Lecture 10 Tacit Collusion and Cartels

Lecture Plan Tacit Collusion Cartels Incentives to Collude Facilitating Practices Price Matching

Collusion and Cartels Collusion Cartel An attempt to suppress competition A group of firms who have agreed explicitly to coordinate their activities to raise market price or decrease market output. Cartel members agree to coordinate their actions Prices Market shares Exclusive territories Prevent excessive competition between the cartel members Cartel

Why doesn't everyone collude? Illegal. In the US, collusive agreements cannot be enforced by legal contracts International cartels do exist, however. Hard to come to an agreement. Strong incentives to cheat -- collusion may not be sustainable.

Types of Collusion Tacit Coordination/Facilitating Practices. Explicit Conspiracy.

1. Tacit Coordination Spontaneous cooperation resulting from strongly perceived interdependence. For example, following a rival’s price change. Difficult to achieve with lots of firms. Hard to find/prove/correct. Facilitating practices: Price matching Most Favored consumer clause

2. Explicit Conspiracy Price fixing agreement. Formal cartel. Per se illegal.

What are the Incentives to Collude? Start with a simple model of a Bertrand Duopoly Without collusion, p1*= p2*= MC=c and thus i = 0 Industry quantity is set at the perfectly competitive level For a monopolist, price is set where MR = MC: P = a-bQ so MR = a -2bQ Set c = a-2bQ and solve for monopoly quantity and price QM = (a-c)/2b and PM = (a+c)/2 So M = (PM - c)*QM = (a+c - 2c)/2 * (a-c)/2b = (a-c)2/4b If each firm produces 1/2 QM, each gets (a-c)2/8b

Collusion in the Prisoner’s Dilemma Framework Firm 2 Collude Defect Collude (a-c)2/8b, (a-c)2/8b Firm 1 Defect 0, 0 But what about the two empty cells?

To fill in the two empty cells: If one firm sets price at the monopoly level, what price will the cheater set? pi* = pM-  Then the cheater gets all the demand and earns a profit only slightly less than what a monopolist would get: C = (PM--c)*(QM +)  ((a+c)/2 -c)*(a-c)/2b = (a-c)2/4b Profit of non-cheater is 0

Collusion in the Prisoner’s Dilemma Framework Firm 2 Collude Defect Collude (a-c)2/8b, (a-c)2/8b 0, (a-c)2/4b Firm 1 Defect (a-c)2/4b, 0 0, 0

Factors that Affect the Success of Collusion Low cost of an agreement Small number of firms in the market Lowers search, negotiation and monitoring costs Similar production costs Avoids problems of side payments Detailed negotiation Misrepresentation of true costs Lack of significant product differentiation Again simplifies negotiation – don’t need to agree prices, quotas for every part of the product spectrum

Collusion and cartels Cartels have always been with us; generally hidden Electrical conspiracy of the 1950s Garbage disposal in New York Archer, Daniels, Midland The vitamin conspiracy But some are explicit and difficult to prevent OPEC De Beers

Whistleblowers and Recent events Whistleblower clause - leniency policy aimed at encouraging people involved in collusion to report it, by promising the first member to blow the whistle that they will not face fines or prosecution. European Truck makers price fixing: MAN and Scania, both owned by German auto giant Volkswagen as well as Daimler, DAF of the Netherlands, Iveco of Italy and Sweden's Volvo are accused of forming an illegal cartel between 1999 and 2011 MAN will escape the prosecution because it reported the price-fixing cartel Likely to be one of the largest EU price fixing fines ($4 bn) Unilever and Procter & Gamble (2011) Fined 315 m euros for fixing washing powder prices Tip-off by Henkel (German company) – whistleblower

Fines in EU

Cartel violations in the 90s F. Hoffman-LaRoche Ltd. Vitamins 1999 $500 International BASF AG (1999) $225 SGL Carbon AG Graphite Electrodes $135 UCAR International Inc. 1998 $110 Archer Daniels Midland co. Lysine and Citric Acid 1997 $100 Haarman & Reimer Corp. Citric Acid $50 HeereMac v.o.f. Marine Construction $49 Hoechst AG Sorbates $36 Showa Denko Carbon Inc. $32.5 Fujisawa Pharmaceuticals Co. Sodium Gluconate $20 Dockwise N.V. Marine Transportation $15 Dyno Nobel Explosives 1996 Domestic $14 Eastman Chemical Co. $11 Jungblunzlauer International Lonza AG $10.5 Akzo Nobel Chemicals BV & Glucona BV $10 http://online.wsj.com/article/SB10001424052748704402404574529241844394428.html?mod

Ten highest cartel fines per case

INFORMANT http://www.youtube.com/watch?v=DPXTsPS-hyw

INFORMANT https://www.youtube.com/watch?v=3SooBX1-kIQ

Price Matching Guarantees Helps a firm to protect its consumers and charge a high price. It makes your competitor “soft.” Takes away the benefit for your competitor to undercut your price.

Counter-Intuitive? Price matching guarantee is simply a mechanism for tacit collusion or competition reduction between firms. Any offer of the price matching guarantee means effectively taking away any gains that its competitor might get from cutting price. If a firm offers a price matching guarantee, then a search consumer will buy from it because the consumer knows that in the event that there is a lower price offered in the market the consumer is insured that it will match that price. Since price matching takes away the gain from price cutting, no firm cuts price and price competition is reduced.

Example Firm 2 Low High Firm 1 , Two firms: Firm 1 and Firm 2 Two prices: low ($4) or high ($5 ) 3000 captive consumers per firm 4000 floating go to firm with lowest price Payoffs = revenue Firm 2 Low High Firm 1 ,

Example Firm 2 Low High Firm 1 20,20 28,15 15,28 25,25 Two firms: Firm 1 and Firm 2 Two prices: low ($4) or high ($5 ) 3000 captive consumers per firm 4000 floating go to firm with lowest price Payoffs in thousands of $ (revenue) Both low = 5000*4 = $20K Both high = 5000*5 = $25K One high = 3000*5=$15K Another low = 7000*4=$28K Firm 2 Low High Firm 1 20,20 28,15 15,28 25,25

Contracting with Customers The game is a prisoner’s dilemma Both firms prefer: {High, High} Only equilibrium: {Low , Low} Cannot credibly promise to play High Even if committed to High, other firm would still respond with Low How to resolve this? Third party contracts with customers

Price Matching If one firm charges low, it does not gain any additional customers, since the competitor “automatically” matches it. What is the effect on the game?

Price Matching Firm 2 Low High Firm 1 20 , 20 28 , 15 15 , 28 25 , 25

Counter-Intuitive? Price matching guarantee is simply a mechanism for tacit collusion or competition reduction between firms. Any offer of the price matching guarantee means effectively taking away any gains that its competitor might get from cutting price. If a firm offers a price matching guarantee, then a search consumer will buy from it because the consumer knows that in the event that there is a lower price offered in the market the consumer is insured that it will match that price. Since price matching takes away the gain from price cutting, no firm cuts price and price competition is reduced.

Example Firm 2 Low High Firm 1 , Two firms: Firm 1 and Firm 2 Two prices: low ($4) or high ($5 ) 3000 captive consumers per firm 4000 floating go to firm with lowest price Payoffs = revenue Firm 2 Low High Firm 1 ,

Example Firm 2 Low High Firm 1 20,20 28,15 15,28 25,25 Two firms: Firm 1 and Firm 2 Two prices: low ($4) or high ($5 ) 3000 captive consumers per firm 4000 floating go to firm with lowest price Payoffs in thousands of $ (revenue) Both low = 5000*4 = $20K Both high = 5000*5 = $25K One high = 3000*5=$15K Another low = 7000*4=$28K Firm 2 Low High Firm 1 20,20 28,15 15,28 25,25

Contracting with Customers The game is a prisoner’s dilemma Both firms prefer: {High, High} Only equilibrium: {Low , Low} Cannot credibly promise to play High Even if committed to High, other firm would still respond with Low How to resolve this? Third party contracts with customers – e.g. price matching guarantee

Price Matching If one firm charges low, it does not gain any additional customers, since the competitor “automatically” matches it. What is the effect on the game?

Price Matching Firm 2 Low High Firm 1 20 , 20 28 , 15 15 , 28 25 , 25

Price Matching Literature focusing on price-matching guarantee typically finds that it supports higher equilibrium prices and profits. Intuition: This is because when all firms are committed to match the lowest price, no firm has incentive to undercut others In practice, if you read fine print, there are quite a few restrictions: price-matching generally applies to products that are homogeneous across stores Firms often match lower prices of only some competitors, typically their close competitors.