What are Cartels?

ECONOMICS 2

TITLE: CARTELS

WORDS: 1300

Cartels are usually happen in an oligopoly market, where a few large firms dominate the market. A cartel is when two or more of these firms make a formal agreement to collude, to try and limit competition between them. This can be done in a few ways. Members may have fixed prices that they sell their goods, this may be low to increase sales and stop new entrants or high as the will dominate the market. Cartel members also agree on such factors as market share and advertising expenditure. Quotas are another way firms collude, the member firms will set quotas on the amount a firm will produce (production quota) and sell (sales quota). But how do the firms agree on each members quota? The normal method would be to divide the market between the members according to their current market share. So basically the firms involved in a cartel act as one firm (a monopoly)

Why would companies want to do this? Well, to capture the benefits of a monopolist.

Diagram 1 shows the benefits that arise from forming and maintaining a cartel. It shows an industry in long-run competitive equilibrium. The price is P1 and the output is Q1. Here there are no economic profits. Now, if the firms that dominate the industry where to form a cartel and reduce output to Qc (production quota), the new price become Pc (cartel price) and profits are equal to CpcAB, which would be shared among members. So with no cartel there where no economic profits. With cartel there profits are gained. Thus there is an incentive for firms to form a cartel.

There are a number of problems that arise from forming a cartel. Once the problem of who joins the cartel is solved then there is the problem of agreeing on a policy. For example, firm A may purpose that all members drop their output by 10%. While firm B might think that the bigger cartel members decrease output by 15& and the smaller members by 6%. Each different member may have a different proposal, which means reaching an agreement would be difficult.

Even once a policy is agreed there is still the problem ...

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Even once a policy is agreed there is still the problem of firms breaking this agreement, as there is a big incentive to do so. Diagram 2 shows a firm in a cartel. Before the cartel is formed produces an output of Q1 at a price of P1 and earns no profit. After joining the cartel it reduces output to Qc and changes the price to the cartel price, Pc. The firm now earns profits of CpcAB. If the firm where to cheat on this agreement and produce an output of Qcc instead of Qc, providing the other members don’t cheat then it can view its supply curve as horizontal at the cartel price (Pc). It cannot affect price by changing output, therefore it can produce and sell additional outputs without changing the price. So if a firm cheats on a cartel it gains the greater profit of FPcDE instead of CPcAB. If all firms where to cheat then they would end up where they started.

So firms have an incentive to from a cartel but they also have an incentive to break that agreement, which could mean even if the cartel was allowed to succeed chances it would not be effective for long.

Roche of Switzerland and Belgium interbrew are two examples of cartels. They were found to be trying to fix the prices of food additive and beer. Total fines on these firms reached £25 million. An investigation concluded that Interbrew, that brews Stella Artois, and Alken Maes, another Belgian brewer, had shared markets, fixed prices and exchanged information between 1993 and 1998. Interbrew admitted some of the charges and is expected to be fined about Euros 45m. Danone, the French food group that owned Alken Maes at the time of the offences, should receive a similar penalty. Alken Maes is now owned by Scottish & Newcastle of the UK. Some smaller brewers could also be fined. Another example, which happened two weeks ago, was where 13 pharmaceutical companies received a record fine of Euros 462 for trying to control the price of vitamins.

So who is there to stop cartels? Well a lot of people say the government. However, the government roles in cartels are mixed. There are examples of the government actually creating cartels rather than stopping them. For example, in agriculture, the government may restrict the amount of acres a farmer can grow certain crops on, this is aimed at reducing supply of that crop, which should bring about higher prices and higher revenues. Could the farmers afford to do this without the help of the government? Not very likely.

But how does a government prove that firms are involved in cartels? This can be very difficult as such factors of price fixing are hard to spot in an oligopoly market as prices are close anyway. There are some tell tale signs to look for in the market. Such things as price changes and behavior that would not be expected unless there was some sort of contact between firms.

if a firm is found guilty of breaking the competition act 1998 (this came into full effect in March 2000). Generally, the Act outlaws any agreements and business practices that have a damaging effect on competition in the UK. It prohibits:

Those agreements between undertakings, decisions by associations of undertakings (such as trade associations), and concerted practices which prevent, restrict or distort competition, or are intended to do so, and which may affect trade within the UK (known as the Chapter I prohibition); and
The abuse by one or more undertakings of a dominant position in a market which may affect trade within the UK (known as the Chapter II prohibition)

If a firm was found guilty of breaking these laws then the firms can be prosecuted and fined up to 10% of there annual uk turnover.

New proposals where to make the fraud office lead prosecutor instead of the OFT (Office of Fair Trading) Company directors were to be jailed for up to 5 years with possible fines on top.

Two years ago OFT where given the power to impose big fines on firms operating cartels, however only two fines have been imposed and are being negotiated.

These laws are no being watered down due to demand from industry groups. Four month after announcing that operating a cartel would carry a strong jail sentence with no fine option, the department of trade and industry said it will allow offenders off with a fine.

So is there need for these regulations and will they work? I believe that these regulations, if not stronger ones are needed. As if firms where allowed to dominate the market then they would be able to charge high prices for there goods, which is not good for consumers. These laws have the potential to work if they stick to strong measures instead of watering them down. As right now there is a bigger gain to be had by firms who form cartels. Even if they are found guilty they would be able to pay the fine and continue to carry on. And if a director was put in jail they would properly only get 2 years at the most and then when thay got out would no doubt have a large payment from the firm for going to jail and could walk back into there job if desired.