International Conference on Applied Economics ICOAE 2009 551

Cartelisation of Oligopoly
Jacek Prokop
224


Abstract
This paper considers possibilities of cartelisation in the oligopolistic industries. We distinguish between two important issues. The first
one, traditionally discussed in the literature, is the problem of cartel stability. The other one, much less analysed, is the process of
cartel formation. Both aspects have important repercussions for the market structure and the role of regulatory agencies.
Even though the profit-maximizing firms have incentives to restrict competition by forming cartels, the collusion has often been
broken due to the prisoners dilemma. Therefore, it could have been claimed that antitrust agencies do not need to intervene. Further
analysis shows, however, that there are markets where stable cartels may be created and persist. We present a model of collusive price-
leadership and show the existence of stable cartels. Next, we investigate the cartel-formation process in a game-theoretical framework.
Our analysis allows to formulate general guidelines for the regulators intervention to prevent cartelisation.

JEL codes: D43, L13, L49

Key Words: antitrust policy, cartels, collusive behaviour

1. Introduction
The profit-maximizing firms in oligopolistic markets have strong incentives to restrict competition by
creating cartels. They recognize that coordination of output or pricing strategies could help them increase profits. In the
most extreme case when all companies in the industry form a cartel, they can duplicate the monopoly outcome, and
share the largest pool of profits that can be generated.

The increased profit is achieved at the expense of consumers, and usually leads to a reduction in total welfare.
Therefore, cartels are illegal and antitrust authorities actively engage in fighting them. Even though there have been
many success stories of governmental activities leading to detection and punishment of firms forming cartels
225
, there is
no doubt that it is not an easy task, and additional tools of analysis should be developed to help eliminate illegal
cooperation.

Following the universal rule that it is better to prevent than cure, antitrust agencies could improve their
effectiveness in eliminating cartels from the markets by identifying the circumstances in which cartelisation is most
likely to occur. It is the objective of this paper to determine conditions under which the antirust authorities should get
actively involved in correcting the market, and to show the basic directions of the intervention.

The first indication of possible cartelisation in a given industry is the theoretical existence of a stable
cartel.
226
Such existence is not guaranteed in every market structure. In some industries, the cartel stability is destroyed
by the occurrence of the prisoners dilemma. In these circumstances, cartelisation does not constitute a major threat.
However, the markets, for which the theoretical existence of a stable cartel can be shown, should be the target of a
closer analysis by the antitrust agency.

The theoretical existence of a stable collusion among firms is not an immediate argument for an active market
intervention. We should analyse the industry situation to determine whether there is a chance for the potentially viable
cartel to form. [Selten: 1973] and [Prokop: 1999] have shown that the discussion about the process of cartel creation is

224
Professor of Economics, Warsaw School of Economics, Al. Niepodleglosci 162, 02-554 Warsaw, POLAND, e-mail: jproko@sgh.waw.pl.
225
Several interesting examples of successful cartel detection by the antitrust authorities are presented, e.g., in [Pepall - Richards - Norman: 2002, pp.
386-400].
226
For references on cartel stability see, e.g., [Martin: 1993].
552 International Conference on Applied Ecomonics ICOAE 2009


at least as important as the research on cartel stability itself.
227
Following that literature, we present a model of cartel-
formation process, and formulate the key conditions that make the cartel creation highly probable. We demonstrate that
in an industry composed of more than five firms the chance of having a cartel is quite small due to the free-riding
problem among the market participants. In the case of industries with up to five firms, we should expect a cartel to be
created for sure; there are strong incentives for the firms to collude.

These results are used to provide the guidance for an intervention of the antitrust authority to prevent industry
cartelisation. When the dynamics of the market structure leads to collusion among firms, the antitrust agency should
step in; such situation takes place for industries with the number of competitors falling below six. Industries with a
larger number of firms (more than five) should not be of large concern by the antitrust authorities; the market itself
makes the cartelisation difficult.

The rest of this paper is organized as follows. In section 2, the cartel stability is defined, and the classical
example of prisoners dilemma is given to illustrate the lack of stable collusion in some oligopolies. Next, we present a
model of an industry characterized by collusive price-leadership where the existence of a stable cartel is shown. In
section 3, we offer the cartel-formation game and discuss the equilibrium behaviour of industry participants as well as
the role of the antitrust agency. The conclusions are in section 4.
2. Cartel Stability
2.1. The Definitions
We consider an oligopolistic industry composed of n > 1 identical firms producing a homogeneous output.
Any number of firms in the industry may form a cartel, i.e. agree to maximize joint profit. Such collusive agreement is
usually aimed at restricting the joint output in order to raise the price, and thereby increase profits. For any cartel to stay
in the market the collusion among firms must be stable.

In order to define cartel stability, we need to distinguish between internal and external stability. A cartel is
said to be internally stable if it is not profitable for a member firm to defect from the collusive agreement. A cartel is
externally stable if it is not profitable for any non-member firm to join the collusive agreement. A stable cartel is a
cartel which is both internally and externally stable.

It has been long known that cartels have a tendency to break due to the prisoners dilemma among the
cooperating firms (lack of internal stability). The most typical behaviour of cartel members can be illustrated by the
following example of the two-firm game given in Table 1.

Table 1: Prisoners dilemma game of cartel members.
Firm 2
Cooperate Defect
Firm 1 Cooperate (25, 25) (15, 35)
Defect (35, 15) (20, 20)

There is only one Nash equilibrium of this game; in the equilibrium both firms decide to deviate from the cartel
agreement i.e. (Defect, Defect). Even though, it is Pareto dominant for the firms to cooperate, there is lack of internal
stability of the cartel due to the strong incentives for the individual members to defect (to cheat).

It has been argued that by taking into account an infinite horizon of the competition the firms are encouraged to
cooperate, and to avoid cheating.
228
Unfortunately, the imperfections of information could destroy the collusion even in
an infinite horizon interactions between companies. When cheating by cartel members is unobservable, the
participating firms may not be sure about the source of their poor performance. The low profit could result either from
not obeying the cartel agreement, or from a reduction in the overall market demand.
229
Hence, the existence of the
prisoners dilemma makes cartels not to function too smoothly. This result provides justification for many observers to
conclude that government intervention is not required because competitive forces keep destroying the cartels.

227
Selten [1973], Prokop [1999], and Morasch [2000] model the cartel formation process and show that not all profitable and stable
cartels will form in a subgame perfect equilibrium.
228
See, e.g., [Tirole: 1997, pp. 258-259].
229
For a discussion of the literature on secret price cuts see, e.g., [Tirole, 1997, pp. 251-253, 262-265].
International Conference on Applied Economics ICOAE 2009 553


The prisoners dilemma game however does not arise in every oligopolistic market. Table 1 captures, for
example, an industry when companies with linear cost functions are engaged in a Cournot-type competition when the
cartel agreement fails.230 Since the cooperative (cartel) output levels do not constitute a pair of best responses, each
firm has a stronger profit incentive to defect or to cheat upon the cooperative agreement than to stick with it. Under
different assumptions about the cost functions and the type of competition among firms, it can be shown that a stable
cartel exists. An example of the existence is discussed below.


2.2. The Existence of Stable Cartels

Let us assume that the market demand for our industrys product is given as
(1) D(p) = 100 p.
Each firm has the following cost function:
(2) 2
2
1
) (
i i
q q C
,
where q
i
is the output of firm i. Further suppose that this market is characterized by price leadership of a dominant firm
or cartel. The non-dominant firms are price takers; they constitute a competitive fringe.
231
Denote the number of cartel
members by k. Then, there are nk remaining firms in the competitive fringe. The latter firms take the cartel price p(k)
as given and choose their production level by setting marginal cost equal to this price.

The cartel behaves as a monopolist with respect to the residual demand curve, i.e. the market demand at price p(k)
reduced by the supply of the competitive fringe. Since all companies are identical, the production within the cartel will
be spread uniformly among its members. We do not allow any redistribution of profits among the firms. In this market,
the profit of each firm in the cartel is
(3)
,
) 1 (
1
5000 ) (
2 2
k n
k
d



and the profit of each firm in the competitive fringe is
(4)
.
] ) 1 [(
) 1 (
5000 ) (
2 2 2
2
k n
n
k
c




From (3) and (4), it is easy to see the following:

Proposition: The profit of a cartel member is smaller than the profit of a competitive-fringe participant, i.e.,
. 0 ) ( ) ( k all for k k
c d



An immediate implication of this proposition is that it is strictly preferred for any firm to be in the competitive
fringe rather than in the cartel. This preference, however, should not be confused with the firms incentives to leave the
cartel for the competitive fringe. As it will be demonstrated, such a departure is not necessarily profitable.
Now, let us turn to the cartel-stability conditions. A cartel will be internally stable if k 1 and
(5)
, ) ( ) 1 ( k k
d c


External stability of a cartel takes place when k n 1 and
(6)
) ( ) 1 ( k k
c d

.

Thus for a cartel to be (internally and externally) stable both conditions (5) and (6) must hold.

Using the profit functions (3) and (4), a straightforward algebra shows that:
232

(a) for an industry composed of n 5 firms, the stability conditions (5) and (6) are satisfied only for k=n,
(b) for an industry composed of n > 5 firms, the stability conditions (5) and (6) hold only for k=3.

Thus, in the oligopolistic industries discussed in this subsection there exists a unique stable cartel.
233
When the
number of industry participants does not exceed five, the cartel consists of all of them. For industries with more than
five companies, the size of the stable cartel does not depend on the number of firms, and is always equal to three.
234


230 For a detailed numerical example see, e.g., [Pepall - Richards - Norman: 2002, pp. 353-357].
231 Other types of competition in the industry characterized by collusion may be found in [Martin: 1993]. For example, a cartel may
act as a Stackelberg leader, and the fringe firms follow the Cournot behaviour.
232 For comparison see [Daskin: 1989].
233 The existence of a stable cartel in the industries with collusive price leadership has been first shown in [dAspremont - Jacquemin
- Gabszewicz - Weymark: 1983]. Further discussion of the existence of stable dominant cartels can be found in [Donsimoni: 1985],
[Donsimoni - Economides - Polemarchakis: 1986], and [Nocke: 1999]. A different approach is offered by [Yong: 2004] who argues
554 International Conference on Applied Ecomonics ICOAE 2009


The existence of a stable cartel does not automatically mean that such cartel can be formed. The formation
process may face some obstacles that prevent the creation of cartels. Some of the difficulties arise from the fact that
cartels are prohibited by the law of most of the democratic countries. Even in the case when these hurdles could be
overcome, however, there are also other reasons why independent firms in some industries may not be able to collude
despite the theoretical existence of a stable cartel in these markets. In the next section, we propose a model of cartel-
formation process and analyse its potential outcomes.
3. The Process of Cartel Creation
3.1. The Cartel-Formation Game

Consider again an industry with n > 1 identical firms. The market demand for the industrys product and the
cost functions of the firms are as described in the previous subsection. The cartel-formation game is played in two
stages.
235
In the first stage, the firms simultaneously and independently decide whether to participate in a cartel or
remain in the competitive fringe. In the second stage, the members of the cartel choose the price that maximizes their
joint profit, and the firms in the competitive fringe take this price as given and choose their profit-maximizing
production level.

Each firm ieN={1, , n} has two pure strategies, 0 to stay in the competitive fringe, and 1 to join the cartel.
Denote the strategy space {0, 1} of firm i by S
i
. Then S
1
S
n
is the outcome space. When each firm i chooses its
strategy s
i
and the dominant cartel is formed, the payoff to firm i is determined. Firm i that chooses to stay in the
competitive fringe obtains a profit of
c
(k), where k=
jeN
s
j
. We assume this profit to be the payoff to firm i if it
decides to stay in the competitive fringe. The payoff to firm i from joining the dominant cartel is
d
(k). Thus the payoff
function of firm i is given as
(7)
( )
( )

=
=
= =

e
e
. 1
, 0
) ,..., ( ) (
1
i
N j
j d
i
N j
j c
n i i
s if s
s if s
s s h s h
t
t

In addition to pure strategies, we allow the firms to play mixed strategies. Denote the set of mixed strategies of firm
i by T
i
, i.e. T
i
= {p
i
: 0sp
i
s1} for ieN, where p
i
is the probability of joining the dominant cartel by firm i; we call it the
participation probability. Define the expected payoff to firm i by
(8)
. ... ) ..., , (
|) (| ) 1 ( ) 1 (
) 1 | (| ) 1 ( ) (
1 1
} {
} {
} {
} {
n n
S j
i N j
S j
c j j
i N S
i
i N S S j
i N j
S j
d j j i i
T T p p p for
S p p p
S p p p p H
e =
(
(
(

+
(
(
(

+ =
[ [
[ [
e
e
e _
_ e
e
e
t
t

The first bracket in (8) is the expected payoff to firm i from joining the dominant cartel, and the second bracket is the
expected payoff from staying in the competitive fringe.
We apply the Nash equilibrium concept to our game. A strategy n-tuple
) ..., , (
1 n
p p p=
is called a Nash
equilibrium if for all ieN,
, ) , ( ) (
i i i j i i i
T p all for p p H p H e >


where
). ..., , , ..., , (
1 1 1 n j j j
p p p p p
+
=

Since it is expected that identical firms will behave in a similar way, we restrict our analysis to the symmetric Nash
equilibria. Denote the symmetric equilibrium strategy of a firm by
0
p
. In the symmetric case, it follows from (8) that
the equilibrium payoff of firm i is
(9)
, ) ( ) 1 (
1
) 1 (
) 1 ( ) 1 (
1
) (
1
0 0
1
0
0
1
0
1
0 0 0
(

|
|
.
|

\
|
+
(

+
|
|
.
|

\
|
=

k p p
k
n
p
k p p
k
n
p p H
c
k n k
n
k
d
n
k
k n k
i
t
t


that the Nash notion of stability used in the literature is too weak, because it only permits deviations by individual firms,
i.e. group deviations are not allowed.
234
It is interesting to observe that for many other specification of demand and cost functions the stable cartel
is usually composed of 3 companies when the number of industry participants is greater than five. See, for example,
comments by [Daskin: 1989, pp. 7-12].
235
Compare [Prokop: 1999].
International Conference on Applied Economics ICOAE 2009 555


where
d
() and
c
() are given by (3) and (4).
In the next section, we use the above definitions to describe the equilibrium strategies of the market players.

3.2. The Equilibrium Behaviour of Firms
The following theorem characterises the symmetric equilibrium of our game:
236


Theorem: The cartel formation game has exactly one symmetric equilibrium point. At this point:
. 5 1 0
, 5 1
0
0


n for p
n for p

According to theorem, in an industry composed of not more than five firms, the equilibrium participation
probability is equal one, i.e. the cartel-formation game leads to the creation of a stable cartel. The probability of joining
the cartel by an individual firm falls below one when the number of firms is greater than five.

The actual chance of forming a dominant cartel in the case of n>5 can be seen only by calculating the exact
levels of the equilibrium participation probabilities. Table 1 shows the simulation results for various numbers of firms
in the industry. Observe that the individual probability of joining the cartel is declining with an increasing number of
firms in the industry. The explanation of this outcome is not difficult. The stable cartel consists of three firms in the
industries with more than five competitors. Hence it is becoming a coordination problem to reach the cooperative
agreement. The firms have a tendency to free ride by waiting for others to form the cartel.
Table 1: Symmetric equilibrium of the cartel formation game.
Number of firms
in the industry
(n)
Participation probability
) (
0
p

2
3
4
5
6
7
8
9
10
11
12
13
14
15
20
50
1,0000
1,0000
1,0000
1,0000
0,4282
0,3159
0,2582
0,2206
0,1932
0,1723
0,1555
0,1418
0,1303
0,1206
0,0879
0,0335

The above outcomes have very important consequences for the behaviour of firms in the market where a
cartel plays the role of the price leader. In the case of industry composed of not more than 5 firms we should expect all
of the firms to create a cartel. The cartel will become a monopolist in this market. Thus, from the point of view of the
total welfare, such market structure is inefficient, and there should be some involvement of the antitrust agency to
correct it.

When the number of firms in the market exceeds five than the participation probability suddenly and
significantly declines to the values much below 0,5. It means that the probability of creating a stable cartel becomes
small, and it is rather hard to expect that it will be formed.
Based on the presented results, in general, the antitrust agency should take measures to block mergers and
acquisitions that lead to a reduction of the number of firms below six in any given industry. Moreover, it would be
beneficial to stimulate an increase of the number of firms in any industry. A relatively large number of companies
(more than five) serves as the best guarantee of a low probability of cartel creation.


236
The proof of theorem follows directly from the reasoning presented in [Prokop: 1999, pp. 250-251].
556 International Conference on Applied Ecomonics ICOAE 2009


Since the industries with a small number of firms (less than six) are expected to be cartelised, an active role
of the antitrust agency in this case is of great importance. One of the suggested actions that could be undertaken by the
antitrust authorities is to break up large companies (e.g. Microsoft) into few smaller ones in order to increase the
number of independent industry participants. Another possibility is to enable other firms to enter the market. Otherwise,
the industries comprised of up to five competitors should be the target of a close watch to detect signs of cartel
behaviour, because all the incentives work here for the market participants to collude.

In summary, only the industries composed of less than six firms should be of major concern to the antitrust
authorities. The markets with at least six firms may be viewed as quite competitive and require much less attention
from the regulators side.

4. Conclusions
Any regulatory measures imposed by antitrust authorities make sense only when the market mechanism leads
to some undesired results. Therefore, on the one hand, research should be conducted towards identification of
conditions under which undertaking any regulatory measures is redundant. On the other hand, it is important to describe
the circumstances when some intervention of antitrust is indispensable. The current paper aimed at contributing to the
literature on cartelisation of industries in order to provide guidance on the needs for governmental regulation of some
markets.

The analysis of markets characterized by price leadership of one firm or a group of firms shows that there are
industries in which the theoretical existence of a stable cartel can be proved. However, such potential existence of
collusion among firms does not necessarily mean that a stable cartel can be actually formed. We illustrated the problem
by offering the cartel-formation game. It is demonstrated that in the industries composed of less than six firms, the
equilibrium outcome has all firms forming a dominant cartel. The process of cartel formation will not be successful in
the markets comprised of more than five firms. The reason for these results stems from the incentives of firms to free
ride on the existence of a cartel in the case of a larger number of companies in the industry.

The analyses of both the cartel stability and the formation process are crucial in the discussion about the
involvement of antitrust agency in fighting cartels. It has been shown that in the industries characterised by collusive
price leadership and quadratic cost functions of firms, a stable cartel always exists. Thus, such industries should be the
target of a closer watch by the antitrust agency. Even though the existence of a stable cartel can be shown, the actual
creation of a cartel in this case is not automatic. We have demonstrated that only in the industries composed of up to
five firms, a cartel composed of all of them will be created for sure. Thus an active involvement on the part of an
antitrust agency is necessary to fight the collusive behaviour. When there are more than five firms in the industry, our
model predicts that the free riding among firms will prevent the creation of a stable cartel. Such industries do not
require immediate regulatory measures by antitrust authorities.

Clearly, further research on the prevention and detection of cartels is necessary.

First, the case of possible cartelisation in the industries with asymmetric firms should be analysed.
The stability of collusion by heterogeneous firms in some industries has been discussed, for
example, by [Donsimoni: 1985], but the process of cartel creation still remains to be considered.

Second, many other types of cost functions and forms of competition among firms should be
considered from the viewpoint of both stability and formation process of a potential collusion.

Third, the role of asymmetric information in the cartelisation process should be investigated.

Fourth, other than the Nash notion of stability could be discussed. For example, [Yong: 2004]
suggested an inclusion of group decisions in the definition of stability. The existence of such
stability should be supplemented by the analysis of the collusion process, as well.

Fifth, the analysis of cartelisation should be extended to a dynamic framework. The discussion of
the collusive behaviour has been conducted in the framework of one shot games. A multi-period
analysis would constitute a natural extension.

International Conference on Applied Economics ICOAE 2009 557


Finally, the empirical studies
237
will be the ultimate judge of the theoretical results of the cartelisation of
oligopolistic industries and the effectiveness of the antitrust authorities.

References

dAspremont, C. - Jacquemin, A. - Gabszewicz, J.J. - Weymark, J.A. (1983), On the Stability of Collusive Price
Leadership, Canadian Journal of Economics, 16:17-25.

Daskin, A.J. (1989), Cartel Stability in the Price Leadership Model: Three-Firm Cartels and the Role of Implicit
Collusion, Working Paper 89-17, Boston University School of Management.

Donsimoni, M.P. (1985), Stable heterogeneous cartels, International Journal of Industrial Organization, 3:451-467.

Donsimoni, M.P. - Economides, N.S. - Polemarchakis, H.M. (1986), International Economic Review, 27:317-327.

Martin, S. (1993), Advanced Industrial Economics, Blackwell: Basil.

Morasch, K. (2000), Strategic Alliances as Stackelberg Cartels-Concept and Equilibrium Alliance Structure,
International Journal of Industrial Organization, 18, 257-282.

Nocke, V. (1999), Cartel Stability Under Capacity Constraints: The Traditional View Restored, Working Paper,
Nuffield College, Oxford.

Pepall, L. - Richards, D.J. - Norman, G. (2002), Industrial Organization: Contemporary Theory and Practice, Second
Edition, South-Western: Cincinnati, Ohio.

Prokop, J. (1999), Process of Dominant-Cartel Formation, International Journal of Industrial Organization, 17:241-
257.

Selten, R. (1973), A Simple Model of Imperfect Competition, where 4 are Few and 6 are Many, International Journal
of Game Theory, 4:25-55.

Suslov, V. (2005), Cartel Contract Duration: Empirical Evidence from Inter-War International Cartels, Industrial and
Corporate Change, 14:705744.

Tirole, J. (1997), The Theory of Industrial Organization, The MIT Press: Cambridge, Massachusetts.

Yong, J.-S. (2004), Horizontal Monopolization via Alliances, or Why a Conspiracy to Monopolize is Harder Than It
Appears, Working Paper, MIAESR, University of Melbourne.


237
For some interesting empirical research on stability of international cartels see, e.g., [Suslov: 2005].
558 International Conference on Applied Ecomonics ICOAE 2009