10.6: Cartels- Acting like a monopolist

A cartel is a group of suppliers that colludes to operate like a monopolist. The cartel formed by the members of the Organization of Oil Exporting Countries (OPEC) is an example of a cartel that was successful in achieving its objectives for a long period. This cartel first flexed its muscles in 1973, by increasing the world price of oil from $3 per barrel to $10 per barrel. The result was to transfer billions of dollars from the energy-importing nations in Europe and North America to OPEC members – the demand for oil is relatively inelastic, hence an increase in price increases total expenditures.

A cartel is a group of suppliers that colludes to operate like a monopolist.

A second renowned cartel is managed by De Beers, which controls a large part of the world's diamond supply. In Canada, agricultural marketing boards are a means of restricting supply legally. Such cartels may have thousands of members. By limiting entry, through requiring a production 'quota', the incumbents can charge a higher price than if entry to the industry were free.

To illustrate the dynamics of cartels consider Figure 10.14. Several producers, with given production capacities, come together and agree to restrict output with a view to increasing price and therefore profit. This may be done with the agreement of the government, or it may be done secretively, and possibly against the law. Each firm has a MC curve, and the industry supply is defined as the sum of these marginal cost curves, as illustrated in Figure 9.3. The resulting cartel is effectively one in which there is a single supplier with many different plants – a multi-plant monopolist. To maximize profits this organization will choose an output level where the MR equals the MC. In contrast, if these firms act competitively the output chosen will be . The competitive output yields no supernormal profit, whereas the monopoly/cartel output does.

Figure 10.14 Cartelizing a competitive industry

A cartel is formed when individual suppliers come together and act like a monopolist in order to increase profit. If MC is the joint supply curve of the cartel, profits are maximized at the output Q_m, where MC=MR. In contrast, if these firms operate competitively output increases to Q_c.

The cartel results in a deadweight loss equal to the area ABF, just as in the standard monopoly model.

Cartel instability

Some cartels are unstable in the long run. In the first instance, the degree of instability depends on the authority that the governing body of the cartel can exercise over its members, and upon the degree of information it has on the operations of its members. If a cartel is simply an arrangement among producers to limit output, each individual member of the cartel has an incentive to increase its output, because the monopoly price that the cartel attempts to sustain exceeds the cost of producing a marginal unit of output. In Figure 10.14 each firm has a MC of output equal to $F when the group collectively produces the output . Yet any firm that brings output to market, beyond its agreed production limit, at the price will make a profit of AF on that additional output – provided the other members of the cartel agree to restrict their output. Since each firm faces the same incentive to increase output, it is difficult to restrain all members from doing so.

Individual members are more likely to abide by the cartel rules if the organization can sanction them for breaking the supply-restriction agreement. Alternatively, if the actions of individual members are not observable by the organization, then the incentive to break ranks may be too strong for the cartel to sustain its monopoly power.

We will see in Chapter 14 that Canada's Competition Act forbids the formation of cartels, as it forbids many other anti-competitive practices. At the same time, our governments frequently are the driving force in the formation of domestic cartels.

In the second instance, cartels may be undermined eventually by the emergence of new products and new technologies. OPEC has lost much of its power in the modern era because of technological developments in oil recovery. Canada's 'tar sands' yield oil, as a result of technological developments that enabled producers to separate the oil from the earth it is mixed with. Fracking technologies are another means of extracting oil that is discovered in small pockets and encased in rock. The supply coming from these new technologies has limited the ability of the old OPEC cartel to increase prices through supply restriction.

Application Box 10.1 The taxi cartel

The new sharing economy has brought competition to some traditional cartels. City taxis are an example of such a formation: Traditionally, entry has been restricted to drivers who hold a permit (medallion), and fares are higher as a consequence of the resulting reduced supply. A secondary market then develops for these medallions, in which the city may offer new medallions through auction, or existing owners may exit and sell their medallions. Restricted entry has characterized most of Canada's major cities. Depending on the strictness of the entry process, medallions are worth correspondingly more. By 2012, medallions were selling in New York and Boston for a price in the neighborhood of one million dollars.

But ride-sharing start-up companies changed all of that. As Western examples, Uber and Lyft developed smart-phone apps that link demanders for rides with drivers, who may, or may not be, part of the traditional taxi companies. Such start-ups have succeeded in taking a significant part of the taxi business away from the traditional operators. As a result, the price of taxi medallions on the open market has plunged. From trading in the range of $1m. in New York in 2012, medallions are being offered in 2019 at about one fifth of that price. In Toronto, some medallions were traded in the range of $300,000 in 2012, but are on offer in 2019 for prices in the range of $30,000.

Not surprisingly, the traditional taxi companies charge that ride-hailing operators are violating the accepted rules governing the taxi business, and have launched legal suits against them and against local governments, and lobbied governments to keep them out of their cities.

In the new 'sharing economy', of which ride hailing companies are an example, participants operate with less traditional capital, and the communications revolution has been critical to their success. Home owners can use an online site to rent a spare bedroom in their house to visitors to their city (Airbnb), and thus compete with hotels. The main capital in this business is in the form of the information technology that links potential buyers to potential sellers.

Information on medallion prices in Canada can be found by, for example, searching at http://www.kijiji.ca