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Cartels in Economics

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Cartels in Economics
Cartels are usually happen in an oligopoly market, where a few large
firms dominate the market. A cartel is when two or more of these firms
make a formal agreement to collude, to try and limit competition
between them. This can be done in a few ways. Members may have fixed
prices that they sell their goods, this may be low to increase sales
and stop new entrants or high as the will dominate the market. Cartel
members also agree on such factors as market share and advertising
expenditure. Quotas are another way firms collude, the member firms
will set quotas on the amount a firm will produce (production quota)
and sell (sales quota). But how do the firms agree on each members
quota? The normal method would be to divide the market between the
members according to their current market share. So basically the
firms involved in a cartel act as one firm (a monopoly)

Why would companies want to do this? Well, to capture the benefits of
a monopolist.

Diagram 1 shows the benefits that arise from forming and maintaining a
cartel. It shows an industry in long-run competitive equilibrium. The
price is P1 and the output is Q1. Here there are no economic profits.
Now, if the firms that dominate the industry where to form a cartel
and reduce output to Qc (production quota), the new price become Pc
(cartel price) and profits are equal to CpcAB, which would be shared
among members. So with no cartel there where no economic profits. With
cartel there profits are gained. Thus there is an incentive for firms
to form a cartel.

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There are a number of problems that arise from forming a cartel. Once
the problem of who joins the cartel is solved then there is the
problem of agreeing on a policy. For example, firm A may purpose that
all members drop their output by 10%. While firm B might think that
the bigger cartel members decrease output by 15& and the smaller
members by 6%. Each different member may have a different proposal,
which means reaching an agreement would be difficult.

Even once a policy is agreed there is still the problem of firms
breaking this agreement, as there is a big incentive to do so. Diagram
2 shows a firm in a cartel. Before the cartel is formed produces an
output of Q1 at a price of P1 and earns no profit. After joining the
cartel it reduces output to Qc and changes the price to the cartel
price, Pc. The firm now earns profits of CpcAB. If the firm where to
cheat on this agreement and produce an output of Qcc instead of Qc,
providing the other members don't cheat then it can view its supply
curve as horizontal at the cartel price (Pc). It cannot affect price
by changing output, therefore it can produce and sell additional
outputs without changing the price. So if a firm cheats on a cartel it
gains the greater profit of FPcDE instead of CPcAB. If all firms where
to cheat then they would end up where they started.

[IMAGE]

So firms have an incentive to from a cartel but they also have an
incentive to break that agreement, which could mean even if the cartel
was allowed to succeed chances it would not be effective for long.

Roche of Switzerland and Belgium interbrew are two examples of
cartels. They were found to be trying to fix the prices of food
additive and beer. Total fines on these firms reached £25 million. An
investigation concluded that Interbrew, that brews Stella Artois, and
Alken Maes, another Belgian brewer, had shared markets, fixed prices
and exchanged information between 1993 and 1998. Interbrew admitted
some of the charges and is expected to be fined about Euros 45m.
Danone, the French food group that owned Alken Maes at the time of the
offences, should receive a similar penalty. Alken Maes is now owned by
Scottish & Newcastle of the UK. Some smaller brewers could also be
fined. Another example, which happened two weeks ago, was where 13
pharmaceutical companies received a record fine of Euros 462 for
trying to control the price of vitamins.

So who is there to stop cartels? Well a lot of people say the
government. However, the government roles in cartels are mixed. There
are examples of the government actually creating cartels rather than
stopping them. For example, in agriculture, the government may
restrict the amount of acres a farmer can grow certain crops on, this
is aimed at reducing supply of that crop, which should bring about
higher prices and higher revenues. Could the farmers afford to do this
without the help of the government? Not very likely.

But how does a government prove that firms are involved in cartels?
This can be very difficult as such factors of price fixing are hard to
spot in an oligopoly market as prices are close anyway. There are some
tell tale signs to look for in the market. Such things as price
changes and behavior that would not be expected unless there was some
sort of contact between firms.

if a firm is found guilty of breaking the competition act 1998 (this
came into full effect in March 2000). Generally, the Act outlaws any
agreements and business practices that have a damaging effect on
competition in the UK. It prohibits:

* Those agreements between undertakings, decisions by associations
of undertakings (such as trade associations), and concerted
practices which prevent, restrict or distort competition, or are
intended to do so, and which may affect trade within the UK (known
as the Chapter I prohibition); and

* The abuse by one or more undertakings of a dominant position in a
market which may affect trade within the UK (known as the Chapter
II prohibition)

If a firm was found guilty of breaking these laws then the firms can
be prosecuted and fined up to 10% of there annual uk turnover.

New proposals where to make the fraud office lead prosecutor instead
of the OFT (Office of Fair Trading) Company directors were to be
jailed for up to 5 years with possible fines on top.

Two years ago OFT where given the power to impose big fines on firms
operating cartels, however only two fines have been imposed and are
being negotiated.

These laws are no being watered down due to demand from industry
groups. Four month after announcing that operating a cartel would
carry a strong jail sentence with no fine option, the department of
trade and industry said it will allow offenders off with a fine.

So is there need for these regulations and will they work? I believe
that these regulations, if not stronger ones are needed. As if firms
where allowed to dominate the market then they would be able to charge
high prices for there goods, which is not good for consumers. These
laws have the potential to work if they stick to strong measures
instead of watering them down. As right now there is a bigger gain to
be had by firms who form cartels. Even if they are found guilty they
would be able to pay the fine and continue to carry on. And if a
director was put in jail they would properly only get 2 years at the
most and then when thay got out would no doubt have a large payment
from the firm for going to jail and could walk back into there job if
desired.

BIBLIOGRAPHY:

* ESSENTIALS OF ECONOMICS, JOHN SLOMAN

* ECONOMICS 2ND EDITION, RODGER A. ARNOLD

* OFT WEB SITE

* FINACIAL TIMES

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