Cartels

Have you ever imagined what would happen if all the companies that produce drinking water colluded together to limit supply and hike prices? Would you stop buying drinking water? Probably not! You will end up buying drinking water even if the prices are higher than usual. This is how cartels take advantage if they are the manufacturers of non-substitutable products. Do you want to learn more about cartels? Let's jump right into it!

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Table of contents

    Oligopolistic Market and Cartels

    The market is known to be oligopolistic when it is dominated by a few large firms that are interdependent. Oligopoly can be seen in various types of industries around the world. Some of the industries in which oligopoly can be seen frequently are:

    • Airline Industry
    • Pharmaceutical Industry
    • Petrochemical Industry

    Each of those industries is dominated by a few large firms and possesses characteristics of an oligopoly.

    • Some of the main characteristics of an oligopolistic market are listed below:- Firms are price makers;- High barriers to entry;- The products sold are differentiated;- The firms are interdependent.

    When a market is dominated by a few large interdependent firms, it is said to be oligopolistic.

    Now that we are familiar with an oligopolistic market let's move on to cartels.

    To learn more about this topic, check out our article: Oligopolistic Market!

    Cartels Definition Economics

    Let's dive straight into the definition of a cartel.

    A cartel is a situation when two or more firms agree to control the level of supply of products and services to reduce competition and drive up the market price.

    Let's look at an example to comprehend the concept more clearly.

    Assume James and Nick are separately running two businesses that are responsible for selling coffee to the entire town. They competed and were able to generate acceptable sales on their own. One day, they agreed to limit the supply after reaching an agreement, which raised the price of coffee. Hence, they both colluded to influence the cost of coffee.

    You must be wondering, aren't cartels illegal? What kind of effect do they have on an economy? Well, various effects of cartels can be seen affecting the economy, but first, we will explore the types of cartels.

    Types of Cartels in Economics

    As we have already learned about cartels, what are some of their types? Well, there are four types of cartels, and these are listed below.

    • Types of cartels in economics:- Price fixing;- Differentiating operation area;- Controlling the amount of output;- Collusion bidding.

    Now, let's explore each of them in detail.

    Types of Cartels in Economics: Price Fixing

    When two or more parties come together to an agreement for buying or selling products at a certain price, it is known as price fixing. Price fixing can be done through both formal channels (written agreements) and informal channels (verbal agreements). Price fixing usually leads to higher-priced products and can lead to market inefficiencies.

    Suppose ABC and XYZ are two independent firms, both responsible for manufacturing chocolates. Knowing that they have no other competitors, they come together to an agreement and decide to sell their product at a higher price than usual.

    Price fixing occurs when two or more parties come together to an agreement for buying or selling products at a certain price.

    Types of Cartels in Economics: Differentiating Operation Area

    This type of cartel occurs when two or more parties decide to separate the territory they operate in. The firms are only permitted to operate in the designated region or to produce the goods that their competitors under the agreement do not. This agreement's principal objective is to minimize competition among the involved parties.

    Let's assume that Justin and Ariana operate in the same market and are each other's competitors. They came to an agreement to divide the market they operate in into two territories. Justin and Ariana will operate separately in two different territories, thereby reducing their competition.

    Differentiating operation area is a type of cartel formed when two or more parties decide to segregate the territory in which they operate to reduce competition.

    Types of Cartels in Economics: Controlling Amount of Output

    Firms forming a cartel may come together to control the amount of output they produce. Limiting the supply of the product or service is done deliberately, as it will drive up the price. The simple demand and supply theory is applied by firms to gain an advantage in the market.

    Let's understand this type of cartel using a diagram.

    Cartels Controlling amount of output in a cartel StudySmarterFig. 1 - Controlling Amount of Output

    The figure above illustrates how a cartel controls the amount of output to drive up the price. Suppose coal mining industries form a cartel and are initially producing a Q1 amount of coal at price P1. Then they decide to decrease the amount of supply from Q1 to Q2, shifting the supply curve leftwards. As the demand for the product is constant, the decrease in output increases the price of coal from P1 to P2. This ultimately increases the profit of companies involved in the cartel without compromising their ability to produce a greater amount of coal. This type of cartel involves a deliberate action taken to increase the price of the product by controlling the amount of output.

    A controlling amount of output is a type of cartel in which firms group together to limit the supply of a product or service to raise the price.

    Types of Cartels in Economics: Collusion Bidding

    Collusion bidding occurs when firms reach an agreement upfront on who should win a business tender at a certain price. The cartel members enjoy the benefits of collusion, bidding in turns, where each member involved could get an opportunity to win the tender. To help a single firm win the tender, other members of a cartel might decide to bid at a higher price or include some unacceptable terms and conditions.

    Let's say ABC and XYZ are two firms in a cartel that went for bidding on a project. They had previously agreed that XYZ would bid at a higher price, enabling ABC to win the tender.

    Collusion bidding occurs when firms reach an agreement upfront on who should win a business tender at a certain price.

    Cartel Economics Example

    While understanding cartels, the best example one can think of is OPEC. OPEC stands for Organization of the Petroleum Exporting Countries, which consists of several oil-producing countries, including Qatar, Saudi Arabia, the United Arab Emirates, and eleven others. OPEC is an agreement between various Middle Eastern and other countries through which they have been able to influence the price of petroleum products. This would not have been possible if the countries had operated independently. It has control of about 80% of the total petroleum supply in the entire world.

    Let us take a look at a graph and understand how OPEC's supply affects the price of petroleum products.

    Cartels Cartel Economics Example StudySmarterFig. 2 - Cartel Economics example

    In Figure 2 above, the initial equilibrium is at point E1, where 10,000 barrels of petroleum products are sold at the price of $80 per barrel. After having a meeting with member countries, OPEC mutually agreed to decrease the amount of output to 8,000 barrels, which would drive up the price per barrel to $120. This deliberate adjustment of supply at the constant rate of demand increases the joint profit of the cartel. This is how OPEC controls the overall petroleum market.

    Effects of Cartels on the Economy

    While learning about cartels, the most common question that arises is: 'Aren't cartels illegal?'

    Well, the answer is: 'Yes, they are indeed illegal.'

    In the United States of America, the cartel is a criminal violation of antitrust laws. If found guilty, heavy fines are imposed under the antitrust laws.

    The major effect of cartels can be seen in the commodities market, where the price starts to increase rapidly as a result of price manipulation by the firms involved. Furthermore, as the amount of output under a cartel can be restricted, the overall production capacity of the big firms will not be fully exploited. Likewise, cartels introduce a lack of competition to the economy in the long run, which can be a major cause of market inefficiencies.

    These are some of the major reasons why cartels are considered illegal.

    • The effects of a cartel can be seen in the economy in the long run due to price manipulation, inefficient production, and a lack of competition, which ultimately causes market inefficiency.

    Advantages and Disadvantages of Cartels

    Let's take a look at some of the advantages and disadvantages of cartels.

    Advantages of Cartels

    Firms agree to create cartels because it gives them substantial advantages in the market they operate. Cartels can help the member firms intentionally drive up prices by lowering the amount of output they produce. As a result, they can increase the price at which they sell their goods, thereby maximizing their profits. Likewise, cartel members tend to experience economies of scale as their manufacturing processes improve, lowering their cost per unit while boosting their output.

    • Some advantages of cartels include the following:- Altering output levels as needed;- Profit maximization;- Economies of Scale.

    Disadvantages of Cartels

    Along with the advantages, there are some disadvantages of cartels. Cartels lead to price manipulation, ineffective production methods, and a lack of competition, all of which eventually result in an inefficient market. The members of the cartels are restricted to certain production levels, which limits their ability to produce higher amounts even if they can do so. Finally, the cost of goods and services constantly remains higher under cartels, which has a significant negative impact on consumers' disposable income.

    • Some disadvantages of cartels include the following:- Can lead to market inefficiency;- Restricted production amount;- Negative impact on consumer disposable income.

    Cartels - Key Takeaways

    • A cartel is a situation when two or more firms agree to control the level of supply of products and services to reduce competition and drive up the price.
    • The negative effects of a cartel, in the long run, are due to price manipulation, inefficient production, and a lack of competition, which ultimately causes market inefficiency.
    • Cartels operate by:- Price fixing;- Differentiating operation area;- Controlling the amount of output;- Collusion bidding.
    • Price fixing occurs when two or more parties come together to form an agreement for buying or selling products at a certain price.Collusion bidding occurs when firms reach an agreement upfront on who should win a business tender at a certain price.
    Frequently Asked Questions about Cartels

    What does cartel mean?

    A Cartel is a situation when two or more firms come into an agreement to control the level of supply of products and services to reduce the competition and drive up the price.

    How does cartel affect the flow of economy?

    Cartel affects the flow of the economy by causing market inefficiency in the long-run.

    What are the effects of cartels?

    The effects of cartel on the economy are price manipulation, inefficient production and lack of competition.

    What are the characteristics of a cartel?

    Some of the characteristics of cartels are:

    1. Price fixing

    2. Differentiating operation area

    3. Controlling amount of output

    4. Collusion bidding

    Why are cartels illegal economics?

    Cartels are illegal because a collusion between firms to raise the price of products by limiting supply deliberately can cause market inefficiencies.

    Test your knowledge with multiple choice flashcards

    In an oligopolistic market, are the firms price makers or price takers?

    What is the effect on price when the supply of the product or service is limited? Assume that the demand is constant.

    OPEC controls the overall world market of ____ products.

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