When somebody mentions cartels, the first thing that may come to one’s mind would be drug cartels, such as the famous Medellín Cartel founded by Pablo Escobar. Despite the similarities between drug cartels being inapparent, it is interesting to know that the functionality and basis of a drug cartel, or any cartel for that matter of fact, comes down to a theoretical concept known as collusion that is embedded within oligopoly markets.
To delve deeper into cartels, it is firstly important to establish the concept of collusion and how it works. Collusion, by definition, is a non-competitive, secret, and sometimes illegal agreement between rivals who attempt to disrupt the market’s equilibrium1. The act of collusion itself involves firms, that would usually compete in an industry or market, working together in order to gain an advantage. However, there are two types of collusion: explicit and implicit. Explicit collusion is when two or more firms in an industry formally agree to control a market, whereas implicit collusion is where the agreement to control a market is more informal and is rather dependent on the actions of the individual firm. Collusion is something that mainly tends to happen in an oligopoly market due to fewer firms having a larger market share. Most of the collusion used by cartels is usually a type of price fixing scheme that leads to firms having the best possible pay-offs.
Collusion itself actually coincides with another economic concept known as game theory – more specifically the Prisoner’s Dilemma model which also highlights some of the problems within it. The prisoner’s dilemma suggests that two or more firms in the industry acting in their own interests do not produce an optimal outcome resulting in a relatively worse outcome relative to if the firms were to corporate. Yet, let’s say the firms in the market were to corporate and decide on fixing a price. Apart from the fact that this sort of collusion is illegal, what is stopping one of the firms from reducing its price, undercutting the other firms and then gaining the larger market share. This is one major problem with colluding. This is actually used by the CMA to disincentivise large firms from colluding. The CMA has a policy which states that if a firm is involved in a collusive agreement, it is able to come and report the behaviour and not face any repercussions.
The problems just stated as well, as the large number of measures which prevent anti-competitive established in each country are actually great preventions of formations of cartels (formal agreement among firms in an oligopolistic industry2). There is one major “legal” cartel that actually exists in the world called OPEC. Which is a collusive agreement between some oil producing countries in the Middle East which uses price fixing to achieve the best possible outcome.
To conclude, cartels are formed when firms in an oligopoly market form an agreement in order to achieve better conclusions, however this poses many costs to society as a result of their anti-competitive nature. One main cost being higher prices for consumers. This is because when a cartel decides to price fix, they raise the price to an optimal level for them leading to a decline in consumer surplus and further allocative inefficiency. The collusive agreement may also act as barrier to entry. This is because a firm wishing to enter the market may notice the higher market power held by the larger firms, thus discouraging them, due to not being able to compete. The abnormal profits made by firms may also cause organisational slack if they decide not to reinvest it back into innovation and efforts to increase productivity3. Contrary to this, if the firms in the cartel were to reinvest the profits into innovation or research there is very small potential for the cartel to pose beneficial for society.