Collusion and Cartels

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Collusion and Cartels. What is a cartel?attempt to enforce market discipline and reduce competition between a group of supplierscartel members agree to coordinate their actionspricesmarket sharesexclusive territoriesprevent excessive competition between the cartel members. Collusion and Cartels.

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Collusion and Cartels

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1. Collusion and Cartels

2. 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

3. Collusion and Cartels Cartels have always been with us electrical conspiracy of the 1950s Alitalia Some are explicit and difficult to prevent OPEC De Beers

4. Collusion and Cartels Other less explicit attempts to control competition formation of producer associations publication of price sheets peer pressure 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 (USA)

5. Recent cartel violations

6. Recent cartel violations 2 Fines steadily grew during the 1990s

7. Collusion and Cartels What constrains cartel formation? they are generally illegal per se violation of anti-trust law in US and EU 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

8. 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

9. 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 + q2

10. The Incentive to Cheat

11. The Incentive to Cheat

12. The Incentive to Cheat (cont.)

13. The Incentive to Cheat (cont.)

14. The Incentive to Cheat (cont.)

15. The incentive to cheat (cont.) This is a prisoners’ dilemma game mutual interest in cooperating but cooperation is unsustainable However, cartels do form So there must be more to the story

16. 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 firm’s 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

17. Repeated Games Formalizing these ideas leads to repeated games a firm’s 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

18. Example 1: Cournot duopoly

19. Example 2: A Bertrand Game

20. 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

21. 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

22. 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

23. 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

24. Industrial Organization: Chapter 7 24 Example 2 / 1 Consider the following pricing game

25. Industrial Organization: Chapter 7 25 Example 2 /2 There are two Nash equilibria

26. 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: set a price of $160 Second period: If history from period 1 is ($160, $160) set price of $130, otherwise set price of $105.

27. A finitely repeated game These strategies reflect historical dependence each firm’s 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

28. 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? why doesn’t one firm, say firm 2, try to improve its profits by setting a price of $130 in the first period?

29. Industrial Organization: Chapter 7 29 Example 2/3

30. 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

31. 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

32. 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?

33. 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)

34. 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.

35. 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

36. 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.

37. 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”

38. 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?

39. Example 1: Cournot duopoly

40. Cartel Stability (cont.) Profit from sticking to the agreement is: PVC = 1.8 + 1.8R + 1.8R2 + …

41. Cartel Stability (cont.) This is an example of a more general result Suppose that in each period profits to a firm from a collusive agreement are pM profits from deviating from the agreement are pD profits in the Nash equilibrium are pN we expect that pD > pM > pN Cheating on the cartel does not pay so long as:

42. 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

43. 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 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

44. 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

45. 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

46. The Folk Theorem Take example 1. The feasible pay-offs describe the following possibilities

47. 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

48. 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

49. 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

50. 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 Similarity in costs

51. 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

52. 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

53. 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

54. 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

55. Meet-the-competition clause

56. Example 2: A Bertrand Game

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