CARTELS AND TACIT COLLUSION

Competing firms can also lessen the intensity of competition by simply agreeing on various aspects of competitive behaviour, including prices/quantities, quality, innovation and/or advertising. Since such agreements are often illegal, they cannot be enshrined in contracts that would be enforceable in Court. This would not be an issue if the firms taking parts to a collusive agreement had a unilateral incentive to respect this agreement. .However, as shown on the following graph, firms have a unilateral incentive to deviate from any agreement to restrict output or raise prices.

Suppose that the two firms agree to produce qT each rather than the amounts qC that would be produced in the non-cooperative Nash equilibrium. If firm 1 truly believes that firm 2 will abide by this agreement, then it can earn larger profits by producing the larger amount qD instead.

So how can firms ever manage to jointly implement a collusive agreement? The answer lies in the fact that those firms interact repeatedly in the market. This makes it possible to punish firms that deviate from the agreement by producing larger quantities (or setting lower prices) later. Before we look at how this mechanism operates though, we must distinguish between cartels and tacit collusion (also known as conscious parallelism).

In a cartel, members do communicate to set up the agreement in the first place. Cartel members meet or exchange messages in order to agree a joint course of action. Further communications to help the cartel adapt to changing circumstances are also common. Because of this “explicit” character, cartels tend to leave some kind of trail of physical evidence (correspondence, meetings,…) that might be used to obtain a conviction, were the cartel to be detected by the competition

authority. No such direct evidence is available in the case of tacit collusion, where firms seek to coordinate their actions without any explicit contact or communication. While this makes prosecution of tacit collusion more difficult, it also means that the parties have to find a way of reaching an implicit agreement in the first place. As we will see later, this opens other avenues for competition policy intervention.

Cartels

Let us now assume that a cartel containing N identical firms has agreed on a collusive outcome C that gives each cartel member a pay-off of πC per period. If N-1 firms stick to the agreement but a

single deviates, this firm gets a pay-off πD, while each of the other firms gets a pay-off πB. Finally, if

all N firms revert to the non-cooperative equilibrium, they each get a pay-off πP per period. We have πD>πC>π P . We now consider the following trigger strategy:

“I start by colluding and keep doing so as long as all other firms do so. However, if even a single firm deviates and even if it deviates only once, then I will revert forever to playing the non-cooperative equilibrium strategy”

Can such a strategy help support collusion between the parties? The answer is negative if the number of period of interaction between the firms is fixed and known to all. With such a fixed horizon, the only equilibrium is one where all firms play the non-cooperative equilibrium in each and every period. This is clearly seen by backward induction. Let us start with the last period. This is just a one shot game, so everybody will play the non-cooperative equilibrium. Let us move back to the next to last period. Should I play along or should I defect. The fear of being punished by a reversion to the non-cooperative equilibrium in the future is the only thing that could keep me from cheating on a collusive agreement…but I already know that everybody will be laying the non-cooperative equilibrium in the last period anyway….so I have nothing to lose by cheating in the next to last period,,,,,hence the only possible equilibrium in the last period is again the non-cooperative equilibrium…which means that the threat of punishment cannot be effective in the next to next to last period either and so on…

We did already encounter this kind of backward induction “unravelling” argument when we discussed bargaining models. There we saw that unravelling was no longer an issue if the time horizon was infinite or if there was sufficient uncertainty about the effective length of the game. Is this also true here? For simplicity, we will limit ourselves to the case of an infinite horizon,

Assume that N-1 firms play the trigger strategy described above. Would it then be optimal for the last firm to also play according to this strategy? If it does, then the firms cooperate forever and the firm woud get otal pay-offs equal to:

πC+δ πC+δ2πC+……..=

πC1−δ

,where δ is the firm’s discount factor.

Suppose now that the firm decides not to cooperate. This means that it gets total payoffs equal to:

πD+δ π P+δ2 πP=πD+

δ πP1−δ

Comparing the two pay-offs, we conclude that the firm is better off also following the trigger strategy if:

δ ≥πD−πCπD−πP

Not surprisingly, then, it is more likely that collusion can be sustained if the firms are patient (high δ ) since collusion is enforced through the threat of future retaliation and such threats can only be effective if the firms care enough about the future. The likelihood that collusion can be sustained is also higher, the more effective the punishment is (i.e. the lower πP).

For the antitrust authorities, it is important to understand the conditions that makes it easier for firms to enforce cartel agreements. This helps the antitrust authority detect cartels since it gives some idea of what type of market ought to be scrutinised. It also help the antitrust authority ensure that conditions that are favourable to cartel formation are not created through other conducts such as exclusion or mergers.

Since collusion is sustained through the threat of punishment, it will be easier to enforce if punishment is swift. This means that collusion is more likely if deviations from the collusive arrangement can be detected quickly and/or if, once the deviation has been detected, rivals can .

Exercise: Assume that it now takes T periods for firms to react an retaliate if a cartel member deviates. Shows that the discount factor required to sustain the cartel is an increasing function of T

This in turns suggests market features and behaviour that would facilitate cartels. For example a cartel should be easier to sustain in a more transparent market, i.e. in a market where it is easier to observe the rival’s actions with precision. Observing rivals’ strategies in the supermarket industry is relatively easy as prices and product lines are displayed for all to see. In fact large supermarket chains do employ a number of people to check on their rivals’ offerings. On the other hand, a market where each deal is struck in secret between the seller and the buyer (as in many industrial markets) would be much less transparent and therefore less propitious to cartels.

This also means that competition authorities will look with suspicion at any attempt to increase market transparency. Such attempts can take the form of exchange of data through trade associations or various practices (such as base point systems) making price comparison easier.

Punishment for deviating can only be effective if it is actually carried on. Hence punishment is less likely, and so cartels harder to secure) if output cannot be increased rapidly. Punishment is also more likely to be carried out if it hurts the firm that deviated more than the firms who must react by increasing output or cutting price. Hence the ability to cut price selectively to hit the customers of the deviating firm more than the customers of cartel-abiding firms would facilitate the formation and survival of cartels.

Cartels are also easier to enforce if the number of cartel members is small. The basic reason for this is that an increase in the number of competitors tends to decrease the individual benefits from cooperating (each firm only gets 1/N of total collusive profits) but it does not decrease the profits from deviating. On the other hand, a greater number of competitors can also lead to lower profits in the punishment phase, which would make cartel enforcement easier, Overall, the negative effect of a greater number of participants on cartel enforcement tends to dominate.

Exercise: Consider a Cournot industry with N identical firms. How does the critical discount factor required for a cartel to sustain the monopoly output change with N and why?

Asymmetries between firms can also make it harder to sustain a cartel. Consider a cartel made of some high cost firms and some low cost firms. The high cost firms have smaller market chare so hey benefit less from the price increase effected by a cartel. This makes then more liable to deviate. Asymmetries also impair cartel formations because the firms find it hard to agree on what is the best level of price or output to agree on (unless they can make direct payments to each others, (which is rather dangerous as cartels are illegal).

Finally cartels are hard to sustain if potential entrant would exploit the cartel’s success in raising prices or if some firms – referred to as “mavericks” – just refuse to “play ball”. This is wide antitrust authorities are very reluctant to condone the acquisition of a maverick by another firm even if the joint market shares involved are not large. They fear that the neutralisation of the maverick might make it easier for the remaining industry participants to reach and sustain a collusive agreement.

So far, we have considered a very simple type of cartel. The parties agree on the prices or quantities that they should choose and punish any firm that does not abide by the agreement by launching into a price war. An implication of this analysis is that we should never witness any punishment episode (price wars) since the mere (credible) threat of such episode is enough to keep everybody in line. In practice, the life of a cartel is often more complicated than this. Consider for example a cartel here members cannot observe each other’s output levels reliably. They can however observe the market price. In a deterministic environment, cartel enforcement would still be straightforward. Given the outputs that each cartel member should produce, the market price should be at a given level. If the price is not at this level, then somebody must have cheated and cartel members enter into a punishment phase. Unfortunately, firms do not operate in a deterministic environment. In particular, hey only have an approximate knowledge of market demand. Market demand might be stronger than they think ,in which case the price will be higher than expected even if each firm produces the amount that it is supposed to. Market demand might also be weaker than expected, in which case the market price will be lower than expected even if nobody deviates. This creates a problem. If the firms observe a low price, does this mean that demand was unexpectedly low or does it mean that some cartel members cheated on the agreement. To avoid unnecessary price wars, the firm will have to be a little less ambitious agreeing that there will be punishment not as soon as the price is lower than the fully collusive price but that punishment will only be triggered by a price somewhat lower than the fully collusive price. However, even with such a lower trigger, there will be times where market demand is unexpectedly so weak that the trigger will be broken. At that point the firms will start a (temporary) price war even if they know that nobody has in fact deviated. In other

words, in order to prevent deviations, firms must occasionally engage in price wars even though they know that, given their strategy, nobody would ever deviate!

Tacit Collusion

The only difference between tacit collusion and cartels comes at the stage of agreeing on a common goal – or modifying that goal to fit new circumstances. While cartel members could simply communicate to argue on price or quantity levels, firms engaging in tacit collusion have to find a way to “get there”.

Typically a firm would raise its price slightly and wait to see if its rivals follow with similar price increase. If it does, his firm – or another one – can try a further price increase and so on, slowly iterating their way to some more collusive price level. Clearly such a process is delicate and fragile since each firm has a short term unilateral incentive not to follow the price increase. As in the case of cartel, uncertainty about the economic environment or asymmetries across firms would make this process even more hazardous. There is therefore a strong incentives for firms to find ways of making convergence on a more collusive outcome easier.

This process is made easier by the presence of a natural leader (maybe the largest firm) who will take it upon herself to “propose” the successive price increases required to get to the collusive outcome. The process is also facilitated if the firms can make announcements about their future plans, be it future prices, future capacity or future product introduction. Such announcements can be especially effective because they can easily signal the price level (for example) over which the firms would like to coordinate without requiring that any firm take any risk in being the first firm to raise prices in a long incremental process. This helps understand why antitrust authorities have rules on the exchange of information between rival firms and why they look especially dimly at exchanges of information about future actions as opposed to past or even current prices.

Detection and Proof

The detection and prosecution of cartel agreements occupies a significant proportion of the resources of competition authorities. Cartels and tacitly collusive agreements are usually detected in one of the following manners:

1. Routine observation of industries where objective conditions (e.g. concentration, transparency) appear to be favourable to cartel activity. The competition authority would be looking for sudden sustained increase in prices not motivated by changes in costs or sustained high rates of return on capital.

2. Complaints from buyers of the cartelised product. This is more likely in industrial mrkets where the buyers are themselves fairly concentrated and have expert knowledge of the market.

3. A whistle-blower provides information on the cartel’s activities. This whistle-blower might be a disgruntled (or honest) employee,….but it also might be a member of the cartel? Indeed such defection is encouraged by competition authority through their leniency programmes granting (total or partial) immunity to the first member(s) to turn the cartel in.

4. Tracking “parallel movements in prices that suggest the succession of collusive and “punishment” episodes.

The use of leniency programmes raises the following puzzle: if cartel members will eventually cheat on each other, why do they form a cartel to start with? The answer is that the gains from reporting on cartel members increases over the lifetime of the cartel because of two factors. Firstly, the longer the cartel goes on the more likely it is to be detected. Secondly, the longer the cartel goes on the larger the damages that the cartel will have to pay if they are caught.

So, assuming that a cartel or a tacitly collusive agreement has in fact been detected, how would the antitrust authority secure a conviction? In the case of a cartel, the burden of proof is most often satisfied by finding a “paper trail” and/or using witnesses, including partners that might have defected under the leniency programme. Most of these approaches are not available in the case of tacit collusion. One might still find internal documents indicating that a firm was indeed trying to “follow” the lead of others toward higher prices, Otherwise one is left with only the indirect evidence provided either by the documented parallelism of the firms’ conduct (i.e. their prices move in unison) or by the existence of a boom and bust pattern symptomatic of collusion followed by periods of price wars. However, such patterns can be explained by other factors and are usually not therefore sufficient to secure a conviction.