Chapter 7

Collusion and Cartels

Industrial Organization: Chapter 7

Collusion and Cartels

What is a cartel?
attempt to enforce market discipline and reduce competition between a group of suppliers cartel members agree to coordinate their actions
prices market shares exclusive territories

prevent excessive competition between the cartel members

Industrial Organization: Chapter 7

Collusion and Cartels

Cartels have always been with us
electrical conspiracy of the 1950s garbage disposal in New York Archer, Daniels, Midland the vitamin conspiracy

Some are explicit and difficult to prevent

OPEC De Beers shipping conferences

Industrial Organization: Chapter 7

Collusion and Cartels

Other less explicit attempts to control competition
formation of producer associations publication of price sheets peer pressure (NASDAQ?) violence

Cartel laws make cartels illegal in the US and Europe Authorities continually search for cartels Have been successful in recent years
Nearly $1 billion in fines in 1999

Industrial Organization: Chapter 7

Collusion and Cartels

What constrains cartel formation?
they are generally illegal
per se violation of anti-trust law in US substantial penalties if prosecuted

cannot be enforced by legally binding contracts the cartel has to be covert

enforced by non-legally binding threats or self-interest

cartels tend to be unstable

there is an incentive to cheat on the cartel agreement MC > MR for each member cartel members have the incentive to increase output OPEC until very recently

Industrial Organization: Chapter 7

The Incentive to Collude

Is there a real incentive to belong to a cartel? Is cheating so endemic that cartels fail? If so, why worry about cartels? Simple reason
without cartel laws legally enforceable contracts could be written by cartel members
De Beers is tacitly supported by the South African government gives force to the threats that support this cartel not to supply any company that deviates from the cartel

Without contracts the temptation to cheat can be strong

Industrial Organization: Chapter 7

The Incentive to Cheat

Take a simple example
two identical Cournot firms making identical products for each firm MC = $30 market demand is P = 150 Q where Q is in thousands Q = q1 + q 2

Price 150 Demand

30 150

MC Quantity
7

Industrial Organization: Chapter 7

The Incentive to Cheat

Profit for firm 1 is: p1 = q1(P - c)

= q1(150 - q1 - q2 - 30) = q1(120 - q1 - q2) To maximize, differentiate with respect to q1: Solve this for q1 p1/q1 = 120 - 2q1 - q2 = 0
This is the best response The best response function for firm 2 is then: function for firm 1

q*1 = 60 - q2/2

q*2 = 60 - q1/2

Industrial Organization: Chapter 7

The Incentive to Cheat

These best response functions are easily illustrated
q2 120 R1 60 40 C

q*1 = 60 - q2/2 q*2 = 60 - q1/2

Solving these gives the Cournot-Nash outputs: qC1 = qC2 = 40 (thousand) The market price is: PC = 150 - 80 = $70 R2 Profit to each firm is: q1 p1 = p2 = (70 - 30)x40 120 = $1.6 million
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40

60

The Incentive to Cheat (cont.)

What if the two firms agree to collude? They will agree on the monopoly output q2 This gives a total output of 60 thousand 120 Each firm produces 30 thousand Price is PM = (150 - 60) = $90 R1 Profit for each firm is: 60 p1 = p2 = (90 - 30)x30 = $1.8 million
40 30 C R2 30 40 60 120 q1

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The Incentive to Cheat (cont.)

Both firms have an incentive to cheat on their agreement If firm 1 believes that firm 2 will produce 30 units q2 then firm 1 should produce more than 30 units 120 Firm 1s Cheating best response is: pays!! 60 - qM2/2 = 45 thousand qD1 =
R1 60 40 30 C

30 40

60 45

Total output is 45 + 25 = 70 thousand Price is PD = 150 - 75 = $75 Profit of firm 1 is (75 - 30)x45 = $2.025 million R2 q1 Profit for firm 2 is 120 (75 - 30)x25 = $1.35 million
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The Incentive to Cheat (cont.)

Firm 2 can make the same calculations! This gives the following pay-off matrix:
Both firms have the incentive to cheat on their agreement

Firm 1
Cooperate (M) Deviate (D) (1.35, 2.025)

Firm 2

Cooperate (M)

This is the Nash equilibrium (1.8, 1.8)

Deviate (D)

(2.035, 1.35)

(1.6, 1.6) (1.6, 1.6)

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Cartel Stability
The cartel in our example is unstable This instability is quite general Can we find mechanisms that give stable cartels?
violence in one possibility! are there others?
must take away the temptation to cheat staying in the cartel must be in a firms self-interest

Suppose that the firms interact over time

Then it might be possible to sustain the cartel
Make cheating unprofitable Reward good behavior Punish bad behavior
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Repeated Games
Formalizing these ideas leads to repeated games
a firms strategy is conditional on previous strategies played by the firm and its rivals
In the example: cheating gives $2.025 million once But then the cartel fails, giving profits of $1.6 million per period Without cheating profits would have been $1.8 million per period So cheating might not actually pay

Repeated games can become very complex

strategies are needed for every possible history

But some rules of the game reduce this complexity

Nash equilibrium reduces the strategy space considerably

Consider two examples

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Example 1: Cournot duopoly

The pay-off matrix from the simple Cournot game

Firm 1
Cooperate (M) Cooperate (M) (1.8, 1.8) Deviate (D) (1.35, 2.025)

Firm 2

Deviate (D)

(2.025, 1.35)

(1.6, 1.6) (1.6, 1.6)

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Example 2: A Bertrand Game

Firm 1
$105 $105 $130 $160

(7.3125, 7.3125) (8.25, 7.25) (9.375, 5.525)

Firm 2

$130

(7.25, 8.25)

(8.5, 8.5) (8.5, 8.5)

(10, 7.15)

$160

(5.525, 9.375)

(7.15, 10)

(9.1, 9.1)

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Repeated Games (cont.)

Time matters in a repeated game
is the game finite? T is known in advance
Exhaustible resource Patent Managerial context

or infinite?
this is an analog for T not being known: each time the game is played there is a chance that it will be played again

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Repeated Games (cont.)

Take a finite game: Example 1 played twice A potential strategy is:
I will cooperate in period 1 In period 2 I will cooperate so long as you cooperated in period 1 Otherwise I will defect from our agreement

This strategy lacks credibility

neither firm can credibly commit to cooperation in period 2 so the promise is worthless The only equilibrium is to deviate in both periods

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Repeated Games (cont.)

What if T is large but finite and known?
suppose that the game has a unique Nash equilibrium the only credible outcome in the final period is this equilibrium but then the second last period is effectively the last period
the Nash equilibrium will be played then

but then the third last period is effectively the last period
the Nash equilibrium will be played then

and so on

The possibility of cooperation disappears

The Selten Theorem: If a game with a unique Nash equilibrium is played finitely many times, its solution is that Nash equilibrium played every time. Example 1 is such a case
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Repeated Games (cont.)

How to resolve this? Two restrictions
Uniqueness of the Nash equilibrium Finite play

What if the equilibrium is not unique?

Example 2 A good Nash equilibrium ($130, $130) A bad Nash equilibrium ($105, $105) Both firms would like ($160, $160)

Now there is a possibility of rewarding good behavior

If you cooperate in the early periods then I shall ensure that we break to the Nash equilibrium that you like If you break our agreement then I shall ensure that we break to the Nash equilibrium that you do not like
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A finitely repeated game

Assume that the discount rate is zero (for simplicity) Assume also that the firms interact twice Suggest a cartel in the first period and good Nash in the second
Set price of $160 in period 1 and $130 in period 2

Present value of profit from this behavior is:

PV2(p1) = $9.1 + $8.5 = $17.6 million PV2(p2) = $9.1 + $8.5 = $17.6 million

What credible strategy supports this equilibrium?

First period: Second period: set a price of $160 If history from period 1 is ($160, $160) set price of $130, otherwise set price of $105.
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A finitely repeated game

These strategies reflect historical dependence
each firms second period action depends on the history of play

Is this really a Nash subgame perfect equilibrium?

show that the strategy is a best response for each player

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A finitely repeated game

This is obvious in the final period
the strategy combination is a Nash equilibrium neither firm can improve on this

What about the first period? does not Defection

why doesnt one firm, say firmthistry to improve its profits by pay in 2, case! setting a price of $130 in the first period?

Consider the impact

History into period 2 is ($160, $130) Firm 1 then sets price $105 Firm 2s best response is also $105: Nash equilibrium Profit therefore is PV2(p1) = $10 + $7.3125 = $17.3125 million This is less than profit from cooperating in period 1
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A finitely repeated game

Defection does not pay! The same applies to firm 1 So we have credible strategies that partially support the cartel Extensions
More than two periods
Same argument shows that the cartel can be sustained for all but the final period: strategy In period t < T set price of $160 if history through t 1 has been ($160, $160) otherwise set price $105 in this and all subsequent periods In period T set price of $130 if the history through T 1 has been ($160, $160) otherwise set price $105

Discounting
Industrial Organization: Chapter 7 24

A finitely repeated game

Suppose that the discount factor R < 1
Reward to good behavior is reduced PVc(p1) = $9.1 + $8.5R Profit from undercutting in period 1 is PVd(p1) = $10 + $7.3125R

For the cartel to hold in period 1 we require R > 0.756 (discount rate of less than 32 percent) Discount factors less than 1 impose constraints on cartel stability But these constraints are weaker if there are more periods in which the firms interact
Industrial Organization: Chapter 7 25

A finitely repeated game

Suppose that R < 0.756 but that the firms interact over three periods. Consider the strategy
First period: set price $160 Second and third periods: set price of $130 if the history from the first period is ($160, $160), otherwise set price of $105

Cartel lasts only one period but this is better than nothing if sustainable Is the cartel sustainable?

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A finitely repeated game

Profit from the agreement
PVc(p1) = $9.1 + $8.5R + $8.5R2

Profit from cheating in period 1

PVd(p1) = $10 + $7.3125R + $7.3125R2

The cartel is stable in period 1 if R > 0.504 (discount rate of less than 98.5 percent)

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Cartel Stability (cont.)

The intuition is simple enough
suppose the Nash equilibrium is not unique some equilibria will be good and some bad for the firms with a finite future the cartel will inevitably break down but there is the possibility of credibly rewarding good behavior and credibly punishing bad behavior
make a credible commitment to the good equilibrium if rivals have cooperated to the bad equilibrium if they have not.

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Cartel Stability (cont.)

Cartel stability is possible even if cooperation is over a finite period of time
if there is a credible reward system which requires that the Nash equilibrium is not unique

This is a limited scenario What happens if we remove the finiteness property? Suppose the cartel expects to last indefinitely
equivalent to assuming that the last period is unknown in every period there is a finite probability that competition will continue now there is no definite end period so it is possible that the cartel can be sustained indefinitely
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A Digression: The Discount Factor

How do we evaluate a profit stream over an indefinite time?
Suppose that profits are expected to be p0 today, p1 in period 1, p2 in period 2 pt in period t Suppose that in each period there is a probability r that the market will last into the next period
probability of reaching period 1 is r, period 2 is r2, period 3 is r3, , period t is rt

Then expected profit from period t is rtpt Assume that the discount factor is R. Then expected profit is PV(pt) = p0 + Rrp1 + R2r2p2 + R3r3p3 + + Rtrtpt + The effective discount factor is the probability-adjusted discount factor G = rR.
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Cartel Stability (cont.)

Analysis of infinitely or indefinitely repeated games is less complex than it seems Cartel can be sustained by a trigger strategy
I will stick by our agreement in the current period so long as you have always stuck by our agreement If you have ever deviated from our agreement I will play a Nash equilibrium strategy forever

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Cartel Stability (cont.)

Take example 1 but suppose that there is a probability r in each period that the market will continue:
Cooperation has each firm producing 30 thousand Nash equilibrium has each firm producing 40 thousand

So the trigger strategy is:

I will produce 30 thousand in the current period if you have produced 30 thousand in every previous period if you have ever produced more than 30 thousand then I will produce 40 thousand in every period after your deviation

This is a trigger strategy because punishment is triggered by deviation of the partner Does it work?
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Cartel Stability (cont.)

Profit from sticking to the agreement is: A cartel is more likely C = 1.8 + 1.8R + 1.8R2 + PV to be stable the greater the = 1.8/(1 - G) probability that the market Profit from deviating from thecontinue and the will agreement is: PVD = 2.025 + 1.6 G + 1.6 G 2 + is the interest rate lower
= 2.025 + 1.6 G /(1 - G)

Sticking to the agreement is better if:

PVC > PVD this requires: 1.8 1-G > 2.025 + 1.6 G which requires G = rR> 0.592 1-G

if r = 1 we need r < 86%; if r = 0.6 we need r < 13.4%

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Cartel Stability (cont.)

This is an example of a more general result Suppose that in each period There is always a profits to a firm from a collusive agreement are pM value are D profits from deviating from the agreementof Gp< 1 for which profits in the Nash equilibrium are pN this equation is we expect that pD > pM > pN satisfied This is the short-run gain Cheating on the cartel cheating on the cartel as: from does not pay so long
G> p D - pM p D - pN This is the long-run loss from cheating on the cartel

The cartel is stable

if short-term gains from cheating are low relative to long-run losses if cartel members value future profits (high probability-adjusted discount factor)
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Cartel Stability (cont.)

What about Example 2?
two possible trigger strategies
price forever at $130 in the event of a deviation from $160 price forever at $105 in the event of a deviation from $160

Which?
there are probability-adjusted discount factors for which the first strategy fails but the second works

Simply put, the more severe the punishment the easier it is to sustain a cartel

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Trigger strategies
Any cartel can be sustained by means of a trigger strategy
prevents destructive competition

But there are some limitations

assumes that punishment can be implemented quickly
deviation noticed quickly non-deviators agree on punishment

sometimes deviation is is difficult to detect punishment may take time but then rewards to deviation are increased

The main principle remains

if the discount rate is low enough then a cartel will be stable provided that punishment occurs within some reasonable time
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Trigger strategies (cont.)

Another objection: a trigger strategy is
harsh unforgiving

Important if there is any uncertainty in the market

suppose that demand is uncertain A firm in this cartel Suppose that the Price does not know if a decline agreed price is PC There is a possibility in sales is natural Actual sales vary that demand And a possibility may be betweenor L and QH cheating Q caused by low demand may be that This is the Expected sales are expected market high PC QE demand DH DL DE Quantity QL QE QH
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Trigger strategies (cont.)

These objections can be overcome
limit punishment phase to a finite period take action only if sales fall outside an agreed range

Makes agreement more complex but still feasible Further limitation

approach is too effective result of the Folk Theorem Suppose that an infinitely repeated game has a set of pay-offs that exceed the one-shot Nash equilibrium pay-offs for each and every firm. Then any set of feasible pay-offs that are preferred by all firms to the Nash equilibrium pay-offs can be supported as subgame perfect equilibria for the repeated game for some discount factor sufficiently close to unity.
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The Folk Theorem

Take example 1. The feasible pay-offs describe the following possibilities
p2 $2.1 $2.0 $1.8 $1.8 million to Collusion on each firm may not The gives monopoly Folk Theorem states If firm $1.8collude be sustainable but firms each thethat any point in this something less triangle is a potential perfectly they share million If the firms compete will be equilibrium $3.6 million for the they each earn repeated game $1.6 million

$1.6
$1.5 $1.6 $1.8 $2.0 $2.1 p1
39

Industrial Organization: Chapter 7

Stable cartels (cont.)

A collusive agreement must balance the temptation to cheat In some cases the monopoly outcome may not be sustainable
too strong a temptation to cheat

But the folk theorem indicates that collusion is still feasible

there will be a collusive agreement:
that is better than competition that is not subject to the temptation to cheat

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Cartel Formation
What factors are most conducive to cartel formation?
sufficient profit motive means by which agreement can be reached and enforced

The potential for monopoly profit

collusion must deliver an increase in profits: this implies
demand is relatively inelastic restricting output increases prices and profits entry is restricted high profits encourage new entry but new entry dissipates profits (OPEC) new entry undermines the collusive agreement

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Cartel formation (cont.)

So there must be means to deter entry
common marketing agency to channel output consumers must be persuaded of the advantages of the agency
lower search costs greater security of supply wider access to sellers denied access if buy outside the agency (De Beers)

trade association
persuade consumers that the association is in their best interests

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Cartel formation (cont.)

Costs of reaching a cooperative agreement
even if the potential for additional profits exists, forming a cartel is time-consuming and costly
has to be negotiated has to be hidden has to be monitored

There are factors that reduce the costs of cartel formation

small number of firms (recall Selten) high industry concentration
makes negotiation, monitoring and punishment (if necessary) easier

similarity in production costs lack of significant product differentiation

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Cartel formation (cont.)

Similarity in costs
suppose two firms with different costs if they collude they can attain some point on p*1p*2 p2 p*1p*2 is curved because the If all output is made pm firms have different costs by firm 2 this is pmpm has a 450 slope and is total profit
tangent to p*1p*2 at M

p* 2 p2C p2m

at M firm 1 has profit p1m and firm 2 p2m

If all output is madeassume Cournot equilibrium is by firm 1 this is at C total profit firm 2 will not agree to

p1C

p1m p*1

pm

p1

collude on M without a side payment from firm 1

44

Industrial Organization: Chapter 7

Cartel formation (cont.)

p2

pm
p* 2 p2C p2m
B C A E D M

with side payments it is possible to collude to somewhere on DE

but side payments increase the risk of detection

without side payments it is only possible to collude to somewhere on AB

p1C

p1m

p*1

pm

p1

this type of collusion is difficult and expensive to negotiate: e.g. possibility of misrepresentation of costs

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Cartel formation (cont.)

Lack of product differentiation
if products are very different then negotiations are complex need agreed price/output/market share for each product monitoring is more complex

Most cartels are found in relatively homogeneous product markets Or firms have to adopt mechanisms that ease monitoring
basing point pricing

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Cartel formation (cont.)

Low costs of maintaining a cartel agreement
it is easier to maintain a cartel agreement when there is frequent market interaction between the firms
over time over spatially separated markets

relates to the discussion of repeated games

less frequent interaction leads to an extended time between cheating, detection and punishment makes the cartel harder to sustain

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Cartel formation (cont.)

Stable market conditions
accurate information is essential to maintaining a cartel
makes monitoring easier

unstable markets lead to confused signals

makes collusion near to monopoly difficult

uncertainty can be mitigated

trade association common marketing agency controls distribution and improves market information

Other conditions make cartel formation easier

detection and punishment should be simple and timely geographic separation through market sharing is one popular mechanism
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Cartel formation (cont.)

Other tactics encourage firms to stick by price-fixing agreements
most-favored customer clauses
reduces the temptation to offer lower prices to new customers

meet-the competition clauses

makes detection of cheating very effective

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Meet-the-competition clause

the one-shot Nash equilibrium is (Low, Low) meet-the-competition clause removes the off-diagonal entries now (High, High) is easier to sustain

Firm 2 High Price High Price 12, 12 Low Price 5, 14

Low Price

14, 5 14, 5

6, 6
50

Industrial Organization: Chapter 7

Cartel Detection
Cartel detection is far from simple
most have been discovered by finking even with NASDAQ telephone tapping was necessary

If members of a cartel are sophisticated they can hide the cartel: make it appear competitive
the indistinguishability theorem ICI/Solvay soda ash case
accused of market sharing in Europe no market interpenetration despite price differentials defense: price differentials survive because of high transport costs soda ash has rarely been transported so no data on transport costs are available

The Cournot model illustrates this theorem

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The Indistinguishability Theorem

q2 R1

R1

R2

R2 q1

start with a standard Cournot model: C is the non-cooperative equilibrium assume that the firms are colluding at M: restricting output M can be presented as noncollusive if the firms exaggerate their costs or underestimate demand this gives the apparent best response functions R1 and R2 M now looks like the noncooperative equilibrium
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Industrial Organization: Chapter 7

An Example

Suppose market demand is P = 100 - Q, that there are 3 firms and that each firm has true marginal costs of $20 The Cournot equilibrium market price and the outputs for each firm are given by the equations: qi = (A - c)/(N + 1); PC = (A + cN)/(N + 1) where we have that A = 100, c = 20, N = 3 So we have: qi = 20 and PC = $40 Suppose the firms are colluding on the monopoly price, which is (A + c)/2 = $60 What production cost 20 + f would make this look like a Cournot price? We need (100 + 3(20 + f))/4 = 60; so 160 + 3f = 240 which gives f = $80/3 = $26.67

The same result can be obtained by overestimating the reservation price

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Cartel detection (cont.)

Cartels have been detected in procurement auctions
bidding on public projects; exploration the electrical conspiracy using phases of the moon
those scheduled to lose tended to submit identical bids but they could randomize on losing bids!

Suggested that losing bids tend not to reflect costs

correlate losing bids with costs!

Is there a way to beat the indistinguishability theorem?

Osborne and Pitchik suggest one test

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Testing for collusion

Suppose that two firms
compete on price but have capacity constraints choose capacities before they form a cartel

Then they anticipate competition after capacity choice

a collusive agreement will leave the firms with excess capacity uncoordinated capacity choices are unlikely to be equal
one firms or the other will overestimate demand

so both firms have excess capacity but one has more excess

Collusion between the firms then leads to:

firm with the smaller capacity making higher profit per unit of capacity this unit profit difference increases when joint capacity increases relative to market demand
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An example: the salt duopoly

British Salt and ICI Weston Point were suspected of operating a cartel BS is the smaller The 1984 firm and makes 1980 1981 1982 1983 profit difference grows more profit per BS Profit 10150 10882 unit of capacity 7065 7622 10489 with capacity 7273 7527 6841 6297 6204 WP Profit

BS profit per unit of capacity

WP profit per unit of capacity Total Capacity/Total Sales

8.6
6.6 1.5

9.3 6.9 1.7

12.7
6.3 1.7

12.3
5.8 1.9

13.2
5.7 1.9

BS capacity: 824 kilotons; WP capacity: 1095 kilotons

But will this test be successful once it is widely known and applied?
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Example 2: A Bertrand Game

Firm 1
$105 $105 $130 $160

(7.3125, 7.3125) (8.25, 7.25) (9.375, 5.525)

Firm 2

$130

(7.25, 8.25)

(8.5, 8.5)

(10, 7.15)

$160

(5.525, 9.375)

(7.15, 10)

(9.1, 9.1)

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Basing Point Pricing

Then it was priced at Suppose that mill price plus the And that it steel is transport costs the is sold made here from Pittsburgh here

Pittsburgh

Birmingham Steel Company

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