Sepiolite-Lipid Adsorption Mechanism

When oligopoly is non-collusive, the firm uses guess-work and calculation to handle the uncertainty of its rivals’ reactions. Another way of handling that uncer-tainty in markets which are interdependent is by some form of central coordination; in other words, collu-sion. At least two features of collusive oligopoly are worth emphasizing: first, the objectives that are

sought through collusion; and second, the methods that are used to promote collusion – these may be formal, as in a cartel, or informal, via tacit agreement.

Objectives of collusion

Joint profit maximization

The firms may seek to coordinate their price, output and other policies to achieve maximum profits for the industry as a whole. In the extreme case the firms may act together as a monopoly, aggregating their mar-ginal costs and equating these with marmar-ginal revenue for the whole market. If achieved, the result would be to maximize joint profits, with a unique industry price and output (P
_I
Q
I), as in Fig. 6.2.

A major problem is, of course, how to achieve the close coordination required. We consider this further below, but we might note from Fig. 6.2 that coordi-nation is required both to establish the profit-maxi-mizing solution for the industry P
_I
Q
I, and to enforce it once established. For instance, some agreement must be reached on sharing the output Q
_Ibetween the colluding firms. One solution is to equate marginal revenue for whole output with marginal cost in each separate market,
⁵ with Firm A producing Q
_A and Firm B producing Q
_B. Whatever the agreement, it must remain in force – since if any firm produces above its quota, this will raise industry output, depress price and move the industry away from the joint profit-maximizing solution.

Fig. 6.2 Joint profit maximization in duopoly.

P_l P_l P_l

Revenue/cost (£)

MC_B MC_A

MC_{A ⫹ B}

D_{A ⫹ B}

MR_{A ⫹ B} Q_l

0 Q_A

Firm A Firm B Industry (Firms A and B)

Output 0 Q_B Output 0 Output

Revenue/cost (£) Revenue/cost (£)

Deterrence of new entrants – limit-pricing

Firms may seek to coordinate policies, to maximize not so much short-run profit but rather some longer-run notion of profit (see Chapter 3). A major threat to long-run profit is the potential entrance of new firms into the industry. Economists such as Andrews and Bain have therefore suggested that oligopolistic firms may collude with the objectives of setting price below the level which maximizes joint profits, in order to deter new entrants. The ‘limit price’ can be defined as the highest price which the established firms believe they can charge without inducing entry. Its precise value will depend upon the nature and extent of the

‘barriers to entry’ for any particular industry. The greater the barriers to entry, the higher the ‘limit price’ will be.

Substantial economies of scale are a ‘barrier to entry’, in that a new firm will usually be smaller than established firms, and will therefore be at a cost dis-advantage. Product differentiation itself, reinforced by extensive advertising, is also a barrier – since product loyalty, once captured, is difficult and expen-sive for new entrants to dislodge. Other barriers might include legally enforced patents to new tech-nologies in the hands of established firms, and even inelastic market demands. This latter is a barrier in that the less elastic the market demand for the product, the greater will be the price fall from any extra supply contributed by new entrants.

The principle of ‘limit-pricing’ can be illustrated from Fig. 6.3. Let us make the analysis easier by sup-posing that each established firm has an identical average cost (AC
) curve, and sells an identical output,

Q
_F, at the joint profit-maximizing price P
_Iset for the industry. Suppose a new firm, with an identical cost profile, is considering entering the industry, and is capable of selling E units in the first instance. Despite the initial cost disadvantage the new firm believes it can survive. One way of preventing the survival of the new firm, perhaps even deterring its entry, would be for the colluding established firms to reduce the industry price to P
_L. Although this would reduce their own excess profits in the short run (by VW per unit) the new entrant would make a loss selling E at price P
_L, since price would be less than average cost at that output. It would have needed to produce as much as output S immediately at the price P
_L, even to have just covered its average costs.

The greater the barriers to the entry of new firms, the higher the ‘limit price’, P
_L, can be, i.e. the closer P
_L can be to P
_I. The most favourable situation for estab-lished firms would be if barriers were so great that P
_L were at, or above, P
_I. In other words, established firms could set the joint profit-maximizing price without inducing entry.

An example of the occurrence of high barriers to entry and relatively high limit prices could be seen in the French market for natural spring water during the early 1990s. In 1992 the French market for such bottled water was dominated by three companies, Nestlé, Perrier and BSN, and the barriers to entry into the industry were high. For example, the transport costs of bringing non-French water to the market were substantial and persuading French retailers to stock new brands was difficult. Advertising costs were also heavy, helping create strong brand loyalties in France for the products of the three companies.

Finally, the fact that the companies held 82% of the market share by volume constituted an additional problem for prospective new entrants (European Commission 1994). As a result, these companies were able to increase their prices substantially during the period, thus keeping their limit prices high and maximizing their joint profits.

Occasionally a limit-pricing policy is explicitly adopted, as in the early 1960s when the three major petrol wholesalers, Shell
BP, Esso and Regent, were threatened with new entrants. In 1963 Shell announced a price reduction ‘to make the UK market less attractive to newcomers and potential new-comers’. Again, in 1973 the Monopolies and Mergers Commission (MMC) found evidence of limit-pricing by Kellogg, concluding that ‘when fixing its prices, Fig. 6.3 Limit-pricing as a barrier to entry.

Revenue/cost (£)

therefore, Kellogg has as an objective the preservation of its share of the market against potential competi-tors’.

An obvious constraint to limit-pricing is that prices cannot be set below X in Fig. 6.3, the level at which the established firms begin to make excess profits (normal profit included in average cost), at least not for any length of time. The established firms may therefore resort to non-price competition to rein-force barriers against new entrants. For instance, the petrol companies sought extensive ‘solus’ agreements, giving discounts to retailers dealing exclusively with them, and sought to buy up retail outlets directly. In the detergent industry, Lever Brothers, by introducing new brands, have increased product differentiation and raised barriers to entry. As much as 58% of their turnover comes from new brands introduced in the past 16 years. Extensive advertising (as shown by Tables 6.3 and 6.4) is yet another way of increasing barriers to entry into a market or industry. Adver-tising can be used to increase brand loyalty, thus making it difficult for new firms with a new product to enter a market. Increased advertising can be used by firms already in the industry not only to keep other firms out, but also to drive out existing firms which have newly entered the industry.

To investigate this latter proposition, a study was undertaken into the behaviour of 42 companies operating in various consumer goods markets, such as electric shavers, deodorants, washing-up liquids and kettles, over the period 1975 to 1981. The study investigated the advertising strategy of companies already in these oligopolistic markets after new firms with new products had managed to enter those markets (Cubbin and Domberger 1988). The results of the study showed that increased advertising was used as a weapon in an attempt to drive out new entrants in 38% of markets studied, and that the response of the firms already in the market to the new entrants depended on the structure of the oligopoly and the nature of the market. For example, in a tightly competitive oligopoly situation, where a domi-nant firm controlled more than 30% of the market, it was more likely that the new entrant would be exposed to increased advertising competition than in a looser oligopoly where there was no clear domi-nance by one firm. Similarly, increased advertising competition was more likely to face new entrants in static markets, i.e. those in which demand is not growing. This is partly because growing markets tend

to be dominated by new consumers with less attach-ment to the products of existing firms. Advertising in this situation is therefore a less certain weapon for driving out a new entrant, as compared to a market in which demand is static.

We now turn briefly to the methods which firms have actually used to promote collusion in oligopolistic markets.

Methods of collusion Formal collusion – cartels

Formal collusion often takes the form of a cartel – in other words, the establishment of some central body with responsibility for setting the industry price and output which most nearly meets some agreed objec-tive. Usually it also has the responsibility for sharing that total output between the members. Cartels are against the law in most countries, including the UK.

However, in the UK the Cement Makers’ Federation was an exception. Up to 1987 it still held monthly meetings in which deliveries, prices and market shares were discussed. The three main companies sharing the market were Blue Circle (60%), Rio Tinto Zinc (22%) and Rugby Portland (18%), with their common price calculated on a formula which averaged the costs of different producers. The Restrictive Practices Court permitted the cartel to continue on the basis that a common price agreement enables cement capacity to be controlled in an orderly way. Nevertheless, increased concentration of the cement industry in the last few years raised the possibility of intervention by the MMC (now the Competition Commission) and this, together with international competition from cheap European imports (especially from Greece), caused the cartel to be abandoned in 1987. However, cartel-type collusion still persists in the UK cement industry. In 2000, the three largest UK producers of ordinary Portland cement (OPC), i.e. Blue Circle plc, Castle Cement Ltd and the Rugby Group, refused to supply bulk OPC to customers such as ready-mix concrete producers who had intended to resell it in bags to builders’ merchants. This was because they themselves sold OPC in bag form to customers. In September 2000 the Office of Fair Trading (OFT) found that such a policy was anti-competitive and told the companies to desist from such supply-fixing cartel behaviour.

An example of a price-fixing cartel operating in the UK was discovered and prohibited by the OFT in

1999. Vitafoam Ltd of Rochdale, Carpenter plc of Glossop, and Recticel Ltd of Alfreton had met to agree on price rises of 8% for foam rubber and 4%

for reconstituted foam which they supplied to the upholstery business. Cartel members agreed that the price rises announced by Vitafoam, the market leader, would be matched immediately by similar announce-ments from Carpenter and Recticel.

Various cartels operate internationally. The most famous is OPEC, in which many but not all (the UK is not a member) oil-exporting countries meet regularly to agree on prices and set production quotas. Whilst OPEC worked successfully in the mid-1970s in raising oil prices, in the worldwide economic slump of the early 1980s coordination proved increasingly dif-ficult. As demand for oil fell, exporters were faced with the necessity of cutting production quotas to maintain prices; and some, such as Iran and Nigeria with major internal economic problems, were unwill-ing to do this, preferrunwill-ing to cut prices and seek higher market share. Of course the Iraqi pressure on OPEC countries to curtail production and raise prices, and the subsequent Kuwait invasion, contributed to higher oil prices in the early 1990s. However, by 1992
93, the continued fall in demand for oil under worldwide recessionary conditions, allied to some additional oil supplies (e.g. from the Gulf States), revived the disagreements between those cartel members in favour of price cuts and those in favour of tighter quotas. In more recent times, OPEC’s ability to enforce the cartel led to a cut in the supply of oil available to industrial countries in March 1999. This resulted in a trebling of the price of a barrel of crude oil from $10 to $34 by March 2000.

The International Air Transport Association (IATA) is the cartel of international airlines, and has sought to set prices for each route. During the 1970s it was seriously weakened by price-cutting compe-tition from non-member airlines, such as Laker Airways. It was further weakened by worldwide recession in the late 1980s and early 1990s, with lower incomes causing demand for air travel, with its high-income elasticity, to fall dramatically. To fill seats, the member airlines began to compete amongst themselves in terms of price, often via a complex system of discounts. The experiences of OPEC and IATA suggest that cartels are vulnerable both to price-cutting amongst members when demand for the product declines, and to competition from non-members.

Another example of an international cartel was brought to light by investigations during 1990 into the activity of the International Telegraph and Telephone Consultative Committee (CCITT), a Geneva-based

‘club’ consisting of the main international telephone companies of the major industrial countries (Financial Times 1990). Major international telephone compa-nies such as AT&T (USA), British Telecom (UK), Deutsche Bundespost (Germany), France Télécom (France), Telecom Canada (Canada) and KDD (Japan) belong to the group. The CCITT had a book of

‘recommendations’ for its member companies which included two important features. First, it suggested a complicated method of sharing the revenues received from international telephone calls. When international phone calls are made from the UK to Japan, for example, BT receives the money for the call but it has to pay KDD in Japan for delivering the call to its final destination in that country. The particular method used to calculate the distribution of the revenue received for the call between the various international telephone companies tended to penalize any company that attempted to cut its telephone prices. This in turn made it difficult for both existing and new companies to decrease prices because their profits would also fall.

Second, it suggested that members of the group should not lease too much of their international telephone circuits to other private companies, since this could increase potential competition.

The effect of the first ‘rule’ was to provide high profit margins for telephone companies because prices were kept artificially high by the peculiar revenue-sharing scheme. Meanwhile, new techno-logical advances had decreased the real costs per minute of using a transatlantic cable from $2.53 in 1956 to $0.04 in 1988. While costs had fallen drasti-cally, the price charged for a peak call from the US to the UK and Italy remained at $2 and $4 per minute respectively! As a result, profit margins on inter-national calls (i.e. profits divided by revenue) of some of the top earners were as follows: Japan 75%, Canada 68%, USA 63%, Britain 58%, West Germany 48%, and France 43%. British Telecom earned a profit of between £600m and £800m on its international busi-ness during the 1988
89 financial year, depending on the accounting definitions used. The second ‘rule’

made it difficult for new companies to enter this market because most of the international cables were built by members of the CCITT and new operators had to get permission from these companies in order

to lease cable space from them. If they were not allowed more space on international cables, then new companies had to use satellite links which were more expensive and of lower quality than cable links.

Tacit collusion – price leadership

Although cartels are illegal in most countries, various forms of tacit collusion undoubtedly occur. In 1776, Adam Smith wrote in his Wealth of Nations that entrepreneurs rarely meet together without conspir-ing to raise prices at the expense of the consumer.

Today the most usual method of tacit collusion is price leadership, where one firm sets a price which the others follow.

1. Dominant-firm leadership. Frequently the price leader is the dominant firm. In the late 1960s Brooke Bond controlled 43% of the market for tea, well ahead of the second largest firm Typhoo with only 18% of the market. Brooke Bond’s price rises were soon matched by those of other firms, bringing the industry to the attention of the Prices and Incomes Board in 1970. Sealink, with 34% of the cross-channel ferry market, seems to have been the price leader in ferry travel to the Continent in the 1980s. In the car industry, Ford has frequently acted as the dominant market leader by being first with its price increases. In 1990, companies that bought fleet cars from Ford, Rover, Vauxhall and Peugeot Talbot, accused the big car manufacturers of operating a price cartel led by Ford. By initiating two separate price rises (amounting to a total of 8.5% by the middle of 1990), Ford was seen as the dominant leader of a

‘cartel’ by the fleet car buyers. We have already noted that Vitafoam acted as a dominant price leader for reconstituted foam in the upholstery business in the UK in 1999.

2. Barometric-firm leadership. In some cases the price leader is a small firm, recognized by others to have a close knowledge of prevailing market condi-tions. The firm acts as a ‘barometer’ to others of changing market conditions, and its prices are closely followed. In the mid-1970s Williams and Glyn’s, a relatively small commercial bank, took the lead in reducing bank charges in response to rising interest rates. Maunder also found this sort of price leader-ship in the glass bottle and sanitary ware markets of the 1960s and early 1970s (Maunder 1972). Since the mid-1970s there have been signs that the ‘minor’

petrol wholesalers have had an increasing influence on petrol prices (see Chapter 9). Again the barometric form of price leadership can be seen in the North American newsprint industry where some 30 firms produce most of the newsprint. In a major study, Booth et al. (1991) found a tendency for a leader to emerge which then acts as an ‘anchor’ for the calcula-tions of other firms in the industry and as a ‘trigger’

for any price adjustment within the group when cost or demand conditions change.

3. Collusive-price leadership. This is a more compli-cated form of price leadership; essentially it is an informal cartel in which prices change almost simul-taneously. The parallel pricing which occurred in the wholesale petrol market (noted in Chapter 9) until the mid-1970s suggested this sort of tacit group collusion. In practice it is often difficult to distinguish collusive-price leadership from types in which firms follow price leaders very quickly. The French market for spring water, referred to earlier in the chapter, is one where both the setting of parallel prices and price leadership were present. Between 1987 and 1992 the prices of bottled water sold by Nestlé, Perrier and

3. Collusive-price leadership. This is a more compli-cated form of price leadership; essentially it is an informal cartel in which prices change almost simul-taneously. The parallel pricing which occurred in the wholesale petrol market (noted in Chapter 9) until the mid-1970s suggested this sort of tacit group collusion. In practice it is often difficult to distinguish collusive-price leadership from types in which firms follow price leaders very quickly. The French market for spring water, referred to earlier in the chapter, is one where both the setting of parallel prices and price leadership were present. Between 1987 and 1992 the prices of bottled water sold by Nestlé, Perrier and