The prisoner’s dilemma behind cartels’ profits and penalties

Turns out the very logic that backs cartels as a rational profit-maximization mechanism also rushes encourages firms to turn themselves in.

The international war waged against cartels in the auto industry can be traced back to 2010, at the latest. In the U.S., collusion has been illegal since the passage of the Sherman Act in 1890, but law enforcement didn’t get tough until the lysine conspiracy in the 1990s. Before then, most companies “saw it as like going 5mph over the speed limit,” Roxann Henry of Morrison & Foerster, a law firm, told The Economist.

Policies and penalties have grown harsher. The maximum corporate fine in the U.S. soared 10 times, and a few dozens of executives in the auto industry were put behind bars in during 2010-2015. In Europe, firms can be fined up to 10 percent of their turnover.

Severe consequences should make it more challenging to bust cartels, right? Not with the incentives to “spill the beans” provided by the American program, which was quickly gained copied globally popularity: The first firm to cooperate with law enforcers can avoid fines and prison time; the second and third could secure lesser benefits, but no criminal immunity.

That’s not hard to understand, given the logic that motivates cartels. Research shows that two-thirds of cartels are in industries where the top four firms own 75 percent or more of the entire market. Cartels’ median duration is five years, and many last decades. A study, “Cartels as Rational Business Strategy: Crime Pays”, looks at 75 cartels and finds they typically raise prices by 20 percent.

The auto industry is particularly a good fit: with each carmaker only approving a few suppliers of each part, the barriers to entry are high and the market encourages supplier concentration.

Fearing other suppliers would lower prices to gobble up more market share, the few players in the game — if behaving rationally and assuming the market size is fixed — would all offer to sell for less, resulting in a profit drop for every one. Instead, they cheat the system by holding, rising or cutting prices together, so no one has to suffer a decrease in profits due to competition.

Those firms find themselves in a similar situation when it comes to law enforcement: if one reveals the scheme to investigators, others not only lose the choice to keep the secret, but also pay an opportunity cost of the “first spiller” benefits.

The price tag on cartels? Last week, Mitsubishi Electric and Hitachi Ltd were fined a total of 137.8 million euros, or $149.8 million for fixing prices of car alternators and starters in Europe. Last year in the U.S., Japanese supplier Kayaba had to pay $62 million in criminal fines, Bosch had to pay $57.8 million, Espar Inc. paid $14.9 million, just to name a few.

 

Sources:
http://www.economist.com/news/business/21599799-trustbusters-have-got-better-detecting-cartels-and-bolder-punishing-them-incentives
http://www.autonews.com/article/20130926/OEM10/130929916/timeline:-how-the-auto-parts-industrys-price-fixing-scandal-has
http://europe.autonews.com/article/20160126/ANE/160129912/eu-antitrust-regulators-will-fine-japanese-suppliers-report-says

11 thoughts on “The prisoner’s dilemma behind cartels’ profits and penalties

  1. The notion of cartels in the auto industry brings to mind the monopolistic nature of the beer industry. SAB Miller relinquished its shares of Miller Coors to Molson Coors partly in order to avoid regulatory concerns; however, Molson Coors continues to be profitable after the acquisition, so the brand carries at least some value. Did SAB Miller sell off its hefty shares in order to avoid the impending regulatory penalties as the first whistleblower in auto cartels does to gain benefits and immunity? Even if this is not the case, Molson Coors stood to gain from the acquisition. I wonder in this case who the whistleblower is. Since nearly all brands run about the same cost to consumer, is there some degree of cartel thinking at play in the beer industry as well?

    • Price-fixing is definitely a thing in the beer industry. Back in 2014, 5 major German breweries were fined more than €100m for price-fixing; however, more than 12 brewers were investigated. This includes AB InBev, escaping the fine after becoming the whistleblower for the cartel operations for 18 months. However, because of the rise of craft beer and premium beer industry, I think this phenomenon would not be as common as before. According to a Time article, consumers are willing to “pay more for a product they deem as superior- be it locally brewed craft beer or an upscale mass-market beer like Budweiser Black Crown.” Clearly there is a much more profitable market for the beer giants so price-fixing would not be their priority as I would imagine.

      http://worldnews.nbcnews.com/_news/2014/01/13/22290655-german-beer-companies-swallow-150-million-fine-for-price-fixing
      http://business.time.com/2013/08/02/big-beers-sales-slump-and-yet-profits-rise/

      • Ah, beer … which reminds me that I’ve not heard back from Devil’s Backbone (or from Blue Lab). So no cartel, but we still have the puzzle of identical prices for Bud Lite, Miller Lite and Coors Lite. Is there a contradiction in this? (Hint: we’ll look at this in Friday’s class.)

    • Mergers & acquisitions are one case where firms need to get advance approval from antitrust authorities. That is, policy is proactive. [Busting a cartel is a reactive policy.] In this case (and similar cases), where the combined firm would have a very high market share in one or another product line, spinning off those businesses is made a requirement for the merger to gain approval. AB InBev was aware of that from the beginning.

      Now that does raise an interesting question: since they had to sell off either Budweiser or MillerCoors, to whom could they sell it? Because either of those is quite large, there may have been only 1-2 possible purchasers. Did AB InBev get a good price from the Canadian firm Molson Coors? [A fallback position would be to spin it off as an independent company with an IPO for 100% of the shares, which I think in this case was very unattractive.]

  2. Interesting post, Athena. I am intrigued by the international cooperation that has led to these collusion busts, in particular the collaboration between the United States and Japan. As a politics major, I also wondered: what does the draft text of the Trans Pacific Partnership (TPP) have to say about any of this, if anything? Exploring this question a little further, I found that while governments are hurting businesses’ bottom-lines with collusion busts, they are also attempting to codify (in this case, through the TPP) access to cheaper cost inputs for players in their respective auto industries (Politico).

    One of the major issues in TPP negotiations is over the “Rules of Origin” provision, which deals with how much of a part or entire vehicle must be sourced from TPP nations in order have the product qualify under the massive trade agreement (Politico). According to Congressman Sander Levin, who wrote the Politico article I am referencing, Japan is very in favor of a relaxed rule, one which would enable them to produce automotive products at a very low cost. Levin, a Michigan Democrat, is in favor of a strict rule—one that aids the auto industry near and dear to his Michigan heart. So, while there is international cooperation on protecting the consumer, there also exists an opposite presence of global disjointedness when it comes to protecting the cost structures and bottom-lines of nations’ domestic industries. Certainly, this is a very interesting dynamic and a reminder that there are many different sides to every industry.

    Sources: http://www.politico.com/agenda/story/2015/10/whats-still-wrong-with-the-tpp-000262; https://en.wikipedia.org/wiki/Sander_Levin.

    • As far as I know antitrust is not covered under the WTO or (potentially, since I’m not sure it will ever pass) TPP.

      On the automotive side of TPP, Levin’s claims need to be taken with a grain shaker of salt. In the background is that in contrast to either Europe or Japan the US maintains high tariffs (25%!!) for certain vehicles. In contrast, tariffs in Japan are zero. US tariffs are on light trucks (other automotive trade, parts and vehicles, is generally at 2.5%), and while the definitions – multiple! – of “truck” for tariffs, safety rules and so on aren’t uniform, pickup trucks aren’t a significant share of either the European or Japanese or Korean markets. Assemblers generally don’t want to have costs in yen or euros when almost all their revenue would be in dollars. So for such vehicles TPP is irrelevant. Oh, and Toyota and Nissan both already assemble full-sized and mid-sized pickups in NAFTA, so TPP is again irrelevant.

  3. Very interesting post Athena. I couldn’t help but think of another major “cartel” in OPEC. I’m careful in using that word because many member nations resent it being called that, but instead choose to say “organization”. Anyways, we see here a group of oil-producing nations who openly meet to control production levels of oil in order to stabilize price as well as their national economies that heavily rely on oil as a main export. However, there seem to be no repercussions or fines handed out to these governments for agreeing on production levels. Upon doing further digging, I found that in 2007 not only was OPEC recognized as a legal entity, but was protected under U.S. foreign trade laws thanks to the Foreign Sovereign Immunity Act of 1976 who deem OPEC’s actions as governmental rather than commercial, thus placing the organization out of reach. Many bills have been proposed to give the U.S. government the ability to declare OPEC illegal, but typically do not receive enough support or are threatened with a veto by the president. It seems to me that our high dependence on foreign oil, especially in the early 2000’s, has left us at the mercy of OPEC. They abuse our inelastic demand for oil in order to maximize their profits while we idly sit by. Although in recent years, the increasing amount of alternative energy as well as oil-drilling in the U.S. has lessened OPEC’s grip on the U.S. economy and eaten away at their market share. Hopefully, this trend will continue and maybe down the line we will see some sort of repercussions.

    Source:
    http://www.newsmax.com/Newsfront/opec-cartel-illegal/2009/12/12/id/341497/

    • Ah, but do OPEC members actually cooperate? The empirical evidence seems to be NO! – the incentive for members to cheat when prices are low is simply too strong. This is basically our Bertrand model, but worth talking about in class!

      In the opposite situation, when demand is strong (relative to potential production), there’s no need to cooperate: prices will be naturally high.

      For more on such incentives see my own blog post “Low Oil Prices: Not a Saudi Conspiracy

    • This was a scary sort of “don’t bite the hand that feeds you” scenario a few years ago. America’s dependence on foreign oil has certainly decreased and with it, so has our reason to turn a blind eye to such illegal behavior. I suppose, though, that it is difficult to compare the oil and gas industries to the beer industry because of their differences in scale and geopolitical significance. Wars are not usually fought over hoppy beverages.

  4. A thoughtful post and (read them!!) good comments. The shift in the legal structure to encourage “spilling the beans” does indeed seem to be making a difference. A really neat example is in a segment of the radio show This American Life, “The Fix is In,” which is on a man who decided to go to the Department of Justice, and ended up wearing a wiretap to meetings. It’s fun to listen to, and very well done.

    Now one point to that you did not raise is what sort of products are and are not part of this wide-ranging price fixing scheme. The answer is that they are items on the commodity end of the spectrum, because it’s generally not possible to coordinate on pricing new technologies or parts are idiosyncratic rather than a standard design adapted to a particular vehicle. This point is subtle, and not highlighted in textbooks, though it makes sense with hindsight. For more see two posts on my personal blog, Japanese Suppliers: May the New Year be Happier! and $2 billion and counting: the supplier conspiracy

  5. I think it would be interesting to further consider why cartels seem to arise. There seems to be a trend in the creation of cartels and when an industry has an oligopoly business structure. For example if we were to look further into the internet service provider industry, at companies like Comcast, there seems to be an agreement that companies will not lower their prices in competition with one and another. Therefore I think it is important to consider why these cartels may come about versus relying on governmental laws to enforce companies’ obedience in not coordinating to set prices.

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