What Is a Cartel? Why Rivals Agree Not to Compete

In a competitive market a firm that raises its price loses customers to rivals, so prices fall towards costs. If the rivals agree to raise prices together, no one loses customers to anyone, and the whole industry earns the extra profit that a single monopoly would; the cartel is a monopoly assembled from parts. The agreement can be about price directly, about output, since restricting supply raises price, about territory, each firm taking a region and staying out of the others', or about bids, the firms taking turns to win contracts at inflated prices. What the customers lose is more than the firms gain, since some buyers who would have paid the competitive price go without, and that deadweight loss is why economists condemn cartels even where they are legal.

Every member of a cartel has an incentive to cheat. With the price held high, a firm that quietly cuts its own price a little wins a flood of customers from its partners, and every member knows that every other member is calculating the same thing; the arrangement is the prisoner's dilemma with several players. Cartels survive where cheating can be detected and punished, which is why they need a few members rather than many, a standard product whose price is easy to compare, regular meetings, and a way to police the deal, whether by sharing sales figures or, in the drug trade, by murder. Demand falling in a recession tempts members to cheat to fill capacity, new entrants outside the cartel undercut it, and the history of cartels is mostly a history of them collapsing, being rebuilt and collapsing again. The conditions that help them hold:

• •Few sellers, so that meetings are small and defection is visible
• •A homogeneous product, so that a price cut cannot be disguised as a quality difference
• •Barriers to entry, so that the high price does not attract new competitors
• •Inelastic demand, so that buyers cannot easily switch to something else
• •Transparent prices and a means of punishing cheats

OPEC, the group of oil-exporting states founded in 1960, is the legal cartel, since sovereign states cannot be prosecuted, and it has spent fifty years trying to hold its members to production quotas that each has reason to exceed, succeeding in the 1970s when it quadrupled the oil price and failing through most of the 1980s and 1990s; Saudi Arabia acts as the swing producer that punishes cheats by flooding the market. De Beers controlled diamond supply for a century by owning the mines and buying up any diamonds it did not, and lost the grip in the 2000s when Russian and Canadian producers sold outside it. The vitamin cartel of the 1990s, in which Roche, BASF and others fixed the world price of vitamins for a decade, was fined nearly a billion dollars in the United States and Europe; the lysine cartel was broken by an executive who wore a wire to the meetings for the FBI; and the LIBOR scandal of 2012 revealed that bankers had colluded to rig the interest rate benchmark on hundreds of trillions of dollars of contracts.

The United States made cartels criminal in the Sherman Act of 1890, Europe in the Treaty of Rome in 1957, and most countries since; price-fixing is now a crime that sends executives to prison in America and a civil offence with fines of up to ten percent of turnover in the European Union. Because cartels are secret, the main tool for finding them is leniency: the first member to confess and hand over the evidence escapes the fine, and every member knows that any other member could go first, which turns the cartel's own instability against it. Most major cartel cases of the last twenty-five years began with a leniency application. Tacit collusion, in which firms follow each other's prices without ever agreeing to, is not a cartel and is legal, and the growing use of pricing algorithms that may learn to coordinate without anyone meeting is the question competition authorities are now trying to frame.

The word also names the criminal organisations of the drug trade, the Medellin and Sinaloa cartels, and the borrowing is loose; drug cartels are more often violent competitors than price-fixers, and the term stuck because the Colombian traffickers of the 1980s did briefly coordinate. In the strict sense a cartel is an economic arrangement, and the lesson of its history is that the arrangement is fragile, that the law's most effective weapon is the members' distrust of each other, and that Smith's tradesmen, two and a half centuries on, still cannot be left alone in a room.

Leniency catches cartels whose members turn on each other, but competition authorities also look for tell-tale patterns in ordinary data. Bid rigging is the most studied case, because public contracts leave a paper trail. Warning signs include the same group of firms winning in a regular rotation, losing bidders later appearing as subcontractors to the winner, bids that are suspiciously close together or rise by identical amounts, and firms that bid for every contract in one region but never in a neighbouring one. International bodies publish checklists of these signals for the officials who buy things on behalf of the public.

Prices can give a cartel away too. In a competitive market, prices usually track costs, so when costs fall and prices stay stubbornly high, or when rival firms change prices by exactly the same amount on the same day, investigators take a closer look. Patterns alone rarely prove an agreement, since similar prices can arise honestly in a market with few sellers. The next step is usually a surprise inspection of offices and devices to find direct evidence such as emails, meeting notes and call records, which is why cartel members have often gone to great lengths to use private channels and code words.

One of the strangest cartels fixed not only the price of a product but how long it lasted. In 1924 the leading makers of incandescent light bulbs, including Osram, Philips and the international arm of General Electric, set up a company in Geneva known as Phoebus to coordinate the industry. Alongside dividing markets and setting quotas, the members agreed that a standard bulb should last 1,000 hours, when many bulbs of the time were designed to last considerably longer. Factories sent samples to be tested, and members whose bulbs burned too long paid fines on an agreed scale.

The arrangement ended with the Second World War, and it is often cited as the founding example of planned obsolescence. The engineering is more tangled than the legend. A filament run hotter gives more light for each watt but burns out sooner, so a shorter-lived bulb can also be a brighter, cheaper-to-run one, and historians still argue over how much of the 1,000 hour standard was a reasonable compromise and how much a way to sell more bulbs. What is not in doubt is the method: a private agreement, a shared standard, inspection, and penalties for members who broke ranks, the same machinery any price-fixing cartel needs.

Competition authorities have a powerful tool for breaking cartels: leniency. In the European Union, the United Kingdom, the United States and many other places, the first company to come forward and report a cartel it belongs to, and to cooperate fully, can receive immunity from fines, while later confessors receive smaller reductions and the rest face the full penalty.

The design deliberately turns every cartel into a prisoner's dilemma. Each member knows that if a partner reports first, it will be hit hard, which gives everyone a reason to rush to confess at the first sign of trouble, and makes the trust needed to keep a cartel together much harder to sustain. A large share of major cartel cases in recent decades have been uncovered through leniency applications.

A cartel is an agreement among competing firms to fix prices, restrict output, divide markets or rig bids so that they earn a monopolist's profit at the customers' expense; it is illegal almost everywhere and secret by nature. Cartels hold where sellers are few, products are standard and cheats can be caught, and fail because every member gains by undercutting the others, an instability that leniency programmes exploit by rewarding the first to confess.