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Tricky Dicky, the Colluder-in-Chief

By Jonathan J. Ariel - posted Friday, 12 October 2007


When a few firms control a particular industry (such as cardboard box making or grocery retailing) then that industry is said to be an oligopoly, as opposed to a monopoly (where there is only one firm) or competition (where there are many, many players).

Economists look at oligopolies as though they were participants in a game. And economists study their behaviour using “game theory”.

Game theory is a means to make sense of a firm’s strategic conduct. It looks at the behaviour of one firm, taking account of expected actions of other firms in reaction to, or in anticipation of, the conduct of that one firm. “Actions” are decisions that impact on pricing, output or, advertising.

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Interdependence between the firms is emblematic of an industry characterised by a few dominant players. Given the behaviour of one, significantly impacts the conduct of another, industry players usually focus more on their rivals than on their customers. They constantly devise and refine strategy, so as to maximise profit and to improve market share.

Games played by oligopolies have four features in common: the terms of an (illicit) agreement between the players; the different actions available to colluders; the array of possible consequences available; and the industry-wide consequences.

While there are several types of games oligopolies play, let’s focus on just one type: price fixing games, as practiced by Visy Industries and Amcor.

Tricky Dicky, the billionaire owner of cardboard box maker Visy Industries has admitted involvement in an illegal price fixing and market sharing arrangement with rival box maker Amcor. Mr Richard Pratt’s mea culpa and the (relative) pocket change (being $40 million) in fines that he’ll have to pony up, constitute a major coup for the Australian Competition and Consumer Commission, which has been chasing Mr Pratt and Visy for illegal conduct that took place in the four years to 2004.

From an economic perspective, just what did Visy and Amcor do that was so horrid?

Visy and Amcor ran a scam (affectionately known in corporate Australia as a “cartel”), where prices for cardboard boxes were agreed to, and the market was divided (on a wink and a nod) between the two operators. The two commanded over 90 per cent of the market (Visy claims that it had 60 per cent and its rival 33 per cent). But who knows what the split between Visy and Amcor really was.

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A comprehensive study of oligopolistic behaviour requires knowledge of costs of production of cardboard boxes; the strength of customer demand for the products; and willingness of the firms to collude so as to maximise profits.

For ease of argument, let us assume:

  1. that the costs of production are lowest if two firms dominate the industry, as opposed to one firm or three firms;
  2. that demand by local customers (such as food manufacturers Cadbury Schweppes) is strong as they have no where else to go and must shop at Visy or at Amcor; and
  3. Visy and Amcor freely and willingly entered into and engaged in illicit and outrageous market behaviour.

So what does the ACCC mean by Visy and Amcor “colluded”? And how did it hurt customers?

A collusive agreement between Visy and Amcor was a pact designed to raise profits, raise prices and restrict output.

Once the illicit pact was created, both Visy and Amcor could either comply with it or could cheat on it. “Compliance” means to carry out the agreement. “Cheating” means to repudiate the agreement. Cheating is the means where one firm seeks to advantage itself and simultaneously cause harm to its rival.

In the case of the Visy-Amcor cartel, there are several possible outcomes to any agreement:

  • both firms could comply with the agreement; or
  • one firm complies while the other cheats (for example, Visy complies and Amcor cheats or Amcor complies and Visy cheats); or
  • both firms could cheat on the agreement.

Given Amcor sang like a kookaburra to the ACCC, it is a safe bet that both firms complied with the illegal agreement, until Amcor realised that it was financially better off by repudiating the agreement than by sticking to it. It no doubt actively considered the benefits of the collusive agreement against the looming financial and reputation related costs that could flow from the ACCC case against it.

Let’s look at the different scenarios.

Both firms comply

In order to maximise industry profit, Visy and Amcor must act in concert as though they are one huge firm. As though they were a monopoly, where there is no competition in price or in output. The two players combine their total costs and revenues, agree on what price to eye gouge their customers and how to share the market spoils between them. The obscene profits made by colluding oligopolists in such a market mirror those made by a monopolist.

To maximise profit, production is restricted to the point where the industry’s marginal cost (being the opportunity cost of producing one more box) equals the industry’s marginal revenues (being the change in total revenue resulting from one more box sold).

The industry’s marginal cost is the sum of Visy’s and Amcor’s production at each level of marginal cost. Let’s assume (see the table below) that at this point for the industry as a whole, no more than 3.1 million boxes can be manufactured and they can fetch no higher price than $1.75 per box. In this case industry revenues of $5.425 million and economic profit (for a definition see below) of $0.775 million, are the highest achievable. This is Case 1.

Visy cheats Amcor complies

Noting that up to a certain point, higher output is accompanied by per unit cost falls, a firm will have the incentive to increase profit by cheating on a collusive agreement.

Assume that Visy convinces Amcor that demand for boxes has collapsed and that it, Visy, will lower its price in response. Silly Amcor takes Dicky at his word and cuts its price while maintaining the agreed production volumes.

In fact demand didn’t budge one iota. Visy plans to raise its output beyond the agreed volumes, but is aware that such actions will depress the price. Visy is most keen to ensure that Amcor does not raise its output beyond the agreed level.

Case 2 illustrates what happens when Visy cheats.

The industry output (of 4 million boxes) exceeds the production levels (of 3.1 million) had the two firms colluded, as shown in Case 1. At 4 million boxes, the price per unit is 140c, somewhat lower than what could be achieved in Case 1 (175c).

There are several reasons why Visy would behave in this manner. It may be after higher market share. It may seek the industry profits to be shared differently among the colluders. It may be trying to send Amcor broke. It may want to show the market that Amcor is an unreliable provider of boxes in terms of price or volumes offered.

In Case 2 Visy has secured more sales. We can infer that its market share has moved from 60 per cent to 67 per cent, and Amcor’s has dipped from 33 per cent to 26 per cent.

Note, that the industry wide economic profit in this case ($0.76 million) is smaller than in the case where the two firms colluded ($0.775 million). Repudiating the illicit agreement is clearly in the interests of the Colluder-in-Chief, Visy, whose revenues and economic profit are much improved when it alone cheats.

Colluder

Output agreed Price in cents per box Cost of production per box Revenues Economic Profit
Case 1: Both parties sticking to agreement
Visy 2 million boxes 175 150 $3.5m $0.5m
Amcor 1.1 million boxes 175 150 $1.925m $0.275m
Industry profit $0.775m
Case 2: Visy cheating on the agreement
Visy 2.9 million boxes 140 110 $4.06m $0.87m
Amcor 1.1 million boxes 140 150 $1.54m $0.11m LOSS
Industry profit $0.76m
Case 3: Both parties cheat
Visy 3 million 110 110 $3.3m 0
Amcor 1.5 million 110 110 $1.65m 0
Industry profit 0

Notes to table:

  1. We begin in Case 1, relying on Visy’s media estimates (however suspect) that the market is divided between Visy (60 per cent) and Amcor (33 per cent).
  2. Economic profit is “profit” after allowing for all expenses, one of which is the opportunity cost of the capital (also includes “normal” profit).

Both Visy and Amcor cheat

In Case 3, both parties tell each other that they will cut their prices due to an inability to sell boxes. While the price exceeds marginal cost, both parties have an incentive to cheat. When the price equals marginal cost, the players no longer have an incentive to cheat. Assume that at 110c per box, price equals marginal cost (and for that matter, also average total cost). At a price under 110c per box each firm starts to bleed.

At 110c, the total output is 4.5 million yielding industry revenues of $4.95m. From a cartel perspective, this compares unfavourably with a collusive arrangement limiting output to 3.1 million boxes selling at 175c ($5.425m)

In short: when both firms cheat, as in Case 3, they act as though they were competitors with no agreement in place. In this situation, economic profit is zero. “Normal” profits only are made.

While economists treat the study of oligopolies as a game, industry box barons like Amcor’s (former CEO) Russell Jones treat their oligopolies as a game. And as with all games, you win some, you lose some. Barons constantly weigh up the financial costs and benefits of behaving wickedly, and continue to do so as long as it pays.

Assuming Tricky Dicky pays the chump change of $40m in fines, what does this say about our laws against anti competitive practices? That they’re a joke? And is such a fine large enough to ensure that the serial offender does not misbehave again? As if.

For the box baron worth upwards of $5.4 billion, the $40 million represents roughly seven tenths of 1 per cent of his worth. Put it another way. Say you’ve paid off your home, and with super and investments you’re worth a nifty $1 million. How debilitating would you consider being found guilty in court and ordered to pay a $7,400 fine? Not very, I suspect.

No wonder the box baron is luxuriating abroad. I mean wouldn’t you make the most of two private jets at your disposal, if you had the chance?

If Canberra is interested in winning the war on corporate crime, which I doubt, it’s time they got serious.

They could start by considering upping the damages payable to injured (corporate) parties. Take Cadbury Schweppes, for instance, who is seeking $120 million for overpaying Amcor and Visy for boxes, bottles and cans. An improvement to the current situation would be, say if Cadbury proved its case in court, then the conspirators should be liable for say, three times the hurt inflicted, say, $360 million payable to Cadbury Schweppes.

But the real motivator against collusion must surely be criminal penalties. This offence by Mr Pratt is not his first. And given the relatively tiny fine, why should anyone believe it will be his last? But, if the penalty for collusion was incarceration for say 8-15 years at Her Majesty’s pleasure in a fine Victorian correctional facility, I think it reasonable to conclude that Mr Pratt (and for that matter amcor’s Mr Jones) would be somewhat circumspect before conniving again against his cardboard box buying customers. And by implication, against every single Australian consumer.

Alas, while politicians on both sides of the aisle, from Spring Street, Melbourne to Capital Hill continue to praise and laud Tricky Dicky, while their snouts are deep in his trough of largesse, not one of us should expect any major changes soon.

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About the Author

Jonathan J. Ariel is an economist and financial analyst. He holds a MBA from the Australian Graduate School of Management. He can be contacted at jonathan@chinamail.com.

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