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Lecture Three Oligopoly and Market Collusion Learning objectives Students should be learnt about • Understand some features of a oligopoly market tend to market collusion • Look into different cases of price fixing • Development of cartel • Understand the price coordination in the market place Features of Oligopoly The Cournot model Duopolists A and B face industry demand P=100-Q, Q=QA+QB Each firm takes the other’s output as fixed E.g., PA=(100-QB*)-QA Marginal revenue for A is MRA=(100-QB*)-2QA If MC=0 (simplify), profit is maximized if QA=50-.5QB, which is reaction function of • the duopoly A Other firm takes the A’s output as fixed E.g., PB=(100-QA*)-QB Marginal revenue for B is MRB=(100-QA*)-2QB If MC=0, profit is maximized if QB=50-.5QA, which is reaction function of duopoly B • Cournot equilibrium 1 Comparison of prices and output among different equilibria The Oligopoly Problem z Prohibitions against Horizontal Agreement z Small number of firms z Interdependence z Strong incentive to collude z Recognition of interdependence removes incentive to compete z In oligopoly non-competitive outcome possible without actual collusion. Collusive Behaviors and Cartel Collusive behavior z Price Fixing z Bid Rigging z Market Allocation z Joint Boycott z Quota z Discriminatory Standard Cartels – An “efficiency’ cooperation, or a policy-induced cooperation, or a regulated market cooperation 2 Per Se Rule against Price Fixing z Per se rule means that only need to prove the conduct such as a cartel agreement, no need to show economic harm. z Per se subsequently upheld by the Supreme Court Standard Oil Company of New Jersey et. al. v. US, 221 US 1 (1911). { US Supreme Court subsequently rejected claims that it was legal to fix prices provided they were reasonable. { “The aim and result of every price-fixing agreement, if effective, is the elimination of one form of competition. The power to fix prices, whether reasonably exercised or not, involves the power to control the market and to fix arbitrary and unreasonable prices. The reasonable price fixed today may through economic and business changes become the unreasonable 3 price of tomorrow. Once established, it may be maintained unchanged because of the absence of competition secured by the agreement for a price reasonable when fixed.” US v. Trenton Potteries Company et. al. 273 US 392 (1927). Oligopolists Take Rivals Reactions into Account in Setting Prices z Study of pricing behaviour of UK firms indicated that a significant proportion were reluctant to cut prices for fear of triggering a price war. {Hall, Walsh and Yates (1996): How do UK Companies Set Prices, Bank of England, Quarterly Bulletin (May). UK Banks z “In such a concentrated structure, it is to be expected that there will be a recognition, however independently, on the part of the companies concerned that price competition is likely to be damaging to them. A price cut that generates little or no increased sales would not be profitable. One that does increase sales, at competitors’ expense, is likely on that account to trigger price cuts by competitors, such that all would end up less profitable than they previously were. In such circumstances there would be a strong disincentive to price cutting. In consequence price competition will be weakened, and largely limited to any segment of the market where such considerations do not apply.” { Competition Commission (2002): The Supply of Banking Services by Clearing Banks to Small and Medium-sized Enterprises, CM5319, Para. 2.141. Explicit v. Tacit Collusion z Phlips (1995): they have the same objectives { Explicit collusion aims at putting the members of an agreement at the point on the profit frontier at which their joint profit is maximised. { Tacit collusion aims at increasing the profits of the colluders above the level implied by a non-cooperative Cournot-Nash equilibrium until, hopefully, the joint profit maximising point is reached. z More complicated with tacit collusion due to absence of agreement in the form of a legally enforceable contract z Tacit collusion typically because such contracts are illegal. Explicit Collusion z The Lysine Cartel {US DoJ Antitrust Division Website Case filings United States v. Michael Andreas and Terence Wilson. {ADM new entrant initiate the cartel {Famous quote “Our competitors are our friends; our customers are the enemy”. (Senior ADM executive outlining the company’s philosophy at a 4 cartel meeting) {The Video z Agreement on price, Volume allocation Side payments z Role of Trade Associations z Secrecy z Adverse effect on buyers 25% mark up {Understand more about cartels with Modern Game Theory Mode The problem of “cheating” { “No one has yet invented a way to advertise price reductions which brings them to the attention of numerous customers but not to that of any rivals.” { Stigler (1964), A Theory of Oligopoly, Journal of Political Economy, 72: 44-61. Milk Bid Rigging Case z A case on how to detect collusion z Public education authorities will ask for bid for the supply of milk every year {Milk is quite a homogenous product {The cost structure is the same {Only matter is the transportation cost z More than 600 school district in Ohio z A district purchase 50K half pints of whole white and 30K half pint of chocolate milk for 450 students z Raw milk thru processed by standardizing the butter fat content and then pasteurizing, packaging and delivering. z Total incremental cost is 10 cents z Bid rigging is per se offence in US z Economic Evidence to prove the behavior {Evidence on the incentives to collude {Evidence whether the behavior is more consistent with competition or collusion {Evidence on the extent of damages Factors Facilitating Collusion z Compete only on price z Publicly announcing bids and the identity of the bidders – able to detect “cheating” on the collusion z Periodically bidding exercise –help retaliation z Set of firms submit bid is small and stable z District defines the market allocation z Predictable Demand – help retaliation z Many trade associations – help communications 5 z z z z Competitors meet very frequency Price information is available Similar cost structure and production processes Competitors also customers of one another Analysis and Effects z If there is no bid rigging, what would you observe about the bids? { Far way bidders bid higher { But if there is bid rigging, the closest one bids higher z Porter and Zona conduct a regression analysis on the winning bid on variables { Contract terms { Cost of potential bidder – the distant travel { Measures of competition: z HHI within 75 miles z Change in HHI within 75 miles with a suspected conspiracy { An average of 6.5% price elevation over 10 years excluding years the cartel indictment { With market power, average price increase can be 24.6% z John Nash, the Nobel Prize winner analyzing selfish rivalries in market phenomena if each firm does its best it can given rival’s actions z For example the duopoly market: { Two firms both do their best it can, given expectation of their rival behaviors { Behaviors are non-cooperative { Two firms when considering a low price or a high price strategy, it formulates its strategy upon its rival’s response { Cooperation has an anti-trust implication Nash Equilibrium of a single/finite business interaction Nash Equilibrium of repeated business interaction Tacit Collusion and Facilitating Practices. z Definition of concerted practice. 6 z “….a form of co-ordination between undertakings which, without having reached the stage where an agreement properly so called has been concluded, knowingly substitutes practical co-operation between them for the risks of competition.” z Case 48/69 ICI v. Commission (“dyestuffs”) [1972] ECR 619. How Much Cooperation Required z In Suiker Unie ECJ held that concept of concerted practice did not require the working out of an actual plan and that: z “…each economic operator must determine independently the policy which he intends to adopt on the common market including the choice of the persons and undertakings to which he makes offers or sells…[T]his requirement …does,…, strictly preclude any direct or indirect contact between such operators…to influence the conduct on the market of an actual or potential competitor or to disclose to such competitor the course of conduct which they themselves have decided to adopt or contemplate adopting on the market.” Case 47/73, Suiker Unie v. Commission [1975] ECR 1663. The Great Salt Duopoly z MMC (1986): White Salt: A Report on the Supply of White Salt in the United Kingdom by Producers of Such Salt, London: HMSO {Firms acted “to restrain competition”. {Evidence of price communications. z Rees (1993): Collusive Equilibrium in the Great Salt Duopoly, Economic Journal , 103: 833-48, reproduced in Phlips ed. Applied Industrial Economics z Rejects arguments that parallel price changes result of competition. z In “homogenous price-setting duopoly with exogenous capacity constraints, non-cooperative behaviour does not result in identical prices.” Parallel Behaviour Not Enough z Commission relied on parallel price changes over a period of several years. z Court held it had failed to prove collusion. z Parallel behaviour not enough if there is an alternative explanation of such behaviour. z See Phlips (1995) on this case. z Such collusion impossible to prove The Ethyl Case z US Case of Facilitating Practices/Concerted Practices Lead-based anti-lock compound Industry 7 z A decline industry z Four major players: DuPont, Ethyl, PPG and Nalco z Industry total turnover 400million pounds in 1980 z Product characteristics What is the main issue? {Sherman Act only outlaw “explicit” collusive agreement but how about Oligopoly Problem, tactic cooperation {What is the problem? Phenomena – parallel pricing, Why? {One party increases price leading to other to follow. z Two important elements: ability and incentive Legal Arguments z Du Pont advance announcement of price rises is not a concerted practices. { Court rejected collusion if alternative explanation for such behaviour. { Record showed that Du Pont had pre-announced price increases even when it had a monopoly. Factors influences facilitating practices { Non-public prices { Lumpy Sales { Complex and non-fungible products { Market concentration But Problems When Other Explanation Lacking. z Re Coordinated Pretrial Proceedings in Petroleum Products Antitrust Litigation, 906 F.2d 432 (1990). z Oil companies disseminated information regarding their wholesale and retail prices for the purposes of quickly informing competitors of a price change in the hope that they would follow suit z Court found some of the information circulated was only of interest to the companies and their franchisees and that there was no legitimate business reason for circulating the information to individual retailers. A final thought on information exchange. z Phlips (1995, p.82) criticises competition authorities for assuming information exchanges is proof of collusion. z Difficulties of enforcing collusion, simple exchange of information cannot be construed as implying a collusive outcome is being achieved. z All it could show is collusive conduct, “in the sense that the oligopolists are trying to achieve a collusive outcome.” (Emphasis in original). 8 Discipline of Cartel 9