Q&A: Why do cartels often collapse?

Recent business history both here in the UK and in international markets is littered with examples of cartel-behaviour by businesses that seem to have come unstuck. Just type price-fixing into Google news and see what comes up! Even on the day I am writing this blog answer, the FT reports that three cargo airlines have agreed to pay fines totalling $214m for their roles in a global conspiracy to fix prices for air freight. Bloomberg reports that a former sales executive at Hitachi Displays Ltd. has been charged with participating in a global conspiracy to fix prices for liquid crystal displays sold to Dell Inc. And in Ireland, a former director of a Dublin car company has been given a 15-month suspended prison sentence and fined €160,000 after pleading guilty to charges of price-fixing.

First we can make a distinction between horizontal collusion and vertical collusion

Horizontal collusion takes place between firms in the same industry. Bus service operators in some cities might decide to share the market. A number of UK independent schools were found to be in breach of competition law by sharing information about proposed annual fee increases.

Vertical collusion (or vertical restraint) refers to the methods used by manufacturers to restrict the ways in which retailers can market their product. Examples in the UK in recent years include car manufacturers and agreements with distributors, price fixing between football kit manufacturers and a small group of well known high street sports retailers and a (legal) cartel in ‘Over the Counter Pharmaceutical products which ended in May 2001.

Price fixing and the law

Competition law prohibits almost any attempt to fix prices - for example, businesses cannot:

– Agree prices with your competitors, e.g. you can’t agree to work from a shared minimum price list
– Share markets or limit production to raise prices
– Impose minimum prices on different distributors such as shops
– Agree with your competitors what purchase price you will offer your suppliers
– Cut prices below cost in order to force a smaller or weaker competitor out of the market

Collusive behaviour by firms is easier when

• There is only a small number of firms in the industry
• The industry has substantial entry barriers
• Total market demand not too variable
• Firm’s output can be easily monitored/ checked so that it is easier to identify firms who are cheating on output quotas

Why are Cartels unstable?

Many price fixing or market sharing aggreements eventually either collapse or whither on the vine - here are some reasons:

1 Falling demand creates excess capacity in the industry e.g. during an economic downturn / recession - the classic example here is the deep tension within the OPEC oil cartel caused by the world economic recession which is causing a steep fall in the global demand for crude oil. Will OPEC deliver on planned output cuts in order to stabilise the price of crude at or aound $50 a barrel?

2 Disruption caused by the entry of non-cartel firms into the industry which creates fresh competition

3 Exposure of price fixing by Government agencies such as the Office of Fair Trading - the OFT , the US Justice Department and the EU competition commission have been especially active in trying to break down cartel behaviour - laws have been tightened and there are incentives / rewards for ‘whistleblowers’ - people who expose price fixing or other anti-competitive behaviour.

4 Over-production which breaks the price fixing - i.e. if firms produce excess output, this drives prices and profits down

Game theory is often applied to the costs and benefits of operating a producer cartel - the classic Prisoners’ Dilemma suggests that collusion breaks down because there is an incentive for one or more firms to cheat because joint-profit maximization does not mean each firm is maximising profits on their own.