cartel or collusion

Oligopoly behavior in which firms coordinate and collectively act as a monopoly to gain monopoly profits.

Apple Always Wins, or Does It?

In the months leading up to 2010, Apple was preparing for the launch of its new iPad and, with it, the introduction of the iBooks Store, which would allow users to buy and read books on mobile devices. But Apple faced a dilemma. It would be difficult for the iBooks Store to succeed unless it could match the $9.99 price point of Amazon’s Kindle, its major competitor. This price, thought by some to be less than marginal cost, had served Amazon well in building a customer base for e-books, but it made it challenging for a new entrant like Apple to successfully compete.

Amazon’s low price point was a concern for book publishers as well. They feared that cheap e-books would hurt sales of their more expensive print copies and, over the longer term, influence the public’s expectations regarding book prices. Amazon’s growing market power also posed the threat that Amazon might start directly competing with publishers.

As early as December 2008, the major publishers began engaging in talks and, later, meeting in private dining rooms in New York City restaurants to discuss ways to force Amazon to price above $9.99. Before one of their meetings, David Young, then chairman and CEO of Hachette Book Group, told a fellow publisher, “I hate [Amazon’s] bullying behavior and will be happy to support a strategy that restricts their plans for world domination.” The publishers started implementing their strategy. They coordinated on raising the wholesale price of e-books and introducing “windowing,” which delayed e-book versions of new releases to protect hardcover sales. After one particular correspondence regarding these tactics, Young advised another publishing executive that “it would be prudent for you to double delete this from your email files.”

Knowing the publishers’ discontent with Amazon’s price point, on December 8, 2009, Eddy Cue, Apple’s senior vice president of Internet Software and Services, began requesting meetings with the major publishers to encourage them to join the iBooks Store. Cue assured the publishers that Apple would price books higher than Amazon, and after the first of his meetings he reported to Apple’s then CEO Steve Jobs that the publishers were “ecstatic” about the prospect of Apple’s entry into the industry.

Over the next several weeks, the publishers and Apple crafted a contract that featured a marketwide transition from a wholesale model to an agency model (whereby the publisher rather than the retailer sets the retail price) and a clause that guaranteed Apple would hold the lowest prices on the market. These changes would effectively drive e-book prices upward while securing Apple’s competitive position in the market.

Amazon responded by also moving to an agency model in the following months. Soon thereafter, e-book retail prices increased an average of 14.2% per unit and 42.7% for New York Times bestsellers. Publishers sold fewer e-books through Amazon, as would be expected, though estimates of the magnitude of this decrease vary. On the whole, however, the collusion between Apple and the publishers appeared to be a massive success. Not only had it raised prices, it seriously eroded Amazon’s monopoly. Before the price-fixing scheme, Amazon held about 90% of the e-book market. In 2012, when the scheme was in full effect, this share was closer to 60%.

Once again, it seemed as if the old Apple magic had worked: The company revolutionized yet another market by entering it. Maybe that would have been the case had things stayed the way they were in early 2012. But any cheers of victory among Apple and the publishers quickly faded when the U.S. government sued them for collusion in April 2012. The presiding judge announced her decision just over a year later: Apple was guilty. The words the judge used were scathing. “To adopt Apple’s theory, a fact-finder would be confronted with the herculean task of explaining away reams of documents and blinking at the obvious.” Several states and private plaintiffs sought more than $800 million in damages. Apple managed to soften the blow by appealing and reaching a $450 million settlement in case its appeal falls through, but it lost the most important gain the scheme had brought it: its ability to control e-book prices.

Amazon responded by pushing prices right back down to the $9.99 price point. Its market share, which Apple had worked so hard to beat down, started to climb again. Amazon wasn’t shy about flexing its market power muscles in other ways. It understocked and refused to accept presale orders for books released by Hachette Book Group, one of the colluding publishers. Amazon was apparently making Hachette pay for its refusal to agree to a contract renewal in which most of its e-book prices would be lowered to $9.99.

Hachette authors like J. K. Rowling and Stephen Colbert and their fans complained loudly about Amazon’s practices and, in November 2014, Amazon and Hachette came to an agreement. Hachette books are again fully stocked. However, as Douglas Preston (founder of Authors United) noted, “If anyone thinks this is over, they are deluding themselves. Amazon covets market share the way Napoleon coveted territory.”

Is it “bad” that Amazon prices so low? In economics, the question is usually not whether something is “good” or “bad,” but rather, “Who is it good or bad for when Amazon prices so low?”

In the short run, these low prices are great for consumers, who get the same good at a much lower price. These low prices are worst for Amazon itself—in the short run. If Amazon is indeed selling e-books at a price below its marginal cost as many suspect, then the more the company sells, the more money it loses! That doesn’t sound like a great pricing strategy. However, if there is one thing Amazon has shown, it is that a long-term perspective is needed. Amazon’s executives are willing to absorb short-run losses to gain and maintain market share. They believe this strategy will have a big long-run payoff in the future, presumably because Amazon can either charge higher prices in the long run or negotiate better deals with the publishers. For that reason, although Apple is a clear loser in this case, who else is winning or losing is difficult to untangle.

One thing we are fairly confident about: Now is a great time to buy e-books. When you can get a firm to sell you a product below its marginal cost, you are getting a bargain.

The Organization of Petroleum Exporting Countries (OPEC) is an example of a cartel that has a lot of difficulty coordinating the actions of all 12 of its members to keep the price of its good, oil, high. First of all, OPEC nations wouldn’t be monopolists even if they could coordinate their actions, because they don’t control all of the world’s supply of oil. More than half of the world’s current oil production comes from non-OPEC nations.4 Oil producers in those non-OPEC counties are happy to let OPEC try to collude, because if OPEC is successful, it raises the price at which these other countries can sell their oil, but the non-OPEC countries don’t have to abide by the cartel restrictions and can sell as much oil as they like. So right away, there’s a problem: OPEC can’t keep all of the gains from its collusion.

On top of that, OPEC has trouble keeping itself together because of a cartel’s natural instability. Since its founding, the cartel had met regularly to assign production quotas for each member. Frequently, however, the members chose not to abide by the agreement and overpump oil. And in this case, “frequently” meant more or less all the time. Figure 11.2 shows OPEC’s production quota agreements compared to its actual production since 2001.5 Through 2011, actual production never matched the agreed upon numbers. Member countries always pumped more, just as economics would predict. Each member has a great temptation to overproduce given the cartel setup.

In 2012 OPEC tried a new strategy for meeting its production quotas: giving up. When Iraq was brought back into the production agreement in January (it had been exempted from adhering to quotas up to that time), OPEC raised its quota by 5.2 million barrels per day, despite the fact that Iraq was only producing 2.7 million barrels per day at the time. Even that wasn’t enough, however; it took another 20 months before OPEC’s production fell below even this expanded target. It has hovered around that level since.

It kept hovering when, in late 2014, a big increase in the supply of oil from North American shale discoveries and a slowdown of demand in China caused oil prices to plunge by about 50% in just six months. All eyes turned to OPEC to see if its member countries would restrict supply and drive the price back up. OPEC could not agree to do so.

OPEC must wish it could just be a monopoly, but it ain’t gonna happen. Getting a cartel to act as a single monopolist is harder than it looks. So next time you pay $60 to fill your gas tank, go ahead and get mad! But don’t just blame this on OPEC. It doesn’t have its act together often enough to actually make your gas prices stay high.

Suppose that Squeaky Clean and Biobase are the only two producers of chlorine for swimming pools. The inverse market demand for chlorine is P = 32 – 2Q, where Q is measured in tons and P is dollars per ton. Assume that chlorine can be produced by either firm at a constant marginal cost of $16 per ton and there are no fixed costs.

Solution:

In 2006 and 2007 the U.S. Department of Justice busted up a long-lived ready-mixed concrete cartel in the Indianapolis Metro and Southwest Indiana areas. The case ended up being one of the largest domestic price-fixing prosecutions in the history of the United States. Millions of dollars in fines were levied, and ten executives were given prison sentences.6

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The Indianapolis cartel struggled with instability issues. Despite the fact that price-fixing conversations had gone on “for as long as anyone could remember,” the cartel members were constantly dealing with cheating by members and struggling for ways to punish firms that deviated from agreements. They also had to figure out how to handle a financially struggling firm that was desperate for revenue and perhaps willing to slash prices to get it.

The group held regular meetings at local restaurants or hotels (paying cash for conference rooms to avoid leaving a paper trail) to try to adjust the agreement to current market conditions. Executives monitored agreements by anonymously gathering price quotes from their competitors over the phone. If a violation occurred, the cartel would issue threats, though it’s unclear exactly what was threatened and how many threats were actually carried out. If violations were widespread enough, the ringleaders would call an emergency meeting at the local Cracker Barrel restaurant.

These efforts met with mixed success. Sometimes cheating would overwhelm their effort to hold to an agreement. Firms were reluctant to give up the customers they had gained by undercutting the other cartel members. Still, the cartel was on occasion able to maintain enough discipline to inflate prices by an amount estimated to be as much as 17% above their noncollusive level.

Everything began to fall apart when the cartel tried to deal too aggressively with a noncooperative manager from a firm that was not part of the cartel. After repeated attempts to cajole the manager into joining the scheme, the cartel members started complaining about various aspects of his performance to his corporate bosses. Feeling backed into a corner, the manager went to the FBI and informed them of the cartel’s operations. By the time criminal proceedings ended a few years later, many careers had been destroyed and several of the cartel companies had been liquidated or bought out.