This is “Price Fixing”, section 21.2 from the book Beginning Economic Analysis (v. 1.0).
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Price fixingSituation in which a group of firms agrees to increase the prices they charge and restrict competition against each other., which is called bid-riggingPrice fixing in an auction context. in a bidding context, involves a group of firms agreeing to increase the prices they charge and restrict competition against each other. The most famous example of price fixing is probably the Great Electrical Conspiracy in which GE and Westinghouse (and a smaller firm, Allis-Chalmers) fixed the prices of turbines used for electricity generation. Generally these turbines were the subject of competitive (or, in this case, not-so-competitive) bidding, and the companies set the prices by designating a winner for each bidding situation and using a price book to provide identical bids by all companies. An amusing element of the price-fixing scheme was the means by which the companies identified the winner in any given competition: they used the phase of the moon. The phase of the moon determined the winner, and each company knew what to bid based on the phase of the moon. Executives from the companies met often to discuss the terms of the price-fixing arrangement, and the Department of Justice (DOJ) acquired a great deal of physical evidence in the process of preparing its 1960 case. Seven executives went to jail and hundreds of millions of dollars in fines were paid.
Most convicted price-fixers are from small firms. The turbine conspiracy and the Archer Daniels Midland lysine conspiracy are unusual. (There is evidence that large vitamin manufacturers conspired in fixing the price of vitamins in many nations of the world.) Far more common conspiracies involve highway and street construction firms, electricians, water and sewer construction companies, or other owner-operated businesses. Price fixing seems most common when owners are also managers and there are a small number of competitors in a given region.
As a theoretical matter, it should be difficult for a large firm to motivate a manager to engage in price fixing. The problem is that the firm can’t write a contract promising the manager extraordinary returns for successfully fixing prices because such a contract itself would be evidence and moreover implicate higher management. Indeed, Archer Daniels Midland executives paid personal fines of $350,000, and each served 2 years in jail. Thus, it is difficult to offer a substantial portion of the rewards of price fixing to managers in exchange for the personal risks the managers would face from engaging in price fixing. Most of the gains of price fixing accrue to shareholders of large companies, while large risks and costs fall on executives. In contrast, for smaller businesses in which the owner is the manager, the risks and rewards are borne by the same person, and thus the personal risk is more likely to be justified by the personal return.
We developed earlier a simple theory of cooperation, in which the grim trigger strategy was used to induce cooperation. Let us apply that theory to price fixing. Suppose that there are n firms and that they share the monopoly profits πm equally if they collude. If one firm cheats, that firm can obtain the entire monopoly profits until the others react. This is clearly the most the firm could get from cheating. Once the others react, the collusion breaks down and the firms earn zero profits (the competitive level) from then on. The cartel is feasible if 1/n of the monopoly profits forever is better than the whole monopoly profits for a short period of time. Thus, cooperation is sustainable if
The left-hand side of the equation gives the profits from cooperating—the present value of the 1/n share of the monopoly profits. In contrast, if a firm chooses to cheat, it can take at most the monopoly profits, but only temporarily. How many firms will this sustain? The inequality simplifies to Suppose the annual interest rate is 5% and the reaction time is 1 week—that is, a firm that cheats on the cooperative agreement sustains profits for a week, after which time prices fall to the competitive level. In this case, 1 − δ is a week’s worth of interest (δ is the value of money received in a week), and therefore According to standard theory, the industry with a weeklong reaction time should be able to support cooperation with up to a thousand firms.
There are numerous and varied reasons why this theory fails to work very well empirically, including that some people are actually honest and do not break the law, but we will focus on one game-theoretic reason here. The cooperative equilibrium is not the only equilibrium, and there are good reasons to think that full cooperation is unlikely to persist. The problem is the prisoner’s dilemma itself: generally the first participant to turn in the conspiracy can avoid jail. Thus, if one member of a cartel is uncertain whether the other members of a price-fixing conspiracy are contacting the DOJ, that member may race to the DOJ—the threat of one confession may cause them all to confess in a hurry. A majority of the conspiracies that are prosecuted arise because someone—a member who feels guilty, a disgruntled ex-spouse of a member, or perhaps a member who thinks another member is suffering pangs of conscience—turns them in. Lack of confidence in the other members creates a self-fulfilling prophecy. Moreover, cartel members should lack confidence in the other cartel members who are, after all, criminals.
On average, prosecuted conspiracies were about 7 years old when they were caught. Thus, there is about a 15% chance annually of a breakdown of a conspiracy, at least among those that are eventually caught.