Few Americans knew the term "cartel" before 1973--1974, when OPEC (Organization of Petroleum Exporting Countries), the best known cartel, became a household word.
A cartel is an organization through which members jointly make decisions about prices and production.
Cartels usually require outright collusion, although in a sufficiently concentrated industry (2 or 3 firms), tacit (unspoken) collusion is possible. Collusive price-fixing for most manufactured products is illegal in the United States, but it is permitted in many international markets.
Cartels operate primarily in natural resource markets, and, at various times, have controlled international markets for such basic materials as copper, tin, bauxite (aluminum ore), diamonds, chrome, phosphate, petroleum, coffee, and bananas. Most successful cartels are coordinated by the governments of major producing countries. Markets were formerly cartelized for sugar, rubber, nitrates, steel, radium, magnesium, and electric lights. Why do cartels seem to come and go? How do cartels set prices and production?
A successful cartel requires control over the bulk of output by a small group of cartel members. Cartels cannot maintain high prices if many fringe competitors are not members. A small group is more likely than a large group to agree about pricing and output strategies, because the members of any group have different goals and objectives.
The good must also be fairly homogeneous; numerous differentiated substitutes would require agreements on an extensive array of prices. After a cartel price is established, sales territories or production quotas must be set. Doing this for multiple goods and prices would be a formidable task. Mature technology is also a key for cartel success. If technology advances rapidly, constant changes in costs make it difficult for members to agree on prices. Moreover, the incentive to cheat on a cartel arrangement may be overwhelming if a firm discovers a new way to cut production costs.
Cartelization will be more successful the less elastic the market demand for the good. A cartel can simultaneously raise prices and boost total revenue if its market demand curve is relatively price inelastic. Less elastic demand also lessens problems of excess capacity as prices are increased. Finally, some method is needed to monitor member compliance and prevent cheating.
Cartel Pricing Policies
A cartel's members jointly decide what price to charge and how much to sell. Most cartels try to produce and price as a monopolist would. This joint-profit maximization approach is diagrammed in Panel A of Figure 5. The cartel sets price at P0 (MR=MC for the cartel at point f) and restricts its members' combined output to Q0. This yields the largest possible total profit (the shaded area abec), but a crucial issue remains: sharing the cartel's output and profit among its members.
How to allocate production depends on the product and the market. In some cases, exclusive territories are assigned: Each firm agrees to service only its own territory. Where this approach is unworkable, output quotas may be established for each firm. OPEC uses this approach; every member country agrees to limit its crude oil sales to the quota set by the cartel leadership. These agreements are, however, routinely broken.
See Game Theory
Each cartel member has strong incentives to cheat. Suppose that you are one of five members of the cartel shown in Panel A of Figure 5 and currently sell your equal share (q0 = Q0 /5) of total output Q0 at the cartel price P0. Your firm's marginal cost is shown in Panel B of Figure 5. At q0 output, your profits equal abxy in Panel B, which also equals abxy in Panel A after adjusting for differences in scale between Panels A and B (q0 = Q0/5).
If you persuade your competitors to maintain the cartel price (P0) but secretly offer a discounted price Pd to selected customers, your profits will grow from pirating some of their customers and servicing some of the demand that is unmet at this higher cartel price. The marginal revenue to you from cheating exceeds your marginal cost. Your profits will rise because (a) you are not giving price cuts to your assigned customers, (b) your competitors do not give price cuts to the customers they retain, and (c) you can sell to more buyers---the customers who will not buy at a cartel price of P0, but who are willing to pay Pd for Q1- Q0 amounts of output. Your profits will rise by the area ywz in Panel B, which is the difference between your marginal cost of producing extra output q1 - q0 and the price Pd you receive for each extra unit of production.
Cheating on a cartel agreement can be profitable, but only if it is undetected. Cartels collapse if widespread cheating is uncovered; most members will cut prices and behave in a fairly competitive fashion, with the result that the profits that originally motivated formation of the cartel vanish. The fact that undetected cheating offers the prospect of great profits is one of the greatest threats to the stability of a cartel. Cheating is only one hazard to cartel stability. There are incentives to try to retain customer loyalty by granting price concessions where sales to individual buyers are large and infrequent. Huge economies of scale and high fixed costs may create irresistible pressure to slash prices during periods of slack demand so that overhead costs can be spread across larger output and sales. For example, cracks in OPEC's effectiveness appeared during the international recession of 1981--1983; worldwide consumption shrank, and an oil glut emerged. OPEC members routinely exceeded their quotas, offering crude oil at big discounts below the official $34-per-barrel price.
Perhaps the greatest threat to a cartel is that high prices and profits will attract new competitors or spur development of substitutes for the cartel's products. From World War II into the 1970s, for example, the Brazilian government restricted coffee exports to bolster its price. The result? Brazilian coffee lost much of its share of the world market when coffee plantations in Africa and Central America were started by profit seekers.