1. EC365 Theory of Monopoly and Regulation Topic 3: Collusion 2013-14, Spring Term Dr Helen Weeds

2. 2 Monopoly power Monopoly outcomes monopoly pricing price discrimination costs, technology

3. 3 Routes to monopoly power Monopoly power Merge ColludeExclude

4. 4 Lecture outline Collusion and reaching agreement Sustainability  Critical discount factor  Facilitating devices Leniency programmes Policy and cases  Cartels  Tacit collusion

5. 5 What is collusion? A type of horizontal agreement  Cooperation over prices, outputs, market shares or territories  Higher profits (at best joint profit = monopoly profit)  Worse for consumers, and social welfare  Typically per se illegal Cartel: explicit agreement (could be verbal) Tacit collusion / coordinated behaviour: understanding reached without explicit agreement (neither written nor verbal)

6. 6 Reaching agreement Communication  “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, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), I:10 Number of firms  Easier to reach agreement if fewer firms Asymmetries, e.g. costs  Efficient for low cost firms produce higher output  May require side payments (illegal)

7. 7 Sustaining collusion: Prisoners dilemma (1) Strategies and payoffs  Both collude: share monopoly profit  Both defect: non-cooperative oligopoly (Bertrand)  One defects: steals entire market demand; other firm makes a small loss Unique Nash equilibrium

8. 8 Infinitely repeated prisoners dilemma Repeat stage game an infinite number of times  Discount factor  < 1 (where  = e  rt ) “Grim-Trigger” strategy (or Nash reversion)  Play collude in period 1  Continue playing collude as long as both players keep on playing collude  Otherwise play defect, permanently Is this strategy an equilibrium?

9. 9 Equilibrium in grim-trigger strategies Assume rival plays grim-trigger Compare payoffs from trigger and defect  Trigger: payoff = 5 (1+  +  2 + … ) = 5 /(1–  )  Defect: payoff = 10 Play trigger iff: 5 /(1–  )  10    ½“critical discount factor” If  is sufficiently high  Collusion is an equilibrium of the infinitely repeated game  Not unique: e.g. {defect, defect} is also an equilibrium

10. Why Infinite Periods? 10

11. 11 Number of firms Cartel payoff (per firm) is  m /n Critical discount factor:  Collusion requires higher  as n increases  i.e., collusion is harder to sustain for higher n

12. 12 What collusive price? Bertrand  Sustainability is independent of   Collusion may occur at any P  (c, P m ]: “folk theorem” Cournot  More complex payoff structure  Nash reversion outcome less harmful to firms

13. 13 Detection (or reaction) lags Suppose defection is not detected for 2 periods Payoffs (duopoly)  Trigger: 5 / (1–  ) as before  Defect: 10 (1+  ) receive monopoly  for 2 periods Critical discount factor:   1/  2  0.71 Collusion is easier when  Prices (or outputs) are observable, and  Output can be increased rapidly

14. 14 Features conducive to collusion Number of firms Barriers to entry Homogeneity  Costs, products  Bertrand outcome very unattractive Transparency & reaction lags  Observable prices, stable/predictable demand  Frequent transactions Capacity constraints (Brock & Scheinkman 1985)  Little incentive to cheat as cannot supply entire market demand  But ability to punish cheating is also weaker Critical  is non-monotonic in capacity

15. 15 Facilitating practices Price leadership: helps solve coordination problem Increase observability of prices  Market transparency: public prices, basing point pricing  Information exchange: e.g. via trade association  “Meet competition” (MC): customers report on rival p’s Commitment devices  MC clause: commitment to match rival’s price cut  “Most favoured nation” (MFN) Entitles customer to lowest price given to any customer Reduces incentive for selective price cuts

16. 16 Leniency programmes Aim: to destabilise a cartel by providing incentives for participants to reveal it Key features  Some probability of detection (without confessions)  Large fines for cartelisation  First to reveal cartel receives immunity from fines Changes prisoner’s dilemma

17. 17 Leniency programmes: Prisoners dilemma (2) Payoffs   = cartel profit (per firm, cumulative)   = probability of detection  F = size of fine Condition for unique Nash equilibrium?

18. 18 Example (e.g.  = 3,  = 1/3, F = 9 Enforcement  Detection powers, e.g. “dawn raids”: affect   Fines: related to turnover & duration  Third party damages

19. The Hollywood Treatment 19 (Source: Amazon) The serious story: “Global Price Fixing”, John M. Connor (2007)

20. 20 Policy towards cartels USA  Sherman Act 1890 prohibits “trusts” and monopolisation EU (Art. 101), UK (Competition Act 1998, Chapter I)  Prohibits agreements “which have as their object or effect the prevention, restriction or distortion of competition”  Bans price fixing, limiting production, or sharing markets UK Enterprise Act 2002  Makes cartelisation a criminal offence  Possible imprisonment (already possible in USA)  Claims for third party damages

21. 21 Prosecuting cartels 2 main issues Evidence of cartelisation  Could be written: cartel agreements  Oral testimony in court  Rewards for “whistleblowers” Quantifying penalties and damages  Penalties related to turnover during period of cartelisation  Third party damages how much did consumers overpay? will consumers claim? Class actions

22. 22 Vitamin cartel (US 1999, EU 2001) Secret price-fixing cartel, Jan 1990–Feb 1999  Fixed prices of vitamins used in foods (bread, milk, cereal)  $5bn-worth of transactions affected  Destabilised by entry into market Cases brought in USA (1999) and EU (2001)  Hoffman-La Roche (leader of cartel) Fined $500m (USA) and €462m (EU): largest corporate fine to date Marketing director pleaded guilty: $100,000 fine + 4 months in jail  BASF: fined $225m (USA) and €296m (EU)  Rhône-Poulenc (now Aventis): escaped fine in USA, in exchange for supplying evidence; fined €5m in EU

23. 23 Replica football kit price-fixing (OFT 2003) 10 firms fixed prices of Umbro replica football shirts  Manufacturer: Umbro  Football clubs / league: Manchester United, the FA  Retailers: JJB Sports, Allsports, Blacks, Sports Soccer, JD Sports, Sports Connection and Sportsetail A number of agreements to fix prices in 2000 and 2001 Fined a total of £18.6m by OFT in August 2003  Some reduced, and one increased, on appeal to CAT  Which? launched “representative claim” against JJB Sports on behalf of customers

24. 24 Policy towards tacit collusion More difficult to identify and prosecute Industry conduct  “Conscious parallelism” But other possible reasons why firms may change prices at the same time; e.g. common cost shock  Estimate firms’ reactions to one another’s price changes High responsiveness  collusion (punishment strategy)  Price leadership Industry performance  Prices: compare with costs  Profits: compare with cost of capital

25. 25 Burden of proof: Woodpulp (EC 1985) Industry conduct & performance  Price parallelism (1975–1981)  Highly visible price pre-announcements  Rising prices, unrelated to costs, despite rising stocks  Cost differences not reflected in prices European Commission ruled concerted behaviour Overturned by ECJ in 1993, citing other explanations  “parallel conduct cannot be regarded as furnishing proof of concertation unless concertation constitutes the only plausible explanation”

26. 26 UK Enterprise Act 2002 Market investigations may be conducted  Where feature(s) of the market or conduct of suppliers prevent, restrict or distort competition  Not a cartel (otherwise tackle under CA98) Remedies  Behavioural: change industry practices to eliminate obstacles to competition (e.g. switching barriers); price controls  Structural: break up industry Recent Investigations  Cement/Aggregates, BAA Airports, Private healthcare, Private motor insurance, Statutory audit services

27. 27 Tacit collusion: White Salt (UK 1986) UK tacit collusion case  Investigation by Monopolies and Mergers Commission (now Competition Commission)  Under Fair Trading Act 1973 (now replaced by Enterprise Act 2002) Two major producers of salt in the UK  British Salt: 45% of market, lower cost producer  ICI: 50% of market Lack of competition between the two What was the evidence?

28. 28 Features of the salt industry Homogenous product Declining market: 30% fall in production 1979-86 Barriers to entry  Large economies of scale: small scale entry suffers significant cost disadvantage  Large excess capacities: BS 75% utilisation, ICI 65% utilisation (1980-84 figures)  Use of long-term contracts foreclose much of market  Legal barriers to entry Cheshire County Council (where the best salt deposits are) unlikely to grant new development licenses due to environmental concerns Imports limited: transport costs high relative to value

29. 29 Conduct and performance Parallel pricing and price leadership  Price changes always matched over previous 10 years  In the previous 5 years ICI had led on all price changes Pre-notification of price changes (by letter)  Parties claimed this was necessary as they traded a small amount of salt with one another! High prices and profits  Prices had risen faster than in other industries  High rates of return on capital ICI: 50%; British Salt: 30% (though falling) NB: 10-15% return might be considered reasonable

30. 30 MMC’s analysis Several features that tend to support tacit collusion  Highly concentrated market (duopoly), high entry barriers  Information sharing  Capacity available for retaliation strategy Some evidence it might be occurring  Parallel pricing and price leadership  Rising prices despite falling demand  Excessive returns on capital Finding: “against the public interest”  BS (lower cost) failing to exert competitive pressure  Imposed price control linked to BS’s costs

31. 31 Rees (EJ 1993): analysis of White Salt Examined the data to test for tacit collusion Concluded that  given firms’ capacities, the threat of punishment was credible and would sustain collusion  though the result was not joint profit-maximising as this would require BS (with lower costs) to produce at full capacity and make side payments to ICI [Also see MMC report at: http://www.competition- commission.org.uk/rep_pub/reports/1986/200white_salt.htm]

32. 32 Merger and collusion Merger in oligopoly market (e.g. 4  3 firms)  Suppose merged firm does not have market power to raise price on its own  But smaller number of firms may sustain tacit collusion i.e. will merger create “collective dominance”? Merger authorities look at  Industry conditions, especially ability to punish cheating Observability, reaction times, capacities, etc.  Calculate change in critical discount factor  Is post-merger critical  significantly lower?

33. 33 Airtours (EC 1999, ECJ 2002) Proposed merger of Airtours and First Choice  Post-merger shares (of market for foreign package holidays) Airtours/First Choice 32%: not single-firm dominance Thomson 27% Thomas Cook 20% (+ competitive fringe) European Commission blocked merger, alleging “collective dominance”  But features of market not conducive to collusion Highly differentiated products Capacity fixed 18 months ahead and not transparent Volatile demand; unstable market shares Low barriers to entry & expansion  Confusion over concept of collective dominance Could this include unilateral effects (e.g. Cournot oligopoly)? Overturned on appeal; caused 2004 revision of EU merger test