from the larger firm.
• If the larger firm matches the price cut, then its
profit is (95 – 50)100 = Rs.4500.
• If it does not match, then its profit is (100 –
50)100(1 – z) = 5000(1 – z).
• The larger firm will not match the price cut if
5000(1 – z) > 4500, i.e. if z < 0.1.
 Multimarket contact
In many real-world cases, firms face largely
the same competitors in several markets
If firms compete in different markets, then a
cooperative solution in one market is
easier to attain through a threat of
retaliation in other markets
On the other hand, deviation from collusion
appears more profitable as firms can
deviate in a number of markets
 Multimarket contact
• Firms competing in several markets can
reach implicit understanding with one
another by dividing the markets
geographically
• Each firm will have an area of dominance,
and other firms should compete weakly or
not at all outside their own area
• Agreement of Intel and Microsoft to divide
the computer market into hardware and
software: example of geographic division in
a product landscape
 Tacit Co-operation
• Explicit collusion is often illegal.
• Firms that cannot explicitly collude can try
to achieve co-operation tacitly, by
employing facilitating practices.
• Example: Third party intervention can help
to convert the Prisoners' Dilemma type of
situation to one where cooperation is a
possible equilibrium.
 Tacit Co-operation
• Self-imposed penalties can help to change
payoffs and create monitoring of the cooperative
outcome.
• Salop has suggested that the most favored
nation (MFN) clauses offered to customers fulfill
this function.
• A MFN (also sometimes called a most-favored-
customer clause - MFC) is a contractual
arrangement between a firm and its customer,
that guarantees the customer that he will always
get the best price offered by the firm to anyone.
 Tacit Co-operation
• Consider a retroactive MFN: the firm
agrees to match all future price reductions
to customers.
• Every time it lowers its price, it must
refund the price difference to customers
who had bought from it earlier.
• This reduces its payoff
 Tacit Co-operation
• Suppose that the payoff reduces by 1.25

Firm 2
Hi price Lo price
(cooperate) (cheat)
------------------------------------------------------
Hi price (2,2) (0,1.75)
Firm 1 ------------------------------------------------------
Lo price (1.75,0) (0.25,0.25)
-------------------------------------------------------
• Cheating is no longer the dominant strategy for the players.
 Price leadership
• One firm in the market is looked upon as a
price leader, perhaps because of its
dominant position in the market. The price
this firm sets is followed by the other firms
in the industry.
• Each firm gives up its pricing autonomy
and cedes control over industry pricing to
a single firm.
• Price leader should be in a position to take
action against defectors.
 Industry associations
• Provide a reason for executives to get
together and learn to know and trust each
other
• Perform studies that suggest mutually
beneficial strategies
• Can be a vehicle for cooperative, build-
the-market kind of advertising
• Can lobby for beneficial legislation
 Indian Trade Associations
In 1977, the MRTP Commission had to issue a cease and
desist order to the Indian Woollen Mills Federation after it
had facilitated a price fixing cartel among its members.
The Commission was forced into action again in subsequent
years, passing similar orders against
- the Food Grains and Kirana Merchants Association (1983),
- the Alkali Manufacturers Association (1985)
- and various local Truck Operators Unions which had
transformed themselves into conduits for cartelisation by
members.
 Unfortunately, the MRTP Commission had no teeth, so the
cartels were let off with warnings.
 Why cartels fail
• Cheating is not the only factor in cartel
failure
• Entry may pose a greater problem
• If cartel agreements divide profits, entry
requires redivision and thus recontracting
 Why cartels fail
• Confessions:
Sometimes executives turn state’s
evidence, implicating the others, in
exchange for immunity
Why?
- Anger at other cartel members
- Crisis of conscience
- Crisis of confidence
 Why cartels fail
• Immunity from prosecution generally goes
to the first to confess
• If the cartel appears shaky or unreliable,
the fear that others may confess can send
the entire group racing to confess
 Leniency programs
• US Antitrust Division of the Department of
Justice has a Corporate Leniency Policy,
which establishes that criminal sanctions
can be avoided in two cases:
• either if a colluding firm reveals
information before an investigation is
opened,
• or if the Division has not yet been able to
prove collusion when a firm decides to
cooperate.
 Leniency programs
• The European Union introduced in 1996 a new
regulation in which
• more generous fine reductions can be given to
firms which cooperate with the antitrust
authority before an inquiry is opened, by
providing evidence of a collusive agreement in
which they have been involved,
• while limited reductions can be granted if
cooperation occurs after the opening of a case