What’s it: A cartel is a formal agreement between several parties to increase economic benefits. It can appear on both the market demand and supply sides, although the latter is more common.
A cartel is a form of anti-competitive behavior. Its purpose is to limit competition among the members. By forming a collective agreement, companies will act as one entity by creating a cooperative agreement (a monopolist or monopsonist).
The parties make a profitable agreement between them, especially regarding the determination of price, quantity, and marketing area.
Cartels are common in markets for legally traded goods and services. However, we can also find it in illegal industries, such as drug cartels.
In some countries, almost all cartels are illegal. It distorts fair competition and harms others. Cartels in the supply chain hurt consumers as they will paying higher prices than they get from a competitive market.
The Organization of the Petroleum Exporting Countries (OPEC) is an example of the world’s largest cartel. Its members consist of oil-producing countries. OPEC’s mission is to coordinate and unify member countries’ petroleum policies and ensure the oil market’s stability.
Some other examples of cartels in the world are:
- Belarusian Potash Company and Canpotex in the global potassium industry.
- Drug cartels in Mexico and Colombia
- Milk cartel in Canada
- International Rail Makers Association (IRMA)
- Rhenish-Westphalian Coal Syndicate
- Airplane ticket cartel in Indonesia.
Cartels are usually present in oligopoly or oligopsony markets. The few numbers of companies make it easier for companies to collude. It would be difficult or even impossible for a monopolistic or perfectly competitive market structure.
In an oligopolistic market, several producers dominate the market. Each manufacturer seeks to evaluate the competitive reaction of competitors when developing strategies and making decisions.
For example, when a company lowers prices, competitors are likely to take similar steps to maintain market share. That can lead to a price war and push market prices down further, reducing all market producers’ profits.
Such circumstances provide strong incentives for players to collude. The goal, of course, is to maximize their mutual benefits.
Cartel members generally agree to avoid various competitive practices between them, especially price reductions. They can also decide on production quotas to keep market supply low and prices high.
Cartels have less market control than monopolies. Some companies may not take part in cartel members. In contrast, the monopolist can easily manipulate because there is only a single player.
For this reason, cartel prices are generally not as high as in monopoly markets. However, it is well above the price in perfectly competitive or monopolistic competitive markets.
When did the cartels appear
In general, cartels often appear in markets where:
First, there are very few companies. Each of these companies has some market power. Such market power allows companies to do credible counterattack when competitors employ a detrimental strategy.
One example is price wars. If one company lowered its price, it would encourage competitors to take similar steps. Because they have market power, competitors are also able to retaliate even more. In the end, it leads to a price war and sends market prices down even further.
To avoid a worse situation, the players will try to collude. If they do it formally, it gives rise to a cartel.
The small number of players makes it easier for them to coordinate and come to a mutual agreement.
Second, participating companies control a large market share. It allows them to control market supply.
Third, barriers to entry are high. Apart from the increasing supply, newcomers can take advantage of the cartel without having to become members.
For example, suppose a cartel charges a high price. Newcomers are also likely to set prices at the same level and enjoy the benefits. That way, new entrants can quickly reach a strong market position and threaten the cartel.
Long story short, high entry barriers protect the monopoly power of cartels and maintain long-term profits.
Fourth, the signal and information are more abundant. Companies have complete information about their competitors’ motivations and strategies. That way, they can communicate well and induce collusion tacitly.
Fifth, market demand is inelastic. I mean, consumers are less sensitive to price changes. When a cartel charges a high price, consumers do not switch to substitute products. In this way, cartel members get high revenue from the high price.
Sixth, the product is standardized. It reduces consumer preference among members’ products. Conversely, if the products between competitors are relatively differentiated, consumers prefer products from individual members over others. That leads to a break up of the cartel.
There are many different types of cartels. On the demand side, there is a buying cartel, in which the members consist of buyers in the market. On the other hand, there is a selling cartel with members of the sellers or producers.
Furthermore, based on the scope of operations, there are domestic cartels and international cartels.
Then, price cartels try to fix prices above competitive prices. The quota cartel distributes a proportional market share to its members.
Common sell cartels sell their joint produce through centralized sales agents. We call this type of cartel a syndicate.
The territorial cartel divides the marketing area into several parts, and each part is controlled by one member.
The standardization cartel applies common standards to the products of the members.
Finally, a hard core cartel is the most serious form of cartel under competition law. This deal cost customers a lot of money as it raised prices and restricted supply. As a result, goods and services are completely unavailable to some buyers and expensive for others.
The OECD identifies four main categories that define how cartels behave:
- Price fixing
- Output limitation
- Market allocation
- Bid rigging
Cartel effects on the economy
Cartel is anti-competitive behavior and is a formal agreement of collusion. The members can make decisions together as if they were the only players in the market.
It’s an easy way to maintain profits. Competition actually produces even more significant losses. Therefore, forming a cartel is the best solution to avoid losses.
A cartel is likely to make policies to their advantage. If it appears in the supply chain, it will have monopoly power over the market’s quantity, quality, and supply. The members can agree on a high price by fixing the market supply. They can also set about product quality in the market.
Such agreements hurt the public interest and the economy. It ultimately distorts the market.
In pursuit of profit, the cartel will try to convert consumer surplus into producer profit. They can also agree on ways to build high market barriers.
Why did the cartels fail
Cartels might not last long, especially in markets with low entry barriers. Newcomers reduce the profits of the members.
Newcomers may join the cartel. But, as members increased, it made communication, negotiation, and enforcement more difficult.
The self-interest motive is also another cause of cartel failure. Indeed, members are bound by mutual agreement. However, when cartel rulings do not match its goal, a cartel member has a strong economic incentive to violate the deal.
For example, cartels set production limits. Some members can choose to increase production quietly. They can sell more to make a higher profit. During the meeting, they may report that their production levels remain as agreed.
There are other ways to break a deal. Member companies can provide better credit terms, faster delivery, or related freebies. Although prices remain in line with cartel prices, companies provide better offerings, allowing consumers to switch to them.
Furthermore, several factors that led to cartel failure were:
- Strict supervision from regulators. The government usually will impose sanctions on members and can lead to dissolution. The government interests to uphold the principles of fair competition. And cartels violate these principles.
- Demand falls. A decrease in demand creates excess supply in the market, making members face a significant inventory increase. Cost and profit pressures are increasing. They will then tend to be selfish and attempt to discount prices to maintain sales.
- The presence of a substitution. Substitution markets replace the markets in which cartels operate. And formal collusion becomes irrelevant as the cartel market will eventually fall.