Consumer and producer surplus in perfect competition market
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Published: Mon, 5 Dec 2016
The cartel case which would be referred to and discussed in detailed would be titled, Antitrust: Commission fines wax producers Euro 676 million fines on 9 groups – ENI, ExxonMobil, Hansen &Rosenthal, Tudapetrol, MOL, Repsol, Sasol, RWE and Total for participating in price fixing and market sharing cartel for paraffin wax in the European economic area. This cartel case was investigated by the Competition Commission in April 2005 after one of the firms involved, Shell, revealed the existence of the cartel to the Commission. The Commission thus decided to start investigation by implementing surprise inspections on the firms mentioned to be involved in the cartel and it was not long before the existence of the cartel was confirmed.
Collusion is the attempt by firms to set and maintain artificially high prices. It is also an act of anti-competitiveness. The group of firms acting together and agreeing not to sell below a given price by engaging in price fixing agreements is referred to as cartels. This means that firms are able to control quantity and fix prices. Cartel is much profitable than profits earned in a competitive oligopoly as it help firms involved in the cartel to maximize joint profits in an act similar to monopoly when they set and maintain artificially high prices. Every firm that colludes will definitely gain even profits from the collusion hence helps in reducing market uncertainty. This is an advantage in the eyes of many firms and the total profit would attract firms in the market to be part of a collusive agreement or cartel. However cartel is illegal in general and it is not easy to detect a cartel.
This section of this essay would discuss reasons in relation to cartel agreements being harmful to the consumer, producers and the competitiveness of the economy as a whole and evaluate the strategies that only facilitate in maintaining collusions.
With a cartel, firms involved would be shielded from competition in the market as cartel allows these firms to charge higher prices thus removing the pressure on these firms to improve their efficiency in production. Furthermore, high prices would mean that consumers would need to pay a higher price now and this is in fact, harms the consumers.
When markets grow and develop, firms would increase their expectations of the amount of profits which they would be likely to earn over time. With a cartel, it ensures that firms involved would maximize joint profits and gain even profits from the cartel. If there is a new product in the market, the consumer demand in the market is likely to increase hence should firms stick to collusion, they would be guaranteed an even profit as compared to firms deviating from the cartel. This acts as an incentive to firms, making them less likely to deviate and thus cartel is being facilitated to sustain. However, should there be a decline in the market, there would be lesser demands and this would cause a decline in the incentive for firms to collaborate. Hence, only a growing market can facilitates firms to be in collusion.
Different firms operate on different capacities for production. Some firms have high capacity while others would have low capacity for production. In cartel cases, firms need not have high capacity in order to gain that even amount of profits. It is always due to this that firms with low capacity would rather be involved in collusion. When firms decide to deviate from the collusion, they would require high capacity in order to supply the entire market. Making a move to deviate from collusion would definitely not be a smart option for firms which experiences capacity constraints. Should they continue to be involved in cartel, it is more likely that they would earn a higher profit as compared to them having to struggle to produce enough to meet the demands of the market. This is because factories with limited capacity may not be huge or resourceful enough to produce more units. Therefore, capacity constraints would facilitate firms to collude.
In some markets, the prices set by the different firms are more visible than others. For instance, prices of products in the supermarket are being shown on the shelves and everyone would be able to read the price off the label. As prices are able to be seen, information of deviations would be observable as well. In order to avoid being discovered to be involved in a cartel, firms in the market would most likely to restrict output and prices to monopoly level. It can therefore be assumed that the more the information is available to the competitive firms, the more firms will stick to collusion hence facilitating firms to collude.
Firms that set low prices would definitely attract consumers’ attention and obtain greater consumer demand. However, when firms set low prices, they detached the existence of competitive advantage for the firm. Furthermore, there is no incentive for another firm to set a price lower than the rest of the firms in the market. This is because once a firm sets a lower price, the prices of other competitive firms in the market is likely to be affected by the first firm and prices would decline. Hence, it results in firms earning lesser profits than they actually do initially before the fall in prices. Furthermore consumers would also report any firms which deviate from the price set by most firms in the market, making it obvious that firms are in a cartel. Therefore, setting high prices in the market would facilitate collusion.
This section of the essay covers economy analysis to examine cartel agreements using the case as reference and the effect of cartel on consumer surplus, producer surplus and total welfare.
Collusion may be tacit or explicit collusion. Tacit collusion refers to firms in a cartel setting prices and quantity without any formal contact or meetings while explicit collusion refers to firms in a cartel setting prices and quantity in a meeting which is as illustrated in the operation of cartel this case. The firms involved had regular meetings held for prices discussions. The meetings of the cartel took place at top hotels all over Europe after the initial meeting in Germany.
Cartel agreement may be legally enforced by a binding contract. In this case, there is no binding agreement. Although deviation from the agreement and undercutting its rivals is thus being made possible for any firms, there is not much to gain from doing so since regular meetings are held. If a firm deviates and sets a lower price or higher output than the prices and quantity set by the cartel, this firm may earn more profits this week but would not make any profits the next week. In an economic point of view, a firm would rather choose to cooperate and earn constant profits rather than risking to be exposed and earn less or even no profits. Therefore, deviation from the agreement would not be an intelligent move to be taken by any firms involved in the cartel.
In general, cartel is illegal in countries such as in the European countries. It is not easy to detect a cartel. Even though firms in a cartel would set high prices, these high prices in the market and common price changes is not necessarily equivalent to firms participating in a cartel. Furthermore, firms can exploit their market power but being competitive with other firms at the same time, hence adding on to the difficulties of detecting a cartel. Despite price data in the market having to provide information needed to investigate an industry, the data is insufficient to provide true evidence of cartel. Hard evidence would be necessary to prove that collusion does exist among those firms.
Before any firm participates in collusion of a cartel, these firms are likely to have operated on a perfect competition market structure where firms compete in the market. No firms have any influence on the prices set by other firms with regards to the output. Give the existence of competition in the market, should one firm try to raise its price, consumers would turn to another producer to instead hence the first firm would not be able to sell anything. Furthermore, competitive firm would set pricing at Marginal Revenue (MR) = Marginal Cost (MC) as a way of profit maximization.
Figure 1: Graph on consumer and producer surplus in Perfect Competition market
Consumer surplus refers to the differences in price which the consumer is willing and able to pay and the actual price they pay whereas producer surplus refers to the difference in cost which the producers are willing and able to produce and the actual price they receive. In a competitive market, the consumer surplus would be area A while the producer surplus would be area B in above Figure 1. This means that consumers and producers enjoy equal welfare.
With cartel, firms behave in a market structure close to monopoly where firms produce at high prices with low output to earn monopoly profits. There is no existence of competition between firms as firms have colluded to form a cartel; prices and output would have been discussed. In a monopoly market structure, firms would produce where Marginal Revenue (MR) meets Marginal Cost (MC). However, unlike a competitive firm, the marginal revenue would be affected by the output of the firm. In a cartel, firms produce lesser (QM) at a higher price (PM) than what firms would produce (QC) and price (PC) their outputs when in a perfect competition market structure.
Figure 2: Graph on consumer and producer surplus in Perfect Competition and Monopoly markets
The consumer surplus would be area A and producer surplus would be area B and C of Figure 2. As discussed above, before the cartel, consumer surplus was a combination of areas A, C and D and producer surplus was a combination of areas B and E. With cartel, there has been a significant loss in total welfare of consumer and producers. Although producers gained from consumer surplus of area C, this gain is still smaller than the loss in consumer surplus and producer surplus as an overall welfare analysis. The deadweight loss in this case would be the combination of areas D and E.
In Figure 1, consumers are able and willing to pay more than the actual price as compared to Figure 2. Therefore, consumers benefit more when firms operate in a perfect competition market structure and the authorities may use this price information as part of the investigation.
The last section of the essay would evaluate on the authority’s decision on the cartel agreements in relation to the case used as reference.
It is always a main challenge for competition authorities to prove that collusion does exist. However in this case, Shell revealed the existence of the cartel to the Commission. This instigated the Commission to conduct a random and surprise investigation on the firms mentioned to be involved in the cartel namely ENI, ExxonMobil, Hansen & Rosenthal, Tudapetrol, MOL, Repsol, Sasol, RWE and Total. Secret cartel is serious offence in relation to competitiveness of firms in the market. The competition regulators would impose regulations on firms to prevent them from affecting the competitiveness of the market due to the fact that anti-competitive market would harm consumer. The investigation revealed that different firms held different names for the cartel in their individual firms such as “Paraffin mafia” in Shell and “Blauer salon” in the Sasol group.
In setting the fines to impose on the 10 firms involved in this cartel case, the Commission took into consideration the sales affected by this collusion. As Sasol is the leader of the cartel, the fine for Sasol was increased by 50%. Furthermore, given that it isn’t the first time ENI and Shell have been fined for cartel agreements, both fines were increased by 60%. However, as Shell was the first firm that came forward to report that it is part of the collusion, Shell was granted 100% leniency of reduction in 96 000 000 Euros of fine, therefore received full immunity from fines. Leniency act was formed to encourage involved firms to provide the Commission with insider information of the cartel. Sasol, Repsol and ExxonMobil cooperated with the investigation and were hence rewarded with reduction of fines of 50%, 25% and 7% respectively.
The fines imposed and the leniency reductions granted by the Commission in this case are as listed:
The fines imposed were decided by the Commission based on a considerable number of factors such as the firm’s depth of involvement in the cartel, the benefits on sales which the firm obtained, the level of cooperativeness in investigation and the cartel records of the individual firms. Guilty firms were fined up to 10% of their turnover during cartel and the fines collected would go to the Commission Budget which helps to ease the burdens of heavy taxations on individuals. Furthermore, it has been granted that firms or individuals that feel that they were affected by this illegal agreement and anti-competitive behavior may seek damages from the Commission. It is agreeable that the correct decision was reached.
However, it can be arguable that leniency granted in this case went too far. Shell has been a repeat offender of cartel agreements and has already been fined the second time. Despite these records, Shell was granted 100% leniency from the initial fines imposed in the decision made by the Commission for this case because Shell was the first firm involved to report on the illegal cartel agreement. A stricter law could be suggested and created to be imposed on repeat offenders. It can be recommended that once a firm participates in a cartel agreement and is found guilty by the Commission, the firm would be suspended from operation for at least a year. This act would hence most likely discourage firms from participate in the illegal cartel agreements because being suspended from operation would mean that the firm’s market shares, profits and reputations would be at stake.
In conclusion, this essay has provided discussions on cartel agreements, examined a cartel case handled by the European Commission in 2005, analyzed the economics involved and evaluated the detection of the cartel and the policy responses and fines imposed by the European Commission on the participants in relation to the case attached in Appendix 1.
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