Incomplete Cartels Iwan Bos Norwich, 2008

1. Incomplete Cartels Iwan BosNorwich, 2008

2. Incomplete cartels are cartels with less than one hundred percent market share. In other words, there is at least one non-participating firm. Most theories of collusion assume the perfect or full cartel to be all-inclusive. Yet, “Many of the cartels that have been uncovered in the past are really “incomplete cartels”, i.e., they do not include all the firms in the industry but just some fraction of them.” (Pakes, 2006). Cartels were not all-inclusive in a significant number of cases in Europe since 1964 (average market share around 75%). Hay and Kelly (JLE, 1974) analyzes 65 horizontal cartel cases. Market share data are available in 45 cases, 32 of which deal with cartels that are not all-inclusive (average market share of around 88%). In 14 cases the market share exceeded 90%. Average CR4 is around 75%, while average number of firms in these cases is 12, suggesting that market shares were unevenly spread. ‘…it is not necessary for a conspiracy to include all the firms in the market to exist, or indeed, to be successful. In general, they [non-conspirators] seem to be the smallest competitors…’ Introduction

3. DeRoos (IJIO, 2007) takes a structural dynamic approach to analyze the well-known Vitamin C cartel. His analysis suggest that a cartel will persist only if fringe competitors remain small. Vitamin conspiracy collapsed due to growing fringe production from China. A similar situation occurred in the Citric Acid industry. In short, evidence, although relatively scarce, suggests that: Many cartels are not all-inclusive Incomplete cartels are often dominant (significant market share) Firms not included in the cartel are typically the small players in the market. Introduction

4. Most literature on collusion assumes cartels to be all-inclusive. Theoretical reasons for why firms fail to form the full (perfect) cartel: incentive to cheat ex ante (participation) and ex post (stability). Most of the literature assumes symmetric firms, which is problematic, because it is difficult to see why similar firms would take non-similar decisions (some should participate in equilibrium, some should not) This problem is particularly severe because in equilibrium outsiders are typically better off than insiders. Theory predicts the incentive to free-ride on a cartel formed by others is strong. To provide a rational basis for incomplete cartels one has to model a setting in which some firms have an incentive to collude, while others simply best respond. At a minimum, this requires firms to differ in at least one respect. Yet, many oligopoly models are not very convenient to study collusion with asymmetric firms. The Theoretical Problem

5. We aim to provide a rationale for the existence of cartels that are not all-inclusive. In particular, we address the question “who is in and who is out?” We take the following approach Dynamic game with firm heterogeneity in terms of production capacity (proxy for firm size). Take into account both the participation problem and the incentive problem. Overt as opposed to tacit collusion (we assume colluding is costly) Aim to relate the theoretical outcomes with partial cartels in practice. Towards a Theory of Incomplete Cartels

6. Small cartels are not viable. Optimal cartel size is all-inclusive when cartelizing is costless. Optimal cartel size is incomplete when cartelizing is costly and the smallest firm(s) are sufficiently small. Sufficiently small firms have no incentive to take part in any cartel Sufficiently large firms have no incentive to free-ride on a cartel formed by rivals. The most profitable cartel is formed by the largest firms in the industry. Under certain conditions, firms have an incentive to form the cartel for which total profits are highest. Main Results

7. A Model of Collusion with Asymmetric Capacity Constraints • Let N be a set of n profit-maximizing sellers which simultaneously set price. • Homogeneous products produced at constant marginal cost c > 0. • Market demand function with and . • Production capacity is denoted by and is assumed fixed for all . Furthermore, without loss of generality, capacities are indexed such that: • Define two sets: and • No particular rationing scheme, but we impose the following mild condition

8. Assumptions • Assumption 1 (some symmetry across firms): • If , then • If , then • Assumption 2 (no very large firms in absolute terms): • Assumption 3 (limited power for largest firm(s)): • Note that Assumption 2 in conjunction with Assumption 3 implies , but this has no bite in our analysis because our focus is on incomplete cartels.

9. Static Nash Equilibrium • Firms choose a price from the set: • Individual profit function: • Proposition 1: In competition, there exists a symmetric equilibrium in which all firms price at marginal cost. Moreover, as , this equilibrium is unique.

10. Collusion • Let denote a (sub)set of firms that engage in a price-fixing cartel and set a cartel price • Lemma 2: If a profitable cartel sets a price , then the best response of an individual profit-maximizing outsider is to sell units at a price , for sufficiently small. • Individual cartel profits then amount to: • Infinitely repeated version of this game with ‘grim-trigger strategies’. The incentive compatibility constraint of is then given by: • Lemma 3: As ,

11. Collusion • Note that as long as which due to Assumption 3 always holds. • Small cartels are not viable! • The cartel problem is: Subject to: • Lemma 4: The optimal cartel price is strictly increasing in total cartel capacity.

12. Let total industry capacity be given by K. The optimal cartel prize is determined by total cartel capacity. The Model Visualized Cartel Capacity Fringe Capacity 0 K

13. Optimal Cartel Size when Cartelizing is Costless • Proposition 5: A cartel can always allocate its profits in such a way that it Pareto dominates every smaller cartel. • This result is non-trivial. For example, in a standard linear Cournot model Pareto improving cartel expansion requires. Which does not always hold (e.g., n=10, x=8, t=1) • The intuition underlying Proposition 5 is that outsiders benefit from the cartel, but not ‘too much’. • Corollary 6: The optimal cartel size is all-inclusive.

14. The assumption of cartelizing being costless is arguably restrictive: Establish the ‘right division’ of profits typically will require negotiations Taking part in a cartel is often illegal and therefore costly (chance of being caught, fines, etc.) Monitor each other to ensure compliance Although not much is known about magnitude of these costs we may safely assume these to increase in the number of participants. Negotiations and reaching an agreement more difficult in larger groups Threat of ‘race to the courthouse’ (leniency, it matters to be (one of) the first) Monitoring efforts Risk of detection, because larger cartels are presumably ‘more visible’. Collusion among the Few

15. Optimal Cartel Size when Cartelizing is Costly • Take account of these costs by introducing a general cost function , with x being the number of cartel participants. In light of the previous discussion we naturally assume that . • Introducing costs tightens the incentive compatibility constraint for all cartel members. • Proposition 7: If the smallest firm in the industry is sufficiently small, then the optimal cartel size is less than all-inclusive.

16. Incentives to Collude • So far, we did not consider the incentives of firms to take part in a cartel or to remain an independent outsider instead. Given that the cartel is not all-inclusive, the question is ‘who is in and who is out?’. • The participation problem has already been formulated by Stigler (AER, 1950): “…the promoter of an incomplete cartel is likely to receive much encouragement from each firm – almost every encouragement, in fact, except participation…” • The incentive to free-ride is due to the fact that cartel members do not fully utilize their capacity, while outsiders produce up to capacity and sell their products at approximately the same price. • In the current setting, firms are characterized by their capacity stock and this might cause a diversity in free-riding incentives.

17. Incentives to Collude • Extend the game with a participation stage at t = 0. We assume that firms play an open membership game as proposed by d’Aspremont et al. (1983). • Outsiders have no incentive to join a cartel if: • Insiders have no incentive ‘to leave’ if: • These two conditions together form the ‘participation constraint’. • The participation constraint is a refinement criterion in the sense that it narrows the set of viable cartels. • We further assume that firms receive a proportional share of total cartel profits (at least three reasons for this: natural way to divide ‘the cake’, empirical evidence (Harrington, 2006) and it facilitates collusion).

18. Incentives to Collude • Lemma 8: As , a sufficiently small firm has no incentive to join any cartel. • Lemma 9: A sufficiently large firm has an incentive to join any cartel. • Proposition 10: A cartel agreement between the largest firms in the industry is a solution of the game. • Note, however, that this result is typically not unique. There may well exist equilibria in which the largest outsider is larger than the smallest insider. • A cartel that is of special interest is the cartel for which total cartel profits are highest, i.e., the most profitable cartel. We denote this cartel by . • Proposition 11: For any given cartel size, the most profitable cartel comprises the largest firms in the industry. • Proposition 12: If the smallest member of is sufficiently large, then is a solution of the game.

19. This paper provides a rationale for the existence of incomplete cartels. Main conclusions: If cartelizing is costless the optimal cartel size is all-inclusive. If cartelizing is costly the optimal cartel size is less than all-inclusive when the smallest firms are sufficiently small. Sufficiently small firms have no incentive to take part in any cartel. Sufficiently large firms have no incentive to free-ride on any cartel. Under certain conditions, firms have an incentive to form the most profitable cartel, which may or may not be all-inclusive. It may be interesting to allow for large firms in absolute terms, but this significantly complicates the analysis. Note, however, that this is unlikely to change any of the main results. Concluding Remarks