Cartel: A clear economic analysis7 min read

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Cartel

Cartel is the formal agreement between two or more oligopolistic firms in terms of price, quantity, and market share in order to reduce uncertainty and risk. In other words, a cartel is a formal agreement between two or more oligopolistic firms to either limit their production and/or to fix prices. Cartel agreements represent the most complete form of collusion among the oligopolistic firms. The cartel having absolute control over its member firms resembles with monopoly.

The cartel operates in both pure and differentiated oligopoly. Organization of Petroleum Exporting Countries (OPEC) is the best example of a cartel that has a significant impact on the world’s fossil fuel market. As of 2018, OPEC with 15 countries accounted for an estimated 44 percent of global oil production and 81.5 percent of the world’s “proven” oil reserves, giving OPEC a major influence on global oil prices.[1]

Some of the models of cartels are as follows:

1.     Joint Profit Maximization Cartel

The joint profit maximization model is the most stable cartel model in which the firms in cartel aims to maximize the joint profit. This situation is identical to that of a multi-plant monopolist who seeks to maximize his or her profit[2]. This model is based on pure oligopoly. Pure oligopoly is the type of oligopoly where firms produce homogenous products.

Assumptions of this model

  • There are two firms in the market, Firm 1 and Firm 2 (say)
  • Firm 1 is assumed to be a low-cost firm and Firm 2 is assumed to be high-cost firm
  • Pure oligopoly
  • Appointment of a central agency
    • The central agency has the authority to decide not only price but also quantity at which the profit is maximized.
    • Central agency allocates production among the members and distributes the joint profit among the participating firms.
    • The central agency knows the cost figure of individual firms and can derive individual demand curves.
    • Central agency acting as the multi-plant monopolist will set the price defined by the intersection of the industry MR and MC curves.

The price and output of the firm under joint profit maximization can be obtained by fulfilling the necessary and sufficient conditions.

Necessary condition: MR = MC [MC = MC1 + MC2]

Sufficient condition: Slope of MC > Slope of MR.

Figurative Analysis

Joint profit maximization cartel

Figure 1 depicts the joint profit maximization. Figure 1 (a), figure 1 (b), and figure 1 (c) represents firm 1, firm 2, and the central agency respectively. In all the panels, a, b, and c, x-axis measures quantity and the y-axis measures price.

According to the assumptions of Joint profit maximization model, central agency acting as the multi-plant monopolist set the price defined by the intersection between MR and MC, that is, MR = MC and slope of MC > Slope of MR. Hence, in figure 1 (c), at point e, industry MR intersects with industry MC that determines the common price (P) for all the firms in the cartel. The industry output (X) is also defined by the same intersection. Similarly, the horizontal line is drawn from point ‘e’ across figure 1 (a) and figure 1 (b) to determine the individual quantity of firm 1 and firm 2.

In figure 1 (a), firm 1 produces  X1 quantity of goods where firm’s MC curve intersects with the horizontal line drawn from the point ‘e’ of figure 1 (c), which represents industry marginal revenue.

Similarly, in figure 1 (b), firm 2 produces X2 quantity of goods where the firm’s MC curve intersects with the horizontal line. Firm 1 is a low-cost firm and firm 2 is a high-cost firm, so firm 1 earns a higher profit than firm 2; however, both the firms enjoy a supernormal profit.

Hence, the central agency allocates production to the member firms on the basis of cost figures and distributes the joint profit to its member firms.

2.     Market sharing cartel

Under this model, the firms are in agreement to share the market. Unlike joint profit maximization, this model does not focus on price or quantity but focuses on market share. Some of the models under market sharing cartel are as follows:

2.1.      Non – price competitive agreements

 Non – price competitive agreement is the loose form of cartel agreement where member firms agree to offer the product at the common price, at which each of them can sell any quantity demanded. The price is set by bargaining with the low-cost firms pressing for a low price and the high-cost firm for a high price[1]; the agreed price must be such that all the members earn a certain amount of profit.

The firms are not allowed to sell the product below the cartel price but are free to vary the style of their product or their selling activities. In other words, the firms compete with each other on a non-price basis.

Features of Non – price competitive agreement

  • Firms offer differentiated products
  • Member firms agree to offer the product at the common price
  • Firms compete with each other on a non – price basis such as quality, appearance, advertisement, and the like
  • Member firms are free to sell any quantity demanded
  • Unlike joint profit maximization cartel, which is a robust form of a cartel agreement, the non – price competitive cartel agreement does not stand long.

Assumptions of this model

  • There are two firms, Firm A and Firm B (say)
  • Firm A is assumed to be a high-cost firm and firm B is a low-cost firm
  • Firms compete on non – price basis
  • Differentiated oligopoly
  • Firms are not allowed to sell below the common price set by the central agency or through their negotiation but can sell any quantity demanded

Under the basis of the above assumptions, the price and output can be determined by the marginal approach.

Necessary condition: ∑ MC = ∑ MR

Sufficient condition:  Slope of MC > Slope of MR

Figurative Analysis

non-price competitive agreement cartel

Figure 2 represents a non – price competitive cartel agreement. Figure 2 (c) represents an industry or central agency. The central agency just sets the common price directed by the intersection of industry MR and industry MC. Industry MR and industry MC are the horizontal summations of firms MR and MC respectively. Hence, PM is the price set forth by the central agency.

Firm A being the high-cost firm readily sells at price set by the cartel agency as shown in figure 2 (a). But the low-cost firm has greater incentive while offering the product at the price below monopoly level, that is at PB, as depicted in figure 2 (b).

The non – competitive agreement is not stable because every firm in a cartel agreement seeks to enlarge its market share. The low-cost firms can split out of the cartel agreement and offer the product at a price lower than monopoly price and can attract considerable numbers of customers from others. Consequently, the demand curve is becoming more elastic and profit increases. Every firm has the incentive to earn higher profit and gradually the member firms leave the cartel agreement. Hence, the cartel is short – lived.

2.2.      Sharing of the market by agreement on quotas

Under this model, the firms agree on the quantity that each member may sell at the agreed price[1]. The firms are in agreement to determine the market share in equal proportion because they produce homogenous goods and the price are the same. The quotas are decided on the basis of the past level of sales or production capacity.

Assumptions of this model

  • There are two firms, Firm 1 and Firm 2.
  • The firms have identical cost.
  • Firms produce homogenous products.
  • The firms have an equal production capacity

Under the basis of the above assumptions, the price and quantity are determined by the marginal approach.

Necessary condition: MR = MC

Such that: Industry MR = Industry MC; Firms’ MR = Firms’ MC

Sufficient condition: Slope of MR = Slope of MC.

Figurative Analysis

sharing of market Cartel

Figure 3 represents the sharing of the market by agreement on quotas. According to the assumptions, figure 3 (a), figure 3 (b), and figure 3 (c) have been drawn. Figure 3 (c) represents an industry where industry price (PM) and output (XM) is determined at the point of the intersection, that is, point ‘e’ between industry marginal revenue and industry marginal cost.

The horizontal line is drawn from point ‘e’ to figure 3 (a) and figure 3 (b) represents the marginal revenue. The point of intersection between marginal revenue (horizontal line) and respective marginal cost curves of firms determine the respective output of the firm.

Hence,

XM = X1 + X2   or X1 = X2 = (1/2) XM

Difficulties in Cartel

  • Difficult to estimate market demand
  • Difficult to estimate marginal cost
  • A slow process of cartel negotiation
  • Price stickiness
  • High-cost firms are in problem
  • A bluffing attitude of members

Other online materials

Cartel | Business Economics

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References

[1] Kutosoyiannis, A. (1979). Modern Microeconomics. Houndsmill: Macmillan Press Ltd.

[1] Kutosoyiannis, A. (1979). Modern Microeconomics. Houndsmill: Macmillan Press Ltd.

[1] Wikipedia. (2018). OPEC. Retrieved from https://en.wikipedia.org/wiki/OPEC

[2] Kutosoyiannis, A. (1979). Modern Microeconomics. Houndsmill: Macmillan Press Ltd.

Suggested Readings:

Ahuja. H.L. (1970). Advanced Economic Analysis: Microeconomic Analysis. New Delhi: S. Chand & Company Pvt. Ltd.

Kutosoyiannis, A. (1979). Modern Microeconomics. Houndsmill: Macmillan Press Ltd.

Varian. H.R. (2010). Intermediate Microeconomics – A Modern Approach. W W Norton & Company: New York.

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