Category: Economics 10e: Ch 14

The car industry has featured heavily in the news in recent weeks with the announcement of plans to ban the sale of new petrol and diesel cars in the UK from 2040. Around the same time, news broke that the European Commission had commenced an investigation into potential collusive behaviour between German car makers.

Since the investigation is ongoing, it is not yet clear exactly what the firms are accused of. However, allegations first published in German magazine Der Spiegel claim that since at least the mid 1990s Volkswagen (and subsidiaries Porsche and Audi), Daimler (owner of Mercedes-Benz) and BMW met several times a year. Furthermore, it is alleged the meetings aimed to give the firms an advantage over overseas rivals by:

co-ordinating the development of their vehicles, costs, suppliers and markets for many years, at least since the Nineties, to the present day.

In particular, Der Spiegel claims that the cartel limited the size of the tanks that manufacturers install in cars to hold chemicals that reduce diesel emissions. Smaller tanks then left more room for the car’s sound system.

Limiting the size of these tanks should be seen in the context of the 2015 emissions scandal where it became clear that Volkswagen had programmed its cars to limit the use of these chemicals and cheated in emissions tests. This meant that 11 million cars worldwide produced excess emissions. Whilst other manufacturers have suggested that the cars they produced may also produce excess emissions, Volkswagen has so far been the only firm to admit to breaking the rules so explicitly. However, if the allegations in Der Spiegel turn out to be true, there will be clear evidence that the harm caused was widespread and that illegal communication between firms played a key role in facilitating this. If found guilty, substantial fines will be imposed by the European Commission and several of the firms have already announced plans to put in place measures to reduce emissions.

It is not clear how the competition authorities discovered the cartel. However, it has been suggested that incriminating documents were uncovered during a raid of Volkswagen’s offices as part of an investigation into a separate steel cartel. It seems that Volkswagen and Daimler are now cooperating with the investigation, presumably hoping to reduce the penalties they could face. It has also been reported that Daimler’s role in the investigation will have serious implications for future cooperation with BMW, including a project to develop charging sites for electric cars. It will be extremely interesting to see what the investigation uncovers and what the future ramifications for the car industry are.

Articles

European officials probe claims of huge German car cartel CNN Money, Mark Thompson (23/7/17)
Automotive corruption: German manufacturer collusion could spell bankruptcy Shout out UK, Christopher Sharp (4/8/17)
Germany’s auto industry is built on collusion Bloomberg, Leonid Bershidsky (31/7/17)
BMW reassured top staff about cartel allegations: sources Reuters, Edward Taylor (4/8/17)

Questions

  1. What are the consequences of the coordination between German car makers likely to have been for consumers? What about for rival car manufacturers?
  2. Are there circumstances in which coordination between car makers might be beneficial for society?
  3. How do you think the German car industry will be affected by these allegations going forward?

Price fixing agreements between firms are one of the most serious breaches of competition law. Therefore, if detected, the firms involved face substantial fines (see here for an example), plus there is also the potential for jail sentences and director disqualification for participants. However, due to their secretive nature and the need for hard evidence of communication between firms, it is difficult for competition authorities to detect cartel activity.

In order to assist detection, competition authorities offer leniency programmes that guarantee full immunity from fines to the first participant to come forward and blow the whistle on the cartel. This has become a key way in which competition authorities detect cartels. Recently, competition authorities have introduced a number of new tools to try to enhance cartel detection.

First, the European Commission launched an online tool to make it easier for cartels to be reported to them. This tool allows anonymous two-way communication in the form of text messages between a whistle blower and the Commission. The Commissioner in charge of competition policy, Margrethe Vestager, stated that:

If people are concerned by business practices that they think are wrong, they can help put things right. Inside knowledge can be a powerful tool to help the Commission uncover cartels and other anti-competitive practices. With our new tool it is possible to provide information, while maintaining anonymity. Information can contribute to the success of our investigations quickly and more efficiently to the benefit of consumers and the EU’s economy as a whole.

Second, the UK Competition and Markets Authority (CMA) has launched an online and social media campaign to raise awareness of what is illegal under competition law and to encourage illegal activity to be reported to them. The CMA stated that:

Cartels are both harmful and illegal, and the consequences of breaking the law are extremely serious. That is why we are launching this campaign – to help people understand what cartel activity looks like and how to report it so we can take action.

This campaign is on the back of the CMA’s own research which found that less that 25% of the businesses they surveyed believed that they knew competition law well. Furthermore, the CMA is now offering a reward of up to £100,000 and guaranteed anonymity to individuals who provide them with information.

It will be fascinating to see the extent to which these new tools are used and whether they aid the competition authorities in detecting and prosecuting cartel behaviour.

Articles

CMA launches crackdown on cartels as illegal activity rises The Telegraph, Bradley Gerrard (20/03/17)
European Commission launches new anonymous whistleblower tool, but who would use it? Competition Policy Blog, Andreas Stephan (21/03/17)
CMA launches campaign to crackdown on cartels Insider Media Limited, Karishma Patel (21/03/17)

Questions

  1. Why do you think leniency programmes are a key way in which competition authorities detect cartels?
  2. Who do you think is most likely to blow the whistle on a cartel (see the article above by A.Stephan)?
  3. Why is it worrying that so few businesses appear to know competition law well?
  4. Which of the two tools do you think is most likely to enhance cartel detection? Explain why.

Cloud computing is growing rapidly and has started to dominate many parts of the IT market. Cloud revenues are rising at around 25% per year and, according to Jeremy Duke of Synergy Research Group:

“Major barriers to cloud adoption are now almost a thing of the past, especially on the public-cloud side. Cloud technologies are now generating massive revenues for technology vendors and cloud service providers, and yet there are still many years of strong growth ahead.”

The market leader in cloud services (as opposed to cloud hardware) is Amazon Web Services (AWS), a subsidiary of Amazon. At the end of 2016, it had a market share of around 40%, larger than the next three competitors (Microsoft, Google and IBM), combined. AWS originated cloud computing some 10 years ago. It is set to have generated revenue of $13 billion in 2016.

The cloud computing services market is an oligopoly, with a significant market leader, AWS. But is the competition from other players in the market, including IT giants, such as Google, Microsoft, IBM and Oracle, enough to guarantee that the market stays competitive and that prices will fall as technology improves and costs fall?

Certainly all the major players are investing heavily in new services, better infrastructure and marketing. And they are already established suppliers in other sectors of the IT market. Microsoft and Google, in particular, are strong contenders to AWS. Nevertheless, as the first article states:

Neither Google nor Microsoft have an easy task since AWS will continue to be an innovation machine with a widely recognized brand among the all-important developer community. Both Amazon’s major competitors have an opportunity to solidify themselves as strong alternatives in what is turning into a public cloud oligopoly.

Articles

While Amazon dominates cloud infrastructure, an oligopoly is emerging. Which will buyers bet on? diginomica, Kurt Marko (16/2/17)
Study: AWS has 45% share of public cloud infrastructure market — more than Microsoft, Google, IBM combined GeekWire, Dan Richman (31/10/16)
Cloud computing revenues jumped 25% in 2016, with strong growth ahead, researcher says GeekWire, Dan Richman (4/1/17)

Data

Press releases Synergy Research Group

Questions

  1. Distinguish the different segments of the cloud computing market.
  2. What competitive advantages does AWS have over its major rivals?
  3. What specific advantages does Microsoft have in the cloud computing market?
  4. Is the amount of competition in the cloud computing market enough to prevent the firms from charging excessive prices to their customers? How might you assess what is ‘excessive’?
  5. What barriers to entry are there in the cloud computing market? Should they be a worry for competition authorities?
  6. Are the any network economies in cloud computing? What might they be?
  7. Cloud computing is a rapidly developing industry (for example, the relatively recent development of cloud containers). How does the speed of development impact on competition?
  8. How would market saturation affect competition and the behaviour of the major players?

Earlier this week FIFA, the world governing body of football, announced plans to expand the World Cup from 32 to 48 teams starting in 2026. It is fair to say that this has been met with mixed reactions, in part due to the politics and money involved. However, for an economist one particularly interesting question is how the change will affect the incentives of the teams taking part in the competition.

As a result of the change in the first stage of the competition, teams will be play the two other teams in their group. The best two teams in the group will then progress to the next round with the worst team going home. This is in contrast to the current format where the best two teams from a group of four go through to the next round.

Currently, in the final round of group matches all four of the teams in the group play simultaneously. However, an immediate implication of the new format is that this will no longer be the case. Instead, one of the teams will have finished their group matches before the other two teams play each other. This could have important implications for the incentives of the teams involved. To see this we can recall a very famous match played under similar circumstances between West Germany and Austria at the 1982 World Cup.

The results of the earlier group games meant that if West Germany beat Austria by one or two goals to nil both teams would progress to the next round. Any other result would mean that Algeria progressed at the expense of one of these two teams. The way in which the match played out was that West Germany scored early on and much of the rest of the game descended into farce. Both teams refused to attack or tackle their opponents, as they had no incentive to so (see here for some clips of the action, or lack of!).

There is no evidence to suggest that West Germany and Austria had come to a formal agreement to do this. Instead, the two teams appear to have simply had a mutual understanding that refraining from competing would be beneficial for both of them.

This is exactly what economists refer to as tacit collusion – a mutual understanding that refraining from competition and keeping prices high benefits all firms in the market. Much like the fans who had to sit through the farce of a game (you can hear the frustration of the crowd in the video clip linked to above), the end result is harm to consumers who have to pay the higher prices or go without the product.

For this reason governments use competition policy to try to stop situations arising in markets that make the possibility of tacit collusion more likely. One way in which this is done is by preventing mergers in markets where tacit collusion appears possible and would be facilitated by the reduction in the number of firms as a result of the merger. The equivalent for the World Cup would be preventing a change in the format of the competition.

An alternative approach is to tinker with the rules of the game in order to make collusion harder. FIFA seems to have some awareness of the possibility of doing this as it is suggesting that it may require all tied games to extra-time and then a penalty shoot-out in order to determine a winner. Clearly, this would go at least some way to alleviating concerns about tacit collusion in the final group matches because coordinating on a draw would no longer be possible. In a similar fashion, competition authorities can also intervene in markets to change the rules of the game (see for example the recent intervention in the UK cement industry).

Therefore, more generally, the World Cup example highlights the fact that variations in the structure of markets and the rules of the game can have significant effects on firms’ incentives and this can have important consequences for market outcomes. It will certainly be fascinating to see what rules are imposed for the 2026 World Cup and how the teams taking part respond.

Articles

World Cup: Fifa to expand competition to 48 teams after vote BBC News (10/1/17)
How will a 48-team World Cup work? Fifa’s plan for 2026 explained The Guardian, Paul MacInnes (10/1/17)
The Disgrace of Gijón and the 48-team FIFA World Cup Mike or the Don (12/1/17)

Questions

  1. What is the difference between tacit collusion and a cartel?
  2. Why does a reduction in the number of firms in a market make collusion easier?
  3. What other factors make collusion more likely?
  4. How does competition policy try to prevent the different forms of collusion?

The Competition and Markets Authority (CMA) has imposed a record fine of £84m on the American pharmaceutical manufacturing company Pfizer and of £5.2m on its UK distributor, Flynn Pharma. The CMA found that the companies charged unfair prices to the NHS for phenytoin sodium capsules, the anti-epilepsy drug.

The price was previously regulated, but Pfizer deliberately de-branded the drug in September 2012 and immediately raised the price to Flynn Pharma by between 780% and 1600%, which, in turn, raised the price to the NHS by nearly 2600%. This made the drug many times more expensive than in any other European country.

The cost to the NHS rose from around £2m per year to around £50m in 2013. Although other generic drugs are available, there would be serious health risks to patients forced to switch drugs. The NHS thus had no alternative to paying the higher price.

Pfizer claimed that the drug was loss-making before it was de-branded. However, the CMA calculated that this did not justify the size of the price increase; that the higher price enabled Pfizer to recover all these claimed losses within just two months.

The usual practice is for pharmaceutical companies to charge high prices for new drugs for a period of time to enable them to recover high research and development costs. Later, the drugs become available as generic drugs that other manufacturers can produce. The price then normally falls dramatically.

Phenytoin sodium was invented many years ago and there has been no recent innovation and no significant investment. But, unlike with many other drugs, there has been no switching by the NHS because of possible dangers to patients. This has given Pfizer and its distributor considerable market power. As the CMA states in its press release:

Epilepsy patients who are already taking phenytoin sodium capsules should not usually be switched to other products, including another manufacturer’s version of the product, due to the risk of loss of seizure control which can have serious health consequences. As a result, the NHS had no alternative to paying the increased prices for the drug.

In conclusion, the CMA found that “both companies have held a dominant position in their respective markets for the manufacture and supply of phenytoin sodium capsules and each has abused that dominant position by charging excessive and unfair prices”.

Articles

Pfizer fined record £84.2m for overcharging NHS 2600% Independent, Zlata Rodionova (7/12/16)
Pfizer fined record £84.2m over NHS overcharging The Guardian, Angela Monaghan (7/12/16)
CMA fines drug firms £90m for over-charging NHS nhe (7/12/16)
Pfizer hit with record fine after hiking price of NHS epilepsy drug by 2,600pc – costing taxpayer millions The Telegraph (7/12/16)
Pfizer, Flynn Get Record Fine on 2,600% Drug Price Increase Bloomberg, Patrick Gower (7/12/16)

CMA publications
Phenytoin sodium capsules: suspected unfair pricing Competition and Markets Authority: Case reference: CE/9742-13, Competition and Markets Authority cases (updated 7/12/16)
CMA fines Pfizer and Flynn £90 million for drug price hike to NHS CMA Press Release (7/12/16)

Questions

  1. What are the arguments for drug companies being allowed to charge high prices for new drugs?
  2. How long should these high prices persist?
  3. Sketch a diagram to illustrate Pfizer’s price for its anti-epilepsy drug before and after it was de-branded. Illustrate the effect on Pfizer’s profits from the drug.
  4. What determines the price elasticity of demand for (a) a drug which is branded and unique; (b) a drug produced by a specific producer but which is generic and can be produced by a number of producers; (c) a generic drug produced by many producers?
  5. How should a regulator like the CMA decide what price a firm with market power should be allowed to charge?
  6. Under what legislation did the CMA fine Pfizer and Flynn Pharma? What is the upper limit to the fine it is able to impose? Did it impose the maximum fine on Pfizer?