TOPIC 9: CARTELS AND COORDINATED EFFECTS

Topic 9 | Part 2 5 September 2013Date

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

Elisa MariscalCIDE, Global Economics Group

Your CPI teaching team

Professor David S. Evansdevans@globaleconomicsgroup.com

Professor Elisa Mariscalemariscal@competitionpolicyinternational.com

Teaching assistantMr. Alexis Pirchio apirchio@competitionpolicyinternational.com

Course SupportMs. Meara HamidianiCPI Community Managermhamidiani@competitionpolicyinternational.com

3Overview

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

Explicit collusion: Detecting cartels

Discouraging cartels: Leniency programs

Guest Speaker: Screening techniques

Punishment and damages

Cooperating for procompetitive

reasons

4 Explicit Collusion: Detecting Cartels

5Explicit vs. Tacit Collusion

Explicit collusion is the result of an agreement to fix price, divide markets, or otherwise achieve a non-competitive outcome. It requires direct communication between the cartel members.

Tacit collusion refers to market interactions between firms that encourage them to keep prices high and discourages them from competing. For example, if all firms believe that a reduction of price will trigger a price war in which they will lose, none will reduce price. In the US and most jurisdictions only explicit collusion is unlawful. In effect, the law doesn’t prohibit “collusion” so much as it prohibits the use of explicit communication to facilitate that collusion.

We focus on explicit collusion but some of the economic analysis is equally applicable to tacit collusion.

6Caught in the Act

YAMAMOTO: Sales meeting, huh? (Laughs).

CHAUDRET: Well, it's easy to know the price, so everything's clear.

MIMOTO: And one from FBI. (Laughs).

YAMAMOTO: (ui) joke.

WHITACRE: And seven from the FTC.

MIMOTO: Yeah. FTC. (Laughs).

WHITACRE: FBI.

MIMOTO: Seven from FTC. (Laughs).

SHINOHARA: Well, I also feel cautious in the way I came into this, uh, hotel. I actually... (Laughs). (ui).

CHAUDRET: In Europe, we...

SHINOHARA: You know and, uh, (ui).

CHAUDRET: Even in Europe now, they're cracking down.

WHITACRE: Everyone has to be careful.

SHINOHARA: Oh, yes.

WHITACRE: When we leave, we're better off to leave separately

• The Lysine Cartel Members Show Disdain For Customers And Antitrust Enforcement (Hammond, “Caught in the Act”, 2005)

One cartel member offered that one empty chair was for Tyson Foods, the largest purchaser of lysine in the United States, and that another chair was for ConAgra Foods, also a large U.S. customer. Another cartel member mocked, ironically, that one chair was for the FBI, and a third cartel executive added that the remaining chairs were for the Federal Trade Commission. Tape Segment One: January 18, 1995 Cartel Meeting in Atlanta, Georgia

7Detection of Explicit Collusion In Practice

An entrant who hasn’t been part of the cartel is solicited and reports this to the authorities.

Customers become suspicious about the prices they are being charged or the bids they are getting.

Disgruntled employees who know about the cartel report it.

The authorities become suspicious because of institutions or contract features that encourage collusion or punish cheaters.

Members of cartel approach authorities as part of a “leniency program” which reduces penalties on those who report it.

8What Can Competition Authorities Do?

• Forbid/limit practices that facilitate cartels (Information exchange, MFNs, RPM—but are these practices ever efficient?)

• Prohibit mergers that will facilitate collusion (e.g. ones that eliminate a maverick player or increase the likelihood of coordinated effects)

Head them off at the pass

• Focus investigative efforts on industries that have features that facilitate cartels—but are these cartels the most damaging or the easier ones to detect?

• Screening technologies (our guest speaker will elaborate)*• Dawn raids when enough suspicion—requires specialized know-how and can

be legally challenging in some jurisdictions

Hunt them down

• Encourage cartel members to report each other (leniency programs)• Get employees to be “whistleblowers”

Get them to squeal

• Fines• Jail• Debarment

Carry a big stick

9Head Them Off At The Pass: Facilitating Practices

A facilitating practice is an activity that makes collusion more likely or more effective, either by making coordination easier or making it easier to sustain a collusive agreement.

A facilitating practice may be prosecuted either as an anti-competitive agreement in and of itself or as circumstantial evidence of price fixing.

• Information exchange of current individual firm sales or prices• Announcements of future price changes• List (or posted) pricing with no discounts• Most favored consumer clauses, meeting competition clauses• Delivered or basing point pricing

Some examples include:

10Information Exchange Agreements Help Collusion

Exchanging future pricing intentions help coordinate price

Exchanging past prices help police price agreement

Exchanging demand and cost data so that firms have:• A more common set of beliefs (this makes it more likely that, without express communication, they can settle on the same collusive price)

• More precise estimates of demand

11Information Exchange Agreements: Cons

They can circumvent cartel prohibition

• In the UK Cartels became illegal with the Restrictive Trade Practices Act of 1956… Subsequently, as much as 50% of British industry adopted information exchange agreements.

They can be a creative way of monitoring and enforcing a price fixing agreement, e.g. Maple Flooring Association (US)• 1916-21: MFA establishes a minimum RPM for the sale

of maple and birch flooring supported by severe financial penalties for deviators.

• Jan 1921: After a government investigation, MFA abandons the price floor policy, and institutes an information sharing system.

• Supreme Court ruled in favor of the defendants– the DOJ did not prove the companies used information to collude in prices and production.

12Information Exchange Agreements: Pros

Sharing past sales and profits can be used for benchmarking and establishing relative performance contracts.

Sharing past prices and sales allow firms to more accurately estimate current demand.

• Industry profit and welfare effects are ambiguous.

Knowledge of past prices may assist consumers in bargaining with firms.

• Positive welfare effect as prices are reduced• Not in the best interest of firms to make this information

public

13Hunt Them Down: Detecting Cartels

Stages in the process: screen, verify, prosecute

• Screening: Identifying markets where collusion is suspected.

• Verification: Systematically distinguish between collusion and competition.

• Prosecution: Developing economic evidence to determine guilt.Two empirical methods for screening: structural, behavioral

• Structural: Identifying industry traits conducive to collusion.

• Behavioral: Identifying collusive behavioral patterns.

14Structural Approaches

Structural approaches identify markets with traits conducive to the formation of a cartel.

Problem of too many false positives

• Imagine the “ideal” market for collusion: Two firms, homogeneous products, stable demand, etc.

• In practice, only a small fraction of such markets probably have cartels.• The reason is that there are many omitted (unmeasured) factors that

influence whether a cartel forms or not.

15Behavioral Methods

Is behavior inconsistent with competition?

Does a collusive model fit the data better than a competitive model?

Is there a structural break in behavior –i.e. statistically distinguishable change?

Empirical methods will vary according to:• The type of data that is required• The need for prior information about collusion• Reduced form or structural estimation methods

16 Discouraging Cartels: Leniency Programs

17Leniency Programs

A leniency program offers reduced penalties to corporations and/or individuals involved in collusion, in exchange for cooperating with enforcement authorities.

U.S. Department of Justice• 1993: Revised corporate and individual leniency program• Three major revisions:

• Amnesty is automatic if there is no pre-existing investigation• Amnesty may still be available even after and investigation has started• All officers, directors, and employees who cooperate are protected from

criminal prosecution.• Annual number of leniency applications increased 20-fold.

European Commission introduce leniency programs in 1996, revised in 2002.

More than 50 jurisdictions have leniency programs (Feb, 2010)

18The Economics of Leniency Programs

A cartel shares common characteristics with organized crime

• Cooperation within an illegal environment means that there is a corporate governance problem at its core

• Repeated interaction, monitoring, threats and reactions against cheaters, means that participants acquire important information about all their co-conspirators

A viable cartel requires that 2 conditions be fulfilled

• Participation Constraint: E(Profit from participating in the cartel) – E(Cost of Punishment)>0

• Incentive Compatibility Constraint:Under incomplete information and different types of agents, the participant will find it in its interest to act in accordance with the cartel rules.

A successful leniency program weakens a cartel by maximizing conflict of interest among its members and reducing the compatibility of interests

19

A Model for Using Leniency in the Post-Cartel Environment

Scenario: auction houses where collusion has stopped. Should they apply for leniency?

Model: Each auction house chooses the option that minimizes expected penalties

• f is the penalty avoided by receiving leniency (government fine).• d is the penalty not avoided by receiving leniency (customer damages).• p is the probability of a conviction when neither applies for leniency

Apply Do not ApplyApply d + f/2 ; d + f/2 d ; d + fDo not Apply d + f ; d p(d + f) ; p(d + f)

Christie’s

Sotheby’s

20

A Model for Using Leniency in the Post-Cartel Environment

Equilibria when the probability of being convicted is low:

• p (d + f) < d or p < d/(d+f) [so expected cost of being caught is less than certainty of paying damages]

• Two possible equilibrium: Both apply for leniency; both do not apply for leniency

• It is a coordination game. (Firms want to coordinate on “do not apply”).Equilibrium when the probability of being convicted is high:

• p (d + f) > d or p > d/(d + f)• Unique equilibrium: Both apply for leniency.• It is the Prisoners’ Dilemma game. (The dominant strategy is “Apply”)

Apply Do not ApplyApply d + f/2 ; d + f/2 d ; d + fDo not Apply d + f ; d p(d + f) ; p(d + f)

Christie’s

Sotheby’s

21 Punishment and Damages

22Simple Theory of Cartel Fines

Deterrence and Fines• Theory is that fines should be set so that the expected fine is greater than the

benefits of cartel• Set properly, fines should eliminate cartels; a higher fine can offset a lower

probability of detection

Assumptions

• M = monopoly profits from cartel (divided among members)• p = probability of detecting the cartel• F = fine imposed on cartel (assume one period for simplicity)

Expected fine for cartel = p x F (divided among members)

• If expected fine is greater than expected monopoly profits then firms will not join cartel. Therefore p x F > M will deter cartels.

• Therefore, firms will choose not to join the cartel when F>M/p

23Fine Questions and Puzzles

Corporate versus individual liability• For publicly traded companies fines reduce shareholder value.• Will punishing shareholders reduce cartel formation?

What’s the role of jail terms• Why not just fines?• Why jail for cartels and not for other antitrust offenses?• What is more effective, jail versus debarment?

Fines vs. detection

• Why not just increase fines and reduce resources on detection?

Is cartel enforcement optimal?• Does the continuing uncovering of cartels evidence that penalties are still too

low?

24Punishment: the Fine Arts Auction Houses Case

25Customer Damages: Purpose

Compensation to harmed consumers

Deterrence and resistance of cartels

• Additional financial penalties to fines levied by the government.• Create added incentives for customers to monitor, report, and investigate.

Customer damages – US• Treble damages: Multiplier serves deterrence since the probability of being

caught and paying penalties is well below one.• Indirect purchasers cannot sue for damages except in some states.• Class action suits used for when many customers each incur a small loss.

26The Economics of Damages

Damages inflicted by firm i from colluding in period t are calculated to be:

• [ Pic(t) – Pi

bf(t) ] * Qic(t)

Pic(t) is the observed (collusive) price charged by

firm i in period t.

Qic(t) is the number of units sold by firm i in period

t.

Pibf(t) is the “but for” (or counterfactual) price for

firm i in period t.

Pic(t) – Pi

bf(t) is the overcharge

27Customer Damages

Customer damages EU (White Paper, April 2008)• Single damages.• Indirect purchaser suits are allowed.

• If an illegal overcharge is passed on to consumers who are not direct buyers then those consumers are harmed.

• Those harmed consumers can claim compensation.Comparison of US and EU

• EU is focused on compensation.• US is primarily concerned with deterrence and resistance.

Allowing indirect purchasers to sue weakens enforcement

• Direct purchasers have the best information when it comes to detecting collusion. Weakening their incentives will reduce the likelihood that they report and sue, thereby reducing enforcement.

• Damage calculation becomes more difficult and could effectively reduce penalties.

28 Cartels vs. Cooperation

29

Firms Often Cooperate For Pro-Competitive Reasons

Joint facilities to obtain scale economies (e.g. Computer Reservation Systems).

Standard setting to obtain network economies and reduce transactions costs for consumers (see Lecture 4) (DVD standards).

Solving various market imperfections (e.g. Portobello Road Antique Dealers).Exchanging information (costs, best practices, etc.) for pro-competitive reasons (e.g. all trade associations). Cooperatives, joint ventures, standard setting organizations, and other horizontal combinations pose difficult problem for antitrust.Engage in obvious efficiency enhancing activities.

30Efficiencies from Cooperation

Sharing of facilities and reduction in duplicative costs

Realization of network effects through e.g. standardization

Cooperation may be essential to the creation of a product (sports leagues, payment cards)

Other efficiencies

31Key Economic Issues for Cooperation

Effect of competition law on choice of organizational form—if mergers are lawful but cooperation isn’t then we will get more mergers. That may lead to inefficient organizational forms and perhaps less competition than with cooperation short of mergers.

Is efficiency justification legitimate or a sham?

Is it possible to obtain efficiencies in less restrictive ways (relative to competition)?

US courts deal with these issues by treating cooperative agreements for which there is an efficiency justification under the rule of reason (since the BMI case which involved a music collecting society).EC law deals with these issues under Article 81(3). Coordinated behavior may be exempt if it is objectively justified.

32Music Collecting Societies

Composers have copyright protection

• But cost of enforcing is too high for individual composers• Would need to negotiate with many venues• Would need to invest in detection

Music collecting societies form to represent composers

• Negotiate with venues• File enforcement actions• Note these are two-sided platforms

But cooperation increases market power when compositions are substitutes

• Where do we draw the line between efficiencies from cooperation and increased market power?

• How have courts/competition authorities resolved this?

33

Collusion, Screening and LIBOR

Guest Speaker: Rosa M. Abrantes Metz

34

End of Topic 9, Next Class Topic 10

Part 1

Market power

Demand side