What is a Cartel? How does it function?

What is a Cartel? How does it function?

A cartel is a group of firm’s (producer’s association) whose objective is to eliminate cut-throat competition and price-wars and to maximize joint profits.

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EduNation Ecofunomics presents to you Cartel.
As students of economics we have all studied the different types of market structures

Market Structures

i) A single seller (monopoly) there are no rivals and hence he need not be concerned with the effect of his actions on his rivals.

ii)Many sellers (perfect competition and monopolistic competition) there are so many sellers that the action of one seller has a negligible effect on its competitors.

iii) Few sellers i.e. Oligopoly- In this market form there is intense rivalry among the firms i.e. if a firm takes any action or strategy then it influences the action or strategy of the rival firms.

The formation of Cartel takes place essentially in an oligopolistic set up. Before, we delve deeper into what a cartel is, let us discuss an oligopoly market structure.

Oligopoly market structure is characterized by few sellers (between 2-10) , large no. of buyers and the product produced by them may be homogeneous or differentiated.

 The Oligopoly market form is the most prevalent market structure in the world. Some examples of oligopoly in India are:

A) The telecom service providers in India which comprises of 4 players namely: Reliance Jio,  Bharti Airtel , Vodafone Idea and BSNl.

B) The country’s print media market is highly concentrated. Four outlets – Dainik Jagran, Hindustan, Amar Ujala and Dainik Bhaskar – capture three out of four readers (76.45% of readership share) within the national Hindi language market.

C) In the airline industry we too have oligopoly set  up and have 6 major players with their market shares as shown in the pie-diagram below:

What is a Cartel???

A cartel is a group of firm’s (producer’s association) whose objective is to eliminate cut-throat competition and price-wars and to maximize joint profits. Thus, for this they jointly enter into an agreement regarding the price-output policy to be pursued by them. In reality however, all the producers of a good do not form a cartel. A cartel usually accounts for only a portion of the total production and must take into account the supply response of the non-cartel members before setting a price.

The agreement among the members may be either formal(open) or tacit(secret). A cartel that is formed by the producers within a country is called domestic cartel. Since formal agreements to form monopolies are illegal in most countries (such as the USA under the Anti-Trust laws), agreements reached between oligopolists are generally tacit

 It can also be formed by producers in different country called international cartel .For e.g. OPEC i.e. The Organization of Petroleum Exporting Countries which has 79.4% of the world’s proven oil reserves is an international agreement among oil producing countries which has succeeded in raising oil prices above competitive level.)

CARTEL OPEC

Example of Cartel in India

 Cartelisation in the cement industry by a group of cement manufacturers under the umbrella organisation of the Cement Manufacturers Association. The cement industry was de-controlled in 1989, and the subsequent consolidation of cement manufacturers took place during 2001-02. The cement industry has been widely been characterized as an oligopolistic market, operating through anti-competitive collusion. Attempts have been made since 1991 to hold liable cement manufacturers for collusive price setting under the MRTP Act. However, these efforts were largely unsuccessful. However these manufacturers were found by the court to significantly increase the price of cement and hence a hefty cumulative fine of Rs. 6,300 crore was imposed on the parties.

Conditions for Cartel’s Success

1) The firms must be able to reach a collusive agreement. Different members may have different cost structures, different assessments of market demand and thus they may want to set price at different levels.

2) The cartel will be successful in raising the price level only if the demand is inelastic.(The demand of a product is said to be inelastic if say price increases by 10% qty demanded will fall by say 1-2% i.e. demand is not very sensitive to change in price level for e.g. as in cases of essential medicines).

3)There is high barrier to entry in the market. Barriers to entry in the market can eb created due to patent rights,

2) When all members can be ‘policed’ by a dominant member. This is because of the fact that firms have a tendency to cheat by selling at a price lower than agreed to, in order to earn higher individual profits, provided the other members do not violate the agreement.

However, if there is a dominant member such as Saudi Arabia in case of OPEC then it can threaten the other members such as say Nigeria, Libya which are trying to go against the agreement by lowering its price as well which will lead to losses of these countries. The threat is credible only if the nation has the reputation of irrationality in carrying out its threat even if it has to actually suffer losses which is possible only when the nation has financial and technological power to carry out its commitment.  Let us understand this with the help of a game theory.

  Saudi Arabia\ \  Libya   Low price       high price
Low price20,2020,10
 high price30,4050,30
game theory

Note: The first no. in the pair shows profits of Saudi Arabia and the second no. shows profits of Libya.

In this above pay-off matrix, the countries had commited to charge a high price and hence not involve in price-cut. In this situation Saudi earns profit of 50$ and Libya of 30$. However, if Libya decides to deviate and charge a higher price then the profits of these two countries are: Saudi Arabia-30$ and Libya- 40$.

Now if Saudi Arabia threatens to lower its price level as well and has the reputation of carrying out its threat then the profits of both the nations will fall down to 20$ each. This is lower than what Libya would have got if it did not deviate from its decision. Thus a dominant firm can stop the other nations to break the agreement.

Thus, in the words of Lipsey and Chrystal, “ Each firm is better off if the cartel is effective in restricting output and so raising price.But each is even better off if everyone else cooperates while it cheats. Yet, if all cheat , all will be worse off”.(Read-https://www.economist.com/finance-and-economics/2019/12/18/the-coming-months-will-test-opecs-sprawling-alliance).

psey and Chrystal, “ Each firm is better off if the cartel is effective in restricting output and so raising price.But each is even better off if everyone else cooperates while it cheats. Yet, if all cheat , all will be worse off”.(Read-https://www.economist.com/finance-and-economics/2019/12/18/the-coming-months-will-test-opecs-sprawling-alliance).

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