Chapter 7: Problem 6

Why is cheating a typical problem for cartels?

Short Answer

Expert verified

Cheating is a typical problem for cartels due to the high incentives for individual firms to maximize their profit by not following the collective agreement. This problem is further compounded by the difficulty of effective supervision and enforcement within the cartel. These factors lead to a situation wherein despite forming a cartel to behave contrarily, self-interest dominates leading to the prevalence of the cheating problem.

Step by step solution

Understanding Cartels

A cartel is a collection of independent market participants who collude with each other to improve their collective profit by means of price fixing, sharing markets, or other restrictive practices. Members of a cartel would try to earn 'supernormal' profits in the market that is not possible otherwise.

Identifying the Problem of Cheating

Cheating in this context typically refers to a member of a cartel secretly pursuing their own interests, particularly through not adhering to the agreed upon pricing or production levels. This can be by producing more than the agreed quantity or selling a product at a lower price than what was collectively fixed, aiming to gain more market share or profit at the expense of other cartel members.

Explaining why Cheating is a Typical Problem

Cheating becomes a typical problem in a cartel for several reasons. Firstly, because the incentive to cheat in a cartel is often high - the cheating firm can increase its own revenues by selling more units or at higher prices than agreed, while still benefiting from the reduced competition resulting from the cartel's overall actions. Referring to basic economic principles, firms are motivated by self-interest and the pursuit of profit, so it tends to be in a firm's individual interest to cheat. Secondly, monitoring and enforcement within cartels can be challenging. Effective monitoring requires transparent sharing of information which can be hindered by several issues like legal issues, trust deficit among members, etc. Without effective enforcement mechanism, chances of cheating increase. Therefore, despite forming a collective agreement to behave contrarily, it is often the case that self-interest dominates over collective interest leading to the cheating problem.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Price Fixing

Price fixing occurs when competing companies agree to set the price of goods or services at a certain level, instead of allowing the forces of competition to determine pricing. In a cartel context, price fixing is designed to inflate prices above what they might be in a competitive market, securing higher profits for all members. However, this invariably impacts consumers, who end up paying more for products than they would in a fair market scenario.

Price fixing agreements can take various forms, such as setting minimum prices, establishing price ranges, or agreeing on discounts. These practices can be implemented overtly or covertly, but either way they undermine the competitive process. The temptation for individual cartel members to undercut agreed-upon prices can be high—cheating on these prices can lead to increased market share and profitability for the cheater, at the expense of the cartel’s collective agreement.

Market Collusion

Market collusion is the action of working together secretly, especially in a deceitful way, to limit open competition. Collusion can involve price fixing, allocating market territories, bid rigging, or setting production quotas. In cartels, collusion is the modus operandi that allows the members to control aspects of the market’s function.

However, maintaining collusion can be difficult due to the inherent incentive to cheat, since members can benefit from violating the terms privately while still reaping the benefits of collective action. Furthermore, the fear of being cheated upon can compel a member to cheat as a preemptive measure. The clandestine nature of collusion activities makes it challenging to monitor, and so, distrust and temptation to cheat proliferate. Increased difficulty in detection and regulatory action can be an additional driving force behind collusion persistence.

Antitrust Issues

Antitrust issues arise when businesses engage in activities that restrain trade and reduce competition in the marketplace. Antitrust laws are designed to protect consumers by ensuring that competition is not restricted. Practices such as price fixing and market collusion are typically prohibited because they lead to higher prices, lower quality, and less innovation.

Regulatory agencies that enforce antitrust laws work towards identifying and punishing collusion and other anticompetitive behaviors. However, the secretive nature of cartels and collusion can make detection difficult. Additionally, substantial legal and economic resources are needed to prove antitrust violations, which can sometimes act as a barrier to the effective enforcement of these laws. Despite these challenges, antitrust issues related to cartels are constantly under scrutiny to preserve market integrity and protect consumer interests.