Panel Discussion Inside the Cartel Robert Porter Northwestern

Panel Discussion: Inside the Cartel Robert Porter Northwestern University / CREST-LEI ACLE 5 th Competition & Regulation Meeting To Enforce and Comply Amsterdam, March 5 -6, 2009 1

Repeated Game Models of Collusion Repeated game models focus on the unilateral incentive to deviate from a collusive agreement, say by undercutting agreed upon prices or producing more than one’s allotted share. A cartel is self-enforcing if the short run gains from deviating are outweighed by the expected punishment that would follow detection. Punishments are typically modeled as symmetric, often the permanent collapse of the agreement with reversion to static equilibrium behavior. Less focus on describing which agreement is reached, in part because of the multiplicity of self enforcing agreements. With discount rates close enough to zero, the folk theorem predicts that virtually any outcome will be self enforcing. If the agreement is the outcome of explicit negotiations, then might restrict attention to the Pareto frontier of self enforcing payoffs. If firms are identical, then natural to consider symmetric point on Pareto frontier of payoffs. 2

Asymmetries If firms are asymmetric, the allotment of quantities under a cartel agreement, or the choice of prices, is more difficult. The agreement will be the result of some bargaining process, under the requirements that the outcome be self enforcing and that it satisfy individual rationality or participation constraints. The latter stipulate that firms’ profits under the agreement exceed what they would earn in the non-cooperative equilibrium. The participation constraint is trivially satisfied for identical firms, e. g. , when firms are assigned equal shares of industry output. The participation constraint can be binding in asymmetric contexts. Suppose that the product is homogenous and costs exhibit constant returns to scale but differ across firms. The joint profit maximizing solution, in which the most efficient firm produces its monopoly output, violates the participation constraint, absent side payments. 3

Private Information Reaching an agreement is complicated further if firms have private information concerning their payoffs. E. g. , firms may have better information than their co-conspirators about their own costs or their customers’ demands. Joint profit maximization would reflect any differences, but there is an additional constraint associated with eliciting private information. Because collusive prices exceed marginal costs, an inefficient firm has an incentive to report low costs and so be allocated a larger market share. Moreover, if the information revealed is valuable in subsequent competition, e. g. , against non-participants, there will be more aggressive bidding for a share of the proceeds. Participation constraints are more subtle, to the extent that the noncooperative default changes when participants “learn from disagreement” about their accomplices’ private information. 4

Legal Cartels A cartel faces a group decision problem, subject to a variety of constraints. The tools available to the cartel vary according to the legal and institutional context. Legal cartels can freely communicate, and they may be able to write binding contracts, make side payments, or restrict entry. They maximize some function of the participants’ profits, subject to participation constraints and the constraints associated with the revelation of private information, as well as the requirement that participants not have an incentive to defect. Self enforcement may not be an issue if the conspirators can rely on the courts or some regulatory body to punish defections. Suggests a mechanism design modeling approach. Even legal cartels with wide ranging powers do not necessarily form or endure, however, if they founder on the problems that result from asymmetries or private information. 5

Illegal Cartels Illegal cartels face many of the same constraints, but often with fewer tools available. They typically cannot write contracts that will be enforced by the courts, and then agreements must be self enforcing. (Legal international cartels may face similar difficulties. ) They cannot restrict entry. Side payments require some agreement on a payment mechanism and the circumstances under which payments are made. The payment mechanism must satisfy an ex post budget balance condition, so that no payments are made from a third party. Example: a market share allocation in which payments compensate for deviations from allotted shares. E. g. , if a firm obtains a larger than allotted share, it would compensate the firms whose shares were lower than allotted. If the payments equal the output difference times an agreed upon cartel price, then there is no incentive to cheat, if shares can be measured accurately. 6

Tacit Collusion Most important, illegal conspirators face legal risks when they communicate. The literature distinguishes between tacit and explicit collusion, where the distinction hinges on whethere is direct communication. The US antitrust laws stipulate that communication is per se illegal, whether or not the communication results in higher prices, with few exceptions. (Exceptions include agricultural marketing agreements, some international agreements, and some R&D joint ventures. ) The problem with tacit collusion, from the perspective of the participants, is that there is no mechanism to reach an agreement, nor any way to resolve disputes. The former problem might be dealt with via price leadership, or preannouncements of price changes, but both can be imperfect collective decision mechanisms. Another imperfect mechanism is a territorial allocation. Many conspiracies choose to collude explicitly, and risk prosecution. 7

A Broader Perspective The cartel formation process involves more than the issues studied in the repeated games literature. Dampening the short run incentives to cheat is only one facet of a cartel’s problems. Factors may facilitate or inhibit collusion solely through the participation and information revelation constraints. Factors that play a role in the self enforcement constraint identified in the repeated games literature, such as the effects of leniency programs, can also affect the other constraints faced by a conspiracy. 8

Punishments The punishments associated with reversion to some competitive equilibrium need not be symmetric. Symmetric punishments are most compelling when firms cannot tell who, if anyone, has violated their agreement. If the cartel members can identify the firms that cheated, they may be able to single out the offenders. Under these circumstances, the punishment does not necessarily have to entail collective sacrifice. A legal cartel could require that members post bonds that would be forfeited in the event of cheating, thereby avoiding costly price wars. Both legal and illegal cartels have used the market share settlement mechanism described above. Alternatively, it may be possible to tailor a reversionary episode to harm the offending parties more than the other firms. This punishment would itself have to be self enforcing, say by the threat of reversion to competition should the intended victim not lower its output. 9

Empirical Questions Thanks in large part to cartel leniency programs, there is now a sizable body of recent evidence on how cartels operate. It is not clear whether this evidence lends itself to cross-industry econometric analysis. But some synthesis of the case evidence could be informative. To date, the profession has relied on a handful of case studies, e. g. , Porter & Zona (JPE 1993): LI highway construction Genesove & Mullin (AER 2001): the Sugar Institute Connor (RIO 2001): ADM and lysine Ashenfelter & Graddy (JCLE 2005): Sotheby’s and Christie’s Asker (NYU mimeo 2008): the NYC stamp ring There remains an issue of sample selection in the data. How representative are the cartels that have been caught? 10

Leniency Programs Several antitrust authorities offer cartel leniency programs. US Do. J lawyers argue that “Race to the courthouse” incentives were created by US Corporate Leniency, or Amnesty, Program, as redesigned in 1993. Under this program, the first to confess, and only the first, receives lenient treatment (offset, to some degree, by its degree of participation in the conspiracy). Example: Sotheby’s and Christie’s – – Christie’s was an equal partner in scheme, but the firm and its executives received much lighter criminal penalties than Sotheby’s. E. g. , Alfred Taubman, owner of Sotheby’s, served almost a year in jail. Since 1993, there have been a number of high profile cases, with record fines. But the number of cartel discoveries has not necessarily increased:

Nathan Miller, forthcoming AER, US data 12