Theory Essay Plan on Cartels

(A) What would be the effects of a decision by the firms in a competitive industry to form a cartel? (10)

Start off with a clear definition of a producer cartel. A cartel exists when the existing firms in an industry
decide to collude through price fixing agreements. The aim of this is to maximise joint profits and act as if the
market was a pure monopoly.

Clearly a cartel is unlikely to occur in a perfectly competitive market. This point should be emphasised. There
are many firms in the market each of whom cannot influence market supply and equilibrium price. Cartels are
much more likely under imperfect competition and in particular oligopoly. An oligopoly is an industry
dominated by a few firms - each of whom has market "price setting" power.

Develop the analysis using diagrams to show how a cartel might work.

Price

MCA
P cartel MC A+B
MCB
P comp

AR
MR

Q1 Q2 Q cartel Q competition Output

Comparing a cartel with the competitive price and output

Answer should contrast the competitive equilibrium price and output (where AR = MC) with the profit
maximizing price established by the producer cartel. There are 3 marks awarded for showing this.

For the cartel to work, the member firms have to agree to allocate total output between them. Normally this is
done through a quota system - perhaps based on the marginal costs of production. Q1 is the output quota
allocated to Firm A (MCA) and Q2 is the output given to Firm B (MCB).

With a cartel, the profit maximizing price is higher and the output lower than under competitive conditions.
This results in a net transfer of consumer surplus into producer surplus. There is also a deadweight loss of
economic welfare since the cartel price > marginal costs of production (i.e. allocative inefficiency).

(B) What economic factors influence the long-term stability of a cartel, such as that organised by
international oil producers? (10)

It is important to use real world examples in your answer. They help to illustrate the theoretical points you are
making. Economic theory predicts that producer cartels will experience tension in the long run that may
undermine the output and price fixing arrangement.

The major problem facing cartel members is that joint profit maximisation is not the same as individual
profit maximisation for each firm. The cartel price lies above the MC of output for each firm. There is
therefore an incentive to "cheat" on output quotas by expanding output (moving up the MC curve) and selling
the extra output at a price slightly below the cartel price. This offers the prospect an extra "marginal profit".
The diagram produced in part A might be used again to show this.
 Price

MCA
P cartel MC A+B
MCB
P comp

AR
MR

Q1 Q2 Q cartel Q competition Output

Firm A can increase profits by expanding supply and cutting

price below the official cartel price

Game Theory might be used to support this view of long-term instability inside a producer cartel. The
Prisoner's Dilemma suggests that once a collusive/cooperative agreement has come into force, there is an
inherent tendency for each prisoner to cheat on that agreement and move back towards an
aggressive/competitive strategy. Cooperation can soon give way to cheating and subsequent retaliation.

There are other economic reasons why cartels can come under pressure:

v Falling demand creates tension between firms - e.g. during an economic downturn
v The entry of non-cartel firms into the industry reduces the percentage of the market controlled by cartel
members. This raises the importance of entry barriers in sustaining the market power of the cartel.
OPEC lost market share with the exploitation of oil reserves by non-OPEC nations (see table below)
v Exposure of illegal price fixing by the Government or other domestic and international regulatory
agencies

All of this should be discussed in the context of a cartel among international oil producers. OPEC has suffered a
long term decline in its market power over recent years - a factor behind the sustained fall in world oil prices in
the 1990s.

WORLD OIL PRODUCTION AND CONSUMPTION

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

PRODUCTION 2942.3 3073.7 3105.4 3180.0 3157.7 3183.3 3182.8 3223.7 3270.3 3369.8 3474.7
OECD 934.1 927.7 889.4 892.2 917.4 927.7 927.5 968.6 976.1 1008.6 1018.7
OPEC 924.9 1037.1 1108.9 1199.1 1197.4 1262.3 1294.3 1310.4 1326.1 1367.7 1441.5
Non-OPEC 1392.2 1412.9 1389.3 1410.3 1444.4 1469.8 1485.4 1549.8 1585.8 1647.1 1670.2
excluding the Soviet
Union

CONSUMPTION 2947.2 3037.9 3087.8 3135.2 3134.8 3163.1 3136.2 3193.6 3234.5 3324.6 3395.5
OECD 1808.6 1875.2 1897.3 1919.1 1926.6 1974.1 1984.3 2039.4 2046.2 2104.2 2130.6
European Union 15 557.2 565.4 569.3 580.1 593.5 604.3 599.0 599.4 606.0 618.9 623.7
Other EMEs 665.9 694.5 723.9 745.7 767.2 807.1 840.8 884.9 935.6 987.9 1028.7

EMEs: Emerging market economies excluding the old Soviet Union

OPEC - A CARTEL IN LONG-RUN DECLINE

Although OPEC is sitting on 75% of the world's identifiable reserves of oil, it no longer has the same price-
setting influence on the world market as it did twenty five years ago. Indeed as the table above shows, the
eleven members of the organisation account for only 40% of total world oil production. OPEC is finding it
difficult to get its members to stick to agreed production cuts. In November 1998, OPEC output was 27.38
million barrels per day, up 500,000 barrels from October and the exact opposite of what is needed to stop the
world price falling.

Recent divisions within OPEC have highlighted the inherent uncertainty and fragility of producer cartels.
Indeed some economists believe price-fixing cartels are always doomed to collapse because of the way the
output quota system works. Economic theory tells us that to price stability requires control over market supply.
Whilst OPEC would like the eleven nations as a whole to stick to output cuts to reduce excess supply in the
market, each individual producer has an incentive to expand output to increase their revenue. What is rational
for one nation also holds for others. This results in over-production and lower prices and profits for each barrel
of oil extracted. Students familiar with the theory of the Prisoner's Dilemma will see useful parallels with the
problems OPEC is having. Perhaps they need some new countries to join the cartel to reinforce the credibility
of its quota system. Russia and Mexico have been touted as potential new entrants to the organisation.

The second half of the essay does not necessarily have to focus exclusively on oil cartels. There are other
examples of price fixing that can be used and earn credit from the examiners.

• International Coffee Agreement (ICA) • Net Book Agreement (ended in 1995)

• Cement price fixing (cartel collapsed in 1987) • ‘Over the counter’ pharmaceutical products
• Electrical goods retailers and computer games • European steel producers (cartel fined heavily in
producers 1996)
• Price fixing for sales of new cars

Geoff Riley
13 April 1999