10 Oligopoly
10.1 Theory of the Oligopoly
Why do Oligopolies Exist?
Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. We typically characterize oligopolies by mutual interdependence where various decisions such as output, price, and advertising depend on other firm(s)’ decisions. Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.
A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly.
Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market.
Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms (and they need not produce differentiated products). Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly (also called a duopoly) for large passenger aircraft.
The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.
The existence of oligopolies can lead to the combination of many firms into larger firms. This is discussed next.
Types of Firm Integration
Conglomerate
From: Wikipedia: Conglomerate (company)
A conglomerate is a combination of multiple business entities operating in entirely different industries under one corporate group, usually involving a parent company and many subsidiaries. Often, a conglomerate is a multi-industry company. Conglomerates are often large and multinational.
Horizontal Integration
From: Wikipedia: Horizontal integration
Horizontal integration is the process of a company increasing production of goods or services at the same part of the supply chain. A company may do this via internal expansion, acquisition or merger.[1][2][3]
The process can lead to monopoly if a company captures the vast majority of the market for that product or service.[3]
Horizontal integration contrasts with vertical integration, where companies integrate multiple stages of production of a small number of production units.
Benefits of horizontal integration to both the firm and society may include economies of scale and economies of scope. For the firm, horizontal integration may provide a strengthened presence in the reference market. It may also allow the horizontally integrated firm to engage in monopoly pricing, which is disadvantageous to society as a whole and which may cause regulators to ban or constrain horizontal integration.[5]
An example of horizontal integration in the food industry was the Heinz and Kraft Foods merger. On March 25, 2015, Heinz and Kraft merged into one company, the deal valued at $46 Billion.[8][9] Both produce processed food for the consumer market.
On November 16, 2015, Marriott International announced that it would purchase Starwood Hotels for $13.6 billion, creating the world’s largest hotel chain once the deal closed.[11] The merger was finalized on September 23, 2016.[12]
AB-Inbev acquisition of SAB Miller for $107 Billion which completed in 2016, is one of the biggest deals of all time.[13]
Vertical Integration
From: Wikipedia: Vertical integration
In microeconomics and management, vertical integration is an arrangement in which the supply chain of a company is owned by that company. Usually each member of the supply chain produces a different product or (market-specific) service, and the products combine to satisfy a common need. It is contrasted with horizontal integration, wherein a company produces several items which are related to one another. Vertical integration has also described management styles that bring large portions of the supply chain not only under a common ownership, but also into one corporation (as in the 1920s when the Ford River Rouge Complex began making much of its own steel rather than buying it from suppliers).
Vertical integration and expansion is desired because it secures the supplies needed by the firm to produce its product and the market needed to sell the product. Vertical integration and expansion can become undesirable when its actions become anti-competitive and impede free competition in an open marketplace. Vertical integration is one method of avoiding the hold-up problem. A monopoly produced through vertical integration is called a vertical monopoly.
Vertical integration is often closely associated to vertical expansion which, in economics, is the growth of a business enterprise through the acquisition of companies that produce the intermediate goods needed by the business or help market and distribute its product. Such expansion is desired because it secures the supplies needed by the firm to produce its product and the market needed to sell the product. Such expansion can become undesirable when its actions become anti-competitive and impede free competition in an open marketplace.
The result is a more efficient business with lower costs and more profits. On the undesirable side, when vertical expansion leads toward monopolistic control of a product or service then regulative action may be required to rectify anti-competitive behavior. Related to vertical expansion is lateral expansion, which is the growth of a business enterprise through the acquisition of similar firms, in the hope of achieving economies of scale.
Vertical expansion is also known as a vertical acquisition. Vertical expansion or acquisitions can also be used to increase scales and to gain market power. The acquisition of DirecTV by News Corporation is an example of forward vertical expansion or acquisition. DirecTV is a satellite TV company through which News Corporation can distribute more of its media content: news, movies and television shows. The acquisition of NBC by Comcast is an example of backward vertical integration. For example, in the United States, protecting the public from communications monopolies that can be built in this way is one of the missions of the Federal Communications Commission.
One of the earliest, largest and most famous examples of vertical integration was the Carnegie Steel company. The company controlled not only the mills where the steel was made, but also the mines where the iron ore was extracted, the coal mines that supplied the coal, the ships that transported the iron ore and the railroads that transported the coal to the factory, the coke ovens where the coal was cooked, etc. The company focused heavily on developing talent internally from the bottom up, rather than importing it from other companies. Later, Carnegie established an institute of higher learning to teach the steel processes to the next generation.
Oil companies, both multinational (such as ExxonMobil, Royal Dutch Shell, ConocoPhillips or BP) and national (e.g., Petronas) often adopt a vertically integrated structure, meaning that they are active along the entire supply chain from locating deposits, drilling and extracting crude oil, transporting it around the world, refining it into petroleum products such as petrol/gasoline, to distributing the fuel to company-owned retail stations, for sale to consumers.
Lateral Integration
Lateral expansion, in economics, is the growth of a business enterprise through the acquisition of similar companies, in the hope of achieving economies of scale or economies of scope. Unchecked lateral expansion can lead to powerful conglomerates or monopolies.
Lateral integration differs from horizontal integration as the integration is not exact. For example, one of the examples of horizontal integration was one hotel chain buying another. This did not enhance the company’s product offerings other than having more hotel options.
On the other hand, Parker Hannifin acquired Lord Corporation. While the two companies make similar types of products, their product offerings were distinct. There was not much overlap with the types of products offered. Instead, Parker Hannifin was not able to provide a far greater product offering in the given sectors.
The Strength of an Oligopoly
From: Wikipedia: Concentration ratio
The most common concentration ratios are the CR4 and the CR8, which means the market share of the four and the eight largest firms. Concentration ratios are usually used to show the extent of market control of the largest firms in the industry and to illustrate the degree to which an industry is oligopolistic.[1]
N-firm concentration ratio is a common measure of market structure and shows the combined market share of the N largest firms in the market. For example, the 5-firm concentration ratio in the UK pesticide industry is 0.75, which indicates that the combined market share of the five largest pesticide sellers in the UK is about 75%. N-firm concentration ratio does not reflect changes in the size of the largest firms.
Concentration ratios range from 0 to 100 percent. The levels reach from no, low or medium to high to “total” concentration
Perfect competition
If there are N firms in an industry and we are looking at the top n of them, equal market share for all of them means that CRn = n/N. All other possible values will be greater than this.
No concentration
If CRn is close to 0%, (which is only possible for quite a large number of firms in the industry N) this means perfect competition or at the very least monopolistic competition. If for example CR4=0 %, the four largest firm in the industry would not have any significant market share.
Low concentration
0% to 40%.[5] This category ranges from perfect competition to an oligopoly.
Medium concentration
40% to 70%.[5] An industry in this range is likely an oligopoly.
High concentration
70% to 100%.[5] This category ranges from an oligopoly to monopoly.
Total concentration
100% means an extremely concentrated oligopoly. If for example CR1= 100%, there is a monopoly.
10.2 Game theory
Game Theory Basics
Dominant versus Non-dominant Strategies
From: Wikipedia: Cooperative game theory
In game theory, a cooperative game (or coalitional game) is a game with competition between groups of players (“coalitions”) due to the possibility of external enforcement of cooperative behavior (e.g. through contract law). Those are opposed to non-cooperative games in which there is either no possibility to forge alliances or all agreements need to be self-enforcing (e.g. through credible threats).[1]
Cooperative games are often analysed through the framework of cooperative game theory, which focuses on predicting which coalitions will form, the joint actions that groups take and the resulting collective payoffs. It is opposed to the traditional non-cooperative game theory which focuses on predicting individual players’ actions and payoffs and analyzing Nash equilibria.[2][3]
Cooperative game theory provides a high-level approach as it only describes the structure, strategies and payoffs of coalitions, whereas non-cooperative game theory also looks at how bargaining procedures will affect the distribution of payoffs within each coalition. As non-cooperative game theory is more general, cooperative games can be analyzed through the approach of non-cooperative game theory (the converse does not hold) provided that sufficient assumptions are made to encompass all the possible strategies available to players due to the possibility of external enforcement of cooperation. While it would thus be possible to have all games expressed under a non-cooperative framework, in many instances insufficient information is available to accurately model the formal procedures available to the players during the strategic bargaining process, or the resulting model would be of too high complexity to offer a practical tool in the real world. In such cases, cooperative game theory provides a simplified approach that allows the analysis of the game at large without having to make any assumption about bargaining powers.
Types of Strategies
General Strategy
This is simply any rule that a player uses. These strategies can be “good” or “bad.” For example, if you have to choose heads or tails for a coinflip, you may use the strategy “tails never fails” and always pick tails even though there is no advantage to this strategy. Additionally, when playing the game of Blackjack, you may have a rule that you always hit when you have a score of 20. If you do not know how to play Blackjack, I will simply state that this is generally a very, very bad idea! Even though it is a poor strategy, it is still a strategy nonetheless.
Dominant Strategy
From: Wikipedia: Strategic dominance
In game theory, strategic dominance (commonly called simply dominance) occurs when one strategy is better than another strategy for one player, no matter how that player’s opponents may play. Many simple games can be solved using dominance.
Nash Equilibrium
From: Wikipedia: Nash equilibrium
In terms of game theory, if each player has chosen a strategy, and no player can benefit by changing strategies while the other players keep theirs unchanged, then the current set of strategy choices and their corresponding payoffs constitutes a Nash equilibrium.
Stated simply, Alice and Bob are in Nash equilibrium if Alice is making the best decision she can, taking into account Bob’s decision while his decision remains unchanged, and Bob is making the best decision he can, taking into account Alice’s decision while her decision remains unchanged. Likewise, a group of players are in Nash equilibrium if each one is making the best decision possible, taking into account the decisions of the others in the game as long as the other parties’ decisions remain unchanged.
Informally, a strategy profile is a Nash equilibrium if no player can do better by unilaterally changing his or her strategy. To see what this means, imagine that each player is told the strategies of the others. Suppose then that each player asks themselves: “Knowing the strategies of the other players, and treating the strategies of the other players as set in stone, can I benefit by changing my strategy?”
If any player could answer “Yes”, then that set of strategies is not a Nash equilibrium. But if every player prefers not to switch (or is indifferent between switching and not) then the strategy profile is a Nash equilibrium. Thus, each strategy in a Nash equilibrium is a best response to all other strategies in that equilibrium.[13]
The Nash equilibrium may sometimes appear non-rational in a third-person perspective. This is because a Nash equilibrium is not necessarily Pareto optimal. [Note: We do not talk about Pareto optimality in this class, but you can think of it as a best-case for everyone situation.]
The Prisoner’s Dilemma
From: Wikipedia: Prisoner’s dilemma
The prisoner’s dilemma is a standard example of a game analyzed in game theory that shows why two completely rational individuals might not cooperate, even if it appears that it is in their best interests to do so. It was originally framed by Merrill Flood and Melvin Dresher while working at RAND in 1950. Albert W. Tucker formalized the game with prison sentence rewards and named it “prisoner’s dilemma”,[1] presenting it as follows:
Two members of a criminal gang are arrested and imprisoned. Each prisoner is in solitary confinement with no means of communicating with the other. The prosecutors lack sufficient evidence to convict the pair on the principal charge, but they have enough to convict both on a lesser charge. Simultaneously, the prosecutors offer each prisoner a bargain. Each prisoner is given the opportunity either to betray the other by testifying that the other committed the crime, or to cooperate with the other by remaining silent. The offer is:
- If A and B each betray the other, each of them serves two years in prison
- If A betrays B but B remains silent, A will be set free and B will serve three years in prison (and vice versa)
- If A and B both remain silent, both of them will serve only one year in prison (on the lesser charge).
It is implied that the prisoners will have no opportunity to reward or punish their partner other than the prison sentences they get and that their decision will not affect their reputation in the future. Because betraying a partner offers a greater reward than cooperating with them, all purely rational self-interested prisoners will betray the other, meaning the only possible outcome for two purely rational prisoners is for them to betray each other.[2] The interesting part of this result is that pursuing individual reward logically leads both of the prisoners to betray when they would get a better individual reward if they both kept silent. In reality, humans display a systemic bias towards cooperative behavior in this and similar games despite what is predicted by simple models of “rational” self-interested action.[3][4][5][6] This bias towards cooperation has been known since the test was first conducted at RAND; the secretaries involved trusted each other and worked together for the best common outcome.[7]
The prisoner’s dilemma game can be used as a model for many real world situations involving cooperative behavior. In casual usage, the label “prisoner’s dilemma” may be applied to situations not strictly matching the formal criteria of the classic or iterative games: for instance, those in which two entities could gain important benefits from cooperating or suffer from the failure to do so, but find it difficult or expensive—not necessarily impossible—to coordinate their activities.
Game Tables
In the game above, we need some way to display all of the information in a condensed format. To accomplish this, we use a game table. For the sake of displaying the game tables in an accessible manner, I will use the following format:
| (A,B) | B- Silent | B- Betrays |
|---|---|---|
| A – Silent | (-1,-1) | (-3,0) |
| A – Betrays | (0,-3) | (-2,-2) |
You will see that the information is exactly the same as the information presented. For example, if A stays silent, but B betrays, we would be in the top, right payout cell (which is -3,0).
The next question is what the “best” outcome is. We will examine that but going back to the two strategies discussed earlier.
Solving Prisoner’s Dilemma with Dominant Strategy
From: Wikipedia: Strategic dominance
The iterated elimination (or deletion) of dominated strategies (also denominated as IESDS or IDSDS) is one common technique for solving games that involves iteratively removing dominated strategies. In the first step, at most one dominated strategy is removed from the strategy space of each of the players since no rational player would ever play these strategies. This results in a new, smaller game. Some strategies—that were not dominated before—may be dominated in the smaller game. The first step is repeated, creating a new even smaller game, and so on. The process stops when no dominated strategy is found for any player. This process is valid since it is assumed that rationality among players is common knowledge, that is, each player knows that the rest of the players are rational, and each player knows that the rest of the players know that he knows that the rest of the players are rational, and so on ad infinitum (see Aumann, 1976).
There are two versions of this process. One version involves only eliminating strictly dominated strategies. If, after completing this process, there is only one strategy for each player remaining, that strategy set is the unique Nash equilibrium [2]. This will be discussed next.
You can use the following set of steps:
-
Pick one person (it doesn’t matter).
-
If their opponent picks choice A, what will your person pick?
-
If their opponent picks choice B, what will your person pick?
-
If you choose the same thing for both of your opponent’s choices, then that is the dominant strategy. We say that choice strictly dominates the other choice and you can cross off the strictly dominated strategy.
-
Repeat for the opponent (this should be easier).
-
If the choices are different, there is no dominant strategy
Let us return to the prisoner’s dilemma game table. Let us act as player A and decide what player A would do in a variety of situations.
If player B stays silent, what should we do as player A? If we stay silent, then we would lose 1 (meaning one year in prison.) If we betray, we earn 0. In this case we should betray as no prison is better than one year in prison.
If player B betrays, what should we do as player A? If we stay silent, then we get three years in prison. If we betray, we get two years in prison. In this case, we should betray as two years in prison is better than 3 years in prison.
Therefore, the dominant strategy for player A is to betray. This is because regardless of what player B chooses to do, player A’s best choice is to betray. We can therefore eliminate “A-stay silent” since player A will not stay silent.
We can now move to player B to see if there is a dominant strategy for player B. It should be noted that, in theory, there does not need to be, but with our games there will be (if player A has one.) So, now let us play our modified game as player B.
If player A chooses to stay silent – STOP! – what did we just discuss? Player A will not choose to stay silent, so we do not need to worry about this. So, if player A chooses to betray, what should we do as player B? If we stay silent, we get three years in prison whereas we only get two years in prison if we betray. Therefore, player B should betray.
Thus, the dominant strategy for this game is (A,B)=(Betray,Betray).
There are additional exercises in the companion. Each player can have either 0 or 1 dominant strategies.
Solving Prisoner’s Dilemma with Nash Equilibrium
As mentioned earlier, we are looking for a stable solution. That is, a situation where neither player has an incentive to change their choice based on the other player’s choice. To find the Nash Equilibrium, you can follow these steps:
-
Choose a player (again, it doesn’t matter which).
-
Pick a choice (it doesn’t matter which).
-
Based on your choice, what will the opponent pick?
-
Based on what your opponent picks, what would you pick?
-
If it is the same as your original choice, it is a Nash Equilibrium. If not, it is not a Nash Equilibrium.
-
Repeat for the other choice(s).
So, let us return to our game. Without loss of generality, let us play as player A. It should be noted that playing as player B will yield the same exact results.
As player A, let us begin by staying silent. What will player B do? Player B can either stay silent (one year in prison) or betray (0 years in prison.) Player B will betray. Now, since we know that player B will betray, what should player A do? If player A stays silent, we get 3 years in prison but if we betray we only get two years in prison. Thus, we, as player A, should betray. But this is different from where we started, thus we do not have a Nash Equilibrium. The chain for this event is:
A: Silent >> B: Betray >> A: Betray — A has changed their choice, not a Nash Equilibrium.
Now, as player A, let us start by betraying. If we betray, player B can either stay silent (3 years in prison) or betray (2 years in prison.) Thus, player B will betray. When player B betrays, what should we do? We can either stay silent (3 years in prison) or betray (2 years in prison.) Thus, we betray. This is exactly where we started, thus, we have a Nash Equilibrium. In fact, we could continue to do this forever and the chain would stay exactly the same. The chain for this scenario is:
A: Betray >> B: Betray >> A: Betray — A has kept their choice the same, so A:Betray, B:Betray is a Nash Equilibrium.
10.3 Cartels and Collusion
Game Theory and Oligopolies
So what was the foray into game theory for? It allows us to explore how individual firms in oligopolies want to act. Let us consider two firms that each produce widgets. They can each choose to either produce at a high price level or low price level. Remember, for a firm to produce more (and sell it) they have to charge less. And if a firm restricts its output, they can charge more. Recall, a monopolist is able to make an additional profit because it restricts output and charges more whereas a firm in a perfectly competitive market may sell more, but at a lower price, and therefore earns a lower profit.
Let us use the following game table showing each firms’ profits:
| (A,B) | B- High Price | B- Low Price |
|---|---|---|
| A – High Price |
(65,90) | (20,100) |
| A – Low Price |
(70,40) | (40,60) |
First, let us step back and just look at the game table. What should each firm do? It seems like each firm should just set their price high. But, is that what will happen?
Let us look for the dominant strategy. As player A, if player B chooses to set a high price, we should should charge a low price (70>65). If player B chooses to set a low price, we should choose low price (40>20). Therefore, as player A, we should always choose to set our price low. The same applies for player B as setting their price low is always better than setting their price high regardless of what player A does (100>90 and 60>40).
So, even though it “makes sense” for both firms to set their prices high, both firms will set their prices low. The same would apply to the Nash Equilibrium.
What does this mean in the real world? If the two firms could cooperate and fully trust each other, they would each set their prices high. This is what we call collusion and will be discussed shortly. But, whether it is due to laws or just human nature, firms are never able to collude too long. Eventually, firms will move to the dominant strategy. While firms would like to keep their prices high, there are typically forces that prevent this.
OPEC
From: Wikipedia: OPEC
The Organization of the Petroleum Exporting Countries (OPEC, /ˈoʊpɛk/ OH-pek) is an intergovernmental organization of 14 nations, founded in 1960 in Baghdad by the first five members (Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela), and headquartered since 1965 in Vienna, Austria. As of September 2018, the then 14 member countries accounted for an estimated 44 percent of global oil production and 81.5 percent of the world’s “proven” oil reserves, giving OPEC a major influence on global oil prices that were previously determined by the so called “Seven Sisters” grouping of multinational oil companies.
The stated mission of the organization is to “coordinate and unify the petroleum policies of its member countries and ensure the stabilization of oil markets, in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers, and a fair return on capital for those investing in the petroleum industry.”[4] The organization is also a significant provider of information about the international oil market. The current OPEC members are the following: Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, the Republic of the Congo, Saudi Arabia (the de facto leader), United Arab Emirates, and Venezuela. Indonesia and Qatar are former members.
The formation of OPEC marked a turning point toward national sovereignty over natural resources, and OPEC decisions have come to play a prominent role in the global oil market and international relations. The effect can be particularly strong when wars or civil disorders lead to extended interruptions in supply. In the 1970s, restrictions in oil production led to a dramatic rise in oil prices and in the revenue and wealth of OPEC, with long-lasting and far-reaching consequences for the global economy. In the 1980s, OPEC began setting production targets for its member nations; generally, when the targets are reduced, oil prices increase. This has occurred most recently from the organization’s 2008 and 2016 decisions to trim oversupply.
Economists often cite OPEC as a textbook example of a cartel that cooperates to reduce market competition, but one whose consultations are protected by the doctrine of state immunity under international law. In December 2014, “OPEC and the oil men” ranked as #3 on Lloyd’s list of “the top 100 most influential people in the shipping industry”.[5] However, the influence of OPEC on international trade is periodically challenged by the expansion of non-OPEC energy sources, and by the recurring temptation for individual OPEC countries to exceed production targets and pursue conflicting self-interests.
At various times, OPEC members have displayed apparent anti-competitive cartel behavior through the organization’s agreements about oil production and price levels.[26] In fact, economists often cite OPEC as a textbook example of a cartel that cooperates to reduce market competition, as in this definition from OECD‘s Glossary of Industrial Organisation Economics and Competition Law:[1]
International commodity agreements covering products such as coffee, sugar, tin and more recently oil (OPEC: Organization of Petroleum Exporting Countries) are examples of international cartels which have publicly entailed agreements between different national governments.
OPEC members strongly prefer to describe their organization as a modest force for market stabilization, rather than a powerful anti-competitive cartel. In its defense, the organization was founded as a counterweight against the previous “Seven Sisters” cartel of multinational oil companies, and non-OPEC energy suppliers have maintained enough market share for a substantial degree of worldwide competition.[27] Moreover, because of an economic “prisoner’s dilemma” that encourages each member nation individually to discount its price and exceed its production quota,[28] widespread cheating within OPEC often erodes its ability to influence global oil prices through collective action.[29][30]
OPEC has not been involved in any disputes related to the competition rules of the World Trade Organization, even though the objectives, actions, and principles of the two organizations diverge considerably.[31] A key US District Court decision held that OPEC consultations are protected as “governmental” acts of state by the Foreign Sovereign Immunities Act, and are therefore beyond the legal reach of US competition law governing “commercial” acts.[32][33] Despite popular sentiment against OPEC, legislative proposals to limit the organization’s sovereign immunity, such as the NOPEC Act, have so far been unsuccessful.[34]
Cartel Theory
From: Wikipedia: Cartel
A cartel is a group of apparently independent producers whose goal is to increase their collective profits by means of price fixing, limiting supply, or other restrictive practices. Cartels typically control selling prices, but some are organized to force down the prices of purchased inputs. Antitrust laws attempt to deter or forbid cartels. A single entity that holds a monopoly by this definition cannot be a cartel, though it may be guilty of abusing said monopoly in other ways. Cartels usually arise in oligopolies—industries with a small number of sellers—and usually involve homogeneous products.
A survey of hundreds of published economic studies and legal decisions of antitrust authorities found that the median price increase achieved by cartels in the last 200 years is about 23 percent.[4] Private international cartels (those with participants from two or more nations) had an average price increase of 28 percent, whereas domestic cartels averaged 18 percent. Less than 10 percent of all cartels in the sample failed to raise market prices.
In general, cartel agreements are economically unstable in that there is an incentive for members to cheat by selling at below the agreed price or selling more than the production quotas set by the cartel (see also game theory). This has caused many cartels that attempt to set product prices to be unsuccessful in the long term. Empirical studies of 20th-century cartels have determined that the mean duration of discovered cartels is from 5 to 8 years[5]. However, once a cartel is broken, the incentives to form the cartel return and the cartel may be re-formed. Publicly known cartels that do not follow this cycle include, by some accounts, the Organization of the Petroleum Exporting Countries (OPEC).
Price fixing is often practiced internationally. When the agreement to control price is sanctioned by a multilateral treaty or protected by national sovereignty, no antitrust actions may be initiated[6]. Examples of such price fixing include oil, whose price is partly controlled by the supply by OPEC countries, and international airline tickets, which have prices fixed by agreement with the IATA, a practice for which there is a specific exception in antitrust law.
Prior to World War II (except in the United States), members of cartels could sign contracts that were enforceable in courts of law. There were even instances where cartels are encouraged by states. For example, during the period before 1945, cartels were tolerated in Europe and were promoted as a business practice in German-speaking countries.[7] This was the norm due to the accepted benefits, which even the U.S. Supreme court has noted. In the case, the U.S. v. National Lead Co. et al., it cited the testimony of individuals, who cited that a cartel, in its protean form, is “a combination of producers for the purpose of regulating production and, frequently, prices, and an association by agreement of companies or sections of companies having common interests so as to prevent extreme or unfair competition.”[8]
Today, however, price fixing by private entities is illegal under the antitrust laws of more than 140 countries. Examples of prosecuted international cartels are lysine, citric acid, graphite electrodes, and bulk vitamins.[9] This is highlighted in countries with market economies wherein price-fixing and the concept of cartels are considered inimical to free and fair competition, which is considered the backbone of political democracy.[10] The current condition makes it increasingly difficult for cartels to maintain sustainable operations. Even if international cartels might be out of reach for the regulatory authorities, they will still have to contend with the fact that their activities in domestic markets will be affected.[11]
For a cartel to be successful, some or all of the following conditions are necessary:
- A small number of firms.
- Products are relatively undifferentiated from one firm to the next.
- Prices are easily observable.
- Prices show little variation over time.