Directed reading in Industrial Organization

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Chapter 15: Collusion in Practice

Collusion in Practice

Chapter 15: Collusion in Practice

Introduction

Collusion is difficult to detect
no detailed information on costs
can only infer behavior
Where is collusion most likely?
look at the cartel member’s central problem
cooperation is necessary to sustain the cartel
but on what should the firms cooperate?
take an example
duopolists with different costs

Chapter 15: Collusion in Practice

An Example of Collusion

Suppose there are two firms with different costs
Profit-possibility frontier describes maximum non-cooperative joint profit
Point M is maximum joint profit

p1m to firm 1

p2m to firm 2

pm in total

This is the profit-possibility curve

This is maximum aggregate profit

p1m

p2m

Chapter 15: Collusion in Practice

Example of Collusion 2

Suppose that the Cournot equilibrium is at C

Collusion at M is not feasible
firm 2 makes less than at C
A side-payment from 1 to 2 makes collusion feasible on DE

With no side-payment
collusion confined to AB

p1m

p2m

Chapter 15: Collusion in Practice

Market Features that Aid Collusion

Potential for monopoly profit
demand relatively inelastic
ability to restrict entry
common marketing agency
persuade consumers of advantages of buying from agency members
low search costs
security
trade association
control access to the market
persuade consumers that buying from non-members is risky
use marketing power

Chapter 15: Collusion in Practice

Features Aiding Collusion 2

Low costs of reaching a cooperative agreement
small number of firms in the market
lowers search, negotiation and monitoring costs
makes trigger strategies easier and speedier to implement
similar production costs
avoids problems of side payments
detailed negotiation
misrepresentation of true costs
lack of significant product differentiation
again simplifies negotiation – don’t need to agree prices, quotas for every part of the product spectrum

Chapter 15: Collusion in Practice

Features Aiding Collusion 3

Low cost of maintaining the agreement
use mechanisms to lower cost of detecting cheating
basing-point pricing

use mechanisms to lower cost of detecting cheating
most-favored customer clauses
guarantees rebates if new customers are offered lower prices
meet-the-competition clauses
guarantee to meet any lower price
removes temptation to cheat
look at a simple example

Chapter 15: Collusion in Practice

Meet-the-competition clause

Firm 2

Firm 1

High Price

Low Price

High Price

Low Price

12, 12

5, 14

14, 5

6, 6

 the one-shot Nash equilibrium is (Low, Low)

 meet-the-competition clause removes the off-diagonal entries

 now (High, High) is easier to sustain

5, 14

14, 5

Chapter 15: Collusion in Practice

Features Aiding Collusion 4

Frequent market interaction
makes trigger strategy more effective
Stable market conditions
makes detection of cheating easier
with uncertainty need a modified trigger strategy
punish only for a set period of time
punish only if sales/prices fall outside an agreed range

Chapter 15: Collusion in Practice

An Example: Collusion on NASDAQ

NASDAQ is a very large market
Traders typically quote two prices
“ask” price at which they will sell stock
“bid” price at which they will buy stock
at the time of the analysis prices quoted in eighths of a dollar
prices determined by the “inside spread”
lowest ask minus highest bid price
profit on the “spread”
difference between the ask and the bid price
competition should result in a narrow spread
but analysis seemed to indicate wider spreads
inside spreads had high proportion of “even eighths”

Chapter 15: Collusion in Practice

Collusion on NASDAQ 2

Suggestion that this was evidence of collusion
NASDAQ dealers engaged in a repeated game
past and current quotes are public information to dealers
so dealers have an incentive to cooperate on wider spreads
Look at an example

Chapter 15: Collusion in Practice

Collusion on NASDAQ 3

Suppose that there are N dealers in a stock
dealer i has an ask price ai and a bid price bi
inside ask a is the minimum of the ai
inside bid b is the maximum of the bi
inside spread is a – b

Chapter 15: Collusion in Practice

Collusion on NASDAQ 4

Since inside spread is a – b
demand for shares of stock by those who want to purchase at price a is D(a)
supply of shares of stock by those who wish to sell at price b is S(b)
both measured in blocks of 10,000 shares
assume D(a) = 200 – 10a; S(b) = -120 + 10b

Chapter 15: Collusion in Practice

Collusion on NASDAQ 5

Two other assumptions
1. dealers set bid and ask prices to equate demand and supply
do not buy for inventory
so 200 – 10a = -120 + 10b
which implies b = 32 – a
only (ask, bid) combinations that we need consider are [(20, 12), (19, 13), (18, 14), (17,15), (16, 16)]

2. Dealer not quoting inside spread gets no business; others share orders equally

Price $/8

Quantity Traded (10,000)

D(a)

S(b)

Chapter 15: Collusion in Practice

Collusion on NASDAQ 6

Value of this stock v defined as price that equates public demand and public supply
v = 16 (or $2.00)
quantity of 400,000 would be traded
Aggregate profit is
revenue from selling at more than v
revenue from buying at less than v
p(a, b) = (a – v)D(a) + (v – b)S(b)
Recall that D(a) = S(b) so that b = 32 – a so that
p(a) = (a – b)(200 – 100a) = (2a – 32)(200 – 10a) or
p(a) = 20(a – 16)(20 – a)

Chapter 15: Collusion in Practice

Collusion on NASDAQ 7

This gives the profits:

Ask Price a Bid Price Volume of Aggregate b = 32 – a Shares Profit (10,000) ($’000)

20 12 0 0

19 13 10 75

18 14 20 100

17 15 30 75

16 16 40 0

Profit is maximized at an ask of 18 and a bid of 14

Is this sustainable or is there an incentive to defect and quote a lower ask and higher bid?

Chapter 15: Collusion in Practice

Collusion on NASDAQ 8

We have the pay-off matrix

Norman Securities (ask, bid)

All Other Market Makers (ask, bid)

(18, 14)

(17, 15)

(16, 16)

(18, 14)

(17, 15)

(16, 16)

(100(N-1)/N;

100/N)

(0, 75)

(0, 0)

(75, 0)

(75(N – 1)/N;

75/N)

(0, 0)

Chapter 15: Collusion in Practice

Collusion on NASDAQ 9

(16, 16) is weakly dominated for all dealers

We now have a prisoners’ dilemma game

Is (18, 14) sustainable in an indefinitely repeated game?

Norman Securities (ask, bid)

All Other Market Makers (ask, bid)

(18, 14)

(17, 15)

(16, 16)

(18, 14)

(17, 15)

(16, 16)

(100(N-1)/N;

100/N)

(0, 75)

(0, 0)

(75, 0)

(75(N – 1)/N;

75/N)

(0, 0)

Chapter 15: Collusion in Practice

Collusion on NASDAQ 10

Suppose that the probability of repetition from period to period is r and the discount factor is R

The pay-off to Norman from cooperation is:

PVc = (1 + rR + r2R2 + …)100/N = 100/(N(1 – rR)

The pay-off to cheating with a trigger strategy is:

PVd = 75 + (rR + r2R2 + …)75/N = 75+ 75 rR /(N(1 – rR)

Cheating does not pay if:

Chapter 15: Collusion in Practice

Collusion on NASDAQ 11

At the time of the original analysis there were on average 11 dealers per stock
with N = 11 we need rR > 0.966
with N = 13 we need rR > 0.972
collusion would seem to need a very high r and high R
but the time period between trades is probably less than an hour
so r is approximately unity
and the relevant interest-rate is a per-hour interest rate
so in this setting rR being at least 0.99 is not unreasonable
Collusion would indeed seem to be sustainable
No collusion was actually admitted but corrections to trading procedures were agreed.

Chapter 15: Collusion in Practice

Cartel Detection

Cartel detection is far from simple
most have been discovered by “finking”
even with NASDAQ telephone tapping was necessary
If members of a cartel are sophisticated they can hide the cartel: make it appear competitive

Chapter 15: Collusion in Practice

Cartel Detection 2

“the indistinguishability theorem” (Harstad and Phlips 1991)
ICI/Solvay soda ash case
accused of market sharing in Europe
no market interpenetration despite price differentials
defense: price differentials survive because of high transport costs
soda ash has rarely been transported so no data on transport costs are available
The Cournot model illustrates this “theorem”

Chapter 15: Collusion in Practice

Cartel Detection 2

 start with a standard Cournot model: C is the non-cooperative equilibrium

 assume that the firms are colluding at M: restricting output

 M can be presented as non-collusive if the firms exaggerate their costs or underestimate demand

 this gives the apparent best response functions R’1 and R’2

R’1

R’2

 M now “looks like” the non-cooperative equilibrium

Indistinguishability Theorem

Chapter 15: Collusion in Practice

Cartel detection 3

Cartels have been detected in procurement auctions
bidding on public projects; exploration
the electrical conspiracy using “phases of the moon”
those scheduled to lose tended to submit identical bids
but they could randomize on losing bids!
Suggested that losing bids tend not to reflect costs
correlate losing bids with costs!
Is there a way to beat the indistinguishability theorem?
Osborne and Pitchik suggest one test

Chapter 15: Collusion in Practice

Cartel Detection 4

Suppose that two firms
compete on price but have capacity constraints
choose capacities before they form a cartel
Then they anticipate competition after capacity choice
collusive agreement will leave the firms with excess capacity
uncoordinated capacity choices are unlikely to be equal
one firms or the other will overestimate demand
so both firms have excess capacity but one has more excess

Chapter 15: Collusion in Practice

Cartel Detection 5

So, firms enter into collusive agreement with different amounts of spare capacity
If so, collusion between the firms then leads to:
firm with the smaller capacity making higher profit per unit of capacity
this unit profit difference increases when joint capacity increases relative to market demand

Chapter 15: Collusion in Practice

An example: the salt duopoly

British Salt and ICI Weston Point were suspected of operating a cartel

BS Profit

WP Profit

BS profit per unit of capacity

1980

1981

1982

1983

1984

WP profit per unit of capacity

Total Capacity/Total Sales

7065

7622

10489

10150

10882

7273

7527

6841

6297

6204

BS capacity: 824 kilotons;

WP capacity: 1095 kilotons

8.6

9.3

12.7

12.3

13.2

6.6

6.9

6.3

5.8

5.7

1.5

1.7

1.9

But will this test be successful if it is widely known and applied?

BS is the smaller

firm and makes

more profit per

unit of capacity

The profit

difference grows

with capacity

Chapter 15: Collusion in Practice

Basing Point Pricing

Birmingham Steel Company

Suppose that

the steel is

made here

And that it

is sold

here

Pittsburgh

Then it was priced at

the mill price plus

transport costs

from Pittsburgh

Chapter 15: Collusion in Practice

Directed reading in Industrial Organization

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