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EC365 Theory of Monopoly and Regulation Topic 3: Collusion

EC365 Theory of Monopoly and Regulation Topic 3: Collusion. 2013-14, Spring Term Dr Helen Weeds. Monopoly power. Monopoly outcomes monopoly pricing price discrimination costs, technology. Routes to monopoly power. Monopoly power. Collude. Exclude. Merge. Lecture outline.

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EC365 Theory of Monopoly and Regulation Topic 3: Collusion

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  1. EC365 Theory of Monopoly and RegulationTopic 3: Collusion 2013-14, Spring Term Dr Helen Weeds

  2. Monopoly power • Monopoly outcomes • monopoly pricing • price discrimination • costs, technology

  3. Routes to monopoly power Monopoly power Collude Exclude Merge

  4. Lecture outline • Collusion and reaching agreement • Sustainability • Critical discount factor • Facilitating devices • Leniency programmes • Policy and cases • Cartels • Tacit collusion

  5. 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)

  6. 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)

  7. 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

  8. Infinitely repeated prisoners dilemma • Repeat stage game an infinite number of times • Discount factor  < 1 (where  = ert ) • “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?

  9. 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

  10. Why Infinite Periods?

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. Leniency programmes: Prisoners dilemma (2) • Payoffs •  = cartel profit (per firm, cumulative) •  = probability of detection • F = size of fine • Condition for unique Nash equilibrium?

  18. Example • (e.g.  = 3,  = 1/3, F = 9 • Enforcement • Detection powers, e.g. “dawn raids”: affect  • Fines: related to turnover & duration • Third party damages

  19. The Hollywood Treatment The serious story: “Global Price Fixing”, John M. Connor (2007) (Source: Amazon)

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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”

  26. 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

  27. 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?

  28. Features of the salt industry • Homogenous product • Declining market: 30% fall in production 1979-86 • Barriers 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

  29. 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

  30. 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

  31. 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]

  32. 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?

  33. 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

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