Cartels

Suppose the industry demand curve in Figure 8.3 shifted up and to the right. What would be the effect on price, output, and profit under competition and under monopoly? Answer these questions again, supposing unit costs increased.

A cartel is a group of producers that enter into a collusive agreement aimed at controlling price and output in a market. The intent of the cartel is to secure monopoly profits for its members. Successful maintenance of the cartel not only has an immediate profit advantage; it also reduces the competitive uncertainties for the firms and can raise additional entry barriers to new competitors.

In the United States, collusive agreements among producers (whether open or tacit) represent violations of antitrust laws and are illegal.3 Some cartels outside the United States have the sanction of their host governments; in others, countries participate directly. The best-known and most powerful cartels are based on control of natural resources. In the 1990s and today, the Organization of Oil Exporting Countries (OPEC) controls about 40 percent of the world supply of oil. De Beers currently controls the sale of more than 90 percent of the world’s gem-quality diamonds.

The monopoly model is the basis for understanding cartel behavior. The cartel’s goal is to maximize its members’ collective profit by acting as a single monopolist would. Based on the demand it faces, the cartel maximizes profit by restricting output and raising price. Ideally, the cartel establishes total output where the cartel’s marginal revenue equals its marginal cost. For instance, if cartel members share constant and identical (average and marginal) costs of production, Figure 8.3’s depiction of the monopoly outcome would apply equally to the cartel. The cartel maximizes its members’ total profits by restricting output and raising price according to QM and PM, where marginal revenue equals marginal cost.4

Output restriction is essential for a cartel to be successful in maximizing its members’ profits. No matter how firm its control over a market, a cartel is not exempt from the law of demand. To maintain a targeted price, the cartel must carefully limit the total output it sells. Efforts to sell additional output lead to erosion of the cartel price. The larger the additions to supply, the greater the

3The law permits trade and professional associations; these organizations sometimes formulate and sanction industry practices that some observers deem anticompetitive. In the 1950s, widespread collusion among electrical manufacturers in contract bidding was uncovered and prosecuted. 4When costs differ across cartel members, there is more to determining the relevant marginal cost curve. To maximize profit, the cartel first should draw its production from the member(s) with the lowest marginal costs. As output increases, the cartel enlists additional supplies from members in ascending order of marginal cost. The cartel’s marginal cost curve will be upward sloping and is found by horizontally summing the members’ curves. This ensures that cartel output is obtained at minimum total cost.

CHECK STATION 3

Business Behavior: The OPEC Cartel

fall in price and, therefore, the greater the decline in the cartel’s total profit. This observation underscores the major problem cartels face: Cartels are inherently unstable. The reason lies in the basic conflict between behavior that maximizes the collective profits of the cartel and self-interested behavior by individual cartel members.

To see this, return to the cartel’s optimal price and output, PM and QM, in Figure 8.3. Suppose the cartel agrees to set total output at QM and assigns production quotas to members. The self-interest of each member is to overproduce its quota. The member can sell this additional output by cutting price very slightly. (Remember that one member’s additional output is small enough to put little downward pressure on price.) What effect does this added output have on the member’s profit? Figure 8.3 shows that the cartel price is well above marginal cost. Thus, even allowing for a slightly discounted selling price, selling the extra output is very profitable. Each member has an incentive to cheat on its agreed-upon output quota. But if all members overproduce, this behavior is self-defeating. If all members increase output (say, by 10 to 15 percent), flooding the market with extra output will have a significant downward effect on price. The total output of the cartel will be far greater than QM, price will fall below PM, and the cartel’s profit inevitably must drop. Thus, overproduction is a constant threat to the cartel’s existence.5 In the presence of wholesale cheating, the cartel may fall apart.

The 11 member nations of OPEC meet twice a year to discuss the cartel’s target price for crude oil and to allot members’ production quotas. Like a continuing drama with many acts, the OPEC negotiations center on (1) an assessment of the world demand for oil, (2) the appropriate limit on total OPEC supply, and (3) the division of this supply among cartel members.

Over the last 15 years, OPEC has had a mixed record in limiting its supply and maintaining high oil prices.6 Until mid-2001, OPEC was largely successful in negotiating lower total output levels for the cartel and, therefore, maintaining high crude oil prices. OPEC successively cut its total output quota from 26 million to 24.2 million barrels per day (mbd), members largely honored their individual quotas, and prices rose to above $40 per barrel. However, with the worldwide economic slowdown in 2002 and greatly increased supply by nonmember Russia, OPEC faced the prospect of soft and falling oil prices. With OPEC members exceeding their quotas by an estimated 1 million total barrels per day, oil prices fell below $20 per barrel.

5A related problem is that an oil producer is typically better off being outside the cartel, where it can take advantage of a high, cartel-maintained price without limiting its own output. Many oil producers, including Mexico, Malaysia, Gabon, Norway, Russia, and Egypt, support OPEC’s initiatives while refusing membership. 6This synopsis is based on industry reports, OPEC’s official communications, and on F. Norris, “Two Directions for the Prices of Oil and Natural Gas,” The New York Times, February 26, 2011, p. B3; and “Oil Pressure Rising,” The Economist, February 26, 2011, pp. 79–80.

In the last decade, OPEC has prospered due to a combination of steadily increasing oil demand and limited supply. The surge in demand has been led by the rapid economic growth in China and India and surprisingly strong consumption in the United States. Supply disruptions in Venezuela and Nigeria and severe reductions in oil from Iraq have contributed to supply shortfalls. In response to increasing demand, OPEC pursued a profit-maximizing strategy, raising its official supply quota from 24 mbd in 2003 to 26 million barrels mbd in 2005 and ultimately to nearly 30 mbd in early 2008. Average crude oil prices climbed steadily, exceeding $40 per barrel in 2004, $60 per barrel in 2005, and $90 per barrel in 2007 before exploding to well over $100 per barrel in mid 2008. Surging demand put OPEC in a no-lose situation. Although many OPEC members overproduced their individual quotas (overproduction was some 2.5 mbd in total during early 2008), prices remained stable.

But the onset of the global recession in the fall of 2008 and the slow economic recovery over the next three years have sharply curtailed worldwide oil demand and caused oil prices to fall as low as $40 per barrel in 2009. Beginning in late 2008, OPEC agreed to slash its total production from 29.0 million barrels per day to 24.8 mbd. Table 8.1 shows the breakdown of output quotas for OPEC members. The adherence to the lower total quota (and a sharp cutback in oil from civil war-torn Libya) helped maintain and buoy average oil prices to above $80 per barrel in 2010 and 2011. However, in 2011 OPEC as a whole was overproducing its quota by some 4 million barrels per day. It remains to be seen whether persistent flaunting of quotas will lead to significant erosion in oil prices.

Algeria Angola Ecuador

Iran

Kuwait

Libya Nigeria Qatar Saudi Arabia

UAE

Venezuela

Total

1.20 1.52 0.43

3.34

2.22 1.47 1.67 0.73 8.05

2.22 1.99

24.84

(Iraq does not currently abide by OPEC quotas.)

TABLE 8.1

Production Quotas of OPEC Members (December 2010)

Quotas are expressed in millions of barrels of oil per day.