Foodstuffs North Island and cartel conduct

If you are covering market structures in NCEA Level 3 or in CIE A Level, the recent news that the New Zealand Commerce Commission is taking Foodstuffs North Island and its subsidiary Gilmours Wholesale to court is very relevant. It believes that Foodstuffs North Island is guilty of cartel conduct.

The regulator indicated that Foodstuffs North Island and its subsidiary Gilmours Wholesale were guilty of pressurising a supplier to a particular hospitality customer to redirect supply through them and therefore ensuring that the hospitality customer had to buy from Foodstuffs. Subsequently this meant that the hospitality company no longer had a choice (Foodstuff or the supplier) that was previously available – See graphic below. Click here for the interview on RNZ Morning Report this morning.

Cartel theory

The simplest way to approach the operation of cartel pricing is to consider the case of just two firms in an industry. This is called duopoly . Therefore we can say that Oligopoly and Duopoly are very similar market structures. In this situation they differentiate their product with heavy advertising and service. Again there are major barriers to entry, and because the market is dominated by these two firms, they face inelastic demand.   The recent difficulties of the oil-producing countries to agree on a common pricing policy illustrate the difficulties that face a cartel like OPEC (Organisation of Petroleum  Exporting Countries). But at least one major oil producer has tried to provide some stability to the oil cartel and achieved some success through its relative importance in this market. This stabilising role as performed by Saudi Arabia as a major oil-producer takes us on to yet another form of price determination within the the world of  oligopoly, that of price leadership.

A formal collusive agreement is called a cartel. A cartel can achieve the same profits as if the industry were a monopoly. In the figure below the total market or industry demand curve is shown as D and the corresponding marginal revenue curve is MR. The cartel’s marginal cost curve (MC) is the horizontal sum of the marginal cost curves of the members of the cartel. The cartel will set a price of p1 (MC = MR) where profits are maximised. Alternatively the cartel could set output at q1 by giving each cartel member an output quota. This would produce the same price (p1).

By contrast, p2 shows the marginal cost price which would be the price under perfect competition, with q2 showing the corresponding output. This means that the cartel will operate with a higher price and lower output when compared to perfect competition.

Covert (formal) collusion occurs where firms meet secretly and make decisions about prices or output. Tacit (informal) collusion is much more difficult to control. This is when firms act as if they have agreements in place without actually having communicated with each other.   Collusion between firms whether formal or informal is more likely when:

• there are only a few firms in the industry, so reaching an agreement is easier and any cheating can be spotted quickly.

• they have similar costs of production and methods of production making any agreement on price easier to reach.

• the firms produce similar products. Cartels have been common in industries such as food production in recent years.

• the products have price inelastic demand meaning that a rise in price by the cartel will lead to a rise in sales revenue for the firms.

• the laws against collusion in a country are weak or ineffective.

Collusive agreements often prove difficult to sustain. Most are illegal as they raise prices to the detriment of the consumer. They cannot, therefore, be enforced by contract, even if cheating could be detected. Each and every party to the collusive agreement has an incentive to cheat by producing more than agreed. This will suppress price slightly, but the firm can still take advantage of artificially high prices as long as the other firms do not cheat as well. However, stable market conditions (a small number of firms; similar costs of production; similar products; high barriers to entry; easy detection of cheating on the agreement) make joint profit maximisation feasible.

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