Tag Archives: cartel theory

Paul Samuelson (1963) on oil cartel stability and cheating


My @DomPost op-ed on petrol pricing and the theory of the empty core @EricCrampton

From http://www.stuff.co.nz/business/103548451/Petrol-prices-competitive-but-inherently-crazy?cid=app-android

Monopoly and Competition (by Murray N. Rothbard)

Why Does Big Business Love Big Government? (Domhoff, Rothbard, and Evers)

.@TheEconomist thinks US domestic airlines are a successful oligopoly!?



@GarethMP @jamespeshaw need message discipline on @NZGreens as honest brokers

Yesterday morning, Green MP Gareth Hughes posted a British Greens’ video about how other politicians are a bunch of squabbling children but the Greens are above that. It’s only the Greens who offer a “true alternative to the establishment parties” and their “same childish Punch & Judy politics”.

Later that same day Greens co-leader James Shaw posted a video that shaded the truth about the history of dividends from Kiwibank as a way of scoring points of the National Party led government.

Shaw claimed that the government is extracting more and more dividends from Kiwibank rather than letting it keep those profits as capital on which the government owned bank can be a more aggressive competitor.


Source: Kiwibank pays its first dividend of $21 million to Government | Stuff.co.nz.

Shaw is vaguely correct in that it is dividends plural when referring to Kiwibank’s dividends. Kiwibank paid dividends of $21 million last year; and $750,000 the year before. Kiwibank has paid two dividends to New Zealand Post in its entire history since 2002.

It shades the truth to say that the government is extracting more and more dividends from Kiwibank when when it has only paid one dividend worth mentioning, which was last year.


Source: New Zealand Treasury – data released under the Official Information Act.

As for James Shaw’s claim that the entry of Kiwibank made banking in New Zealand much more competitive, Michael Reddell disposed of that by linking to a 2013 Treasury assessment of competition in retail banking.



Source: New Zealand Treasury Official Information Act Releases.

There are no excess profits in the New Zealand banking market for Kiwibank to undercut. Entry barriers are low, banking products are easy substitutes for each other between the competing banks, and the banks compete for market share by advertising  of, for example, special packages to switch banks.

Adding to the analysis of the Treasury, Posner and Easterbrook suggest that these industry behaviours together are suspicious.

  1. Fixed relative market shares among top firms over time.
  2. Declining absolute market shares of the industry leaders.
  3. Persistent price discrimination.
  4. Certain types of exchanges of price information.
  5. Regional price variations.
  6. Identical sealed bids for tenders.
  7. Price, output, and capacity changes at the time of the suspected initiation of collusion.
  8. Industry-wide resale price maintenance or non-price vertical restraints.
  9. Relatively infrequent price changes; smaller price reactions as a result of known cost changes.
  10. Demand is highly responsive to price changes at market price.
  11. Level and pattern of profits relatively favourable to smaller firms.
  12. Particular pricing and marketing strategies.

As the Treasury noted in its analysis, there are several small banks offering competitive rates that would allow them to expand if they offered value for money over the existing offerings. Returns on equity of the big banks are not discernibly higher than for the smaller ones.

To add again to the Treasury analysis, it is not easy to organize a cartel. There are markets to divide, prices to set, and production quotas to assign. The best place to be in a cartel is outside of it undercutting the higher price and selling as much as you can before the cartel inevitably collapses. Brozen and Posner suggest the following pre-conditions to collusion:

  • market concentration on the supply side;
  • no fringe of small sellers;
  • high transport costs from neighbouring markets;
  • small variations in production costs between firms;
  • readily available information on prices;
  • inelastic demand at the competitive price;
  • low pre-collusion industry profits;
  • long lags on new entry;
  • many buyers (otherwise selective discounting to big buyers will be too tempting while monitoring adherence to the agreement will be difficult);
  • no significant product differentiation;
  • large suppliers selling at the same level in the distribution chain;
  • a simple price, credit and distribution structure;
  • price competition is more important than other forms of competition;
  • demand is static or declining over time; and
  • stagnant technological innovation and product redesign.

Stable collusive arrangements are thus likely to be rare because the absence of any of the above conditions will tend to undermine the potential for successful collusion.

Successful cartel operation is even harder than its initial formation. Members of the cartel must continue to believe that they enjoy net profits from participating in the collusion.

The more profitable the collusive price fixing, the greater the incentive for outsiders to seek entry to compete. In cartel theory, these new entrants are known as interlopers.


The more numerous the participants in the cartel and the more lucrative the collusion, the greater the temptation for individual members to cheat and the greater the fear of each that some other member will cheat first.

Cartel members that cheat early profit the most from the cartel price before it collapses. That is why the history of cartels is a history of double-crossing. Long-term survival of the cartel has two fundamental requirements:

  1. cheating by a member on the cartel prices, outputs and market shares must be detectable; and

  2. detected cheating must be adequately punishable without breaking-up of the cartel.

If banking was a cartel, you would not see advertising on the TV every night inducing customers to switch but you do. That advertising is cheating on the banking cartel the New Zealand Greens want to break up.

There is an infallible rule in competition law enforcement. It arises mostly crisply in merger law enforcement. If competitors oppose a merger, the merger must be pro-consumer. If the merger is anti-competitive, that merger will increase prices. The competing firms can follow those prices up and profit from the weakening of competition subsequent to the merger.

Milton Friedman predicted this police calling card to competing drug gangs

via The funny, surprisingly successful tactic some police are using to catch drug dealers – Vox.

Why all this sucking up to the dead Saudi dictator?

We are not living in the 70s, but nonetheless the death of the late unlamented Saudi dictator has flags at half-mast and other sycophantic behaviour that hasn’t been seen since the death of the last totalitarian dictator who was something of a player in geopolitics and American foreign policy.

We are not living in the 70s where the West in fear of the OPEC cartel and the behaviour of Saudi Arabia as the swing producer and purported cartel enforcer.

Spot price of Brent crude as of January 5, 2015 (Joss Fong/Vox)

OPEC and Saudi Arabia are both shadows of the former selves in terms of dominance in the global oil markets. OPEC as a whole represents about one third of global oil production, which was down for a little over 50% in 1973.


Within OPEC, Saudi Arabia As oil reserves that aren’t much bigger than those of either Iran or Venezuela. All of these countries, including Saudi Arabia have large populations and few other ways to servicing needs than from the oil revenues.

Russia is in the same position of needing to pump out as much oil as it can while letting someone else do the hard lifting regarding keeping the price of the oil up by cutting back production. US oil production has been on the rise, and has lessened the need for imported crude oil.

Obama and Abdullah

The best place to be in any cartel is outside the cartel selling as much as you can at the cartel price. The next best option is to be a cartel member, pretending to be a loyal while selling under the counter bias, much as you can. Recent discounts given by the Kingdom to some customers have been interpreted as showing a determination to maintain market share. David Friedman explains:

One great weakness of a cartel is that it is better to be out than in. A firm that is not a member is free to produce all it likes and sell it at or just below the cartel’s price.

The only reason for a firm to stay in the cartel and restrict its output is the fear that if it does not, the cartel will be weakened or destroyed and prices will fall.

A large firm may well believe that if it leaves the cartel, the remaining firms will give up; the cartel will collapse and the price will fall back to its competitive level.

But a relatively small firm may decide that its production increase will not be enough to lower prices significantly; even if the cartel threatens to disband if the small firm refuses to keep its output down, it is unlikely to carry out the threat.

Maurice Adelman regards the oil glut as the chronic condition of the world oil market, given the continuous tendency to underestimate reserves and undiscovered oil.

There was a glut 70 years ago, 50 years ago in 1933, 15 years ago in 1970 …But that condition of everlasting glut is periodically broken by dangers of oil shortage.

All cartels break-down and only some get back together. Cartels contain seeds of their own destruction. Cartel members are reducing their output below their existing potential production capacity, and once the market price increases, each member of the cartel has the capacity to raise output relatively easily. Adelman explains:

Opinions vary as to what is the right price for maximum profit, and opec has often had to find its right price through trial and error…

Each opec member could reap a windfall by cheating and producing over quota because the cost of production is so far below the market price. But, if some cartel members were to defect, output would climb and the prices — and windfall profits — would fall.

OPEC members pay scant regard to their actual production quotas and their national production quotas are always increased when push comes to shove. As Bill Allen said:

Long-term survival of the cartel has two fundamental requirements: first, cheating by a member on the stipulated prices, outputs and markets must be detectable; second, detected cheating must be adequately punishable without leading to a break-up of the cartel.


All cartels must decide how to allocate the reduction of output that follows the price increases across members with different costs structures and spare capacity.:

  • The tendency is for cartel members to cheat on their production quotas, increasing supply to meet market demand and lowering their price.
  • Most cartel agreements are unstable and at the slightest incentive they will quickly disband, and returning the market to competitive conditions.

The exercise of collective market power will not be stable unless sellers agree on prices and production shares; on how to divide the profits; on how to enforce the agreement; on how to deal with cheating; and on how to prevent new entry.

A cartel is in the unenviable position of having to satisfy everyone, for one dissatisfied producer can bring about the feared price competition and the disintegration of the cartel. Thus a successful cartel must follow a policy of continual compromise. Little wonder that John. S McGee wrote that:

The history of cartels is the history of double crossing.

Was it important to suck up to the Saudi dictator because of its role as swing producer in OPEC. In 1983, 1984, and 1986, for example, the Saudis produced only about 3.5 million barrels per day, despite their (then) production capacity of about 10 million barrels per day. Whatever else you can say about those production cutbacks  to defend  posted OPEC  cartel price, they were a long time ago.

Monthly change in oil price

Saudi Arabia, Kuwait, and the United Arab Emirates have large reserves relative to the financial needs of their population but what they have is only a small share of global reserves and global production of oil and trivial share if you add global shale production.

With the exception of the wake of the 1979 Iranian upheaval, and market anticipation of a possible destruction of substantial reserves in the 1990–1991 and 2003 Gulf wars, real prices of crude oil fell from 1974 through 2003. Prices increased in 2004 onwards because of demand in Asia.

Bryan Caplan summarised the views of leading oil economist James Hamilton in 2008 as follows:

1. OPEC has almost no effect on world oil prices; most countries produce less than their quota, and when countries want to produce more, their quota goes up.

2. The price of oil follows a random walk. But the oil industry isn’t trying very hard to develop new sources because oil execs believe that the price of oil is mean-reverting (i.e., what goes up must come down). Why are the oil execs so wrong? Hamilton’s guess: They’re putting too much weight on their last big experience with high oil prices in the 70s and 80s.

No amount of cutting can support prices when supply outside OPEC is growing strongly and demand is weak in the wake of the global financial crisis and the slower recoveries both in the USA and Europe. Hamilton’s current view is that:

…of the observed 45% decline in the price of oil, 19 percentage points– more than 2/5– might be reflecting new indications of weakness in the global economy.

Whatever reason people are sucking up to the dead Saudi dictator, they have nothing to do with the global oil market.

Source: IMFDirect.