Friday, June 15, 2012

Cartels: what are they and why do they fail? (I call it the Lemonade Effect)

A cartel is best defined as an agreement between competing firms in order to standardize features such as price and amount of output in order to increase each firm's profit. Why would competing firms be willing to sacrifice a potential area of interest or agree to limit the amount of products they sell? I always like to think of it as something I call the lemonade effect.

Imagine two people are selling lemonade at stands right next to each other. They both may set the price at a dollar and they would both get equal amounts of traffic for a while. After a few minutes though, one person realized they would get more traffic if they reduce the price to 75 cents. Well, the other person would too... and you can see how it would only go down-hill from there. Pretty soon, they would both end up either reducing the price to where they're making negligible profit OR, they would have to shut down. You can see why it would make sense, then, for the both to agree to take different zones. One person can take the north part of town and the other the south. Cartels also often include a production quota in order to ensure that prices stay up. Both parties selling lemonade may agree to only make 20 cups of lemonade a day.

Cartels, however, often fail long-term.

If you've kept up with my posts up until now, you can probably guess why! Game theory (prisoner's dilemma) suggests that there would be many incentives for a company (or in this case, a lemonade stand) to lower their prices. If it isn't clear to you as to why, here's a link back to the Prisoner's Dilemma explanation. :
One person may start to cheat and sell 30 glasses a day. The other person will notice and produce the same. Soon, the cartel is broken!

A real example of a cartel is OPEC (Organization of the Petroleum Exporting Countries) which influences aspects of oil production for all firms that produce oil. By this point, it must be evident that consumers benefit from the absence of cartels.

No cartel means cheaper lemonade!
In a future post, I will explain how OPEC has managed to remain successful.


  1. This comment has been removed by the author.

  2. Good post. Helped me understand it in the simplest way possible.