Collusion is an agreement between two or more parties, sometimes illegal and therefore secretive, to limit open competition by deceiving, misleading, or defrauding others of their legal rights, or to obtain an objective forbidden by law typically by defrauding or gaining an unfair advantage.  It is an agreement among firms or individuals to divide a market, set prices, limit production or limit opportunities. It can involve “wage fixing, kickbacks, or misrepresenting the independence of the relationship between the colluding parties”.
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In legal terms, all acts affected by collusion are considered void. In the study of economics and market competition, collusion takes place within an industry when rival companies cooperate for their mutual benefit. Collusion most often takes place within the market structure of oligopoly, where the decision of a few firms to collude can significantly impact the market as a whole. Cartels are a special case of explicit collusion. Collusion which is not overt, on the other hand, is known as tacit collusion. How is OPEC a collusive oligopoly?
OPEC is a collection of oil exporting countries. Oligopoly – Industry that is controlled by a few major players (firms or countries) Collusion – When industry leaders secretly agree to limit quantities of production. This will guarantee the colluders a higher price for their product OPEC meet to discuss the quantity of oil they will allow onto the world market. This is collusion. Because the OPEC members are the main suppliers of oil they are said to be an Collusion and Cartels by David A. Mayer One of the blessings of competition is that it leads to lower prices for consumers.
For the producer, however, this blessing is a curse. Low prices often mean low profits. Given a choice between competition and cooperation, profit-maximizing firms would more often than not prefer cooperation. Regardless of what you learned in kindergarten, you do not want the businesses you buy from to cooperate. You want them to compete. Adam Smith, the father of modern capitalism, warned that nothing beneficial comes from the heads of business getting together. In the United States, firms are forbidden from cooperating to set prices or production.
The abuses of the late nineteenth and early twentieth century trusts were the impetus for the “trust-busting” of President Theodore Roosevelt. With the Sherman Antitrust Act and later the Clayton Antitrust Act, the government prohibited outright collusion and other business practices that reduced competition. Prior to OPEC, world oil prices were mainly under the control of the Texas Railroad Commission. With the rise of OPEC came a shift in power from U. S. producers to the oil states of the Middle East. Even though it violates the law, businesses from time to time will collude in order to set prices.
Colluding firms can divide up the market in a way that is beneficial for them. The firms avoid competition, set higher prices, and reduce their operating costs. Because collusion is illegal and punishable by fine and prison, executives at firms are reluctant to engage in the practice. The meetings of business leaders are almost always in the presence of attorneys in order to avoid the accusation of collusion. Forming Cartels Businesses that collude may form cartels. A cartel is a group of businesses that effectively function as a single producer or monopoly able to charge whatever price the market will bear.
Probably the best-known modern cartel is the Organization of the Petroleum Exporting Countries, or OPEC. OPEC is made up of thirteen oil-exporting countries and is thus not subject to the antitrust laws of the United States. OPEC seeks to maintain high oil prices and profits for their members by restricting output. Each member of the cartel agrees to a production quota that will eventually reduce overall output and increase prices. OPEC is bad news for anyone that enjoys cheap gasoline. Fortunately for consumers, cartels have an Achilles heel.
The individual members of a cartel have an incentive to cheat on their agreement. Cartels go through periods of cooperation and competition. When prices and profits are low, the members of the cartel have an incentive to cooperate and limit production. It is the cartel’s success that brings the incentive to cheat. If the cartel is successful, the market price of the commodity will rise. Individual members driven by their own self-interest will have an incentive, the law of supply, to ever-so-slightly exceed their production quota and sell the excess at the now higher price.
The problem is that all members have this incentive and the result is that eventually prices will fall as they collectively cheat on the production quota. Cartels must find ways to discourage cheating. Drug cartels use assassination and kidnapping, but OPEC uses something a little more civilized. The single largest producer in the cartel is Saudi Arabia. Saudi Arabia also has the lowest cost of production. If a member or members cheat on the cartel, then Saudi Arabia can discipline the group by unleashing its vast oil reserves, undercutting other countries’ prices, and still remain profitable.
After a few months or even years of losses, the other countries would then have an incentive to cooperate and limit production once again. * Definition: OPEC stands for The Organization of Petroleum Exporting Countries. It is an organization of 12 oil-producing countries that effectively control the world’s oil. OPEC members pump out 42% of the world’s annual supply, controlling 61% of exports. This situation isn’t likely to change, since these 12 countries hold 80% of the world’s proven oil reserves. For these reasons, OPEC’s decisions are critical to countries that depend on oil imports.
What Does OPEC Do? OPEC states quite plainly that its goal is to manage the world’s supply of oil. It does this to make sure its members get what they consider a good price for their oil. Since oil is a fairly uniform commodity, most of its consumers base their buying decisions on nothing other than price. What’s a good price? In the past, OPEC said it was around $70-$80 per barrel. If prices drop below that target, OPEC members agree to restrict supply to send prices higher. Otherwise, they would wind up increasing the supply to make more national revenue.
By competing with each other, they would drive prices even lower. This would stimulate even more demand, and OPEC countries will run out of their most precious resource that much faster. When prices are higher than $80 a barrel, oil-producing countries would naturally want to produce more to bring in extra national revenue. However, if they did that, they increase supply, lowering the price. Instead, OPEC members agree to produce only enough to keep the price high for all members. Furthermore, if prices are too much higher than $80 a barrel, then other countries have the incentive to drill more expensive oil fields.
Sure enough, now that oil prices are closer to $100 a barrel, it’s become cost effective for Canada to explore its shale oil fields, and for the U. S. to use fracking. As a result, non-OPEC supply has increased. OPEC’s second goal is to reduce oil price volatility. That’s because, at current prices and rates of production, OPEC countries have enough oil to last for 113 years. In addition, oil is expensive to produce. For maximum efficiency, oil extraction must run 24 hours a day, seven days a week. In addition, closing facilities could physically damage oil installations and even the fields themselves.
Ocean drilling is especially difficult and expensive to shut down. Therefore, it’s in OPEC’s best interests to keep world prices stable. For example, in June 2008, prices spiked to $143/barrel. OPEC responded by agreeing to produce a little more oil, which brought prices down. However, the global financial crisis brought oil prices down to $33. 73/barrel in December. OPEC responded by reducing the supply, helping prices to again stabilize. A slight modification is usually enough to restore price stability. OPEC also adjusts the world’s oil supply in response to crises and shortages.
For example, it replaced the oil lost during the Gulf Crisis in 1990. Several million barrels of oil per day were cut off when Saddam Hussein armies destroyed refineries in Kuwait. OPEC alos increased production in 2011 during the crisis in Libya. The Oil and Energy Ministers from the OPEC members meet twice a year, or more if needed, to coordinate their oil production policies. Each member country abides by an honor system, agreeing to only produce a certain amount. However, if a country winds up producing more, there really is no sanction or penalty.
Furthermore, each country is responsible for reporting its own production. Therefore, there is room for “cheating. ” On the other hand, a country won’t go too far over its quota, since it doesn’t want to risk being kicked out of OPEC. Despite its power, OPEC cannot completely control the price of oil. In some countries, additional taxes are imposed on gasoline and other oil-based end products to promote conservation. More importantly, oil prices are actually set by the oil futures market. Much of the oil price is determined by these commodities traders. For more on this, see Why Are Oil Prices So High?