Chapter 35: Cartels
Updated: 1/13/20
Christian Economics: Teacher's Edition
Am I not allowed to do what I choose with what belongs to me? Or do you begrudge my generosity? (Matthew 20:15).
In Chapter 34, I wrote about monopoly. A person or a business produces goods that others want to rent or buy. There are no competitors. The owner can charge a higher price to some buyers because they are willing to pay what he asks. He refuses to sell for less. This upsets buyers who would like to pay less, which means all buyers. A few buyers complain to politicians about the terms of sale. They seek state intervention to force the seller to lower his prices.
The legal principle announced in Matthew 20 supports the legitimacy of monopoly pricing. This is the principle of competitive bidding. If a seller does not face competitive bidding, he can charge more. High bid wins.
This principle of ownership cuts both ways. It also supports the idea that an owner should be allowed to price his services or product lower than has been common. Price competition is a familiar strategy for newcomers in a field, or outsiders, or innovators. This marketing strategy is resented by established sellers. They do not want to face price competition. It lowers their income.
There may be more than one seller who is in a position to sell at a lower price. Some sellers may collude with the monopolist to set prices higher. These sellers control enough of the market so that most buyers are unable to obtain all they would like to buy at a lower price. The quantity demanded would rise in response to a lower price, but supplies would not rise with it. The major sellers would refuse to sell at this price. So, they informally agree not to sell at a lower price. This is called an oligopoly.
A cartel is similar, but with this distinction: a formal structure exists. Members of a group of sellers formally agree with each other to maintain high-cost production techniques and therefore high prices. There is some form of enforcement system within the cartel to maintain adherence to the agreement by all members. The main enforcement is exclusion from the cartel.
Why would expulsion matter to a seller? Here is one reason. There might be high perceived value associated with the group. Some buyers see a cartel’s logo, and they conclude: “This product must be higher quality. I am willing to pay more.” But not all buyers are impressed. They want lower prices, not an industry logo. These buyers offer a deal to a member of the cartel: full payment at the time of sale in exchange for lower prices. This is a tempting offer.
Here is the problem for the cartel. If one member decides to sell at a lower price, this will reduce sales by other members. If this continues, another member of the cartel may defect. He also may sell at a lower price. This threatens to cause what might be called a chain reaction. The cartel may blow up. Better put, it may implode. It will no longer be possible to enforce the agreement. This is why cartels usually break down. The cartel has no institutional means of bringing negative sanctions against members who violate the agreement, either openly or clandestinely.
Why not? Because courts do not recognize the legality of most cartel agreements. In fact, cartel agreements are illegal in most nations. So, a cartel agreement is enforceable only if it avoids openly calling for price fixing. Higher prices must be regarded by courts and regulators as a side-effect.
If the cartel gets the support of the state, this makes it difficult for its members to sell at a lower price than the cartel’s members have informally agreed to. Its lawyers must dream up an excuse that is not openly related to price-fixing. For example, the cartel may be able to gain state support in the name of consumer protection.
Lawyers in America have a cartel: the American Bar Association. Membership is mandatory in order to practice law for a fee. This is a case of licensing by the state. Lawyers who are elected to the legislatures pass laws that support the lawyers’ cartel, sometimes called a guild. From 1908 until 1977 in the United States, it was declared by the American Bar Association to be a violation of ethics for a lawyer to advertise his prices. He might be willing to sell his services at a low price, but he was allowed to reveal this information only when a potential client spoke with him face to face. This way, it was difficult for low-cost lawyers to make buyers aware of their lower prices. This cartel agreement was declared unconstitutional by the United States Supreme Court in 1977. Within hours, law firms began advertising lower prices. This transformed the practice of law within a few years.
For decades, the airline industry in the United States was a regulated cartel. Its members kept fares high. This was accomplished with the cooperation of a government regulatory agency that was controlled by the airlines, the Civil Aeronautics Board. It existed from 1938 until 1985. Any airline whose planes flew across a state line came under the CAB’s jurisdiction. The CAB also assigned routes to airlines. Because the airlines could not legally compete in terms of price, they competed in non-price ways. They served free meals. It was free to ship luggage. The stewardesses were young, good looking, and single until the stewardess’s union forced airlines to keep ageing married women on the job.
Non-price competition is a standard strategy of cartels. Rich people or people with business expense accounts are the targeted market. When the cartel breaks down due to the removal of government regulation, its members begin to cut prices. The targeted market moves from rich people to middle-class people. Services grow more sparse. This displeases the previous buyers, but it pleases the middle class. They had been kept out almost completely by high prices. Now this changes. They can afford a stripped-down version of the service. They take advantage of this. The market gets larger as prices decline. This is in accord with a fundamental law of economics: when the price declines, more is demanded.
Another mark of a cartel is discriminatory pricing. Rich people are charged more for the same item. This is not possible in an industry with open entry. In a supermarket’s checkout line, you will be charged the price on the item. The cashier at the checkout does not ask about your income. You are not charged less because your income is low. But when a high school student applies for entrance at a college, and he seeks financial aid, his parents must fill out forms on their income and net worth. All students ask for aid. The admissions office charges full tuition to rich parents, but offers various kinds of aid to most students. Sometimes the aid comes in the form of a scholarship. But there was no money donated to the college for these scholarships. They are rarely set aside for a specific amount. Then where does the money come from? It comes from parents who pay full tuition. These scholarships are discounts. The admissions office knows that a particular student may not attend if his parents do not receive a discount, so the school calls it a scholarship. The school would otherwise be perceived as a bargain store, not an educational institution.
How can a school or any seller charge different prices for the same item, depending on the wealth of the buyer? Because the cartel allows discount pricing for certain people, but not others. Normally, price competition sets the same price for all buyers. Why would any buyer pay more than the lowest price? Any seller who tried to charge richer buyers more money would find competition from other sellers. They would tell richer buyers this: “We will sell it cheaper.” But in a cartel, the members agree to charge lower prices only to poorer people. Any cartel member who charges the same price to everyone would be expelled.
The cartel for higher education receives protection from the state. Each state sets standards for any institution selling higher educational services. Sellers cannot use the word “college” or “university” unless they meet standards set by a board. The board’s standards are recommended by colleges and universities in the cartel. Regional accrediting associations do not grant accreditation to low-cost, low-price schools that do not have large libraries and other marks of cartel members. This has begun to change with a handful of online colleges that offer degrees by distance education. They charge a low flat rate to all students. This pricing policy is a major threat to the higher education cartel, which charges different prices to different families. Parents may begin to shop price. This would bankrupt hundreds of small private colleges with mediocre reputations.
Physicians and hospitals also use discriminatory pricing. They can do this only because they are licensed by states. This keeps out price-competitive sellers who would otherwise charge rich patients the same fees as poor patients. This would take rich patients away from rivals who charge the rich full price, but offer lower prices to poorer people. The rich would no longer be forced by the cartel to pay a discriminatory high price.
A buyer who faces a cartel has difficulty getting low prices. Members of the cartel have informally agreed with each other not to sell at prices close to their cost of production. They seek a higher rate of profit per sale. So does every other business, but a cartel is different. It can police its members to see if any of them is selling items for less than an agreed-upon price. This keeps rival sellers from adopting the marketing strategy of price competition. Price competition forces prices toward the cost of production. The sellers’ surplus disappears.
Because prices are higher than prices in a market with open entry, some lower-income buyers are unable to buy. Their budgets do not allow this. Sometimes these buyers can locate a seller who offers discounts for lower-income people. These sellers are not allowed to advertise this policy, however. To do so would be a form of price competition against sellers who do not offer discounts.
Cartels sell to people with above-average incomes. They discriminate against low-income buyers. Their marketing strategy is to skim the cream off the market: sales to rich people who can afford to pay more. These buyers are less likely to balk at high prices than poor people are.
A buyer who wants a lower price must order in bulk. Cartels usually allow members to offer discounts for bulk sales. Discounts for bulk purchases are common with non-cartel businesses. The cartel’s members do not fear bulk sales by competitors, because they know that most buyers buy only one or two retail items at the most. The exceptions are not numerous enough to affect the distribution of income in the cartel-controlled market.
Cartels are fragile arrangements. Without the ability to bring negative economic sanctions against a member who defects, the cartel cannot easily sustain the informal price-fixing agreement. Some members cheat. This is why it is not necessary that the state break up a cartel, nor is it necessary to pass legislation against price fixing. We are back to this principle: “Am I not allowed to do what I choose with what belongs to me?” (Matthew 20:15a). To honor this principle, the state should neither break up cartels nor create them by creating legal barriers to entry.
Price competition forces prices close to the cost of production of the most efficient producers. Sellers with high production costs may go out of business.
Sellers that enjoy high margins between sales prices and production costs want to maintain this advantage. This is the seller’s equivalent of the consumer’s surplus. He therefore is interested is arranging an agreement with other sellers not to compete in terms of price. Competition must be in terms of non-price advantages. The problem is this: for the masses, these non-price advantages are marginal. What they want is lower prices.
There are sellers whose marketing strategy is to generate high income by means of low prices and volume sales. This strategy is the opposite of the seller with a high mark-up of prices and reduced volume. The former strategy targets the middle class or even the poor. It undermines the second strategy. By making goods available at lower prices, the seller lures buyers away from high-priced goods. These buyers want deals. They want bargains. Even if they are buying high-prestige items, they want to buy at a discount. There are rich people who take this attitude: “Let everyone think I paid retail. I don’t pay retail. Ever.”
Cartel leaders strive to keep its members in line: refusing to offer low prices for anything except volume sales. When successful, this leads to high income for low-cost manufacturers. There is a large seller’s surplus. But this surplus becomes a target of cartel members with lower costs of production. They seek to increase sales by reducing prices. They cheat.
A pencil has no attributes that cannot be easily copied by other producers. The design has not changed much since the late 1800s. It is a mature industry. Any company can enter the trade. Not many do.
The attributes of rival brands of pencils are not advertised. Everyone knows about them: buyers and sellers. This means that no seller can come up with a unique selling proposition within the industry. So, price competition is an obvious way for a seller to gain market share. If existing producers attempted to create a cartel, new competitors could enter the market and underbid the cartel members’ prices. There is nothing unique about pencil manufacturing that would serve as a barrier to entry to new competitors. It is an old industry.
The product is sold to parents who are buying them for school children. This is a price-competitive market. A pencil is not a prestigious item. The seller cannot easily make the case that a child will do better in school with as more expensive pencil.
There might be a case for selling an expensive unique pencil to artists. But this is a tiny share of the pencil market.
A cartel is a market anomaly. One the one hand, a deliberate price-fixing agreement among sellers will run afoul of the law. Such agreements are universally illegal. On the other hand, cartels that have been created by the state in order to achieve other ends besides price-fixing can withstand defections from within the cartel and also entry into the market by price-competitive outsiders.
Wherever there is price discrimination against buyers with a lot of money, there is a cartel in action. This means discounts to the poor. The main exception is discounts for senior citizens. The reason why these are offered by sellers in a non-cartelized industry—mainly restaurants, movie theaters, and air fare—is because the public is willing to accept this. People expect to grow old. They want to take advantage of such discounts when they are old.
Wherever there are laws against unlicensed producers making offers to sell to consumers, there is a cartel in action.
Wherever there is a threat by a regulatory agency to revoke the license of a producer that offers lower-priced products or services to the general public, there is a cartel in action.
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