Chapter 5: Cartels (Collusion) Why Cartels Form Cartels are formed to increase individual profit for the firm.

This is accomplished by using the monopoly strategy of decreasing output and increasing price. However, there is a free rider problem that can be overcome with a cartel. Any individual firm can decrease output independently in an oligopoly and see prices and profits increase for all firms in the industry with the larger gains going to the firms that did not change their output. A cartel therefore becomes 1. An enforcement mechanism to overcome free-riding 2. An enforcement mechanism to punish cheating 3. An agency to determine output levels, and 4. An agency to divide the gains of the cartel. Difficulties: 1. Coordinating collusion is a problem, despite the fact that is maximizes industry profit 2. Overt or explicit collusion is illegal in the U.S. 3. Most efforts to fix prices are tacit (conscious parallelism) 4. The trick is to influence rivals behavior by signaling and threatening to punish defection 5. Need cooperation-inducing strategy as a focal point a strategy so compelling that a firm would expect all other firms to adopt it Need repeated competition over a number of periods to establish a focal point or reputation. The development of repeated, multi-period games in Game Theory was an important development for IO, allowing for more complex and realistic interactions between firms. Why is cooperation so difficult for finite games (where the last period is known for certain)? Factors Necessary to Establish a Cartel 1. Must be able to raise price w/o inducing competition from outside the cartel 2. Expected punishment for forming the cartel must be low relative to the gains (Note: most cartels are international) 3. Cost for establishing and enforcing the cartel must be less than the gains Facilitating Practices for Cooperative Pricing: 1. Price leadership 2. Advanced announcement of price changes 3. Most favored customer clause 4. Uniform delivered pricing 5. Meet the competition clauses Repeated competition allows firms to create and maintain a reputation for cooperation. Pricing rivalry then is a repeated or dynamic process.

Strategies for Maintaining Effective Collusion 1. Detect Cheating 2. Punish Cheating Grim Trigger Price Strategy: The firm (1) sets a high price in the first period, (2) sets a high price in every succeeding period, provided the other firm does likewise, and (3) sets low prices forever after, if the other firm ever charges a low price Any defection from the cooperative high-price outcome is penalized by immediate and perpetual movement to low prices. The grim trigger strategy can be highly provocative and unforgiving, but it is difficult to communicate to other competitors that this is the game being played. Furthermore, the perpetual nature of the punishment lacks credibility. The difficulty with the grim trigger is that it is unforgiving. In addition, there is the possibility for a defector to profit with a grim trigger strategy. Consider the following: PVcollusion = t=0 (High price profit) / (1 + i)t PVdefection = Big Profit (1st period only) + t=1 (Low price profit) / (1 + i)t Defect if PVdefection > PVcollusion

Folk Theorem: If the discount rate, i, is not too large the cooperative outcome is sustainable. An alternative strategy that is more compelling is the tit-for-tat pricing strategy. Tit-For-Tat Price Strategy: The firm (1) sets a high price in the first period, and (2) in each succeeding period, echoes (imitates) the competitors previous price The tit-for-tat pricing strategy is more compelling than alternative strategies for collusion because it is 1. Nice. The firm is not the 1st to defect 2. Provocative. Punishment is immediate 3. Forgiving. If the rival returns to the cooperative price, the tit-for-tat firm does too Clearly, it will take multiple periods to signal that the tit-for-tat game is being pursued, especially in signaling forgiveness. The firm might signal through pronouncements like We will not be undersold or We will match our competitors prices, no matter how low. Despite the robustness of tit-for-tat against a wide range of strategies, there can be problems with misreads which are usually met with punishment or lose of market share.

Example: Sydney, Australia newspaper market. John Fairfax & Sons: acted as price leader Rupert Murdochs paper: acted as follower In 1974, Murdoch stopped playing the game when Fairfax increased price, but Murdoch did not follow, lasting for 3 years. Murdoch increased market share and profit at Fairfaxs expense. Problems with collusive price strategies: 1. 2. 3. 4. 5. Grim trigger is not forgiving. Defection results in an infinite price war, which is not a credible outcome. Rules of the games are difficult to communicate. Difficult to be provocative. Misreads create problems. Strategies may draw the attention of antitrust authorities. Price-Fixing is a per se violation of antitrust law in the U.S. There is an incentive to cheat No incentive to play if your firm is introducing new products or services or your firm is looking for growth.

INCENTIVE TO CHEAT Consider the Residual Demand

Unexploited Profit Residual Demand MC = AC

Residual demand is the demand left under the cooperative price. A defector can capture this unexploited profit.

Where Collusion is Most Likely PVcollusion is high i. Demand is relatively inelastic Product has few subs Control of market is high ii. Ability to restrict entry II. Low cost of reaching a cooperative agreement i. small number of firms ii. high CR iii. close similarities in production costs iv. little product differentiation III. Cost of maintaining an agreement is low i. need frequent market intervention facilitates detection lowers cost of monitoring ii. However, low frequency of sales increases the incentive to collude IV. Stable market conditions Rapid technological change makes it difficult to collude I. Reasons for Not Colluding When seeking a strategic position for Competitive Advantage. The firm develops innovations that will lead to a 1. Cost Advantage 2. Benefit Advantage (product differentiation) To achieve a cost advantage a firm might invest in innovations to achieve economies of scale. This requires a lower price to increase demand and therefore the volume of production to realize economies of scale. The collusive price is too high to reach the objective. To achieve a benefit advantage a firm would invest in innovations for product differentiation. The pricing strategy is to increase the consumer surplus bid to consumers, yet increase producer surplus for the firm. If the collusive price does not satisfy these conditions then ignore it. A grim trigger strategy that drops the price has small impact on the differentiated product. Look for collusion in commodity markets