Notes on Cartels and Collusion (ECON 262)

A cartel is a group of firms (or sometimes individuals or governments) acting together to raise price and (sometimes) limit output in order to increase economic profit.  (Note:  are labor unions cartels?)

Cartels are usually assumed to take place in markets characterized by oligopoly (small number of firms) and sometimes even by duopoly (two producers in the market).

According to economists - for a cartel to even begin to be successful, certain criteria must be met.  The book mentions four - I want to add one more:

1.

2.

3.

4.

5. 

But even if these criteria are met - there are still two problems cartels face:

1.  The first problem is that the members of all cartels will have an incentive to cheat.  This is the main reason why we don't see many successful cartels.  Once the members begin cheating (lowering price or expanding output for example), the cartel falls apart.  We will go into this in detail later.

2.  There is a second problem.  Other firms will now have an incentive to enter the industry once the cartel is formed. When this happens, again, the cartel breaks down as new competitors pull customers away.

Anatomy of a Cartel

Examples of real world cartels: 

OPEC

Probably the most famous cartel - OPEC http://www.opec.org/opec_web/en/

The Football Cartel

On the playing field, college football is highly competitive.  But it is also a highly profitable business for the major schools that participate in football.  The combination of gate receipts, television rights, and increased alumni giving make it quite lucrative.  A number of studies indicate that a successful football team translates into success for the university with its alumni in terms of annual donations, and, if it is a state university, into success with the state legislature.

How can colleges earn these enormous profits, year after year?  Effectively the NCAA sets itself up as a cartel, making entry into big time college football difficult, and similarly protecting the team profitability. 

To see how this works, suppose a school like Kent State decided to build a football dynasty.  For a business, the solution would be quite simple: buy in.  But Kent does not have this option, for NCAA rules explicitly prohibit paying players salaries (although that might change)!

Universities are heavily regulated in what they can pay athletes: tuition, room and board, and a certain amount of pocket money is all that is allowed.  There are even limits on the number of “free” trips that a player can take in order to interview schools before signing with them.  The crucial problem is that schools like Kent and Oklahoma and Texas all pay their players “salaries” well below their MRP (marginal revenue product) - at least for many players that is probably true.  Thus temptations to cheat are clear, and lead to all sorts of stories about free cars, plush make-work summer jobs and the like.  All are attempts to evade the NCAA rules.

Normally when we think of a cartel as an effort by sellers to collude.  Here, we have an effort by buyers (employers) to collude and it is relatively successful.  The major schools are very attractive places to play football for students who aspire to be NFL stars.  Because these schools don’t face competition from other schools such as Kent State, they are not forced to pay market wages, and hence increase their profits (revenues) from professional college level football.

Here, the justification is maintaining the “academic integrity” of the game by removing “money” from the system.  Of course, that doesn’t stop the money from entering the pockets of the major teams, nor does it stop the relatively low graduation rates of athletes.  But it does stop entry, which would break the cartel and thus raise the going rate of football players. 

Game Theory Applied to a Cartel

A good way to explain the incentive for cartel members to cheat is through what is called game theory (a tool that some economists sometimes use to analyze strategic behavior -- where the players take into consideration the expected behavior of others).  It's application to real world issues is questionable - but in the issue of a cartel it might help understand the behavior of cartel members.

    All "games" share three features:  rules, strategies, and payoffs (how useful this is in the real world is questionable - but perhaps one of the few places it might help explain human action - to an extent - is in the case of cartels).

John Nash - pointed out (1951) that Adam Smith was right, people act in their own self interest.  But he added that people act in their own self interest while taking into consideration what they think others will do (who are, of course, also acting in their own self interest).

    Good example:  the prisoners' dilemma:  Two prisoners, Bob and Betty are questioned about a crime the police think they have committed.  They are put in separate rooms and given terms to either confessing or not confessing (depending upon what the other does).  The payoff matrix:

For both players the incentive is to confess (given the action of the other player).  There is both a defensive reason to confess and an offensive reason to confess.  Take Betty for example:  if she doesn't confess but Bob does, she gets 10 years (defensive reason to confess).  On the other hand, if she confesses and Bob doesn't, she only gets one year (offensive reason to confess).  It's the same situation for Bob.  They both confess!  

Not the best outcome for them -- if they both deny the crime, they are both better off.  But without communication, they are in a dilemma and they end up confessing (most of the time).

Basic Game Theory Applied To A Cartel -- or "Why Cartel Members Cheat":

Applying this theory to a cartel (in particular, a duopoly):

    Two companies attempt to form a cartel and agree upon a price and output level.  Cheating on the agreement would mean lowering their price or increasing their output level or both.

Again, both have a defensive and an offensive reason to cheat!  They end up back to competing with each other (both cheating on the agreement). 

Offensive Reason To Cheat: 

Defensive Reason To Cheat:

Therefore, as Nash demonstrated, competition between firms, not collusion, is the norm.  The "Nash Equilibrium" is the square where both cheat.

DO ICE SEVENTEEN