L3+4 - Cartels

Question 1

What is tacit and explicit collusion?

Answer 1

Tacit collusion - a collusive outcome that requires no formal agreement and no direct communication

Explicit collusion - verbal and written agreements

Question 2

Why might companies want to collude?

Answer 2

Collusion - a way of easing competitive pressure

Eliminates the uncertainties of independent action and reduces interdependence

Question 3

What are cartels and what is the overall objective of a cartel?

Answer 3

Cartels - an association of companies that take action to
coordinate their prices, contract tender, split the market, fix
market shares

Associations of independent firms that restrain competition and exploit market power

Overall objective: ease competitive pressure through collective agreements that enable members to increase prices and profits above competitive level

Cartel formation may be described by a cooperative game

Question 4

What might cartel agreements be?

Answer 4

Agreements to:

Impede entry or the development of new products that might threaten the profitability or survival of incumbent firms (most important)

Sales conditions; costs, prices and profit margins; allocation of territories or customers; productive capacity allocation

Question 5

What are trade associations?

Answer 5

Provide members with industry data information on
industry sales, productive capacity, creditworthiness of
customers, etc

Promote activities to reduce inefficiency

Promote better relations with customers

Question 6

What is a joint venture?

Answer 6

Join venture - an association between two or more otherwise competing firms. Might take the form of a consortium or syndicate

Firms may enter joint ventures to:

combine firm resource to increase efficiency

overcome entry barriers and enter new markets

develop joint research and development undertakings

Question 7

What is semi-collusion?

Answer 7

Occurs in cases where it is difficult to formulate specific agreements covering all aspects of the firms’ behaviour.

Firms may opt to collude in some activities and compete in others.

Question 8

What is state-sponsored collusion?

Answer 8

State-sponsored collusion -government imposes cartel conditions on firms

Question 9

What are the assumptions for profit-maximization for cartels (when all firms in the industry are in the cartel)?

Answer 9

All firms in an industry are in a centralised cartel with complete control over price and output

Identical products

Produce under different cost structure

No threat of entry

Question 10

When is profit maximized (when all firms in the industry are in the cartel)?

Answer 10

Maximization of combined profit of boils down to joint profit
maximization as if a multi-plant monopolist

Output level at which marginal revenue (derived from industry
average revenue function) equals industry’s marginal cost function

The total cost of producing QM is minimised by allocating
quotas in such a way that the marginal costs of each firm, when producing its own quota, are the same

Question 11

What are four motives for collusion?

Answer 11

Risk management and the enhancement of security

Exchange of information

Unsatisfactory performance

Profit-maximization

Question 12

How can risk management and exchange of info be motives for collusion?

Answer 12

Risk management and the enhancement of security:

Risk arises from changes in consumer tastes and risk results directly from competition between producers

Firms can choose to take independent actions (product differentiation, advertising and marketing) or collude and act jointly

Exchange of information: It lowers firms’ vulnerability, encourages cooperative behaviour and increases industry stability

Question 13

How can unsatisfactory performance and profit-maximization be motives for collusion?

Answer 13

Unsatisfactory performance:

Low profitability due to industry conditions such as intense competition and demand decline can encourage firms to collude

Firms in a declining industry are perhaps more likely to collude in an attempt to restore profitability to some historical level.

Profit-maximization:
Higher profit by exercising (near monopoly) market power

Question 14

What are five factors conducive to cartel formation?

Answer 14

Structural characteristics for formation and stability of cartels

1. Seller concentration and number of firms
2. Cost functions
3. Size and product differentiation
4. Vertical integration
5. Transaction costs of collusion: costs of ensuring compliance and punishing non-compliant members

Question 15

How can seller concentration and the number of firms be conducive to cartel formation?

Answer 15

Small number of firms or high concentration facilitates collusion.

As the number of firms increases, the contribution of each firm to total output decreases, and the firms become more likely to ignore their interdependence.

As the number of firms increases, there is more temptation for a rogue firm to undercut the agreed price, as it perceives a low risk of detection.

Since firms often have different views as to the optimal cartel policy, communication and negotiation between firms is required to reconcile differences. Coordination becomes more difficult as numbers increase

A more explicit form of collusion is needed as the numbers increase

Question 16

How can cost functions be conducive to cartel formation?

Answer 16

Firms with similar cost structures enhances collusive behaviour

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.

Question 17

How can size and product differentiation be conducive to cartel formation?

Answer 17

It is easier to collude when most firms are similar in their market share, size, product ranges, production technology and capacity

Small firms may be reluctant to adopt quotas based on existing market shares, while large firms may collude with each other to enhance their (collective) dominance.

Difficult to agree on price if products are very different

Demand that is relatively inelastic at the pre-cartel price ensures that revenues can be increased significantly by reducing output levels and raising price.

Question 18

How can vertical integration be conducive to cartel formation?

Answer 18

It renders effective monitoring of cartel members difficult and thus may impede collusion

Question 19

How can transaction costs of collusion (costs of ensuring compliance and punishing non-compliant members) be conducive to cartel formation?

Answer 19

Ability to specify contractual relations correctly

Extent to which agreement can be reached over joint gains (might require the reduction of some firms’ output and the expansion of others)

Uncertainty associated with change in the economic environment

Monitoring especially when there are non-price forms of competition

Penalties particularly important in the absence of legal protection. Successful collusion must rest on the availability of effective sanctions against firms that fail to comply with the agreement

Question 20

Are cartels inherently unstable?

Answer 20

Coordination/Collusion/cartel outcome: behave like a monopolist and split market

However, both have an incentive to deviate

Hence, cartel outcome is not a Nash equilibrium and therefore inherently unstable!

Question 21

What are the assumptions in the joint profit-maximization model where some firms are outside the cartel?

Answer 21

Two groups of firms, one forms a cartel and one does not

Number of firms N

Number of firms that form a cartel K

Large number of small firms in both groups

Identical product

Identical cost function

Entry is successfully deterred

Price-taking behaviour on the part of non-cartel firms

Question 22

Where do cartel firms maximize profits (when not all firms in the industry are in the cartel)?

Answer 22

Cartel firms maximize profits where residual marginal revenue equals collective marginal cost, MR = C

Market demand left for the cartel is reduced by the free rider’s supply

The resulting demand curve relevant
for the cartel is D_cartel which cartel takes as given when deciding on the price

Question 23

What is the freerider problem?

Answer 23

The freeriding non-cartel firms (N-K) earn higher profits than the cartel firms, thanks entirely to the sacrifices made by the latter.

The N - K firms behave as price takers and sell everything they can until their marginal costs are equal to the price

The cartel members are allowed to produce q1 only, according to the cartel rules, while free riders can offer q2, thus earning a higher profit (The free riders also gets additional producer surplus in form of the little triangle in the figure on the left)

Question 24

How does increased transparency affect cartel stability?

Answer 24

If transparency is increased, less likely firms will deviate from cartel

With increased market transparency,

Cartel members will find it easier to detect deviators

At the same time, expected gain from deviation and loss after break-up becomes larger

Deviations from cartels become less attractive (under certain assumptions):

o more transparency

o conventional view: A increases less than B increases

o expected net gain from deviation shrinks

o better to stay in cartel (get cartel profit in all periods)

Question 25

What are 10 factors affecting cartel stability?

Answer 25

Seller concentration and number of firms – high concentration
and small number of firms contributes to cartel stability

Different goals of firms – conflicting objectives of members
makes cartels unstable

Process of cartel formation and assignment of quotas

Non-price competition – significant opportunities for non-price
competition makes cartels unstable

Monitoring and detection of cheating – cartels are stable if
there is effective mechanism of monitoring and detection of
non-compliance

Sanctions – ability of the cartel to impose punishment on
non-compliance behavior increases chance of cartel stability

Buyer concentration – lower buyer concentration facilitates
cartel stability

Fluctuations in demand - firms might be tempted to undercut if demand falls

Entry – profitability and stability of cartels depends on
effective deterrence of entry by new firms

Competition law – Leniency program

Question 26

When is the risk of information sharing harming competition greater?

Answer 26

Rule of thumb: The more unfavourable market structure is for competition, the greater the risk that information sharing may harm competition. I.e. focus on the ’usual suspects’ for cartel-promoting factors:

High market concentration

High entry barriers

Homogeneous products

Similar companies (same size, costs, etc.)

Stable market development

Regular demand

Small, frequent orders

Question 27

What are the socio-economic effects of cartels?

Answer 27

The buyers of the products pay a higher price, some of the
consumer surplus goes to the cartel firms) increase in
producer surplus, another part becomes deadweight loss.

Same effect as comparing competition and monopoly.
Producers get a higher profit

The allocation of resources in society becomes inefficient as it produces at lower MC than the price consumers have to pay (same issue as with monopoly)

The speed of innovation in the industry may decrease as firms collaborate on price, market sharing and not competing with each other through innovations

Firms’ productivity can go down

Lower innovation and enjoying ’business as usual’ imply higher costs (ATC and MC move upwards), even higher prices, losses in both consumer and producer surplus

Question 28

What are the objectives of fines and what are the effects?

Answer 28

Objectives of fines: to punish and to deter

With fines, the likelihood of cartel formation becomes smaller due to greater risk and less expected returns

Question 29

How large are fines?

Answer 29

Fines are proportional to the (estimated) damage

Question 30

What can the competition authorities do?

Answer 30

Fines

Competition authorities may hand over cartel cases to the State Attorney for
Special Economic and International Crime (SØIK) so that a lawsuit is brought
to the judicial system.

Competition authorities have the right to conduct ’dawn raids’ (I.e. by a court order to carry out inspections that allow the board to access the premises and means of transport of a company or association in order to acquaint themselves with and copy any information irrespective of the information medium

Competition authorities may grant leniency reductions for cartel members who
voluntarily inform the competition authorities of the existence and content of
the cartel. DCA §23a.

Question 31

What are the effects of leniency rules?

Answer 31

In theory - a company may choose to participate in a cartel with the option later to report the cartel to the authorities (and go without fines if the first one to report). However, hardly a widespread strategy in practice because it is quiet risky gamble …

The likelihood that the cartel is stable becomes smaller due to the greater risk that the cartel will be reported by one of the participants (see last lecture - prisoners’ dilemma).

On the other hand, the cartel may become stronger by threatening members with very severe sanctions themselves

The destabilizing effect is probably more important in practice

Question 32

What is an increase in producer transparency?

Answer 32

Increase in PT (producer transparency) increases the info about competitors’ prices, discounts and
capacity, etc., so it removes asymmetric information among producers

Question 33

Why is producer transparency a prerequisite for cartel agreements?

Answer 33

Makes it easier to align interests and actions

Easier to detect if rules are violated

Thus, gain of lowering price is only short-lived as the cartel can launch a price war

Question 34

What is an important difference of increased PT for new entrants to the market and incumbent (existing) firms?

Answer 34

Increased PT gives potential new companies better market information, perhaps increased business access, perhaps increased competition. But also, as existing cartel companies more easily detect market penetration and can engage in actions to deter entry of new businesses

Question 35

What does an increase in consumer transparency imply and why is it important?

Answer 35

Increase in CT implies that consumers are better informed and can respond faster and stronger to price and quality signals

The faster and stronger the consumer responds, the greater the incentive for the companies to compete on price and quality

Increase in CT increases incentives for companies to break cartel agreements, for example - a big potential gain by lowering the price. With higher CT the market demand is more elastic, so consumers switch faster to the cheaper company.

Question 36

How could consumer transparency increase cartel formation/stability?

Answer 36

More CT could cause the counter-response from the (loyal) cartel firms. They could engage in a price war or even use predatory pricing (sell the good/service below average variable costs).

Consumers would switch to the cartel and forcing all other companies into price reductions as well; some firms might not survive this price war this leading to exit and lower competition.

In practice, however, this last effect is considered to be less significant in terms of the initial positive competitive effect

Question 37

Dilemma for competition regulation: Can you increase consumer transparency (which in general has
positive effects on competition) without increasing producer
transparency (which in general has negative effects on competition through facilitating cartel formation)?

Answer 37

Information exchange that only benefits producers tend to be forbidden however, if it also benefits consumers it typically is not

Information exchange of trade associations means collecting, processing and retransmitting information and statistics to its members.

This creates market transparency for the producers, usually without creating consumer information at the same time

Increased risk of coordination, cartel-like conditions

Any kind of recommendation for prices, discounts, etc. from trade associations is prohibited.

Recommending limits to trade association members in form of maximum prices is, as a rule, prohibited.

Disclosure of future price information to trade association members is, as a rule, prohibited.

Disclosure of current price information is prohibited. An exception to this may be some types of price portals aimed at consumers

The distribution of historical prices by trade unions may be legal if the information is sufficiently old and aggregated

When collecting individual price information, trade associations must ensure full confidentiality about the information, i.e. the individual company must not be identifiable