Efficient Cartels and the Public Interest Defence – Do They Exist?

Cento Veljanoski —  30 December 2019

[TOTM: The following is the seventh in a series of posts by TOTM guests and authors on the politicization of antitrust. The entire series of posts is available here.]

This post is authored by Cento Veljanoski, Managing Partner, Case Associates and IEA Fellow in Law and Economics, Institute of Economic Affairs.

The concept of a “good” or “efficient” cartel is generally regarded by competition authorities as an oxymoron. A cartel is seen as the worst type of antitrust violation and one that warrants zero tolerance. Agreements between competitors to raise prices and share the market are assumed unambiguously to reduce economic welfare. As such, even if these agreements are ineffective, the law should come down hard on attempts to rig prices. In this post, I argue that this view goes too far and that even ‘hard core’ cartels that lower output and increase prices can be efficient, and pro-competitive. I discuss three examples of where hard core cartels may be efficient.

Resuscitating the efficient cartel

Basic economic theory tells us that coordination can be efficient in many instances, and this is accepted in law, e.g. joint ventures and agreements on industry standards.  But where competitors agree on prices and the volume of sales – so called “hard core” cartels – there is intolerance.

Nonetheless there is a recognition that cartel-like arrangements can promote efficiency. For example, Article 101(3)TFEU exempts anticompetitive agreements or practices whose economic and/or technical benefits outweigh their restrictions on competition, provided a fair share of those benefits are passed-on to consumers. However, this so-called ‘efficiency defence’ is highly unlikely to be accepted for hard core cartels nor are the wider economic or non-economic considerations. But as will be shown, there are classes of hard core cartels and restrictive agreement which, while they reduce output, raise prices and foreclose entry, are nonetheless efficient and not anticompetitive.

Destructive competition and the empty core

The claim that cartels have beneficial effects precedes US antitrust law. Trusts were justified as necessary to prevent ‘ruinous’ or ‘destructive’ competition in industries with high fixed costs subject to frequent ‘price wars’. This was the unsuccessful defence in Trans-Missouri (166 U.S. 290 (1897), where 18 US railroad companies formed a trust to set their rates, arguing that absent their agreement there would be ruinous competition, eventual monopoly and even higher prices.  Since then industries such as steel, cement, paper, shipping and airlines have at various times claimed that competition was unsustainable and wasteful.

These seem patently self-serving claims.  But the idea that some industries are unstable without a competitive equilibrium has long been appreciated by economists.  Nearly a century after Trans-Missouri, economist Lester Telser (1996) refreshed the idea that cooperative arrangements among firms in some industries were not attempts to impose monopoly prices but a response to their inherent structural inefficiency. This was based on the concept of an ‘empty core’. While Tesler’s article uses some hideously dense mathematical game theory, the idea is simple to state.  A market is said to have a ‘core’ if there is a set of transactions between buyers and sellers such that there are no other transactions that could make some of the buyers or sellers better off. Such a core will survive in a competitive market if all firms can make zero economic profits. In a market with an empty core no coalition of firms will be able to earn zero profits; some firms will be able to earn a surplus and thereby attract entry, but because the core is empty the new entry will inflict losses on all firms. When firms exit due to their losses, the remaining firms again earn economic profits, and attract entry. There are no competitive long-run stable equilibria for these industries.

The literature suggests that an industry is likely to have an empty core: (1) where firms have fixed production capacities; (2) that are large relative to demand; (3) there are scale economies in production; (4) incremental costs are low, (5) demand is uncertain and fluctuates markedly; and (6) output cannot be stored cheaply. Industries which have frequently been cartelised share many of these features (see above).

In the 1980s several academic studies applied empty core theory to antitrust. Brittlingmayer (1982) claimed that the US iron pipe industry had an empty core and that the famous Addyston Pipe case was thus wrongly decided, and responsible for mergers in the industry.

Sjostrom (1989) and others have argued that conference lines were not attempts to overcharge shippers but to counteract an empty core that led to volatile market shares and freight rates due to excess capacity and fixed schedules.  This type of analysis formed the basis for their exemption from competition laws. Since the nineteenth century, liner conferences had been permitted to fix prices and regulate capacity on routes between Europe, and North America and the Far East. The EU block exemption (Council Regulation 4056/86) allowed them to set common freight rates, to take joint decisions on the limitation of supply and to coordinate timetables. However the justifications for these exemptions has worn thin. As from October 2008, these EU exemptions were removed based on scepticism that liner shipping is an empty core industry particularly because, with the rise of modern leasing and chartering techniques to manage capacity, the addition of shipping capacity is no longer a lumpy process. 

While the empty core argument may have merit, it is highly unlikely to persuade European competition authorities, and the experience with legal cartels that have been allowed in order to rationalise production and costs has not been good.

Where there are environmental problems

Cartels in industries with significant environmental problems – which produce economic ‘bads’ rather than goods – can have beneficial effects. Restricting the output of an economic bad is good. Take an extreme example. When most people hear the word cartel, they think of a Colombian drugs cartel. . A drugs cartel reduces drug trafficking to keep its profits high. Competition in the supply would  lead to an over-supply of cheaper drugs, and a cartel charging higher prices and lower output is superior to a competitive outcome.

The same logic applies also to industries in which bads, such as pollution, are a by-product of otherwise legitimate and productive activities.  An industry which generates pollution does not take the full costs of its activities into account, and hence output is over-expanded and prices too low. Economic efficiency requires a reduction in the harmful activities and the associated output.  It also requires the product’s price to increase to incorporate the pollution costs. A cartel that raises prices can move such an industry’s output and harm closer to the efficient level, although this would not be in response to higher pollution-inclusive costs – which makes this a second-best solution.

There has been a fleeting recognition that competition in the presence of external costs is not efficient and that restricting output does not necessarily distort competition. In 1999, the European Commission almost uniquely exempted a cartel-like restrictive agreement among producers and importers of washing machines under Article 101(3)TFEU (Case IV.F.1/36.718. CECED).  The agreement not to produce or import the least energy efficient washing machines representing 10-11% of then EC sales would adversely affect competition and increase prices since the most polluting machines were the least expensive ones.

The Commission has since rowed back from its broad application of Article 101(3)TFEU in CECED. In its 2001 Guidelines on Horizontal Agreements it devoted a chapter to environmental agreements which it removed from its revised 2011 Guidelines (para 329) which treated CECED as a standardisation agreement.

Common property industries

A more clear-cut case of an efficient cartel is where firms compete over a common property resource for which property rights are ill-defined or absent, such as is often the case for fisheries. In these industries, competition leads to excessive entry, over-exploitation, and the dissipation of the economic returns (rents).  A cartel – a ‘club’ of fisherman – having sole control of the fishing grounds would unambiguously increase efficiency even though it increased prices, reduced production and foreclosed entry. 

The benefits of such cartels have not been accepted in law by competition authorities. The Dutch competition authority’s (MNa Case No. 2269/330) and the European Commission’s (Case COMP/39633 Shrimps) shrimps decisions in 2013-14 imposed fines on Dutch shrimp fleet and wholesalers’ organisations for agreeing quotas and prices. One study showed that the Dutch agreement reduced the fishing catch by at least 12%-16% during the cartel period and increased wholesale prices. However, this output reduction and increase in prices was not welfare-reducing if the competitive outcome resulted over-fishing. This and subsequent cases have resulted in a vigorous policy debate in the Netherlands over the use of Article 101(3)TFEU to take the wider benefits into account (ACM Position Paper 2014).

Sustainability and Article 101(3)

There is a growing debate over the conflict between and antitrust and other policy objectives, such as sustainability and industrial policy. One strand of this debate focuses on expanding the efficiency defence under Article 101(3)TFEU.  As currently framed, it has not enabled the reduction in pollution costs or resource over-exploitation to exempt restrictive agreements which distort competition even though these agreements may be efficient. In the pollution case the benefits are generalised ones to third parties not consumers, which are difficult to quantify. In the fisheries case, the short-term welfare of existing consumers is unambiguously reduced as they pay higher prices for less fish; the benefits are long term (more sustainable fish stock which can continue to be consumed) and may not be realized at all by current consumers but rather will accrue to future generations.

To accommodate sustainability concerns and other efficiency factors Article 101(3)TFEU would have to be expanded into a public interest defence based on a wider total welfare objective, not just consumers’ welfare as it is now, which took into account the long-run interest of consumers and third parties potentially affected by a restrictive agreement. This would mark a radical and open-ended expansion of the objectives of European antitrust and the grounds for exemption. It would put sustainability on the same plank as the clamour that industrial policy be taken-into-account by antitrust authorities, which has been firmly resisted so far.  This is not to belittle both the economic and environmental grounds for a public interest defence, it is just to recognise that it is difficult to see how this can be coherently incorporated into Article 101(3)TFEU while at the same time as preserving the integrity and focus of European antitrust.