Collusion and Cartels
One of the blessings of competition is that it leads to lower prices for consumers. For the producer, however, this blessing is a curse. Low prices often mean low profits. Given a choice between competition and cooperation, profit-maximizing firms would more often than not prefer cooperation. Regardless of what you learned in kindergarten, you do not want the businesses you buy from to cooperate. You want them to compete. Adam Smith, the father of modern capitalism, warned that nothing beneficial comes from the heads of business getting together.
In the United States, firms are forbidden from cooperating to set prices or production. The abuses of the late nineteenth and early twentieth century trusts were the impetus for the “trust-busting” of President Theodore Roosevelt. With the Sherman Antitrust Act and later the Clayton Antitrust Act, the government prohibited outright collusion and other business practices that reduced competition.
Prior to OPEC, world oil prices were mainly under the control of the Texas Railroad Commission. With the rise of OPEC came a shift in power from U.S. producers to the oil states of the Middle East.
Even though it violates the law, businesses from time to time will collude in order to set prices. Colluding firms can divide up the market in a way that is beneficial for them. The firms avoid competition, set higher prices, and reduce their operating costs. Because collusion is illegal and punishable by fine and prison, executives at firms are reluctant to engage in the practice. The meetings of business leaders are almost always in the presence of attorneys in order to avoid the accusation of collusion.
Businesses that collude may form cartels. A cartel is a group of businesses that effectively function as a single producer or monopoly able to charge whatever price the market will bear. Probably the best-known modern cartel is the Organization of the Petroleum Exporting Countries, or OPEC. OPEC is made up of thirteen oil-exporting countries and is thus not subject to the antitrust laws of the United States. OPEC seeks to maintain high oil prices and profits for their members by restricting output. Each member of the cartel agrees to a production quota that will eventually reduce overall output and increase prices. OPEC is bad news for anyone that enjoys cheap gasoline.
Fortunately for consumers, cartels have an Achilles heel. The individual members of a cartel have an incentive to cheat on their agreement. Cartels go through periods of cooperation and competition. When prices and profits are low, the members of the cartel have an incentive to cooperate and limit production. It is the cartel's success that brings the incentive to cheat. If the cartel is successful, the market price of the commodity will rise. Individual members driven by their own self-interest will have an incentive, the law of supply, to ever-so-slightly exceed their production quota and sell the excess at the now higher price. The problem is that all members have this incentive and the result is that eventually prices will fall as they collectively cheat on the production quota. Cartels must find ways to discourage cheating. Drug cartels use assassination and kidnapping, but OPEC uses something a little more civilized. The single largest producer in the cartel is Saudi Arabia. Saudi Arabia also has the lowest cost of production. If a member or members cheat on the cartel, then Saudi Arabia can discipline the group by unleashing its vast oil reserves, undercutting other countries' prices, and still remain profitable. After a few months or even years of losses, the other countries would then have an incentive to cooperate and limit production once again.