International Cartels

A Lesson in Politics as Exchange

From time to time, the production of particular commodities are dominated by international cartels. Obvious examples are things like the Organization of Petroleum Exporting Countries (OPEC) or the International Coffee Agreement (ICA). At first glance, the existence of international cartels seems difficult to explain. Economists tend to think of cartels as generating inefficiencies by restricting trade. Economists also think of cartels as being part of agreements that are difficult to maintain. Policymakers tend to dislike monopolies and have policies against collusive agreements. Yet, these cartels persist. One might wonder whether price theory has something to say about politics and not just markets. After all, political agreements are a form of exchange.

One reason that these cartels might be hard to explain is that there are many reasons in which cartels will not emerge or, if they do emerge, will not survive.

For example, one of the first lessons of game theory that many students learn is the “Prisoner’s Dilemma.” In the context of a cartel, the basic idea is as follows. If each member of the cartel cooperates and restricts output, then each cartel member can charge a price above marginal cost. If none of the members of the cartel cooperate, competition will drive price down to marginal cost. What makes this problem complicated is that the best strategy for the cartel is to cooperate. The worst strategy for the cartel is not to cooperate. But the best option for each individual member of the cartel is to get everyone else to cooperate and then to cheat (charge a price above marginal cost for a higher level of output than agreed upon by the cartel). However, this is the source of the dilemma. Since each individual member of the cartel knows that the other members have an incentive to cheat, this gives each member an incentive to cheat. However, if everyone cheats, all members end up in the worst possible outcome.

If this is a once-and-for-all decision, then it is likely that everyone will try to cheat and end up in the “bad” equilibrium for the would-be cartel members in which price equals marginal cost. If the game is repeated over time, then the outcome isn’t that simple. Each member has an incentive to cooperate with the cartel because the decision will be repeated over time. At the same time, each member has an incentive to treat the agreement like an optimal stopping problem in which the member is choosing the optimal point in time in the future to defect from the cartel.

In short, this sort of decision-making process makes it hard for cartels to survive. When there are incentives to cheat, someone is bound to cheat and the cartel will disband.

Another reason that it is hard for cartels to survive is antitrust law. Many countries have laws against collusion between firms. One would therefore expect that those countries that are net consumers of the cartelized industry might pursue various legal or foreign policy strategies to break up the cartel. Creating a cartel and announcing to the rest of the world that, “hey we have formed this cartel and it is going to be really great for us” doesn’t seem like the best decision. And yet countries that are net consumers of the commodities produced by the cartel seem to be willing participants in the scheme (sometimes implicitly and sometimes explicitly).

So what exactly is going on here? How might we explain the existence of international cartels for particular commodities?

Defense?

It has been awhile since I mentioned Earl Thompson. Those of you who know me also know that I’m a big fan of Earl’s work (see here). One big theme of Earl’s work was using the state’s national defense objectives to think about policy. For example, he once argued that contrary to popular opinion, the U.S. tax system is actually efficient if one treats the objective of tax policy as an attempt to eliminate defense-related externalities.

Earl also had a companion paper on defense-related subsidies. It is this paper that is potentially useful for discussing international cartels. What he argued in this subsidy paper is that during wartime, states tend to impose price controls and rationing on the population. This creates an intertemporal distortion in production decisions. Firms that rationally expect to have price controls and rationing imposed on their industry during wartime will tend to underinvest during peacetime.

A solution to this underinvestment problem is to offer subsidies during peacetime to the industries that are subject to price controls and rationing during wartime. By doing so, this raises the price that sellers receive during peacetime and increases their investment. The subsidy therefore eliminates the intertemporal distortion in prices caused by the wartime policies and prevents underinvestment.

However, not all of the goods subject to price controls and rationing are produced domestically. It is difficult to provide subsidies to foreign producers, for both practical and political reasons. One alternative, however, is to let these international producers form a cartel. The cartel can then use its market power to set a price for its good at a level high enough to offset the intertemporal distortion caused by wartime price controls and this higher peacetime price will attract sufficient investment to offset the disincentive to invest otherwise caused by wartime policies.

As evidence in support of this idea, Thompson noted that the only durable international cartels of the post-World War II era were the international cartels in coffee and tin production, both of which happened to be subject to wartime controls. Furthermore, he noted that traditional arguments about monopolies and cartels would not work when applied to these specific cartels. If the goal was simply monopoly, the goals of the cartel would simply be to choose a price that maximized the profit of the cartel. However, if his theory was correct, the cartel would balance its objective of maximizing profit with the foreign desire to merely offset the distortions created by wartime controls. As evidence in favor of his theory, he cited that the concerns of foreigners were explicitly incorporated into the decisions of these cartels. In particular, he noted that consumer countries of the cartel’s product approved and enforced the quotas of the cartel. It is hard to explain why consumers would be willing participants in the cartel scheme unless they were benefiting in some way from the cartel.

Writing in the 1970s, he also noted that the recent creation of OPEC coincided with an increased dependence of the United States on foreign oil and that oil was subject to price controls and rationing during wartime. Furthermore, he noted that OPEC’s existence policy seemed to be “encouraged by U.S. energy policy.”

Thompson provides empirical support for his theory. Whether one thinks his evidence is sufficient to accept the theory is left as an exercise for the reader. The point of bringing up this example is to demonstrate the role that price theory plays in the evaluation of policy and in the process of understanding the world around us. Thompson starts his argument with a discussion of the intertemporal distortion caused by the controls imposed during wartime. He then asks how one might construct a peacetime policy that would eliminate that distortion. That path leads him to policy conclusions for which there appears to be real world evidence. Only by thinking through those original distortions would any of these policies seem to make sense.

Of course, Thompson doesn’t have the only theory of international cartels. There are alternatives.

Consider the Counterfactual

Probably the natural response to most economists when hearing about international cartels is that these agreements exist for the sole purpose of capturing the benefits of a monopoly. If that is your belief, then you are likely to conclude that the cartel is bad and that the world would be a better place if the market for these commodities was competitive.

However, we have to be careful to consider the relevant counterfactual. If the choice is between an international cartel and an international competitive market, then of course the international competitive market is likely to generate the more desirable outcome. That might not be the relevant counterfactual.

The fact that this might not be the correct counterfactual should be evident in recalling Thompson’s observation that the consumer countries tend to be part of the cartel agreement. If the choice is between cartel and competition, why would the consumer countries pick a cartel?

Sebastian Galiani, Jose Manuel Paz y Miño, and Gustavo Torrens offer a different theory of these international cartels. In particular, they note that a particular country, or group of countries, might want to provide financial support to a foreign country in order to prevent said foreign country from aligning with its enemies. One way to do this is to simply send money to foreign country as a sort of payment for remaining an ally and not aligning with an enemy.

The problem with this sort of strategy is that it is subject to a free-rider problem. If the U.S. and its allies wanted to prevent a particular foreign country from aligning with the Soviet Union during the Cold War, they could all agree to send money. However, each individual country in the group has an incentive to free ride on the contributions of other members of the group. This has two potential outcomes. One, either insufficient support will be provided to prevent the foreign country from aligning with the Soviet Union or the members of the group that do contribute will have to pay more than their fair share to keep allegiances intact.

An alternative to simply offering money transfers would be to allow the foreign country (or foreign countries) to create a cartel within a particular important industry for which the country (or countries) are exporters and the U.S. and its allies are importers. By doing so, the U.S. and its allies are providing a benefit to the foreign country (or countries) through the monopoly profits earned by the cartel. This effectively makes the transfer more specific. Importantly, however, the cartel solves the free-rider problem. Since some of the U.S.’s allies might have an incentive to free ride on the generosity of the transfers from the U.S. and its other allies, the cartel does not allow anyone to free ride. The U.S. and each of its allies are forced to pay their “fair share” in the form of higher prices on the commodity produced by the cartel.

Some Conclusions

Maybe these explanations are correct. Maybe they are not. However, what the arguments illustrate is how one can use the tools of price theory to think about political outcomes. What are people trying to achieve? What is their objective? Are there “gains from trade” to be had from a political agreement? Might these odd political outcomes solve a problem that we didn’t know existed precisely because these political outcomes exist? Answering these questions can help us to better understand the world — even if our ultimate conclusion is that such policies are a mistake.