The Negative Impact of Cartels Research Paper

Introduction

Competition can be a good thing, especially in the world of commerce. From the point of view of consumers and governments competition is a great thing. It allows for the creation of businesses that will provide products and services of high quality and yet available at affordable prices. If there is no competition, the business entities that will monopolise a particular industry have no incentive to innovate and improve. But for businessmen, competition is not always a good thing. It cuts into their profit margins and can easily drive a company to bankruptcy. Since a monopoly is impossible some businessmen tried to find a way around this legal problem and they discovered that the best way to do it is through the creation of cartels. But it did not take long before consumers and economists saw the danger of perpetuating this anti-competitive practice. Still, various firms from highly industrialized countries such as Germany, the United Kingdom and the United States continued to develop cartels. This paper will take a closer look at the nature of cartels and their impact on the economy.

Background

In Medieval times much of the Western world was either governed by feudal lords or kings. But before the rise of geopolitical nations, it was the monarchical system of government that was the stabilizing force in Europe. It is not hard to imagine how kings and queens controlled the populace. Their word was law and that was nothing of significance that can occur without their permission. It was the kings and queens of England, France, Germany, Spain, Portugal, and Sweden, to name a few, that made major decisions concerning war, territorial expansions and trade.

A particular kingdom may choose to sell timber, precious metals or slaves but everything has to go through the principal rulers. The money-making schemes were all under one leader and therefore a monopoly ensued. The king or queen can delegate or provide charters that allow the nobility to participate. But the decision-making process as well as the bulk of the profit from all trading activities belongs to the monarch and his family. There is no better way to perpetuate a dynasty than to have this level of control over a nation.

But somewhere along the way, the people grew tired and very much discontented with inefficiency and inequality produced by a centralised system of managing all human and natural resources. In the famous French revolution, the people were forced to overthrow and destroy the royal family because they were constantly in dire need of food. The French Revolution provided a glimpse of democracy and freedom where the citizens of the nation can participate in nation-building not only in terms of politics but also in terms of the economy (Cody, par. 3). It was the beginning of a new form of government and from then on men and women in the West experienced a degree of freedom that they never experienced before. When it comes to commerce, liberty meant that different groups can compete and that there is no single entity that can come in and monopolise industries. But in the middle of the 19^th century, some businessmen in Europe realised that a cartel can help them become more efficient yet unfortunately it will be to the detriment of the consumers.

What is a Cartel?

The majority of the information about the nature of cartels will be taken from the UK’s Office of Fair Trading (OFT) unless otherwise stated. According to the OFT a cartel, in its simplest form is an agreement, “…between businesses not to compete with each other…” and it is usually made in secret, verbal and informal. The way that the deal was finalised hints at the illegal nature of cartels. It is an offence in the UK, the US and in many other countries around the world. There is a great deal of profit that can be made through the creation of cartels making it very hard to resist the temptation to participate in the said illegal activity. Since the latter part of the 19^th century, it is becoming very much difficult to catch and prosecute firms that are guilty of this crime.

But governments, consumers and interest groups need not lose heart in continuing their campaign against cartels because if they do then a great number of people will suffer from the absence of competition in the marketplace. This is because members of a particular cartel will scheme together and agree on the following:

• Prices;
• Output levels;
• Discounts;
• Credit Terms;
• Consumers they will or will not supply; and
• Who should win a contract or bid rigging (OFT, par. 2)?

Based on the aforementioned areas of concern one can easily understand why cartels can create a negative impact in the lives of consumers and the national as well as global economy as a whole. Take for instance pricing. If firms in a particular industry, say, computer microprocessors manufacturers will come together and form a cartel they will be able to dictate the prices of computer chips and therefore the consumers will have no choice but to accept their terms having nowhere else to go for their computer hardware needs. If it is a cartel that involves items more crucial than personal computers then a great number of men and women will be forced to buy something at a higher price when they could acquire the same at a lower cost.

But cartels can also find other ways to make more money and one strategy is that members can agree on the type of discounts that they will offer. Thus, from the consumer’s point of view, there is no incentive to choose one over the other. They can also agree on credit terms making it difficult for consumers to consider which among the supposed competitors are offering a better deal. Since there is not much difference in the discounts offered then customers will be forced to continue using the services of their current suppliers and if they are buying consumer goods then they will find no incentive to choose another brand.

If cartels will manipulate output levels then it is very much possible to have shortages. There will be citizens who will not be able to avail of a very important commodity, not because they cannot afford it but the cartel simply could not be persuaded to increase their output levels. It is understandable why firms may collude to restrict output levels. If a cartel will do this then each member is assured of a cost-efficient operation, producing only what can be easily sold, hot off the oven so to speak. It will be great for members of the cartel because they can eliminate wastage, but many people, especially the consumers will be unable to get the much-needed commodity because of the limited production.

Aside from increasing the profit margins of firms by agreeing on the price, discounts and credit terms, there is another way to improve their bottom line and it is called bid-rigging. Submitting bids will no longer serve the purpose of determining the best contractor that can take on a particular job or project. The cartel will make sure that each member will win a bid or will profit by going along with the ploy. As a result member of the cartel will find no reason to improve their service because they are assured that there will always be work or projects waiting for them.

A cartel can be created artificially – meaning sellers can come to a point of realisation that they can make more money through collusion and fixing prices and manipulating output levels so that they can have total control from production to distribution. This in turn will allow them to accurately predict earnings and significantly reduce their risks. But a cartel can also develop naturally – competitors may be working in the same area and have the capability to communicate with each other. According to the OFT, the following factors make some sectors more susceptible to cartels because of the structure or the way they operate, for example:

• there are a few competitors;
• the products are very similar and that there is little that can be done to improve on them;
• communication channels between competing firms are already established (OFT, par. 5).

This phenomenon is very much evident in the Ruhr coalfields of Germany in the latter part of the 19^th century. Due to intense pressure coming from their British counterparts, German coalfield operators had to find a way to make their products more attractive or more profitable. They decided to work closely with each other. The iron and steel industrialists also formed their cartels. Thus, it was no longer simply about coal mining but coal mining working in conjunction with other coal mining companies and they were able to dictate prices and take control of the flow of products. In a time of oversupply, these firms can work out a system where each member can earn a profit.

The same thing happened to the iron and steel industries. But according to another school of thought, the cartels were the answer to lukewarm demand and were even instrumental in increasing high-quality products. The iron that was mined in the region was then smelted using coal as fuel and then improved further by turning it into something more valuable – steel (Kleeberg, 5). This means that the cartel was viewed not as a violation of trust between suppliers and consumers but as a means of creating synergy, cooperation of various groups that help amplify their strengths while at the same time helping lessen their weaknesses. It is in this atmosphere of intense cooperation that cartels began to grow.

According to Treue, “Within this small region, the iron and steel industrialists developed a synergistic economy, Verbundwirtschaft (Kleeberg, p. 5). The same can be said of coal mining companies that needed to band together or share resources to survive in a tough economy. Before the Great Wars of the 20^th century, German firms were able to develop highly sophisticated cartels having the following aims: 1) to satisfy the profit hunger of private business organisations; 2) to win influence over the political and economic organisation of the nation on behalf of private interests; and 3) to serve as a means of governmental and political power (Kronstein, p. 645). But it can be argued that German firms were forced into this position, due in part to the fact that German industrialists came late into the game and also from the fact that they faced intense competition from Great Britain.

Early History of Cartels

There is evidence to show that even as early as the 19^th-century cartels are in existence in Europe. According to Bamberger, a Belgian company called the Vielle Montagne created a cartel in the zinc industry in 1846 (Kleeberg, p. 10). But in Germany, it was in the iron industry where one can find the first documented example of a full-blown cartel and it was established in 1859. The sellers of iron rails became members of this cartel (Kleeberg, p. 10). In the Age of Industrialisation railroads are an integral part of the transportation sector and that iron was used to make rails.

Yet changes in technology as well as the negative impact of war made it impossible to sustain the said cartel. Thus, it evolved into the steel rail cartel where producers of steel rails were able to sell their products at a price higher than prevailing market prices. After the steel rail cartel, there was also another major cartel that emerged in Germany. It was the potash cartel that supplied the main ingredient for artificial fertilizers. Then in 1893, another major cartel was established – the coal cartel was the Ruhr mining community’s answer to uncertainty.

Although cartels were created in response to recession and the need to protect the interest of businesses and workers, German cartels became so successful that there came a point in history when cartels are no longer “children of necessity” but rather became “children of prosperity” (Kronstein, p. 646). According to one report:

The exports of Germany increased as never before. After this date, in almost every field German industry developed into the most powerful in Europe, whereas in 1876 the German commissioner of the Philadelphia World Exposition called the German goods ‘an exhibition of cheap and bad products.’ England was suddenly confronted with a competitor, not only in the European counties outside of Germany but in all parts of the world (Kronstein, p. 646).

Modern History of Cartels

At the turn of the 20^th century, there was a considerable upsurge in the number of cartels in Europe. In Germany alone there were over one thousand cartels and the following figures provide the estimates for each year:

• 1911 – 550 to 600 cartels;
• 1922 – about one thousand cartels;
• 1923 – 1,500 cartels;
• 1926 – 3000 cartels;
• 1933 – 1500 cartels; and
• 1938 – 1800 cartels (Kleeberg, p. 2).

Before World War I the German Reich had an ambivalent view with regards to cartels. Government officials are torn between the negative and positive effects of cartels. In 1905 there were 385 cartels with a total of 12,000 participating companies and 350 were legalized by the court of the German Reich (Schwalbach & Schwerk, p. 4). Then almost two decades later the neutrality towards cartels was shattered when the German government decided to limit cartels but the number increased much further.

Before the Second World War and before Hitler became a household name in Europe the German government’s dealings with cartels took a strange turn. This time around almost all companies was forced to join government-sponsored cartels for them to support the massive build-up of arms in preparation for World War II (Schwalbach & Schwerk, p. 4). But this was temporary as Hitler and his cohorts preferred a more authoritarian form of government to further strengthen the military capability of Germany. Hitler’s main goal was to dominate these industries to serve him and his need for conquest.

It was during the reign of the Nazis that the existence of German cartels was justified. The following figures will show how the German cement industry was fully utilised during this era (Newman, 591):

• 1934 ………………………………………. 51%
• 1935 ………………………………………. 64%
• 1936 ………………………………………. 80%
• 1937 ………………………………………. 82%
• 1938 ………………………………………. 94%

For the Nazis, the cartels are not only money-making schemes but a means to an end in terms of world dominion and conquest. Members of the Nazi party were convinced that economic goals were in line with their patriotic objectives, “With the conquest of Poland and the expectation that France and other European countries would fall before the German war machine, the Reich Minister of Economics saw the cement industry in a new light”, it was to assist in the task to rebuild the war-torn cities of Europe (Newman, p. 591). This is another interesting facet of German cartels because for the first time it was demonstrated that cartels can be used not only to improve the bottom line of the company but can also be used in support of political ambitions.

Recent Developments

In the UK anti-competitive behaviour is prohibited under the Competition Act of 1998. There is a stiff penalty for those who will violate these laws and when it comes to financial penalties violators can expect to be fined up to ten percent of their worldwide turnover (OFT435, p. 3).¹ Based on this act it is made clear that UK officials had no ambivalent view when it comes to cartels. For them, cartels are a “particularly damaging form” of anti-competitive behaviour and are seen as a means by which companies can increase prices without justification (OFT435, p. 3). There is not a single consumer on this planet that would love to pay more than what is required.

Aside from creating unfair pricing schemes the UK government is cracking down on cartels because they are the primary reason why there is poorer quality in the products and services offered as well as the lack of innovation that in turn will result in limited options for the consumers. This will also discourage the entry of new players that could help increase the level of competition in a particular industry.

In the United States, anti-competition laws became tougher in the 1980s and this means radical changes where law enforcement shifted emphasis from civil towards criminal cases, in prosecuting cartels (Schinkel, 2). In the early 1990s improvements were made in terms of increased funding and effective revision of U.S. cartel leniency programs that resulted in several high-profile cartel arrests (Schinkel, p. 2). The United States and the United Kingdom share a common belief that cartels should be eradicated.

Aside from the U.S. and U.K. there is another major participant in the fight against cartels and it is none other than the European Union or E.U. Under the E.U. the main agency assigned to combat cartels is the European Commission. The following data will show that the European Commission is very committed to significantly reducing the number of cartels in Europe. These are the ten highest cartel fines since 1969:

Fig. 1: Cartels and fines imposed by the commission

Making Sense of Cartels

The various anti-competitive laws in existence in both Europe and America attests to the fact that highly industrialised nations are not in favour of cartels. Based on the information taken from the UK’s Office of Fair Trading, the U.S. Antitrust Division and the E.U.’s European Commission it can be understood that cartels will create a negative impact on the economy. This can be felt in a national setting but the effects can also be seen globally depending on how successful cartels can operate without being detected.

The most obvious problem linked to cartels is price-fixing. It is common knowledge that the price of a product is relative to the willingness of the consumer to pay for that product. For instance, the cost of producing a commodity is less than 1 euro therefore the company can sell it at a price slightly higher than 1 euro and they can make a profit. But in the presence of a cartel, the price can go up significantly. And there is no need to elaborate what will be the effect of high prices on the lives of consumers especially if the commodity is very vital such as gas, electricity or petrol.

Aside from prices there are other factors that a consumer can consider when it comes to deciding to choose one supplier over the other. It can be discounts or credit terms. But a cartel can make this exercise useless if all the members will agree to offer similar terms. This is the best way to maintain the status quo and will assure the members of the cartel that each one has ensured a generous slice of the market share and that they will not go out of business. They can also improve their bottom line by creating sophisticated bid-rigging schemes or establishing a system where they can control the supply of goods and services.

But a closer examination of German cartels will reveal that there is another school of thought when it comes to anti-competitive behaviour. The German government in the latter part of the 19^th century was able to demonstrate that cartels can be utilised to increase efficiency and even to save a dying industry from extinction. For those who will justify the creation of cartels, they will probably use the term synergy – it is a kind of teamwork that will allow competing firms to work together for the common good. If the CEOs are threatened by recession they can band together to weather the storm.

In Nazi Germany cartels were not only utilised to simply make money. This anti-competitive device was expertly used to harness the capabilities of German industries to build a strong government and strong army ready to make Germany a great empire once again. Hitler and his Third Reich failed but not before showing the world what can be done when instead of competing people will work together to achieve an impossible task. If not for the Americans and the resolute stand of British Europe would have been annexed to Germany.

Conclusion

Still, there is not enough evidence to show that cartels are the best strategy in increasing production and efficiency. Looking at the big picture and having sustainability in mind it can be argued that cartels can work in the short term and maybe in dire circumstances. But in the long run, it will prove to be harmful to the economy. Consumers will be forced to purchase obsolete products at very steep prices. Consumers will be forced to pay for substandard work because members of the cartel can find no reason why they need to work harder and produce quality products. In the long run, complacency and greed will settle in and weaken the economy.

Works Cited

Cody, David. “French Revolution.” 2009. Web.

European Commission. “Statistics.” 2009. Web.

Garza, Deborah. Review of the Final Judgments by the United States and New York Group.

Antitrust division: Department of Justice. 2009. Web.

The Office of Fair Trading. “What is a Cartel?” 2009. Web.

Kronstein, Heinrich. The Dynamics of German Cartels and Patents. The University of Chicago Law Review 9(4): 643-671.

Newman, Philip. Key German Cartels Under the Nazi Regime. The Quarterly Journal of Economics 62(4): 576-595. MA: MIT Press.

Schinkel, Maarten. Effective Cartel Enforcement in Europe. Amsterdam Center for Law & Economics. Web.

Schwalbach, Joachim & Anja Schwerk. Stability of German Cartels. Humboldt – University Berlin.

Footnotes

1. Please note that OFT435 corresponds to the product number of the brochure that can be downloaded from the Office of Fair Trading website.