The Effects of Price Fixing in the Industrial Thread Industry - Research Paper Example

The Effects of Price Fixing in the Industrial Thread Industry Introduction Before we proceed to analyse the effects of price fixing in the industrial thread industry in economic terms; it is better to consider the actions of the European Commission a few years back while investigating and convicting “thread producers from Germany, Belgium, The Netherlands, France, Switzerland and the United Kingdom” (“Competition: Commission fines producers of industrial thread a total of €43.497 million for cartels”, 2005, p.1) in order to grasp the level of crime involved in such a mal-practise. More than five years back the European Commission fined the industrial thread producers a staggering amount of 43.5 million euro owing to their indulgence in cartels. Industrial thread is a very important product regarding its use in various other sectors. It is used to “sew or embroider various products such as clothes, home furnishings, automotive seats and seatbelts, leather goods, mattresses, footwear, ropes, etc.” (“Commission fines nine companies a total of € 43.5 million for participating in industrial thread cartels”, 2006, p.1) The 6 billion Euro worth of market world wide even back in 2005 depicts its importance. The case: The commission identified three cartels operating within the system; two of them belonging to industrial thread. The two industrial thread cartels were i) “a cartel on the market in thread for industrial customers in Benelux and the Nordic countries from January 1990 until September 2001”; ii) “a cartel on the market in thread for industrial customers in the United Kingdom from October 1990 until September 1996.” (“Competition: Commission fines producers…”, 2005, p.1) The cartel in industrial thread that remained operative in Benelux and Nordic countries involved seven companies. All of them were identified and their names with their respective amount of fines are given below. Name of the Company Amount of Fine (in million Euro) Coats Ltd € 15.050 Amann und Söhne GmbH € 13.090 Gütermann AG € 4.021 Barbour Thread Ltd € 2.145 Belgian sewing thread N.V. € 0.979 Bieze Stork B.V. € 0.514 Zwicky € 0.174 (“Competition: Commission fines producers of industrial thread a total of €43.497 million for cartels”, 2005, p. 2) The industrial thread cartel that was operative in United Kingdom had been spared from any fine since there was “no proof that the undertakings participated in a continuous cartel within the five years preceding the Commission’s inspections in November 2001.” (“Competition: Commission fines producers of industrial thread a total of €43.497 million for cartels”, 2005, p.1) The anger and hate that was involved in the words of Neelie Krores the Competition Commissioner might be of interest while realising the evil of cartel, “Cartel behaviour is illegal, unjustified and unjustifiable, and will be punished severely no matter how large or small the companies involved…I will not allow consumers to be denied the benefits of the Single Market by companies carving up markets between themselves”. (“Competition: Commission fines ….”, 2005, p.1) Thesis statement The reasons of such worries lie deep into the economic impact of such cartel. However it is better to start with a brief discussion on cartel or collusion and price fixing and then gradually move into a more detailed discussion on deadweight loss associated with cartel. Again at the end a brief discussion on the gains associated with the cheating among partners involved in a cartel would also reveal the instability that a cartel is capable of injecting into an economy apart from the previous mentioned deadweight loss that is a mark of economic inefficiency. The industrial thread price fixing would involve a deadweight loss that would leave the producers and the consumers of industrial thread both at a loss and it will also inflict severe instability within the economy through the usual incentives of cheating among partners involved in a cartel. Cartels A cartel or collusion is an agreement among competing firms that performed to reach an agreement regarding prices, output, market shares, allocation of customers and territories, rigging of bids and common sales agency establishment. Usually cartels occur in oligopolistic industry where a small number of sellers involved in the production of similar products face a large numbers of buyers. Cartels are aimed at increasing the member’s profit through reduction of competition among the participating members. Such agreement is not done in papers rather accomplished through under the table agreements in order to avoid any legal step on behalf of the government since it is legally prohibited. Since it is believed that competition paves the way for greater social welfare and economic benefit hence to welcome competitiveness within an economy cartels must be eradicated from the economic environment of a country. (Miller, Vandome, McBrewster, 2010; Russo, Schinkel, Günster, & Carree, 2010) Price fixing Price fixing on behalf of the seller is particularly important for the present study. In general it is an outcome of cartel or collusion among sellers where the price level is maintained at a level usually higher than that of the competitive level by maintaining the supply and demand. There are several methods of price fixing and some of them are; maintenance of a common minimum price among sellers, imposition of surcharge etc. However in the rest of the part of the current paper the economic inefficiency and instability that is associated with cartel and price fixing or more precisely the same with industrial thread industry has been illustrated without getting into such details of price fixation. Rather a simplified type of price fixation where a quantity is produced to maintain a predetermined fixed price that stands for an ideal cartel on behalf of the producers of industrial thread has been used. Furthermore in order to avoid redundancy industrial thread industry has been referred as industry. (Koutsoyiannis, 2003; McEachern, 2008) Analysis of the case of fines imposed by the Commission An ideal cartel will act like a monopoly and try to reap up monopoly profit by restricting the quantity produced that will hike the price. The firms expect that the new set of quantity and price will increase the industry profit and eventually the individual profit of the firm. Since the firms are willing to behave like a monopolist and willing to earn monopoly profit, while acting in cartel; hence the firms collectively will produce at monopoly quantity and price. (McEachern, 2008) The monopoly equilibrium is attained where marginal revenue (MR) is equal to marginal cost (MC). In the diagram below the monopoly equilibrium is attained at point D. Respective price and quantity are Pm and Qm. The competitive price (Pc) and output (Qc) is determined at point C through the equality of marginal cost and the demand curve. This clearly depicts that at cartel the industry produces at lower output and higher price. Hence it will obviously involve a deadweight loss. The yellow shaded area stands for the involved deadweight loss in this case. In other words since the cartel works at monopoly price and output hence the deadweight loss would be same as that under a monopoly situation. The determination of the area A in the above diagram follows a simple interaction of consumer and producer surplus. The figure below depicts the competitive situation for an industry. Equilibrium in perfect competition for an industry is determined at the interaction of the marginal cost (MC) curve with the demand curve at point C. at this point the consumer surplus (CS) is the area with grey shade (A) just between the demand curve and the price. The demand curve is determining the upper boundary of area A and the price the lower one. The producer surplus (PS) in this competitive situation is the area with green shade (B) just above the marginal cost curve and beneath the price. The situation as illustrated by the diagram depicts absolutely no deadweight loss since the industry is in competitive equilibrium. As illustrated earlier with the formation of a cartel the output reduces from the competitive level to the monopoly level. Hence it depicts higher price and lower output comparing to the competitive equilibrium. As shown in the diagram below the consumer surplus as producer surplus in cartel. However another part that is E together with a part of producer is now the grey shaded area A. This is a loss of (D+E) area from what was the consumer surplus in competitive industry equilibrium. The producer surplus is the green area (B) together with the green stripped area D. Hence a part of the loss in consumer surplus is taken back surplus (F) gets leaked away as the deadweight loss to the society under cartel arrangement. It is obvious that this deadweight loss is a mark of economic inefficiency and that’s why almost all the governments are dead against any sort of cartel between firms. Though in some special cases cartels have been permitted yet according to the neoclassical economists’ price fixation through or without cartel does more harm than good. Considering the fact that industrial thread is an important product and used by many other sectors this deadweight loss would have a lingering effect on the economy. (McEachern, 2008) Apart from this economic loss, price fixation through cartel also introduces severe economic instability that is our point of discussion for the rest of the paper. It is apparent that a cartel to be successful all the associated firms must follow suit. Otherwise a single firm if opt to decrease the level of production would fail to influence the market price of the product by any means. The figure below illustrates that a single firm encounters a horizontal demand curve; hence it would be bereft of any type of price influencing power. However once a cartel is formed all the firms participating in the cartel needs to track the level of individual production quota in order to restrict output to their desired level and raise price. (Gould, & Ferguson, 1980; Koutsoyiannis, 2003) The following figure depicts that at perfect competition the level of output for the industry is 500 units with the presence of 20 firms and each producing 25 units each at a price of USD12 per unit. Now if these 25 firms decide to form a cartel to raise price of the concerned product then if they all agree to maintain a quota of 20 units each; the industry output will fall to 400 units and the price will rise to USD15 per unit. At this point it is an ideal cartel, since collectively the firms produce the monopoly output at monopoly price hence earning them the monopoly profit. The simpler the above operation seems the complex it is. In a cartel if a participatory firm instead of complying with the cartel agreement regarding the predetermined individual quota of production; decides to cheat the other firms then it can experience arise in its profit provided the other firms remains momentarily at a dark regarding its action. In simple terms, once the cartel restores a higher price for the participatory firms; if a single firm then raises its production level over the determined quota then it can realise a rise in its profit. It has been mentioned earlier that a single firm faces a horizontal demand curve. Therefore once the monopoly price is reached through the cartel formation among firms; if a firm decides to produce more than 20 units (that is the agreed individual quota under this particular cartel) price will remain the same. The concerned firm can easily produce 30 units and still sell it at USD15 to maximise profit. However the irony is each firm has the same incentive to cheat and if everyone decides to raise the level of out put then it will dampen the price again and profit maximisation would not be possible. This might be termed as the incentive to cheat under price fixation through cartels. In the diagram below the yellow shaded area B in right hand side diagram is the incentive to cheat. Profit for individual firm is maximized at point C where the level of production for the individual firm is 30 and price is at cartel price USD15. Point C is determined through the intersection of marginal cost curve (MC) and the new marginal revenue curve (MR’). The profit of the competitive firm is depicted by the blue shaded area in the right hand side diagram. Conclusion The breaking up of cartel might seem as the restoration of competitive equilibrium; however it can be something far from that and can inject severe instability within the economy. As mentioned earlier that industrial thread is used by many other sectors; this instability can easily remain for quite some time and might be hard to get rid of. First of all, once the trust is broken it can initiate retaliatory action on behalf of other firms. Large firms might incur temporary loss to throw away smaller firms from the market that will eventually bring in a monopolist environment within the industry. A temporary economic anarchy might eat away vital time and resources of the government to restore the equilibrium. It can also bring bad reputation regarding economic management and corporate governance of a country. Hence deadweight loss and economic instability are the main economic consequences of price fixation through cartel in industrial thread industry. These expected evil consequences generated a prompt response on behalf of the European Commission back in 2005 while courting price fixation in industrial thread. References “Competition: Commission fines producers of industrial thread a total of €43.497 million for cartels” (September 2005), Europa, Brussels, retrieved on December 14, 2010 from: http://europa.eu/rapid/pressReleasesAction.do?reference=IP/05/1140&guiLanguage=en “Commission fines nine companies a total of € 43.5 million for participating in industrial thread cartels”, (2006), Competition Policy Newsletter, 1, retrieved on December 14, 2010 from: http://ec.europa.eu/competition/publications/cpn/2006_1_64.pdf Gould, J.P. & Ferguson, C. E. (1980), Microeconomic Theory, Illinois: R. D. Irwin, 1980 Koutsoyiannis, A. (2003), Modern Economics, Hampshire: Palgrave Publishers, 2003 Russo, F, Pieter Schinkel, M., Maria Günster, A. & M. Carree, (2010), European Commission’s Decision on Competition, Cambridge University Press McEachern, W. A. (2008), Microeconomics, New York: Cengage Learning Miller, F. P. Vandome, A.F., McBrewster, J. (2010), Cartel: Oligopoly, Commodity, Price fixing, Market share, Bid rigging, Collusion, Profit (economics), Competition law, Competition regulator, Anti-copyright, ... Beers, Drug cartel, Regulator (economics), Alphascript Publishing Read More