Introduction
A cartel results when agents form a unique coalition to coordinate behaviour (Weikard, 2009). The intended purpose of a cartel is to reap excess profits by restricting output in order to drive the price above the level that would prevail if they remained in competition with one another. In November 2010 the European Commission fined 11 air cargo carriers a total of €799.445.000 for operating a worldwide cartel which affected cargo services within the European Economic Area (European Comission, 2010). This report will present an overview of the case and present a detailed account on the arguments of the accusation, the arguments of the defendants and thirdly the final decision of the court. Finally the main focus of the report will be to provide an in depth analysis of the factors that contributed to the duration and success of the cartel based on the theory of Industrial Organisation.
Overview of the case study
Air Canada, Air France-KLM, British Airways, Cathay Pacific, Cargolux, Japan Airlines, LAN Chile, Martinair, SAS, Singapore Airlines and Qantas were the 11 undertakings fined (European Comission, 2010). Communication on prices between the airlines initially began with a view to discuss fuel surcharges. The airlines contacted each other in order to ensure that airfreight carriers worldwide imposed a flat rate surcharge per kilo for all shipments. The cartel members extended their involvement by adding a security surcharge and refusing to pay commission on surcharges to freight forwarders. The aim of this was to ensure that these additional charges were introduced by all the carriers involved and changes to the surcharge levels were applied in full without exception. By refusing to pay a commission, the airlines ensured that these charges did not aid competition, as discounts were not granted to customers. These practices breached the EU competition rules.
Arguments of the accusation
“Following a tip-off from whistle-blower Lufthansa, the United States Department of Justice raided the offices of several carriers on 11 February 2006, seizing thousands of documents” (Campbell & Feunteun, 2012). The firms were challenged based on the evidence that the carriers coordinated their action on surcharges for fuel and security without discounts over a six year period. According to the regulators, between 1999 and 2006, cargo carriers allegedly participated in meetings and conversations in the United States, Europe and elsewhere where they agreed to fix the base rates and surcharges for international air cargo services.
Reasons why firms pursued their conduct
The carriers indulged in price fixing with regards to base rates and surcharges in order to boost profitability. The other aim of the collusion was to ease competitive pressure and create a manageable operating environment hence why the charges were not allowed to aid in competition as why no firm could pass on these additional savings to customers in the form of lower prices.
Final decision of the Court
The European Commission fined Air Canada (€21m), Air France (€182.3m), British Airways
(BA) (€104m), Cargolux (€79.9m), Cathay Pacific (€57.1m), Japan Airlines (€35.7m), LAN Chile (€8.2m), Martinair (€29.5m), Qantas (€8.8m), SAS (€70.1m) and Singapore Airlines (€74.8m). These decisions were based on EU competition laws concerning collusion. The Commission operates a leniency policy whereby “companies that provide information about a cartel in which they participated might receive full or partial immunity from fines” (European Commission, 2015). In order for full immunity to be obtained under the leniency policy, a company which participated in a cartel must be the first one to inform the Commission of an undetected cartel by providing enough evidence to enable the Commission to launch an investigation. Lufthansa received full immunity from fines based on this.
Under the programme, fines can also be reduced for co-operation. As such, the following carriers had their fines reduced: Martinair (50%), Japan Airlines (25%), Air France-KLM (20%), Cathay Pacific (20%), LAN Chile (20%), Qantas (20%), Air Canada (15%), Cargolux (15%), SAS (15%) and British Airways (10%). The Commission also reduces fines for those legitimately claiming inability to pay. However, while five carriers applied for such treatment, none met the conditions for a reduction. The Commission increased the fine for SAS by 50% for its previous involvement in a cartel in the airline sector (European Commission, 2010).
Factors that contributed to the duration and success (or lack) of the cartel
The more homogenous the products of different firms, the greater the awareness of competitors (Lipczynski et al, 2005). When a small amount of firms within a clearly defined industry produce a fairly homogenous service, there is always some form of interdependence. Thusly profit maximisation and survival depends on how efficiently each firm operates in a situation of interdependence. Conjectural variation refers to assumptions a firm makes about its rivals in response to its own actions. The solution to this issue is either pure independent action or pure collusion.
Collusion arises when firms recognise their interdependence. This creates the opportunity for bargaining to take place with a view to establishing some form of joint action. There are two forms of collusion, tacit and overt. Tacit collusion occurs when firms coordinate through market interactions without explicitly saying so (Luz, 2015). Overt collusion on the other hand is coordination through private communication prior to conduct in the market via a formal agreement. The latter was the chosen course of action for the air cargo carriers.
With regards to the success of the cartel Levenstein and Suslow (2006) state that the duration of a cartel is utilised to measure how successful it is, and is thought to be the most common criteria to evaluate cartel success. Based on a sample of 94 explicit collusion cases from 1990 to 2007, the European Commission established that short duration cartels lasted less than one year, medium duration (one to five years,) and long duration (more than 5 years) (De, 2010). Based on this criterion, this air cargo cartel was fairly successful as it lasted 6 years before dissolving.
One factor that may have contributed to the initial success of the cartel is the similarity of the firms in terms of offering the same homogenous service. This is due to the fact that by offering the same service, all the firms had similar and non-conflicting goals. For example discounts on surcharges to fuel was beneficial to all the firms involved as it increased profitability thus providing an incentive to remain under collusion.
Another factor that would have contributed to the success of the cartel is industry concentration and high cartel market share. Studies by Dick (1996), Marquez(1994), and Suslow(1991) all find that cartel duration increases with the share of the market controlled by cartel members. For example out of the total 12 airlines involved in the collusion, 4 of them (Lufthansa, Cargolux, Singapore Airlines, Cathay Pacific Airways) ranked in the top ten international worlds largest cargo airlines in 2011 according to the International Air Transport Association (Aviainform, 2011). This signals that concentration may “reflect barriers to entry to the extent that concentration exhibits its own, independent effect on collusive success” (Grossman, 2004). For example because some of the participants involved dominated the market, it was easier to design an agreement and adhere to it as they had the power to influence others in the market.
Repeated games in the market could have also led to collusion. According to the Prisoners Dilemma game, players are more likely to collude in a series of repeated games than in a one-shot game. The firms involved probably had to determine prices based on the expected behaviour of other firms on so many occasions that they decided to collude. This shows the role game theory could have possibly played in the collusion.
The same repetition concept applies to role that the scope of punishment plays in containing the duration of the collusion. Abreu (1988) states that before deviating, a member needs to weigh the benefits of trading future losses against present gains due to the threat of retaliation in future rounds of the games by the other firms. When the cost of retaliation exceeds the present benefit of deviating, firms will opt to remain under collusion.
Failure Factors
Though there are many factors that contributed to the duration of success for the cartel, there are also many that brought this to an end with one of the main reasons being the number of firms involved. A large number of firms creates coordination problems, and increases the likelihood that there exists a firm willing to cheat or whistle-blow. For example with the 12 firms that were found guilty and possibly even more members involved who were not caught due to insufficient evidence, the vast number of firms would have reduced the ease of coordination.
In addition to this, Grout and Sonderegger (2005) state that when all firms in the industry are not members of the cartel, an increase in the number of firms in the industry which then proceed not to join the cartel threatens cartel stability by decreasing the total market share and profits of the cartel. The 12 firms involved only make up a small percentage of the overall firms in the market. This increases the likelihood of a firm whistleblowing if operations are no longer beneficial to them due to threats to stability by other firms. This motivation is further enhanced with the added incentive of immunity from punishment for the first mover.
Another factor that could have contributed to the dismantling of the cartel is the industry condition. Levenstein and Suslow (2006). state that “cartel instability is a prominent feature in those industries susceptible to violent changes in economic conditions”. A variety of factors make this air cargo industry very volatile. For example constantly fluctuating oil prices affects the stability of profitability in the industry. There is also a shrinking market place as a result of mode shifts e.g. freighters moving back to other modes of transport, such as sea or road, as these options have become more reliable and remain the less expensive option in comparison to air cargo. Furthermore airlines are reducing cargo rates just to fill space, making it difficult for cargo-only carriers to compete on price (Fernandes, 2015). During the lows of these volatile conditions, firms in the cartel feel the pressure to sustain profit and revenue, which increases the incentive for them to defect.
A further factor that could have aided in the dissolution of the cartel also is the type of demand the industry has. Inelastic demand helps to maintain a cartel because it means that no matter how high prices become e.g. through price fixing, consumers will continue to acquire these services thereby providing an incentive for cartel members to remain under collusion and reap excess profits. Despite the continuous increases in prices charged to consumers as a result of increasing fuel prices since 2003, demand in the airfreight industry is fairly inelastic and the market had been growing until 2008 (Boeing, 2009). In May and June 2008 however, rising fuel costs, coupled with slowing economic growth in North America and Europe, turned world monthly growth in air cargo traffic negative. Though jet fuel prices fell by nearly 30% during the third quarter of 2008, world air cargo traffic levels continued to fall as economic and financial uncertainty worsened during the same time frame. This change in pattern could have been the reason why Lufthansa decided to whistle blow because trends showed that future profitability would be reduced therefore there would no longer be a significant incentive to remain in the cartel.
Though this factor does not apply specifically to this cartel case, another reason that results in the collapse of a cartel is the private incentive to deflect illustrated by the diagram in the appendix. In order for cartel members to achieve a high price, all firms need to reduce output below their existing potential production capacity and thus a quota is set to restrict output e.g. lowering output from Qe to Qm which increases price to Pk. Once the market price increases, there is an incentive to cheat as each member of the cartel has the capacity to raise output relatively easily e.g. from Qm to Qk in order to maximise individual profit at Pk. Increasing output while the price is raised, results in supernormal profits as marginal revenue will far exceed the marginal costs for that firm. Once one firm acts on this incentive and is found out, all firms will follow thereby returning the market to its usual competitive conditions and ending the cartel.
Conclusion
Overall this cartel was successful because of the duration it lasted based on the European Commission criterion. Though all the factors listed provide logical possibilities concerning the success and failures of the air cargo cartel, these are only hypothetical assumptions. What stands firm in all of this is the importance of the leniency programme. This is due to the fact that it was the ultimate determining factor in ending the cartel. “The greatest challenge in the fight against hard-core cartels is to counter increasingly sophisticated means used by companies to conceal collusive behaviour” (European Free Trade Association, 2015). Had this not provided an incentive for Lufthansa to deflect who knows how much longer the cartel would have gone on for. This signifies how important of a role that the level of antitrust enforcement and sanctions levels within the industry affects the success of a cartel. Regardless of the many benefits that remaining in a cartel may bring, the fear of being caught will always provide an incentive to defect. This is essentially what ended this cartel.