Understanding Collusion and its Impact on Market Competition

Collusion is an agreement between two or more parties, sometimes illegal and therefore secretive, to limit open competition by deceiving, misleading, or defrauding others of their legal rights, or to obtain an objective forbidden by law typically by defrauding or gaining an unfair advantage. [citation needed] It is an agreement among firms or individuals to divide a market, set prices, limit production or limit opportunities. [1] It can involve "wage fixing, kickbacks, or misrepresenting the independence of the relationship between the colluding parties". 2] In legal terms, all acts affected by collusion are considered void. [3] | In the study of economics and market competition, collusion takes place within an industry when rival companies cooperate for their mutual benefit. Collusion most often takes place within the market structure of oligopoly, where the decision of a few firms to collude can significantly impact the market as a whole. Cartels are a special case of explicit collusion. Collusion which is not overt, on the other hand, is known as tacit collusion. How is OPEC a collusive oligopoly? Answer:

OPEC is a collection of oil exporting countries. Oligopoly - Industry that is controlled by a few major players (firms or countries) Collusion - When industry leaders secretly agree to limit quantities of production. This will guarantee the colluders a higher price for their product OPEC meet to discuss the quantity of oil they will allow onto the world market. This is collusion. Because the OPEC members are the main suppliers of oil they are said to be an Collusion and Cartels by David A. Mayer One of the blessings of competition is that it leads to lower prices for consumers.

For the producer, however, this blessing is a curse. Low prices often mean low profits. Given a choice between competition and cooperation, profit-maximizing firms would more often than not prefer cooperation. Regardless of what you learned in kindergarten, you do not want the businesses you buy from to cooperate. You want them to compete. Adam Smith, the father of modern capitalism, warned that nothing beneficial comes from the heads of business getting together. In the United States, firms are forbidden from cooperating to set prices or production.

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The abuses of the late nineteenth and early twentieth century trusts were the impetus for the “trust-busting” of President Theodore Roosevelt. With the Sherman Antitrust Act and later the Clayton Antitrust Act, the government prohibited outright collusion and other business practices that reduced competition. Prior to OPEC, world oil prices were mainly under the control of the Texas Railroad Commission. With the rise of OPEC came a shift in power from U. S. producers to the oil states of the Middle East. Even though it violates the law, businesses from time to time will collude in order to set prices.

Colluding firms can divide up the market in a way that is beneficial for them. The firms avoid competition, set higher prices, and reduce their operating costs. Because collusion is illegal and punishable by fine and prison, executives at firms are reluctant to engage in the practice. The meetings of business leaders are almost always in the presence of attorneys in order to avoid the accusation of collusion. Forming Cartels Businesses that collude may form cartels. A cartel is a group of businesses that effectively function as a single producer or monopoly able to charge whatever price the market will bear.

Probably the best-known modern cartel is the Organization of the Petroleum Exporting Countries, or OPEC. OPEC is made up of thirteen oil-exporting countries and is thus not subject to the antitrust laws of the United States. OPEC seeks to maintain high oil prices and profits for their members by restricting output. Each member of the cartel agrees to a production quota that will eventually reduce overall output and increase prices. OPEC is bad news for anyone that enjoys cheap gasoline. Fortunately for consumers, cartels have an Achilles heel.

The individual members of a cartel have an incentive to cheat on their agreement. Cartels go through periods of cooperation and competition. When prices and profits are low, the members of the cartel have an incentive to cooperate and limit production. It is the cartel's success that brings the incentive to cheat. If the cartel is successful, the market price of the commodity will rise. Individual members driven by their own self-interest will have an incentive, the law of supply, to ever-so-slightly exceed their production quota and sell the excess at the now higher price.

The problem is that all members have this incentive and the result is that eventually prices will fall as they collectively cheat on the production quota. Cartels must find ways to discourage cheating. Drug cartels use assassination and kidnapping, but OPEC uses something a little more civilized. The single largest producer in the cartel is Saudi Arabia. Saudi Arabia also has the lowest cost of production. If a member or members cheat on the cartel, then Saudi Arabia can discipline the group by unleashing its vast oil reserves, undercutting other countries' prices, and still remain profitable.

After a few months or even years of losses, the other countries would then have an incentive to cooperate and limit production once again. * Definition: OPEC stands for The Organization of Petroleum Exporting Countries. It is an organization of 12 oil-producing countries that effectively control the world's oil. OPEC members pump out 42% of the world's annual supply, controlling 61% of exports. This situation isn't likely to change, since these 12 countries hold 80% of the world's proven oil reserves. For these reasons, OPEC's decisions are critical to countries that depend on oil imports.

What Does OPEC Do? OPEC states quite plainly that its goal is to manage the world's supply of oil. It does this to make sure its members get what they consider a good price for their oil. Since oil is a fairly uniform commodity, most of its consumers base their buying decisions on nothing other than price. What's a good price? In the past, OPEC said it was around $70-$80 per barrel. If prices drop below that target, OPEC members agree to restrict supply to send prices higher. Otherwise, they would wind up increasing the supply to make more national revenue.

By competing with each other, they would drive prices even lower. This would stimulate even more demand, and OPEC countries will run out of their most precious resource that much faster. When prices are higher than $80 a barrel, oil-producing countries would naturally want to produce more to bring in extra national revenue. However, if they did that, they increase supply, lowering the price. Instead, OPEC members agree to produce only enough to keep the price high for all members. Furthermore, if prices are too much higher than $80 a barrel, then other countries have the incentive to drill more expensive oil fields.

Sure enough, now that oil prices are closer to $100 a barrel, it's become cost effective for Canada to explore its shale oil fields, and for the U. S. to use fracking. As a result, non-OPEC supply has increased. OPEC's second goal is to reduce oil price volatility. That's because, at current prices and rates of production, OPEC countries have enough oil to last for 113 years. In addition, oil is expensive to produce. For maximum efficiency, oil extraction must run 24 hours a day, seven days a week. In addition, closing facilities could physically damage oil installations and even the fields themselves.

Ocean drilling is especially difficult and expensive to shut down. Therefore, it's in OPEC's best interests to keep world prices stable. For example, in June 2008, prices spiked to $143/barrel. OPEC responded by agreeing to produce a little more oil, which brought prices down. However, the global financial crisis brought oil prices down to $33. 73/barrel in December. OPEC responded by reducing the supply, helping prices to again stabilize. A slight modification is usually enough to restore price stability. OPEC also adjusts the world's oil supply in response to crises and shortages.

For example, it replaced the oil lost during the Gulf Crisis in 1990. Several million barrels of oil per day were cut off when Saddam Hussein armies destroyed refineries in Kuwait. OPEC alos increased production in 2011 during the crisis in Libya. The Oil and Energy Ministers from the OPEC members meet twice a year, or more if needed, to coordinate their oil production policies. Each member country abides by an honor system, agreeing to only produce a certain amount. However, if a country winds up producing more, there really is no sanction or penalty.

Furthermore, each country is responsible for reporting its own production. Therefore, there is room for "cheating. " On the other hand, a country won't go too far over its quota, since it doesn't want to risk being kicked out of OPEC. Despite its power, OPEC cannot completely control the price of oil. In some countries, additional taxes are imposed on gasoline and other oil-based end products to promote conservation. More importantly, oil prices are actually set by the oil futures market. Much of the oil price is determined by these commodities traders. For more on this, see Why Are Oil Prices So High?

OPEC Members OPEC members are Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, UAE and Venezuela. Saudi Arabia alone produces enough oil to materially impact the world's supply. For this reason, it really has more authority and influence than the other countries. Here's a ranking of production by member: 1. Saudi Arabia - 9. 311 million barrels/day. 2. Iran - 3. 576 mb/d. 3. Venezuela - 2. 881 mb/d. 4. Kuwait - 2. 659 mb/d. 5. Iraq - 2. 653 mb/d. 6. UAE - 2. 565 mb/d. 7. Nigeria - 1. 975 mb/d. 8. Angola - 1. 618 mb/d. 9. Algeria - 1. 162 mb/d. 10. Qatar - . 734 mb/d. 11.

Ecuador - . 5 mb/d. 12. Libya - . 489 mb/d. (Source: OPEC Annual Statistical Bulletin 2012) Many non-OPEC members also voluntarily adjust their oil production in response to OPEC's decisions. In the 1990s, they learned that increasing their own production to take advantage of OPEC's restraints meant oil prices stayed low, restricting profits for everyone. These cooperating non-OPEC members include Mexico, Norway, Oman and Russia. OPEC History In 1960, five OPEC countries formed an alliance to regulate the supply, and to some extent, the price of oil. These countries realized they had a non-renewable resource.

If they competed with each other, the price of oil would be so low that they would run out sooner than if oil prices were higher. This first meeting was held September 10-14 1960 in Baghdad, Iraq. The five founding members were Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. OPEC was registered with the UN on November 6, 1962. (Source: OPEC Frequently Asked Questions) Article updated March 13, 2013 The acronym OPEC is short for the Organization of Petroleum Exporting Countries. Through its 12 member countries, the group controls nearly 80% of the world’s crude oil reserves and about 45% of its worldwide production.

This makes it extremely influential in the market for crude oil and its derivatives, like gasoline and diesel fuels. OPEC member countries include: Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela. Most of these countries rely on oil prices to sustain their 408 million combined inhabitants. Consequently, OPEC was designed to unify petroleum policies, ensure price stability and facilitate market efficiency. The Origins of OPEC OPEC was originally started by Iran, Iraq, Kuwait, Saudi Arabia and Venezuela in the 1960s.

While their initial objectives were reasonable, OPEC was soon labeled a cartel by many Western countries, given its practice of adopting output rationing in order to maintain certain price levels. Similarly, its political motivations have also contributed to its image. In 1973, OPEC became infamous for its oil embargo that punished the United States and Western Europe for its support of Israel against Arab nations in the Yom Kippur War. The resulting shortage led to limits on gas available at gas stations and eventually a worldwide economic recession that saw high unemployment and inflation.

OPEC’s Declining Influence In the 1980s, OPEC suffered from a six-year decline in oil prices due to reduced demand and over-supply that led to a glut in the world market. While OPEC lost its unity during the 1980s and early 1990s during the Gulf War, oil prices recovered after the September 11th attacks against the United States and the subsequent invasion of Afghanistan. As of 2011, OPEC continues to publish recommended production quotas designed to increase the price of oil, but member countries aren’t as keen as they used to be on compliance.

For instance, one Saudi Arabian official told the New York Times that the country would meet the market’s demand, presumably despite any quotas from OPEC. OPEC Finally Reaches an Agreement In December of 2011, OPEC reached a new agreement on production quotas for the first time in three years. Output from the 12 member states was set at 30 million barrels per day, which was roughly in-line with the supply at the time. The result in the financial markets after the announcement was a muted 1. 8% decline in crude oil futures.

OPEC leaders also discussed how to handle the decreased production from Libya after the fall of Moammar Qaddhafi. Shortly after the supply cut, Saudi Arabia stepped in and increased production, which was met with distaste from Iran and Venezuela. The matter was resolved by temporarily eliminating country-specific quotas until a June 2012 meeting. OPEC’s Influence on Investors While OPEC hadn’t agreed on production targets for some time, primarily due to Saudi Arabia’s opposition, the organization did manage to set a new production target in late-2011 of 30 million barrels per day, which was largely in-line with current production.

The agreement could mean more cohesion among its membership and additional quotas imposed down the line. Those trading in the crude oil or derivative markets since the 1970s are very familiar with OPEC’s influence on pricing. If the organization can agree on set prices, their control over a large portion of the market enables them to significantly influence prices. Until 2011, this was largely a non-issue given Saudi Arabia’s opposition to any limits. Key Takeaway Points * OPEC began in the 1960s as a way to control oil prices in countries where oil was a primary source of livelihood for citizens. OPEC turned political in the 1970s after the oil embargo and member disagreements hurt its power throughout the 1980s and early 1990s. * While OPEC has struggled with member cohesion, the organization has managed to strike an agreement in late-2011 and will meet again in June of 2012. Definition Collusion occurs when firms in a market chose an optimal level of output for that market in order to maximize total industry profits (Baye, 2006). Collusion typically occurs in the oligopoly market model when the number of firms are few as opposed to many.

This can simply be explained by the fact that when firms are working together, the more firms that have to work together the harder it is to make everyone happy. See Wiki page about oligopoly for further information: http://mbaecon. wikispaces. com/oligopoly%26nbsp%3B. See Wiki page about monopolistic competition to see why collusion is more difficult with many firms: http://mbaecon. wikispaces. com/monopolistic+competition. Monitoring the agreement This can be seen in that firms must monitor one another such that their collusion agreement is kept.

This can be accomplished by monitoring the other firms in the collusion agreement. There comes a point at which because there are so many firms in the agreement that the costs of monitoring the other firms outweighs the benefits from the collusion agreement. This monitoring can be seen by the formula n*(n-1) where n is the number of firms in the agreement. If there are six firms in agreement there must be 30 (6*(6-1)=30) monitors to keep everyone aware that all the firms in the agreement are holding to the terms. As the number of firms increase in the market the number of monitors increases dramatically.

How collusion occurs The first way collusion occurs is that firms will meet and agree not to steal each others customers, and if one firm tries to steal anothers customers there will be retaliation. This form of collusion is called explicit collusion. Another way firms collude may not involve physically meeting or talking at all. Overtime firms may reach a nonverbal understanding that they will leave each other alone, but if one firms tries to steal customers there are consequences. The second form of collusion just discussed is called tacit collusion.

Tacit collusion occurs when the behaviors of the players in the market are learned. If you try to steal customers and get attacked back, eventually your firm will probably stop trying to steal customers. On the other hand if you lower prices in order to steal customers and there is no retaliation, or the retaliation is not effective, tacit collusion will not occur. Legality Collusion is considered illegal within the United States, European Union, and Canada. Collusion falls within the category of antitrust laws/competition laws. These are laws that prohibit anti-competitive behavior and unfair business practices.

These laws make certain practices illegal because they hurt the businesses, consumers, or both, typically violating standards of ethical behavior (wikipedia-antitrust, 2006). Tacit collusion because of the fact that it is the learned behaviors of the players in the market is much more difficult to enforce, because specifically there has been no formal agreement, because of this tacit collusion can and does occur today. Questions: Which is not a form of collusion? A. ) The behaviors of a competing firm in the same market of a second firm are learned. B. Two firms meet and agree not to steal one another's customers. C. ) If an agreement has been reached to not steal one another's customer has been breached, retaliation will occur. D. ) One firm lowers prices to compete against another when there was no agreement against it. Answer: D. ) This is just the normal game of business that occurs every day. There is no collusion because one firm is lowering a price without specific knowledge or an understanding that there will be repercussions or action taken or not taken because of this action. In a finite number of games collusion will be more likely to occur: A. On the second to last turn. B. ) From the beginning. C. ) Once a tacit understanding of business practices has been reached. D. ) Will not occur because there is no effective punishment method that can be used. Answer: D. ) Will not occur because there is no effective punishment method that can be used. This is because of the ending nature of the finite number of games to be played. Each period the players in the game know what the last period will hold, and because they know the last periods outcome, the second to last game is the last game.

It is because the second to last game is now the last game that once again the players know how each member of the collusion will act because there is no punishment that can be effective. This continues on until the first game being played, and each member of the collusion knows that each member will cheat, so collusion will not occur. Sustained collusion is more likely to occur when firms know: A. ) their rivals. B. ) who their rivals customers are. C. ) when their rivals deviate from the agreement. D. ) All the above. Answer: D. ) All the above.

This are all reasons why a sustained collusion is more likely to occur. The last reason not listed is that firms must be able to successfully punish rivals for deviating from the agreement. A small firm with 1 outlet and a large firm with 10 outlets decide to collude, the small firm: A. ) is at an advantage because they only have to focus on the big competitor. B. ) is at an advantage because they are now "safe" from the big competitor. C. ) is at a disadvantage because they have to monitor more locations then the larger firm does. D. is at a disadvantage because they have less bargaining power when the "contract" needs to be renegotiated. Answer: C. ) is at a disadvantage because they have to monitor more locations then the larger firm does. This is because economies of scale exist within the monitoring act. The larger firm only has to monitor the one outlet of its collusive partner. The smaller firm has to monitor the larger firms 10 outlets, which most likely will cost more and be a larger percentage of the "savings" associated with the collusive agreement.

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