Cartel: A Formal Agreement Between Firms
How Cartels Work: From Agreement to Action
Cartels are formed when companies realize that competing against each other lowers everyone's profits. Instead of fighting for customers, they decide to act as one. The core mechanism of a cartel involves two main actions: price fixing and production quotas.
First, the member firms agree on a common price for their product, which is typically higher than the competitive market price. Second, they assign each member a production limit (a quota) to ensure that the total supply in the market is low enough to support that high price. For example, imagine two companies, A and B, are the only producers of a rare metal. Without a cartel, they might produce 100 tons each, driving the price down to $50 per ton. If they form a cartel and agree to produce only 70 tons each, the total supply drops to 140 tons, and the price could rise to $80 per ton. They sell less, but earn much more per ton, increasing total revenue.
Real-World Example: The OPEC Oil Cartel
The most famous and enduring example of a cartel is the Organization of the Petroleum Exporting Countries (OPEC)[1]. OPEC is a formal group of oil-producing nations that coordinates its petroleum policies. Member countries meet regularly to decide on production levels (quotas) for crude oil. By adjusting the global oil supply, they influence the world oil price.
For instance, if OPEC members agree to cut production by 1 million barrels per day, the reduced supply pushes prices up. This benefits all member countries as their oil revenues increase, even though they are selling less. This example perfectly illustrates how a cartel restricts supply to raise prices, acting like a multi-country monopoly.
The Instability of Cartels: The Cheating Incentive
While cartels promise higher profits, they are notoriously unstable. Each member faces a powerful temptation to cheat on the agreement. If a cartel has set a high price, an individual firm can secretly lower its price just a little to steal customers from other members. This firm would sell much more, making a huge profit—until other members follow suit, starting a price war that destroys the cartel. This situation is a classic example of the prisoner's dilemma[2] from game theory.
The table below shows a simple game between two cartel members, Firm X and Firm Y. Each can either Cooperate (stick to the quota) or Cheat (produce more). The profits (in millions) for (X, Y) are shown.
| Firm X \ Firm Y | Cooperate (Y) | Cheat (Y) |
|---|---|---|
| Cooperate (X) | X: $20, Y: $20 | X: $5, Y: $30 |
| Cheat (X) | X: $30, Y: $5 | X: $10, Y: $10 |
Analysis: If both cooperate, they earn $20 each. But if X thinks Y will cooperate, X can cheat and earn $30. Since both think this way, the likely outcome is both cheat, earning only $10 each.
Important Questions About Cartels
Cartels are illegal because they harm consumers and the economy. By fixing prices and reducing output, they eliminate the benefits of competition, such as lower prices, higher quality, and more innovation. Antitrust laws, like the Sherman Act[3] in the U.S., are designed to prevent, break up, and punish cartels.
OPEC is a cartel of sovereign nations, not private companies. International law is complex, and it is difficult for one country's antitrust laws to control the actions of other sovereign states. While OPEC's actions influence global markets, it operates in a different legal sphere than private, domestic cartels.
A monopoly is a single firm that controls an entire market. A cartel is a group of independent firms that agree to work together to act like a monopoly. The goal is the same (higher prices), but a monopoly is one company, while a cartel is a collaboration of several.
Footnote
[1] OPEC (Organization of the Petroleum Exporting Countries): An intergovernmental organization of oil-exporting nations that coordinates and unifies the petroleum policies of its member countries.
[2] Prisoner's Dilemma: A standard example of game theory that shows why two completely rational individuals might not cooperate, even if it appears that it is in their best interest to do so.
[3] Sherman Act: A landmark U.S. federal statute passed in 1890 that outlawed monopolistic business practices and is the basis for modern U.S. antitrust law.