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TOPIC 9:CARTELS AND COORDINATED EFFECTS Topic 9| Part 129 August 2013 Date ANTITRUST ECONOMICS 2013 David S. Evans University of Chicago, Global Economics.

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Presentation on theme: "TOPIC 9:CARTELS AND COORDINATED EFFECTS Topic 9| Part 129 August 2013 Date ANTITRUST ECONOMICS 2013 David S. Evans University of Chicago, Global Economics."— Presentation transcript:

1 TOPIC 9:CARTELS AND COORDINATED EFFECTS Topic 9| Part 129 August 2013 Date ANTITRUST ECONOMICS 2013 David S. Evans University of Chicago, Global Economics Group Elisa Mariscal CIDE, Global Economics Group

2 2 Overview 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 Detecting, discouraging and punishing cartels Screening techniques Economics of leniency programs Tacit collusion and cartels

3 3 The Economics of Price Fixing “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 (1723-1790) The Wealth of Nations, Book I, Chapter X (1776)

4 4 The Economics of Price Fixing Illegal by virtue of the behavior regardless of its intent or effect, the “inherent nature” of the practice is injuriously restraining trade. There is no allowable defense (though some industries are exempted) Focus in on the existence of an agreement (see Kaplow, Competition Policy and Price Fixing for critique). Price fixing is per se illegal in the U.S., E.U. and many other jurisdictions. There is an extremely high likelihood that the practice can have only an anti-competitive effect. It is very difficult and costly to investigate claims of pro-competitive vs. anti-competitive effects, making a per se approach economical The practice can be defined specifically enough so that companies can identify what they are, and are not, allowed to do Per se prohibitions should be reserved for practices for which:

5 5 The Six Palaces Price Fixing Scandal Six exclusive Paris hotels were found guilty of price fixing: the Hotel de Crillon, the Four Seasons Hotel George V, the Hotel Ritz, the Hotel Plaza Athenee, the Hotel Meurice, and Hotel Le Bristol. They were fined a total of 709,000 Euros by the French Competition Authority. There were regular exchanges between the hotels about the average room price, and room occupancy data. “It is true that these practices exist and in very many fields. If they are not legal, they are very common.” Françoise Parguel, communications director for the Crillon. A graph of average room price shows there was very little variations between the prices charged by the colluding hotels during 2000 to 2001. (Is this convincing economic evidence?)

6 6 Some Other Cartel Price Paths Citric Acid Railroads Lysine

7 7 Cartel Duration Harrington, CRESSE Lectures, 2011

8 8 Cartel Harm Connor (2001), Levenstein y Suslow (2001), OECD, and World Integrated Trade Solution database. SITC: Standard International Trade Code.

9 9 Fact About Cartels Data Biased sample because we only observe discovered cartels. Cartel duration has been underestimated. Welfare losses have been underestimated. Suppose only the less effective cartels are caught. Cartel duration has been overestimated. Welfare losses have been overestimated Suppose only the more effective cartels are caught because the less effective ones collapse before being discovered. Policy challenge: How can we measure the efficacy of cartel enforcement policies, when we cannot measure the number of cartels in an economy? Harrington, CRESSE Lectures, 2011

10 Agreements on Price and Agreements on Output Replicating the Monopoly Outcome with a Cartel 10

11 11 Price Agreements Suppose there are 20 competing firms. With competition they each a charge competitive price of $5 dollars, sell 100,000 units (total 2 million) and just earn a competitive return. If they each agree to charge $20, they sell 50,000 each on average (total 1 million) and make $750,000 of monopoly profit each (total $15 million). [How does output get allocated?] MR P M = $20 P C = $5 2,000,0001,000,000 D Q P MC Monopoly Perfect competition Number of identical firms = 20 Profit margin of $15 a unit and total profit of $15 million.

12 12 Output Agreements Divided up by geographic regions so that each sold 50,000 units Divided up by customers so that each had customers to whom they could sell 50,000 units Competing firms in the example could achieve monopoly price if they each agreed to offer only 50,000 units to the market: We have assumed firms are all the same size and have the same bargaining power. They could also divide things so that some got a larger share of profits by getting a larger region or more customers. Which is better: price agreement or output agreement?

13 13 Cartels with Two-Sided Platforms If competing newspapers could fix subscription and advertising prices they could exactly replicate the monopoly outcome Note that this issue is different than “customers” on one side colluding Replicating monopoly outcome requires fixing prices (or allocating output) on both sides If competing shopping malls fixed rental prices but shoppers continued to get in for free they could replicate the monopoly outcome If one side is constrained to zero then fixing price on the other side replicates monopoly outcome Monopoly profits get competed away if competition is intense on other side Increased profits but suboptimal if imperfect competition on other side If a cartel can’t fix price on one side then: Fixed priced to buyers, not clear to sellers

14 14 So You Want to Start a Cartel … You and your accomplices need to reach an agreement on what to do and how to divide up the loot. You need to figure out how to make sure everyone abides by the agreement and detect those who don’t. You need to figure out how to deter cheating including punishing those who engage in it. You need to figure out how to prevent the competition authorities and your victims from uncovering you.

15 The Incentives to Cheat 15

16 16 Importance of Cheating for Antitrust Ability to detect and prevent cheating is key to having a cartel. Cartels are more likely when detection and prevention are possible. Detection and punishment methods leave traces of evidence that authorities can look for. Certain seemingly legal practices may “facilitate” detection and prevention of cheating and therefore authorities may want to prohibit or monitor these. First look at role of cheating, then detection/punishment methods, and conclude by looking at “facilitating practices”.

17 17 Incentives to Cheat on a Cartel Agreement Could an individual firm do better than with the cartel? The answer is always “yes” when it is certain that the other firms stick with their cartel agreement (this case is unrealistic of course). The answer may be “yes” whenever the gains from cheating exceed the losses from either punishment or from de-stabilizing the cartel (considered in our next example). The “cheater” just needs to make enough extra profit long enough in order to outweigh the losses of the cartel breaking down or possible “retribution”. Effective cartels must be able to detect and punish cheating.

18 18 Incentives to Cheat on Price Agreement Suppose firms 2 …. 20 charge the cartel (monopoly) price of $20. Suppose firm 1 drops its price to $19.95. Firm 1 gets monopoly profits of almost $15 million (up from 750,000) Firms 2 … 20 get nothi ng Then all customers will buy from firm 1 (in a frictionless world). To avoid detection it could drop price but increase sales just enough not to be detected. A successful cheater can’t be too greedy. If many firms cheat competition reemerges.

19 19 Incentives to Cheat on Output Agreement Each firm has the incentive to expand output to where MR = MC (the profit- maximizing level given the fixed price). If only one firm does so, it can get away undetected if the increase is a small fraction of total output. If many firms follow this strategy, output expansion will force price down and destabilize the cartel. Lysine cartel: one company Claimed it reported “misleading” sales info to the other companies and other company hid 3500 tons of Lysine from the cartel’s auditors. Harrington, CRESSE Lectures, 2011

20 20 Incentives to Cheat Brazen cheating won’t work for long because the other firms will be better off returning to competition and at least getting their competitive return. The additional monopoly profit from cheating now outweighs the future stream of monopoly profits lost as a result of precipitating the collapse of the cartel Is it worthwhile in the example above? But could cheating still be profitable? It will be if: Firms could profit by engaging in “a little cheating” but not enough for others to figure it out. They could look for the optimal amount of cheating that balances risk and rewards. Cheating is an example of a game where each player must consider its cheating strategy given its expectations about the cheating strategies engaged in by others.

21 21 Cheating Makes It Hard for Cartels to Achieve Monopoly Price Every firm has the incentive to cheat a lot or a little. Each firm has even more of an incentive to cheat, knowing that the others have an incentive to cheat. Even if every firm just cheats a little, in the aggregate this will lower price towards the competitive level. Note: this is important for calculation of cartel damages. Just because firms aspire to price at the monopoly level they may not succeed in doing so.

22 Methods for Detecting and Punishing Cheaters 22

23 23 Detecting and Punishing Cheaters Detect cheating Punish cheating To reduce cheating the cartel must be able to: Economic factors behind detection and punishment are key to understand viability of cartel agreements and ways for enforces to help destabilize.

24 24 Detecting Cheating Given incentives to cheat cartels and their participants must be able to detect firms that are deviating from the agreement. Goods are homogeneous Pricing is transparent Customer relationships are well known Some market situations make it easier to detect cheating: Cartel and its members can also devise special arrangements to make it easier to detect cheating

25 25 Output Allocation and Cheating Exclusive territories: if a firm has exclusive rights to a region, the appearance of a competitor alerts firm to cheating. Exclusive customers: if a firm has exclusive rights to a customer then the defection of that customer alerts firm to cheating. Exclusive contract wins: with bidding rigging, one firm is designated to be the winner of each contract; deviation is detected instantly. But some of these methods can also raise suspicions and increase likelihood of detection. Some cartels therefore incorporate some flexibility.

26 26 Price Setting and Cheating Shared resource with posted prices (airlines computer reservation systems; multiple listing services for real estate)—transparency in price information. Meeting competition clauses in contracts—customers therefore have to reveal the existence of lower bids. Common public distribution channel—so all competitors see all prices; minimum resale price maintenance may be a facilitating practice. Other information exchanges and auditing mechanisms.

27 27 Detecting Cheating: Meeting Competition Clauses Meeting Competition Clause requires a buyer to allow a seller to keep business by meeting a competitor’s offer. It detects cheating by alerting the seller that its customer is getting a better offer from a competitor. It halts cheating by preventing the other seller from making a sale.

28 28 Punishing Cheating: Brute Force Death, dismemberment, torture. Burning down factories. Organized crime syndicates behind bid rigging and collusion in many industries dominated by smaller firms (e.g. highway construction).

29 29 Punishing Cheating: Gentle or Not So Gentle Retribution Target cheater’s customers with low prices. Predation strategy to drive cheater out of business (see Basil Yamey’s “Predatory Price Cutting” reprinted in CPI Autumn 2005).

30 30 Punishing Cheating: Price Wars If rivals deviate from agreed on price this period then lower price to competitive level next period. This strategy leads to price wars where periods of high prices are followed by price wars. To end price wars firms move back to collusive equilibrium.

31 31 Entry and Cartels High industry prices and profits attract entry. What does the cartel do about this? Entrant faces the same issue as the cheater; Needs to weigh profit from undercutting the cartel against its future profits from joining it. Bring entrant into the business… the cartel Legal restrictions: licenses, regulation. Refusal to supply joint facility. Predatory and other exclusionary strategies. Prevent entry by raising barriers or “gently” nudging…

32 Factors That Make Collusion Easier to Sustain 32

33 33 Factors that Facilitate a Cartel Facilitating factors include anything that increases the gains from operating a cartel, helps detect cheating on a cartel, and enables punishment of cheaters. Structural features of the market (number of firms, entry conditions, etc.) Institutional features (information exchanges, joint facilities, etc.) Contractual relationships and methods of transacting between buyers and sellers. Facilitating factors include:

34 34 Facilitating Factors—Structural Features Smaller number of similar firms lowers gains from cheating (why?) and makes coordination easier (but maybe tacit collusion is easier). More symmetric firms make gains and losses from cheating more equal; with asymmetric firms largest firms may gain from cheating while smaller firms can’t detect. Entry barriers: easier entry disrupts collusion and makes gains harder since they must be shared with entrants; paying off entrants attracts more entrants. More homogenous products usually make coordination easier and also easier to detect cheating. Greater linkages e.g. overlapping boards, family members, trade associations, and other meeting places makes it easier to coordinate, increases trust, and makes punishment easier. Many disconnected buyers: a small number of buyers can use buyer power to break cartel and, if buyers can compare notes, more likely to detect cartel. More stable demand makes coordination easier and makes it easier to detect cheating while growing demand increases cost of killing cartel (discounted future gains exceed current gains).

35 35 Facilitating Factors—Institutional Features Information exchanges —formal mechanisms for collecting and exchanging price and sales information that can be used to coordinate pricing and detect cheating; that’s what the six palaces had (how about cost information?) Trade associations and meetings —activities that promote contact, provide opportunities for exchanging information, and form social bonds that increase trust and raise the cost of cheating. Access to joint facilities —Businesses that cooperate in creating a joint facility can use the facility to monitor output, discipline cheaters by denying them access, and preventing entry. E.g., airline reservation systems.

36 36 Facilitating Factors—Contractual Practices Most favored customer clauses require the seller not to charge a favored customer less than the lowest it charges any other customer (might be applied contemporaneously or retroactively leading to rebates). Makes it more expensive to cheat (but if competitors don’t know, how would the customer?) and more expensive to retaliate (same point). Meeting-competition clauses gives the seller the opportunity to match a lower price offered by the competition. It leads to exchange of information (and therefore detection of cheating) and makes cheating less profitable (since existing seller may match). Resale price maintenance requires distributors to charge a given price. This makes it easier to observe deviations from prices. Question: should these contractual practices be prohibited? What do you need to know to help answer this?

37 37 End Part 1, Next Class Part 2 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 Detecting, discouraging and punishing cartels Screening techniques Economics of leniency Tacit collusion and cartels vs. cooperation

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