Table of contents
1. Introduction 2
2. The truck cartel 2
3. The importance of the disruption of cartels 3
3.1 Perfect competition and consumer surplus 3
3.2 Why the EC wants to disrupt cartels 5
4. How the EC disrupts cartels 7
5. Conclusion 8
6. References 8
1. Introduction
The world of economics is one with many conflicting interests. Consumers want to buy their products at the lowest prices possible, whereas producers want to maximize their profits. In some cases, these two interests can coincide with each other, such as in cases in which perfect competition exists. In some others, they simply cannot. Take the phenomenon cartels for example. Firms form cartels in order to maximize their profits, but this will be at the cost of the consumer’s share. Since consumers are seriously damaged whenever cartels are formed, several institutions have been created with the task to find cartels and to disrupt them. One of the institutions which has this task in its portfolio is the European Commission (EC). The purpose of this paper is to examine in more depth why the EC wants to disrupt cartels and how it is able to do so. Firstly, this paper provides one example of a disrupted cartel in the truck industry. Secondly, the importance of the disruption of cartels is discussed. Lastly, this papers shows how the EC is able to destabilize a cartel, with the use of game theory.
2. The truck cartel
In July 2016, the truck cartel consisting of MAN, Volvo/Renault, Daimler, Iveco, and DAF was imposed a record fine of nearly 3 billion euros for breaking EU antitrust rules (European Commission, 2016). The firms colluded on coordinating prices, passing on the costs of emission technologies to consumers and the timing for the introduction of emission technologies from 1997 until 2011. According to commissioner for competition, Margrethe Verstager, the infringement of this cartel was important for the European society:
“We have today put down a marker by imposing record fines for a serious infringement. (…) It is not acceptable that MAN, Volvo/Renault, Daimler, Iveco and DAF, which together account for around 9 out of every 10 medium and heavy trucks produced in Europe, were part of a cartel instead of competing with each other. For 14 years they colluded on the pricing and on passing on the costs for meeting environmental standards to customers. This is also a clear message to companies that cartels are not accepted." (European Commission, 2016)
Volvo/Renault was fined for €670.448.000, Daimler for €1.008.766.000, Iveco for €494.606.000 and DAF for €752.679.000. MAN did not received a hundred percent reduction, because of the Reduction under the Leniency Note.
This example makes clear that whenever the EC fines a cartel, it will not hesitate to impose sanctions in order to disrupt it. The question remains however, why the EC would impose sanctions that could be as high as 3 billion euros, only to disrupt a cartel. For the answer on this question it is important to understand the relation between perfect competition and surpluses, which will be discussed in the next section.
3. The importance of the disruption of cartels
3.1 Perfect competition and consumer surplus
One important aspect of markets is that of competition. Competition means in this context that firms compete with each other for some market share. The more competitive the market is, the more “perfect competitive” it becomes. For a market to be called perfective competitive, the following five characteristics are important: many buyers and sellers, identical products, full information, low transaction costs and free entry and exit. As a consequence of these five characteristics, producers and consumers are both considered to be price takers, implying that these two forces have no power to change the market price (Perloff, 2015).
Besides these characteristics of perfect competition, a general trait of producers is to maximize their profits. This means in practice that firms will produce at a level where marginal revenues (MR) are equal to their marginal costs (MC). For applying this rule of thumb, it does for firms not matter whether the market is one of perfect competition or not (Perloff, 2015). A study, conducted by Peteraf and published in the Strategic Management Journal, shows empirical evidence for this theory (Peteraf, 1993).
Another important aspect markets is that of surpluses. A surplus is in this context the positive difference between what an entity is willing to sacrifice for and actually has to sacrifice (Perloff, 2015). In markets there are roughly two entities: buyers (consumers) and sellers (producers). Each of these entities has to sacrifice something. For consumers this sacrifice is the difference between the market price consumers can buy products for and the price consumers are willing to pay (which is higher than the market price). For producers, it is the difference between the market price products can be sold for and the price firms are willing to produce it for (which is lower than the market price). Figure 1 below shows a perfect competitive market for pears. These prices are not based on the real prices for pears, but will hold in order to examine the surpluses of consumers and producers in a competitive market.
Figure 1: a competitive market for pears
As mentioned earlier, the definition of a surplus is the positive difference between what someone is willing to sacrifice and actually has to sacrifice. As figure 1 shows, the market price (the price where demand is equal to supply) is 4 euros. From this market prices, two surpluses can be derived: the consumer surplus (CS) and the producer surplus (PS). The consumer surplus is the triangle with 0 to 3 million (the x-axis) as length and the difference 14 to 4 (the y-axis) as height. The producer surplus is the triangle with 0 to 3 million (x-axis) as length and the difference 4 to 1.7 (y-axis) as length. This means that the consumer surplus would be 15 million and the producer surplus 3.45 million. Adding these two up gives a total surplus of 18,45 million.
The market equilibrium in the pears market (figure 1) has some straightforward implications. At this market price of 4 euros, 3 million pears will both be produced (and sold) and bought (and consumed). The willingness to produce is therefore equal to the willingness to pay. Furthermore, at this equilibrium the total surplus (the sum of CS and PS) is maximized. Whenever the market price exceeds 4 euros, producers would be able to increase producer welfare, but at the expense of consumers. Conversely, consumers would be able to increase consumer surplus, but at the expense of producer surplus. Additionally, whenever the price exceeds or becomes lower than the market price, an entire area of surplus will be lost. This is the so called deadweight loss (Perloff, 2015). Since these cases do not occur at the market equilibrium, at market equilibrium welfare is maximized. Another way of saying this, it that at market equilibrium, the Pareto optimality exists (Perloff, 2015).
3.2 Why the EC wants to disrupt cartels
Given that only at market equilibrium Pareto Optimality exists, it is easy to understand that cartels will break this rule. However, an extension of the perfect pears market (figure 1) will make it even more clear.
Figure 2: A cartel in the pears market
Figure 2 displays exactly the same market as figure 1. The only thing that has changed, is that now some pear producers have decided to form a cartel. In this cartel the producers cut the production of pears by a million, so there are only 2 million pears produced in this market. Since demand remained the same, the consequence of this cut in quantity is that the market price has been driven up from 4 euros to 8 euros. As a result, the consumer surplus has decreased by from 15 million to 6 million. A part of this loss has been transferred to the producers, which surplus has risen from 3.45 million to 9.95 million. The part that has not been transferred to the producers (the triangle to the right of the red line) is the deadweight loss, which is 2.5 million.
What figure 2 shows, is that cartels will increase the producer surplus at the cost of consumer surplus. This has some bad consequences for a society, which consists of consumers. In the case of essential goods with inelastic demand, such as food, some people who were once able to pay for food at market equilibria will have more trouble when the prices rise above these equilibria. In a study, conducted by Andreyeva, Long and Brownell, it is found that the elasticity of fruit is 0.7 (Andreyeva, Long, & Brownell, 2010).
Although the truck market is not as competitive as a food market (due to a lack of homogeneity and number of buyers and sellers), the truck cartel has some similarities with the above mentioned example. The truck cartel coordinated prices, with the purpose to increase the market price above equilibrium. Commissioner Verstager explains this is in the following way:
“First, the truck producers discussed their envisaged "gross list" price increases for medium and heavy trucks. Simply speaking, these gross list prices are the basis for pricing in the trucks industry. (…) What the truck producers did was to coordinate with each other on increasing this gross list price of trucks.” (European Commission, 2016)
As a result of the price coordination, the gross price was higher than it would have been at market equilibrium, implying that the truck buyers faced a decreased consumer surplus. Furthermore, the decrease from consumer surplus was not one-to-one be transferred to the producers, so there occurred a deadweight loss. So on the basis of pricing, the EC wants to prevent cartels, because the increase of producer surplus does not outweigh the loss in consumer surplus. This results in a deadweight loss.
Furthermore, the truck cartel harmed society in a broader sense by transferring costs of emission to consumers and by delaying the introduction of new technologies. As the study of Lambrecht and Heidelberg, trucks damage the environment in a negative way (Lambrecht, 2011). So when firms withhold on purpose technologies that could minimize these effects, it can easily be said that firms are damaging society. That is why EC had even more reason to disrupt this cartel.
4. How the EC disrupts cartels
Game theory can help to understand why firms would want to whistle blow. Consider a firm which is in a cartel at the moment, but has a feeling that the other firm will whistle blow soon. The firm knows that if you whistle blow first, you do not have to pay a fine and if you deny that you are in a cartel, but the other firm blows the whistle, you will receive a fine of 1 million euros. If both firms confess, the both firms will receive a reduction of 40% on their fine. Since the firm has some serious doubts about the credibility of the other firm, it decides to analyse its options.
Firm1/Firm2 Confess Deny
Confess -0.6 million/ -0.6 million 0 /-1million
Deny -1 million/ 0 0/0
Table 1: Game theory about cartels
Table 1 shows the options that firm 1 has given the decision that firm 2 makes. All the possible outcomes for firm 1 are indicated in blue. It can be easily seen that when Firm 2 chooses confess, firm 1 will also choose confess (-0.6 million > -1 million) and when firm 2 chooses deny, firm 1 is indifferent between the options (0=0). This means that, based on this table, firm 1 does not have dominant strategy (and neither does firm 2).
Nevertheless, firm 1 is in serious doubt. Since it is really plausible that firm 2 will confess, the consequence for firm 1 would be to face a fine of 1 million. That is why firm 1 decides to whistle blow first.
The preceding example shows, that whenever firms start to distrust each other, institutions which want to disrupt cartels (such as the EC) has some leverage. By (partly) providing immunity for whistle blowers, such institutions are able to crack cartels open.
In the case of the truck cartel, the EC used the same approach. It granted the firm that blew the whistle immunity. Additionally, it granted firms that cooperated with the EC a reduction in their fines, varying from forty to ten percent (European Commission, 2016). This immunity alone is not sufficient to destabilize a cartel, but whenever cartel members lose credibility in each other, it will provide them an incentive to quit the cartel and blow the whistle.
5. Conclusion
The EC wants to disrupt cartels, because they harm total welfare. Whenever cartels are formed, consumer surplus is lost, and will only partly be transferred to the producers. This results in a deadweight loss. Furthermore, the particular truck cartel damaged society also on an environmental level, which gave the EC more reasons to disrupt it. One way in which the EC is able to disrupt cartels, is by providing immunity to whistle blowers. This will not be sufficient to destabilize a cartel on its own, but whenever the strength of a cartel weakens, it provides the EC power to persuade firms to blow the whistle.
6. References
Andreyeva, T., Long, M., & Brownell, K. (2010). The Impact of Food Prices on Consumption: A Systematic Review of Research on the Price Elasticity of Demand for Food. Retrieved from https://www.ncbi.nlm.nih.gov/pmc/articles/PMC2804646/
European Commission. (2016, July). Antitrust: Commission fines truck producers € 2.93 billion for participating in a cartel . Retrieved from http://europa.eu/rapid/press-release_IP-16-2582_en.htm
European Commission. (2016, July). Statement by Commissioner Vestager on decision to fine truck producers €2.93 billion for participating in a cartel. Retrieved from http://europa.eu/rapid/press-release_STATEMENT-16-2585_en.htm
Lambrecht, F. D. (2011). Fuel efficiency and emissions. Heidelberg: GIZ.
Perloff, J. (2015). Microeconomics (7th ed.). Berkeley: Pearson education limited.
Peteraf, M. A. (1993). The Cornerstones of Competitive Advantage: A Resource-Based View. Strategic Management Journal, 179-191.