TOPIC 9: CARTELS AND COORDINATED EFFECTS

Topic 9 | Part 1 29 August 2013Date

ANTITRUST ECONOMICS 2013David S. EvansUniversity of Chicago, Global Economics Group

Elisa MariscalCIDE, Global Economics Group

2Overview

Part 1

Replicating the monopoly

outcome with a cartel

The incentives to cheat

Methods to detect and

punish cheaters

Factors that make collusion

easier

Part 2

Detecting, discouraging

and punishing

cartels

Screening techniques

Economics of leniency programs

Tacit collusion and

cartels

3The Economics of Price Fixing

“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 (1723-1790)The Wealth of Nations, Book I, Chapter X (1776)

4The Economics of Price Fixing

• Illegal by virtue of the behavior regardless of its intent or effect, the “inherent nature” of the practice is injuriously restraining trade.

• There is no allowable defense (though some industries are exempted)• Focus in on the existence of an agreement (see Kaplow, Competition

Policy and Price Fixing for critique).

Price fixing is per se illegal in the U.S., E.U. and many other jurisdictions.

• There is an extremely high likelihood that the practice can have only an anti-competitive effect.

• It is very difficult and costly to investigate claims of pro-competitive vs. anti-competitive effects, making a per se approach economical

• The practice can be defined specifically enough so that companies can identify what they are, and are not, allowed to do

Per se prohibitions should be reserved for practices for which:

5The Six Palaces Price Fixing Scandal

Six exclusive Paris hotels were found guilty of price fixing: the Hotel de Crillon, the Four Seasons Hotel George V, the Hotel Ritz, the Hotel Plaza Athenee, the Hotel Meurice, and Hotel Le Bristol.

They were fined a total of 709,000 Euros by the French Competition Authority.

There were regular exchanges between the hotels about the average room price, and room occupancy data.

“It is true that these practices exist and in very many fields. If they are not legal, they are very common.” Françoise Parguel, communications director for the Crillon. A graph of average room price shows there was very little variations between the prices charged by the colluding hotels during 2000 to 2001. (Is this convincing economic evidence?)

6Some Other Cartel Price Paths

Citric Acid

Railroads

Lysine

7Cartel Duration

Harrington, CRESSE Lectures, 2011

8Cartel Harm

Connor (2001), Levenstein y Suslow (2001), OECD, and World Integrated Trade Solution database. SITC: Standard International Trade Code.

9Fact About Cartels Data

Biased sample because we only observe discovered cartels.

Suppose only the less effective cartels are caught.

• Cartel duration has been underestimated.• Welfare losses have been underestimated.

Suppose only the more effective cartels are caught because the less effective ones collapse before being discovered.

• Cartel duration has been overestimated.• Welfare losses have been overestimatedPolicy challenge: How can we measure the

efficacy of cartel enforcement policies, when we cannot measure the number of cartels in an economy?

Harrington, CRESSE Lectures, 2011

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Agreements on Price and Agreements on Output

Replicating the Monopoly Outcome with a Cartel

11Price Agreements

Suppose there are 20 competing firms. With competition they each a charge competitive price of $5 dollars, sell 100,000 units (total 2 million) and just earn a competitive return.If they each agree to charge $20, they sell 50,000 each on average (total 1 million) and make $750,000 of monopoly profit each (total $15 million). [How does output get allocated?]

MR

PM = $20

PC = $5

2,000,0001,000,000

D

Q

P

MC

Monopoly

Perfect competition

Number ofidentical firms = 20

Profit margin of $15 a unit and total profitof $15 million.

12Output Agreements

Competing firms in the example could achieve monopoly price if they each agreed to offer only 50,000 units to the market:

• Divided up by geographic regions so that each sold 50,000 units• Divided up by customers so that each had customers to whom they

could sell 50,000 unitsWe have assumed firms are all the same size and have the same bargaining power. They could also divide things so that some got a larger share of profits by getting a larger region or more customers.

Which is better: price agreement or output agreement?

13Cartels with Two-Sided Platforms

Replicating monopoly outcome requires fixing prices (or allocating output) on both sides

• If competing newspapers could fix subscription and advertising prices they could exactly replicate the monopoly outcome

• Note that this issue is different than “customers” on one side colludingIf one side is constrained to zero then fixing price on the other side replicates monopoly outcome

• If competing shopping malls fixed rental prices but shoppers continued to get in for free they could replicate the monopoly outcome

If a cartel can’t fix price on one side then:

• Monopoly profits get competed away if competition is intense on other side

• Increased profits but suboptimal if imperfect competition on other side

Fixed priced to buyers,not clear to sellers

14So You Want to Start a Cartel …

You and your accomplices need to reach an agreement on what to do and how to divide up the loot.

You need to figure out how to make sure everyone abides by the agreement and detect those who don’t.

You need to figure out how to deter cheating including punishing those who engage in it.

You need to figure out how to prevent the competition authorities and your victims from uncovering you.

15 The Incentives to Cheat

16Importance of Cheating for Antitrust

Ability to detect and prevent cheating is key to having a cartel. Cartels are more likely when detection and prevention are possible.

Detection and punishment methods leave traces of evidence that authorities can look for.

Certain seemingly legal practices may “facilitate” detection and prevention of cheating and therefore authorities may want to prohibit or monitor these.

First look at role of cheating, then detection/punishment methods, and conclude by looking at “facilitating practices”.

17Incentives to Cheat on a Cartel Agreement

Could an individual firm do better than with the cartel?

The answer is always “yes” when it is certain that the other firms stick with their cartel agreement (this case is unrealistic of course).The answer may be “yes” whenever the gains from cheating exceed the losses from either punishment or from de-stabilizing the cartel (considered in our next example). The “cheater” just needs to make enough extra profit long enough in order to outweigh the losses of the cartel breaking down or possible “retribution”. Effective cartels must be able to detect and punish cheating.

18Incentives to Cheat on Price Agreement

Suppose firms 2 …. 20 charge the cartel (monopoly) price of $20.

Suppose firm 1 drops its price to $19.95.

Then all customers will buy from firm 1 (in a frictionless world).

• Firm 1 gets monopoly profits of almost $15 million (up from 750,000)• Firms 2 … 20 get nothingTo avoid detection it could drop price but increase

sales just enough not to be detected. A successful cheater can’t be too greedy.

If many firms cheat competition reemerges.

19Incentives to Cheat on Output Agreement

Each firm has the incentive to expand output to where MR = MC (the profit-maximizing level given the fixed price).

If only one firm does so, it can get away undetected if the increase is a small fraction of total output.

If many firms follow this strategy, output expansion will force price down and destabilize the cartel.

Lysine cartel: one companyClaimed it reported “misleading” sales info to the other companies and other company hid 3500 tons of Lysine from the cartel’s auditors.Harrington, CRESSE Lectures, 2011

20Incentives to Cheat

Brazen cheating won’t work for long because the other firms will be better off returning to competition and at least getting their competitive return.

But could cheating still be profitable? It will be if: • The additional monopoly profit from cheating now outweighs the future stream

of monopoly profits lost as a result of precipitating the collapse of the cartel• Is it worthwhile in the example above?Firms could profit by engaging in “a little

cheating” but not enough for others to figure it out. They could look for the optimal amount of cheating that balances risk and rewards.

Cheating is an example of a game where each player must consider its cheating strategy given its expectations about the cheating strategies engaged in by others.

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Cheating Makes It Hard for Cartels to Achieve Monopoly Price

Every firm has the incentive to cheat a lot or a little.

Each firm has even more of an incentive to cheat, knowing that the others have an incentive to cheat.

Even if every firm just cheats a little, in the aggregate this will lower price towards the competitive level.

Note: this is important for calculation of cartel damages. Just because firms aspire to price at the monopoly level they may not succeed in doing so.

22 Methods for Detecting and Punishing Cheaters

23Detecting and Punishing Cheaters

To reduce cheating the cartel must be able to:

• Detect cheating• Punish cheatingEconomic factors behind

detection and punishment are key to understand viability of cartel agreements and ways for enforces to help destabilize.

24Detecting Cheating

Given incentives to cheat cartels and their participants must be able to detect firms that are deviating from the agreement.

Some market situations make it easier to detect cheating:

• Goods are homogeneous• Pricing is transparent• Customer relationships are well known

Cartel and its members can also devise special arrangements to make it easier to detect cheating

25Output Allocation and Cheating

Exclusive territories: if a firm has exclusive rights to a region, the appearance of a competitor alerts firm to cheating.

Exclusive customers: if a firm has exclusive rights to a customer then the defection of that customer alerts firm to cheating.

Exclusive contract wins: with bidding rigging, one firm is designated to be the winner of each contract; deviation is detected instantly.But some of these methods can also raise suspicions and increase likelihood of detection. Some cartels therefore incorporate some flexibility.

26Price Setting and Cheating

Shared resource with posted prices (airlines computer reservation systems; multiple listing services for real estate)—transparency in price information.Meeting competition clauses in contracts—customers therefore have to reveal the existence of lower bids.

Common public distribution channel—so all competitors see all prices; minimum resale price maintenance may be a facilitating practice.

Other information exchanges and auditing mechanisms.

27Detecting Cheating: Meeting Competition Clauses

Meeting Competition Clause requires a buyer to allow a seller to keep business by meeting a competitor’s offer.

It detects cheating by alerting the seller that its customer is getting a better offer from a competitor.

It halts cheating by preventing the other seller from making a sale.

28Punishing Cheating: Brute Force

Death, dismemberment, torture.

Burning down factories.

Organized crime syndicates behind bid rigging and collusion in many industries dominated by smaller firms (e.g. highway construction).

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Punishing Cheating: Gentle or Not So Gentle Retribution

Target cheater’s customers with low prices.

Predation strategy to drive cheater out of business (see Basil Yamey’s “Predatory Price Cutting” reprinted in CPI Autumn 2005).

30Punishing Cheating: Price Wars

If rivals deviate from agreed on price this period then lower price to competitive level next period.

This strategy leads to price wars where periods of high prices are followed by price wars.

To end price wars firms move back to collusive equilibrium.

31Entry and Cartels

High industry prices and profits attract entry. What does the cartel do about this?

Bring entrant into the business… the cartel

• Entrant faces the same issue as the cheater;• Needs to weigh profit from undercutting the cartel against its future

profits from joining it. Prevent entry by raising barriers or “gently” nudging…

• Legal restrictions: licenses, regulation.• Refusal to supply joint facility.• Predatory and other exclusionary strategies.

32 Factors That Make Collusion Easier to Sustain

33Factors that Facilitate a Cartel

Facilitating factors include anything that increases the gains from operating a cartel, helps detect cheating on a cartel, and enables punishment of cheaters.

Facilitating factors include:

• Structural features of the market (number of firms, entry conditions, etc.)• Institutional features (information exchanges, joint facilities, etc.)• Contractual relationships and methods of transacting between buyers and

sellers.

34Facilitating Factors—Structural Features

Smaller number of similar firms lowers gains from cheating (why?) and makes coordination easier (but maybe tacit collusion is easier).

More symmetric firms make gains and losses from cheating more equal; with asymmetric firms largest firms may gain from cheating while smaller firms can’t detect.

Entry barriers: easier entry disrupts collusion and makes gains harder since they must be shared with entrants; paying off entrants attracts more entrants.

More homogenous products usually make coordination easier and also easier to detect cheating.

Greater linkages e.g. overlapping boards, family members, trade associations, and other meeting places makes it easier to coordinate, increases trust, and makes punishment easier.

Many disconnected buyers: a small number of buyers can use buyer power to break cartel and, if buyers can compare notes, more likely to detect cartel.

More stable demand makes coordination easier and makes it easier to detect cheating while growing demand increases cost of killing cartel (discounted future gains exceed current gains).

35Facilitating Factors—Institutional Features

Information exchanges—formal mechanisms for collecting and exchanging price and sales information that can be used to coordinate pricing and detect cheating; that’s what the six palaces had (how about cost information?)Trade associations and meetings—activities that promote contact, provide opportunities for exchanging information, and form social bonds that increase trust and raise the cost of cheating.Access to joint facilities—Businesses that cooperate in creating a joint facility can use the facility to monitor output, discipline cheaters by denying them access, and preventing entry. E.g., airline reservation systems.

36Facilitating Factors—Contractual Practices

Most favored customer clauses require the seller not to charge a favored customer less than the lowest it charges any other customer (might be applied contemporaneously or retroactively leading to rebates). Makes it more expensive to cheat (but if competitors don’t know, how would the customer?) and more expensive to retaliate (same point). Meeting-competition clauses gives the seller the opportunity to match a lower price offered by the competition. It leads to exchange of information (and therefore detection of cheating) and makes cheating less profitable (since existing seller may match).

Resale price maintenance requires distributors to charge a given price. This makes it easier to observe deviations from prices.

Question: should these contractual practices be prohibited? What do you need to know to help answer this?

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End Part 1, Next Class Part 2

Part 1

Replicating the monopoly outcome with a Cartel

The incentives to cheat

Methods to detect and punish cheaters

Factors that make collusion easier