Cartels

Public policy’s traditional hostility to cartels is rooted in the view, summarized by eighteenth-century economist Adam Smith, that rival sellers will almost always prefer to raise their prices in unison than to aggressively compete for customers by undercutting each other’s prices. But this statement tells only half the story. The same profit motive that entices sellers to want to collude also creates strong and sometimes uncontrollable temptations to “cheat” on a cartel. This is because any individual seller can usually garner a larger share of the market and earn larger profits by undercutting the cartel’s price. If enough other sellers behave in this way, however, then attempts to raise prices artificially will fail under the collective weight of cheating.2

To understand whether or when a cartel can avoid this problem, economists have studied two questions: (1) Why have cartels proven much more effective in some settings than in others? and (2) Why in many industries have cartels proven impossible to form in practice? In an influential article addressing these questions, Nobel laureate George Stigler identified two principal hurdles for any successful cartel: first, reaching a consensus on the terms of coordination, and, second, establishing a system to detect and punish cheating against those terms. These twin hurdles have proven to be higher in some industries than in others, and in many settings, sellers have found them insurmountable.

Consensus can take the form of an explicit agreement to coordinate prices, an unwritten understanding to limit competition, or simply a mutual recognition that all firms would be better off if they restrained their competitive impulses and stabilized prices. Whatever form the consensus takes, cartel members must do more than simply agree on what price to charge; they also must close off all other avenues of potential competition that could threaten the cartel’s ability to increase prices. In general, therefore, a cartel must also reach consensus on what level of services to offer, what grades of quality to produce, and how to ensure that product upgrades and new product introductions do not prompt a resurgence of competition.

While building consensus might appear to be a relatively straightforward task, actual experience suggests otherwise. According to one study, failure to reach a consensus has caused the demise of roughly one out of every four attempted cartels.3 Experience has also shown that successful cartels often find it necessary to adopt complicated and sometimes cumbersome rules to restrain competitive impulses. For example, participants in the famous electrical equipment conspiracy of the 1950s and 1960s not only fixed prices but also had to agree on how to allocate market shares and divide up the largest customers. The vitamin cartel of the 1990s, whose prosecution led to the largest antitrust fines in U.S. history, involved sellers who not only fixed prices but also rigged bids, divided up customers, and set sales quotas. The need to add layer upon layer of cartel rules not only directly complicates the process of building consensus; it also increases the likelihood that the government will learn of the illegal actions.

Once formed, a cartel must then remain vigilant against “cheating” from within its ranks and competition from outside. Experience has shown that, very frequently, the greatest threat comes from entry into the industry by sellers who choose not to follow the cartel’s pricing lead. For example, an entrant might find it more profitable to undercut the cartel price if it believes it can attract a substantial number of customers. Entry has been responsible for breaking up cartels in industries ranging from ocean shipping to oil to railroads. A somewhat less prevalent cause of breakups has been underpricing by cartel participants themselves. Internal cheating has undermined cartels operating in electric turbines and railroad transportation, among other industries, when sellers could not resist the temptation to quickly capture a large share of the market by discounting their price to a select group of major customers. Requiring audits of participants’ sales, creating financial incentives for customers to report price discounts offered to them, and setting up systems to monitor emerging threats of entry are among the tools that can help cartels detect cheating.

If cheating is detected, it must then be punished to discourage repeat occurrences. Sellers will be discouraged from cheating only if their temporary gains from underpricing the cartel are outweighed by the longer-term cost of punishment. Punishment can take many forms, ranging from other sellers targeting price discounts at the offender’s customers, to cutting the offender’s allocated sales quota, all the way to suspending the cartel’s activities for some period. In almost all instances, however, punishment will be costly not only to the offender but also to the sellers who mete out the penalties. Discipline will work, therefore, only when the cartel members believe it would be costlier to turn a blind eye to sporadic cheating than to mete out punishment as a lesson for the future. The fact that many cartels have fallen victim to cheating suggests either that the punishment was inadequate or that cartel members recognized the futility of punishment.

Economists have identified a range of conditions that tend to make forming and defending a cartel harder in particular industries, and practically impossible in some. By analyzing cartel experiences within and across industries, economists have learned that cartels tend to be less likely to form and less likely to endure in industries where:

To supplement these “economic” hurdles to cartel operation, governments also can take additional measures to discourage industry cartels from forming. Antitrust laws in the United States and some other countries expose cartels to criminal and civil penalties. The wave of recent high-profile cartel indictments, leading in many cases to large fines and prison sentences for corporate executives, suggests that antitrust laws may have a substantial deterrence effect. Yet, at the same time, the continuing stream of prosecutions also suggests that deterrence remains incomplete.

In other instances, however, government policies have purposefully facilitated industries’ efforts to cartelize. During the Great Depression, for example, the National Recovery Administration (NRA) imposed “Codes of Fair Competition” that exempted cartels from antitrust penalties to stop “destructive price-cutting.” Throughout the late 1930s, government-encouraged cartels flourished in literally hundreds of industries ranging from steel and textiles to beer and pasta. Several of these cartels survived long after the NRA codes were struck down, which suggests that the government’s actions “taught” sellers how to collude to the long-term detriment of consumers. Governments both at home and abroad also have facilitated agricultural cartels by establishing marketing boards that specify price floors or production ceilings (quotas) for particular crops.

In some industries, governmental facilitation of cartel activity has been unintentional. An infamous example originated from a decision in the early 1990s by the Danish Competition Council to collect and publish transaction prices for sellers of ready-mix concrete. Following publication of the price information, customers wound up paying 15 to 20 percent more for concrete. The government’s actions made pricing more transparent among supposedly competing sellers and thereby facilitated their efforts to detect and punish those sellers who sought to undercut the cartel’s fixed price. Unwitting facilitation of cartels also occurs in government procurement auctions. In an effort to discourage political corruption, many governments announce winning and losing bids after such auctions. However, this practice also broadcasts the identity of cheating sellers to members of the cartel, and thus unintentionally facilitates the detection and punishment of price cutters.4

Notwithstanding governments’ occasional sponsorship of cartels, historical experience indicates that cartels remain rare in most industries. Even though the United States has granted broad antitrust immunity to exporting industries, for example, fewer than 5 percent have sought to fix prices to customers abroad.5 The reluctance of most sellers to attempt a conspiracy to raise prices—even with their government’s blessing—suggests that the economic hurdles to successful cartel operation remain high.