Econ 545, Spring 2016 Industrial Organization Anticompetitive actions: Cartels and collusion

Collusion and cartels Goals We consider what circumstances and events allow cartels to remain together. We consider what policy actions are possible to prevent cartels from forming or break them apart if they do form. We will consider how cartels stay together when their illegality prevents explicit contracts. Broader importance Cartels hurt consumers with artificially high prices. US and EU antitrust authorities actively pursue and prosecute collusive behavior. 2Econ 445: Anticompetitive actions

Collusion and cartels What is a cartel? Cooperation among firms to increase their profit relative to non- cooperative equilibrium. How is this implemented? Agreements to set: -Prices -Market shares or quantities -Exclusive territories to serve These agreements sacrifice welfare to increase profits. Prices and DWL increase 3Econ 445: Anticompetitive actions

Collusion and cartels Cartels are illegal in U.S. but still occur. Examples: Garbage disposal in New York prosecuted in mid-1990s Bid-ask margins on NASDAQ in 1980s and early 1990s ADM in lysine (animal feed additive) in mid-1990s Samsung in DRAM (computer memory) in early 2000s Cartels can operate in the open abroad: OPEC for oil De Beers for diamonds US and EU governments search for and prosecute cartels. Total values of fines have grown, with many billion dollars in fines assessed in last 10 years. 4Econ 445: Anticompetitive actions

Collusion and cartels Implications of illegality: Because collusion is illegal, groups of firms cannot write contracts to enforce pricing arrangements. There are incentives to cheat on cartel agreements. -Charge a low price when all others are charging high. To last, cartels members must believe it is in their own self interest to continue collusive behavior. Two types of collusive arrangement: Tacit: Unspoken agreement for coordinated action. Explicit: With communication among firms in cartel. Perhaps more precise, but generates evidence. 5Econ 445: Anticompetitive actions

Gains from collusion, example 6Econ 445: Anticompetitive actions

Gains from collusion, example 7Econ 445: Anticompetitive actions

Gains from collusion, example In a payoff matrix, the payoffs from playing the cooperative or non- cooperative strategies are: Firm B Cooperate Don’t Cooperate Cooperate Firm A Don’t Cooperate The simultaneous-move equilibrium is that each firm chooses the non-cooperative action. Very similar to the Prisoner’s Dilemma 8Econ 445: Anticompetitive Actions 1800, , , , 1600

Repeated interaction The one-shot game avoids the cartel outcome. Self-interested firms cannot resist the non-cooperative profit. Cartels of (own-)profit maximizing firms do happen. How? Firms compete over time in a repeated game. This allows a change to reward cooperation and punish defection. We saw a repeated game in the chain-store paradox example, which did not allow a long-term strategy different from one-shot equilibrium. Will this be different? 9Econ 445: Anticompetitive actions

Finite interaction Suppose firms A and B compete with each other for a known and finite number of time periods (T). The number of periods could be determined by: -A production license held by A and B that expires. -Management teams with finite contracts or careers. We will ask whether the following reward/punishment strategy is possible in equilibrium: -I will begin the game by cooperating. -If you cooperate too, I will cooperate again next period. -If you fail to cooperate, I will not cooperate next period and (possibly) never cooperate again. 10Econ 445: Anticompetitive actions

Finite interaction with T=2 Assume that game lasts for two periods with each period’s actions and payoffs in the previous payoff matrix. Firm B Cooperate Don’t Cooperate Cooperate Firm A Don’t Cooperate In period 2 both firms should expect non-cooperative behavior. There is no opportunity to punish afterwards. In period 1, the threat of future punishment is empty because A and B anticipate what will happen next. 11Econ 445: Anticompetitive Actions 1800, , , , 1600

Finite and infinite interaction If T=2, the firms take non-cooperative actions in both periods. What happens if the game is repeated three times (T=3)? In general, when T is finite and known, backward induction implies that cooperation is not a subgame perfect equilibrium. What if the firms do not know when the game will end? -Can think of this as a repeated game of infinite length. -Could be because there is always a chance for “tomorrow”. When there is a great enough chance for later choices: -“Good” behavior has an opportunity to be rewarded. -“Bad” behavior has an opportunity to be punished. 12Econ 445: Anticompetitive actions

Valuing indefinite profit streams 13Econ 445: Anticompetitive actions

Trigger strategies In a trigger strategy, my current choice is triggered or determined by my competitors’ previous choices. We will work with the “grim trigger” strategy: -Cooperate now if no other firm has defected in a previous period. Note this covers first period. -Defect forever (play non-cooperative strategy) if any other firm has ever defected in the past. Similar but less harsh: Tit for tat. -Cooperate in first period. -In all subsequent periods, do whatever competitor did in previous period. 14Econ 445: Anticompetitive actions

Cartel stability 15Econ 445: Anticompetitive actions

Cartel stability 16Econ 445: Anticompetitive actions

Cartel stability 17Econ 445: Anticompetitive actions Benefit from cheating Benefits from cheating and stability

Cartel stability: twists 18Econ 445: Anticompetitive actions

Cartel stability: twists 19Econ 445: Anticompetitive actions

Cartel stability: twists What can affect cartel stability? Differences between firms Any successful agreement must make the cartel’s hardest-to-please member happy to participate. Product and cost differences lead to challenges or complexity in … -How to set prices or market shares to generate total and individual profit. -How to monitor many distinct prices or shares across cartel members. -Deciding who is hurt by cheating and who should punish 20Econ 445: Anticompetitive actions

Cartel possibilities 21Econ 445: Anticompetitive actions

Cartel possibilities 22Econ 445: Anticompetitive actions

Public Policy In the US, the DOJ’s and FTC’s responsibilities include policing markets for signs of cartel activity. Why is this hard? Firms act to minimize evidence. Tacit collusion has no paper trail at all. Firms will not admit that prices are high due to collusion – many alternative explanations can be offered. Investigations are not always successful. Policy instruments: Enforcement effort: Let s be the change of getting caught. Penalty size: Let $F be the penalty from getting caught. 23Econ 445: Anticompetitive actions

Public Policy 24Econ 445: Anticompetitive actions

Public Policy 25Econ 445: Anticompetitive actions

Public Policy: amnesty 26Econ 445: Anticompetitive actions

Conclusions What we covered: The challenges of cooperation when doing so is illegal Discounting future payoffs from infinite interaction Firm’s decisions to remain in a cartel vs. break apart. Market factors that make cartels easier or harder to maintain. Public policy can make cartels harder to create and sustain What is coming next: Legal cooperation between firms. Vertical relations between firms. 27Econ 445: Anticompetitive actions