EU Bursts Soap Giants' Bubble

Published in Investing on 18 April 2011

We look at the economics of cartels.

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices – Adam Smith

Last week Procter & Gamble and Unilever (LSE: ULVR) were respectively fined €211 million and €104 million by the European Commission for having operated a cartel between January 2002 and March 2005 to fix the price of detergents in eight European countries.

In forming a cartel, agreeing to charge higher prices than they would normally have done in a free market, these firms and fellow cartel member Henkel had significantly increased their profits.

So why wasn't Henkel fined? The answer lies in "game theory", a branch of mathematics which is used by lawmakers and regulators to break up cartels and stop them from being formed in the first place. Since Henkel eventually blew the whistle on the cartel, it was given immunity.

Cartels make money by pushing up prices

The world's best-known cartel is OPEC, the Organization of the Petroleum Exporting Countries, whose members agree to limit how much oil they produce. By restricting production OPEC ensures that oil prices are higher than they would be in a free market.

Some OPEC members will nonetheless cheat by producing more than their agreed quota, which depresses prices. So even though we're still paying more for oil because OPEC exists, the existence of quota cheats means that we're paying lower prices than if the cartel was operating perfectly.

It's all a game

Leaving aside the moral issues, any rational profit-maximising firm will enter a cartel if it expects to make a profit.

By granting immunity to any member of a cartel which becomes a whistleblower, the authorities are sending out a strong signal that firms should not form cartels in the first place. The offer of immunity means that any cartel member can damage all other members of the cartel, who by definition are its competitors, but not itself, by informing to the authorities.

This is why cartel members who turn informer are often rewarded as well as being given immunity. If the authorities actively encourage whistleblowers it makes it more likely that cartels will be discovered, which in turn makes it less likely that firms will form cartels.

A little bit of maths

The mathematics behind deciding whether or not to be a cartel member is fairly straightforward. You multiply the excess profits that you'd make as a cartel member by the probability of not being caught, then subtract the amount you'd be fined if caught multiplied by the probability of being caught. It's easier than it looks!

Let's say that a firm expects to make an extra £30 million by joining a cartel and that there is only a 10% chance of being caught. If it was caught it would be fined £70 million. So the firm's expected profit from joining the cartel is 30 x (1 – 0.1) – 70 x 0.1 = £20 million. That's twenty million incentives to cheat!

But if pro-whistleblower laws caused the probability of being caught to jump to 40%, the firm would expect to lose £10 million. So it wouldn't become a cartel member in the first place.

Game theory brings down the mob

The treatment of cartel whistleblowers is similar to what America's FBI does when it goes after organised crime. Mob insiders who agree to turn state's evidence are often granted limited or even total immunity from prosecution.

The most famous example of this is "Sammy the Bull" Gravano, underboss of the Gambino family, who in 1991 obtained immunity for nineteen murders in return for his testimony which brought down John Gotti.

One of the staples of organised crime fiction is when someone is given a big incentive to rat on their comrades. If you've seen the second series of The Sopranos you'll remember what happened to Salvatore "Big Pussy" Bonpensiero when he was busted by the Feds. He was given a choice; take thirty years to life without parole or become an informant.

It's tough to become a florist

Businesses can collude in other ways; one of the most popular of which is to get politicians to pass laws and regulations which restrict the number of new entrants to their market.

A good example of this is the law which makes it illegal to practice as a florist in the American state of Louisiana unless you have passed a written examination! That smells of protectionism to me; florists don't pose a risk to the public so there's no need to enforce minimum standards. The "invisible hand" of the market will do that.

But this is a piece of cake compared to what prospective florists faced before June 2010. Then they also had to pass a demonstration exam which was marked by their future competitors.

Naturally the "qualified florists" had a vested financial interest in stopping people from "qualifying." Limiting the number of new florists meant that those florists who had already qualified would earn bigger profits.

It was no surprise that the failure rate for the Louisiana florists' demonstration exam was twice that of the state bar exam!

You're fined, so your share price goes up

You might think that the share prices of Procter & Gamble and Unilever would be affected by the fine. They were; they rose after the fines were announced!

If that seems a bit odd, consider the following. Once the fines were announced this removed any uncertainty as to whether the companies would be fined and how much the fines would be. Stock markets, above all else, hate uncertainty.

Furthermore, the market was probably expecting heavier fines and had already priced this into the shares!

More from Tony Luckett:

> Tony owns shares in Procter & Gamble and Unilever. Whilst The Sopranos is one of his favourite shows, he prefers Boardwalk Empire.

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AlysonThomson 19 Apr 2011 , 11:14am

Virgin also got off Scot free when it blew the whistle on the cartel with BA it was involved in.

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