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EC365 Theory of Monopoly and Regulation
Topic 3: Collusion
2013-14, Spring Term
Dr Helen Weeds
2
Monopoly power
Monopoly outcomes
• monopoly pricing• price discrimination• costs, technology
3
Routes to monopoly power
Monopoly power
Merge
Collude Exclude
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Lecture outline
Collusion and reaching agreement
Sustainability Critical discount factor Facilitating devices
Leniency programmes
Policy and cases Cartels Tacit collusion
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What is collusion?
A type of horizontal agreement Cooperation over prices, outputs, market shares or
territories Higher profits (at best joint profit = monopoly profit) Worse for consumers, and social welfare Typically per se illegal
Cartel: explicit agreement (could be verbal)
Tacit collusion / coordinated behaviour: understanding reached without explicit agreement (neither written nor verbal)
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Reaching agreement
Communication “People of the same trade seldom meet together, even for
merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
– Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (1776), I:10
Number of firms Easier to reach agreement if fewer firms
Asymmetries, e.g. costs Efficient for low cost firms produce higher output May require side payments (illegal)
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Sustaining collusion: Prisoners dilemma (1)
Strategies and payoffs Both collude: share monopoly profit Both defect: non-cooperative oligopoly (Bertrand) One defects: steals entire market demand;
other firm makes a small loss
Unique Nash equilibrium
Collude Defect
Collude 5, 5 , 10
Defect 10, 0, 0
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Infinitely repeated prisoners dilemma
Repeat stage game an infinite number of times Discount factor < 1 (where = ert )
“Grim-Trigger” strategy (or Nash reversion) Play collude in period 1 Continue playing collude as long as both players keep on
playing collude Otherwise play defect, permanently
Is this strategy an equilibrium?
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Equilibrium in grim-trigger strategies
Assume rival plays grim-trigger
Compare payoffs from trigger and defect Trigger: payoff = 5 (1++2+ … ) = 5 /(1–) Defect: payoff = 10
Play trigger iff: 5 /(1–) 10
½ “critical discount factor”
If is sufficiently high Collusion is an equilibrium of the infinitely repeated game Not unique: e.g. {defect, defect} is also an equilibrium
Why Infinite Periods?
10
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Number of firms
Cartel payoff (per firm) is m /n
Critical discount factor:
Collusion requires higher as n increases i.e., collusion is harder to sustain for higher n
Collude Defect
Colludenn
10 ,
10 , 10
Defect 10, 0, 0
n
n 1
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What collusive price?
Bertrand Sustainability is independent of Collusion may occur at any P (c, Pm]: “folk theorem”
Cournot More complex payoff structure Nash reversion outcome less harmful to firms
Collude Defect
Colludenn
,
, Defect , 0, 0
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Detection (or reaction) lags
Suppose defection is not detected for 2 periods
Payoffs (duopoly) Trigger: 5 / (1–) as before Defect: 10 (1+) receive monopoly for 2 periods
Critical discount factor: 1/2 0.71
Collusion is easier when Prices (or outputs) are observable, and Output can be increased rapidly
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Features conducive to collusion
Number of firms
Barriers to entry
Homogeneity Costs, products Bertrand outcome very unattractive
Transparency & reaction lags Observable prices, stable/predictable demand Frequent transactions
Capacity constraints (Brock & Scheinkman 1985) Little incentive to cheat as cannot supply entire market demand But ability to punish cheating is also weaker
• Critical is non-monotonic in capacity
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Facilitating practices
Price leadership: helps solve coordination problem
Increase observability of prices Market transparency: public prices, basing point pricing Information exchange: e.g. via trade association “Meet competition” (MC): customers report on rival p’s
Commitment devices MC clause: commitment to match rival’s price cut “Most favoured nation” (MFN)
• Entitles customer to lowest price given to any customer• Reduces incentive for selective price cuts
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Leniency programmes
Aim: to destabilise a cartel by providing incentives for participants to reveal it
Key features Some probability of detection (without confessions) Large fines for cartelisation First to reveal cartel receives immunity from fines
Changes prisoner’s dilemma
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Leniency programmes: Prisoners dilemma (2)
Payoffs = cartel profit (per firm, cumulative) = probability of detection F = size of fine
Condition for unique Nash equilibrium?
Keep quiet Reveal
Keep quiet (1 ) F, (1 ) F F, 0
Reveal 0, F ½F, ½F
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Example
(e.g. = 3, = 1/3, F = 9
Enforcement Detection powers, e.g. “dawn raids”: affect Fines: related to turnover & duration Third party damages
Keep quiet Reveal
Keep quiet 1, 1 9, 0
Reveal 0, 9 4.5, 4.5
The Hollywood Treatment
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(Source: Amazon)
The serious story:“Global Price Fixing”, John M. Connor (2007)
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Policy towards cartels
USA Sherman Act 1890 prohibits “trusts” and monopolisation
EU (Art. 101), UK (Competition Act 1998, Chapter I) Prohibits agreements “which have as their object or effect
the prevention, restriction or distortion of competition” Bans price fixing, limiting production, or sharing markets
UK Enterprise Act 2002 Makes cartelisation a criminal offence Possible imprisonment (already possible in USA) Claims for third party damages
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Prosecuting cartels
2 main issues
Evidence of cartelisation Could be written: cartel agreements Oral testimony in court Rewards for “whistleblowers”
Quantifying penalties and damages Penalties related to turnover during period of cartelisation Third party damages
• how much did consumers overpay?• will consumers claim? Class actions
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Vitamin cartel (US 1999, EU 2001)
Secret price-fixing cartel, Jan 1990–Feb 1999 Fixed prices of vitamins used in foods (bread, milk, cereal) $5bn-worth of transactions affected Destabilised by entry into market
Cases brought in USA (1999) and EU (2001) Hoffman-La Roche (leader of cartel)
• Fined $500m (USA) and €462m (EU): largest corporate fine to date• Marketing director pleaded guilty: $100,000 fine + 4 months in jail
BASF: fined $225m (USA) and €296m (EU) Rhône-Poulenc (now Aventis): escaped fine in USA, in
exchange for supplying evidence; fined €5m in EU
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Replica football kit price-fixing (OFT 2003)
10 firms fixed prices of Umbro replica football shirts Manufacturer: Umbro Football clubs / league: Manchester United, the FA Retailers: JJB Sports, Allsports, Blacks, Sports Soccer,
JD Sports, Sports Connection and Sportsetail
A number of agreements to fix prices in 2000 and 2001
Fined a total of £18.6m by OFT in August 2003 Some reduced, and one increased, on appeal to CAT Which? launched “representative claim” against JJB
Sports on behalf of customers
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Policy towards tacit collusion
More difficult to identify and prosecute
Industry conduct “Conscious parallelism”
• But other possible reasons why firms may change prices at the same time; e.g. common cost shock
Estimate firms’ reactions to one another’s price changes• High responsiveness collusion (punishment strategy)
Price leadership
Industry performance Prices: compare with costs Profits: compare with cost of capital
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Burden of proof: Woodpulp (EC 1985)
Industry conduct & performance Price parallelism (1975–1981) Highly visible price pre-announcements Rising prices, unrelated to costs, despite rising stocks Cost differences not reflected in prices
European Commission ruled concerted behaviour
Overturned by ECJ in 1993, citing other explanations “parallel conduct cannot be regarded as furnishing proof
of concertation unless concertation constitutes the only plausible explanation”
26
UK Enterprise Act 2002
Market investigations may be conducted Where feature(s) of the market or conduct of suppliers prevent,
restrict or distort competition Not a cartel (otherwise tackle under CA98)
Remedies Behavioural: change industry practices to eliminate obstacles to
competition (e.g. switching barriers); price controls Structural: break up industry
Recent Investigations Cement/Aggregates, BAA Airports, Private healthcare,
Private motor insurance, Statutory audit services
27
Tacit collusion: White Salt (UK 1986)
UK tacit collusion case Investigation by Monopolies and Mergers Commission
(now Competition Commission) Under Fair Trading Act 1973 (now replaced by Enterprise
Act 2002)
Two major producers of salt in the UK British Salt: 45% of market, lower cost producer ICI: 50% of market
Lack of competition between the two
What was the evidence?
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Features of the salt industry
Homogenous productDeclining market: 30% fall in production 1979-86Barriers to entry
Large economies of scale: small scale entry suffers significant cost disadvantage
Large excess capacities: BS 75% utilisation, ICI 65% utilisation (1980-84 figures)
Use of long-term contracts foreclose much of market Legal barriers to entry
• Cheshire County Council (where the best salt deposits are) unlikely to grant new development licenses due to environmental concerns
Imports limited: transport costs high relative to value
29
Conduct and performance
Parallel pricing and price leadership Price changes always matched over previous 10 years In the previous 5 years ICI had led on all price changes
Pre-notification of price changes (by letter) Parties claimed this was necessary as they traded a small
amount of salt with one another!
High prices and profits Prices had risen faster than in other industries High rates of return on capital
• ICI: 50%; British Salt: 30% (though falling)• NB: 10-15% return might be considered reasonable
30
MMC’s analysis
Several features that tend to support tacit collusion Highly concentrated market (duopoly), high entry barriers Information sharing Capacity available for retaliation strategy
Some evidence it might be occurring Parallel pricing and price leadership Rising prices despite falling demand Excessive returns on capital
Finding: “against the public interest” BS (lower cost) failing to exert competitive pressure Imposed price control linked to BS’s costs
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Rees (EJ 1993): analysis of White Salt
Examined the data to test for tacit collusion
Concluded that given firms’ capacities, the threat of punishment was
credible and would sustain collusion though the result was not joint profit-maximising as this
would require BS (with lower costs) to produce at full capacity and make side payments to ICI
[Also see MMC report at: http://www.competition-commission.org.uk/rep_pub/reports/1986/200white_salt.htm]
32
Merger and collusion
Merger in oligopoly market (e.g. 4 3 firms) Suppose merged firm does not have market power to raise
price on its own But smaller number of firms may sustain tacit collusion
i.e. will merger create “collective dominance”?
Merger authorities look at Industry conditions, especially ability to punish cheating
• Observability, reaction times, capacities, etc. Calculate change in critical discount factor
• Is post-merger critical significantly lower?
33
Airtours (EC 1999, ECJ 2002)
Proposed merger of Airtours and First Choice Post-merger shares (of market for foreign package holidays)
• Airtours/First Choice 32%: not single-firm dominance• Thomson 27%• Thomas Cook 20% (+ competitive fringe)
European Commission blocked merger, alleging “collective dominance” But features of market not conducive to collusion
• Highly differentiated products• Capacity fixed 18 months ahead and not transparent• Volatile demand; unstable market shares• Low barriers to entry & expansion
Confusion over concept of collective dominance• Could this include unilateral effects (e.g. Cournot oligopoly)?
Overturned on appeal; caused 2004 revision of EU merger test