Economic Analyses of Collusive Bidding Behavior - Case Study Example

Economic Analyses of Collusive Bidding Behaviour - The Ohio School Milk Case - Total Number ofWords: 2,033 Table of Contents 1. Introduction ……………………………………………………………….. 3 1.1 Thesis Statement …………………………………………….. 3 1.2 Purpose of the Study ………………………………………… 4 2. Market of School Milk Supply …………………………………………... 4 3. Economic Issues behind the Procurement Process and the Nature of Auction for School Milk……………………………………….. 4 3.1 Market Prices of School Milk Supply ………………………. 5 3.2 Consumer Welfare …………………………………………… 7 3.3 Potential Competitors on Market Competition …………….. 7 4. Key Economic Issues behind the Development of Collusion in School Milk Auction ………………………………………………………. 8 5. Discussion ………………………………………………………………… 9 6. Conclusion ………………………………………………………………… 9 References ………………………………………………………………………… 10 1. Introduction As a common practice, the local school district officials are inviting bidders to supply milk and other dairy products each year. In line with this, suppliers are required to submit their bids in exchange for a potential business contract. As a general rule, the lowest bidders are more likely to be awarded the benefit to supply half pints of milk for the entire school year. However, it remained uncontrollable for some of the milk suppliers to enter into a collusive agreement in order to keep the prices of milk as high as possible (Porter & Zona, 1997). In the United States, some legislation has been made to minimize the incidence of collusion behind the supply of school milk. In line with this, anyone who will be caught guilty of entering into a collusion to control the auction price of milk will be required to pay fine, sent to jail for a period of six month, or both (Porter & Zona, 1997). Despite the government’s effort to control the incidence of collusion in school milk auctions in the U.S., the culture behind collusion in school milk auctions has been going on for a long period of time. The economic issues behind the procurement process and nature of auction for school milk will be provided to give the readers a better understanding of the case study. In response to the case study, some of the key economic issues that could explain the development of collusion in school milk auction will be identified and tackled in details. In line with this, the impact of economic factors like prices, consumer welfare, actual and potential competitors on market competition will be examined to enable us to determine whether or not economic reasons could stimulate the high incidence of collusion in school milk auction will be answered. As part of going through the explanation, the theory of supply and demand will be use to explain what really happens in the market of school milk. 1.1 Thesis Statement “The economic explanation behind the high incidence of collusion in school milk auctions” 1.2 Purpose of the Study The main purpose of the study is to encourage the student to develop his/her expertise in analyzing the economic factors that could trigger the high incidence of collusion in school milk auction in Ohio. 2. Market of School Milk Supply The market of school milk supply in the United States is purely affected by the demand, production process, and competition among the suppliers within a geographic area (Porter & Zona, 1997). Although the market of school milk supply is dictated by supply and demand curve, the fact that each school conducts a yearly auction does not necessarily mean that a higher the demand for milk supply would invite more potential milk suppliers to join the market competition. Likewise, the lesser the demand for milk supply does not necessarily mean lesser number of milk supplier. The market of school milk suppliers is oligopoly. Since each of the qualified supplier is required to bid for the annual business contract with each of the nearby school, there is a strong possibility that the number of interested suppliers would be limited since most of the small-scale milk manufacturers or milk distributors that are not able compete with the price offered by other large-scale bidders during the school milk auction. This is true since large-scale milk manufacturers and milk distributors have better economies of scale as compared to small-scale bidders. 3. Economic Issues behind the Procurement Process and the Nature of Auction for School Milk As part of the procurement process for school milk auction, qualified school milk suppliers are required to participate in the annual school milk auction where interested suppliers would bid for the school milk contract. In line with this, milk manufacturing companies and milk distributors who are in the position to supply the milk demand of each school will submit their bid during the auction date the school will publicly announced. In line with this, milk distributors are qualified to bid for the school milk contract since large scale distributors are able to purchase milk products on a wholesale price (Porter & Zona, 1997; Lanzillotti, 1996). As a way to invite potential milk suppliers to join the school milk auction, each of the local school district would publicly announced a detailed information concerning the upcoming contract which includes the name and location of schools to be supplied, the exact date of the contract period, the number of times milk is expected to be delivered to school area, and the estimated quantity of milk to be supplied each month (Pesendorfer, 2000). After publicly announcing the date of the auction, potential milk suppliers are normally given at least 30 days to submit their bids together with signing the non-collusive affidavit which forms as an agreement that the bidder should avoid entering into collusive behaviour on or before the company has joined the school milk auction (Pesendorfer, 2000). 3.1 Market Prices of School Milk Supply Regardless of a sudden price increase in raw materials, gasoline, or labour costs, the market prices of school milk supply is not sensitive to price change since the price bided for the annual business contract would apply for the entire school year. In case there is a sudden price in the raw materials, gasoline, or labour costs, it is the company who win the school contract who is going to shoulder the loss (Ashenfelter & Graddy, 2004; Pesendorfer, 2000). (See Figure I – Supply and Demand Curve of School Milk Market Price in Case the Cost of Milk Production Increased More than the Annual Fixed Market Price on page 6) Figure I – Supply and Demand Curve of School Milk Market Price in Case the Cost of Milk Production Increased More than the Annual Fixed Market Price Because of the fixed annual market price of school milk, the price of school milk will remain the same regardless of whether or not the demand for milk in school would increase. The only difference when demand for milk increases is that the milk manufacturer or a large-scale milk distributor is obliged to find ways to meet the supply of milk even though the milk manufacturer or milk distributor is already shouldering net profit loss. (See Figure II – Supply and Demand Curve of School Milk Market Price in Case the Demand for Milk in School Increase or Decrease on page 7) Figure II – Supply and Demand Curve of School Milk Market Price in Case the Demand for Milk in School Increase or Decrease 3.2 Consumer Welfare In terms of consumer welfare, the process of subjecting the selection of qualified school milk supplier is beneficial on the part of the school administrators and students. In the absence of collusive bidding, each of the local school will enjoy the benefit of having an adequate supply of milk at a much lesser price. For this reason, the students and school staff are able to pay a low price for milk every time they have a break from school activities. The problem with collusive bidding is that it makes the bid price of milk higher than the expected market price of school milk. As a result of collusive bidding, the school is not able to sell a cheaper milk product to the students and school staff. For this reason, the students and school staff has to shoulder a higher cost of milk supply. 3.3 Potential Competitors on Market Competition Majority of the bidders of school milk auctions comes from nearby milk plants rather than those that are located in far-away places (Scott, 2000; Porter & Zona, 1997). Given that the distribution cost associated with transporting the milk supply to the nearby schools, a milk supplier will be able to save more money out of the transportation and delivery cost. This gives the nearby companies the competitive advantage in terms of being able to offer a lower bid during the school milk auction. Because of the high cost of transportation and distribution requirements, milk manufacturing companies and large-scale milk distributors are unlikely to win the annual contract for school milk. 4. Key Economic Issues behind the Development of Collusion in School Milk Auction Companies that manufacture homogenous product such as in the case of milk have similar and constant incremental costs (Bajari & Ye, 2003; Porter & Zona, 1997). For this reason, milk manufacturers have an idea how much the cost of raw materials its close competitors are spending in order to manufacture milk. Considering that each of the local schools have no other choice but to pay a premium price for school milk in case milk manufacturers and milk distributors would have a hidden agenda concerning the price they would bid for the school contract. For this reason, a free market competition in the supply of school milk is unlikely to happen (Pesendorfer, 2000). In general, characteristics of a market that can easily trigger collusion among the suppliers include market competition based on price alone (Sullivan & Sheffrin, 2003). Since school milk suppliers are competing only for the unit price of milk, competing companies may form a cartel wherein each company would talk about an agreed and coordinated price for school milk (Sullivan & Sheffrin, 2003, p. 171; Pesendorfer, 2000). If not for an agreed fixed price, these companies would more or less bid with price close to what other companies have bided during the school milk auction. Although there is still a possibility for cartel bidders to compete with the bidding price of the non-cartel bidders (Pesendorfer, 2000), it remains undeniable that entering into price collusion among the milk manufacturers and milk distributors who are interested in participating in the annual bidding for school milk supply is advantageous on the part of the bidders. Not only would these companies be able to dictate the market price of school milk supply but also make a strategic move on which school each of the milk suppliers are interested in winning a contract (Genesove & Mullin, 2001; Cramton & Schwartz, 2000; Cave & Salant, 1995). 5. Discussion The bidding for school milk auction can be considered more as collusion rather than a free market competition simply because of the fact that most bidders of school milk auctions comes from nearby milk plants rather than those that are located in far-away places. Given the fact that the market price of raw milk could anytime fluctuate within the one year contract, it is more likely for milk suppliers to meet up or call each other to come into an agreement with regards to how much each company is willing to bid for the school milk auction. This way, nearby milk manufacturers or milk distributors who are willing to bid for the school contract will have price allowance in case the market price of raw milk and other related raw materials would suddenly increase along the way. 6. Conclusion Economic reasons such as the ability of milk manufacturers and milk distributors to have the benefit of economies of scale including the market prices of raw materials used in manufacturing milk, the market prices of gasoline and labour cost could stimulate the high incidence of collusion in school milk auction. Since there are normally a relatively small number of milk suppliers who are willing to participate in the school milk auction, the risk for collusion among the school milk suppliers increase. Given that each of the local school is ordering milk by bulk, it is but necessary for the school to be able to enjoy a bigger discount for the benefit of the students. Unfortunately, this is not always possible because of the possible collusion among the milk suppliers. The problem with collusive bidding behaviour of suppliers behind the school milk auctions lies behind the fact that the students and school staff has to pay for a higher price of milk. *** End *** References Ashenfelter, O., & Graddy, K. (2004). Anatomy of the Rise and Fall of a Price-Fixing Conspiracy: Auctions at Sotheby’s and Christie’s’, National Bureau of Economic Research working paper no. 10795. Bajari, P., & Ye, L. (2003). ‘Detecting Collusion in Procurement Auctions. Review of Economics and Statistics , 85:971 - 989. Cave, J., & Salant, S. (1995). Cartel Quotas Under Majority Rule. American Economic Review , 85:82 - 102. Cramton, P., & Schwartz, J. (2000). Collusive Bidding: Lessons from the FCC Spectrum Auctions. Journal of Regulatory Economics , 17:229 - 252. Genesove, D., & Mullin, W. (2001). Rules, Communication, and Collusion: Narrative Evidence from the Sugar Institute Case. American Economic Review , 91:379 - 398. Lanzillotti, R. (1996). The Great Milk Conspiracies of the 1980s. Review of Industrial Organization , 11:413 - 458. Pesendorfer, M. (2000). A study of collusion in first-price auctions. Review of Economic Studies , 67: 381 - 411. Pesendorfer, M. (2000). A Study of Collusion in First-Price Auctions. Revuew of Economic Studies , 67:381 - 411. Porter, R., & Zona, D. J. (1997). Ohio School Milk Markets: An Analysis of Bidding. Working paper 6037. MA: National Bureau of Economic Research. Scott, F. (2000). Great school milk conspiracies revisited. Review of Industrial Organization , 17: 325 - 341. Sullivan, A., & Sheffrin, S. (2003). Economics: Principles in Action. NJ: Pearson Prentice Hall. Read More