EC365 Theory of Monopoly and Regulation

Topic 3: Collusion

2013-14, Spring Term

Dr Helen Weeds

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Monopoly power

Monopoly outcomes

• monopoly pricing• price discrimination• costs, technology

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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?

 

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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”

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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

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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

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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

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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]

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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?

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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