Collusive Behavior in the Industrial Thread Industry

Table of contents

1. Introduction……………………………………………………………………… 2

2. The Thread Industry 2.1 Market Structure………………………………………………………………. 2 2.1 The Agreements ……………………………………………………………….. 3

3. Economic Impact on Competition 3.1 The Nature of a Carte………………………………………………………………… 4 3.2 Welfare analysis ……………………………………………………………………… 5

4. The European Commission`s decision 4.1. The decision…………………………………………………………………….. 7

5. Conclusion………………………………………………………………………… 8

References………………………………………………………………………………. 9

1. Introduction

The European Commission (EC) convicted eleven companies in the thread industry for arranging cartels for customers in Benelux, the Nordic countries and the EEA in 2005. The 23 producers investigated are from Germany, Belgium, the Netherlands, France, Switzerland and the United Kingdom and were fined to a total of 43.5 million € (European Commission, 2005). Industrial thread itself is a kind of thin yarn that is used for sewing. It is therefore a main component in the production of various products, such as clothes, home furnishings, mattresses, footwear and others. Additionally, the production of automotive seats and seatbelts can be assigned to the so called automotive thread. Both markets together amounted to around 6 billion € in in sales worldwide in 2000. The antitrust investigation revealed that some companies in fact arranged illegal meetings to collude upon target prices. Such behavior is anticompetitive and harms consumers and overall competition. It needs to be abolished as well as prevented in the future. This raises the question if the antitrust authorities have decided correctly to punish the thread industry for collusion and if the fines were set high enough to discourage cartel formation in the future.
This paper at first strives to describe the market structure of industrial thread within the context of a perfectly competitive market. It then elaborates on the anticompetitive behavior of cartels to further determine the economic impact on competition. In the end all arguments are taken into account to evaluate the EC’s decision and if the right actions were taken to prevent future collusions.

2. The Thread Industry Market 2.1 Market Structure

The antitrust authorities discovered a total of three cartels for industrial and automotive thread within the EEA. It becomes therefore a crucial factor to examine the market without the anticompetitive behavior, to estimate how much competition was harmed. When elaborating on the thread market as a whole it seems to be very competitive. First of all, there are many companies producing thread within Europe. This is the reason why the European Commission concentrated its investigation on the 23 manufacturing firms only and left out the retailers completely. Next, according to OECD statistics, the textile manufacturing industry was one of the easiest markets for investors to enter and exit, relative to other markets in the US from 1989 to 1996 (Perloff, 2009). Perloff describes clearly that the total economy’s entry rate is 10 percent, while the exit rate lies at 8 percent as compared to 12 percent for both in the textile industry. Even though Perloff’s data refers to the US market it can be applied to the EEA as well, since market conditions are well comparable with respect to labor cost or capital. Furthermore, transaction cost, the expenses of finding a trading partner, are very low because of better-emerging technologies. Especially the communication advantages through internet or e-mail provide consumers and producers with all necessary information by a worldwide standard, so that trading becomes less expensive. This all leads to better, yet not complete price transparency for the buyers.

So far the thread industry is very competitive but to become even more efficient, it needs to produce a homogenous product. Thread however, is not as it seems homogeneous. There are for example different techniques to twist the yarns or types of finishing. Thread can also differ in size, tenacity, loop or breaking strength and color fastness (YIL Corporation, n.d./2010). This means thread can be differentiated easily, to satisfy customers’ needs and wishes. It is also important to emphasize that without differentiation the consumers are in the position to make a trade off in quality by switching to a company from an emerging country, like China, to get much lower prices due to local and undervalued labor costs (Athukorala, 2007). To sum it up, the industrial thread industry within the EEA is very competitive. The only striking factor is the production of a differentiated product which can be explained by the increasing competition from the East. The damage by the cartels can therefore be estimated to be very extensive, so it is now interesting to investigate what agreements were made by the cartel members.

2.2 The Agreements

A competitive market is what an economy should strive for. It maximizes total welfare and benefits all parties. The textile industry itself is very competitive, so that it is impossible for individual firms to generate additional economic profits in the long run. Some companies would therefore find it very beneficial to coordinate their actions. For example they could reduce the quantity supplied, so that the market price would rise artificially. In the thread market there were two kinds of agreements to be found, one on the price-fixing itself and another on price discrimination. First, it was revealed that in all three markets the thread producers took part in regular meetings and exchanged sensitive information on price lists (EC, 2005). Through this first agreement, companies wanted to avoid undercutting each other. They agreed upon price increases or a target price that was higher than the market-based price. Next the meetings also regulated the prices that should be charged to individual customers. This indicates that the colluding companies shared the market jointly by allocating costumers by different prices for the same product. This is a form of price discrimination and reduces competition. Both agreements show extremely collusive behavior in a very competitive market. This leads to the question what economic effects price fixing and price discrimination have on competition in this case.

3. Economic impact on competition 3.1 The nature of a cartel

To understand the economic impact of cartels on competition it is best to first describe the nature of a cartel to then further examine through a supply-and-demand model the explicit changes in consumer and producer surplus. In a cartel each member has an incentive to cheat on the cartel agreements. If for instance the colluding companies agree on a target price like in this case, the owner of a firm may decide to undercut this price for some of his customers. This cheating will be hard to detect for the other members so that this company will increase its profits by more than the other colluding firms. The problem that arises is that many owners would consider such a cheating action for themselves. This way the cartel would collapse. On the other hand Duncan Reekie (1997) also found an interesting aspect, namely that a cartel will break down, if it does not enjoy a protection by an institution or law. In this case the cartel would for example agree to reduce the quantity supplied to artificially raise the price. If there are no government regulations, non-cartel members could “chisel” into the cartel and also generate higher revenues without running the risk to be charged by the commission for attending the former meetings. Both scenarios emphasize that collusive behavior is more likely to collapse due to cheating and deregulation. But if the cartel members manage to stick to the agreements, economic efficiency will be reduced, which is best described in a welfare analysis.

3.2 Welfare analysis

It is best to start a welfare analysis with a supply-and-demand model for the thread market without collusion. In such a model the price is allowed to be determined naturally through free market forces. First of all, since the thread market allows free entry and exit, it makes economic sense to determine the model in the long run only, since the short-run faces a fixed number of companies. Under this assumption the market supply curve becomes a horizontal line at the equilibrium price. This is due to the fact that there is no producer’s surplus that can be generated in the long run. Imagine if companies would have the opportunity to make a profit, more and more new companies would enter the market until the final economic profit would be zero (Perloff, 2009). The demand curve on the other hand is assumed to be regular downward sloping. The reason is that the firms are differentiating the thread in many ways, so that they can charge markups on the price and in this way become price setters. According to an OECD working paper by Oliveira Martins, Scarpette and Pilat (1996), the markup for the textile industry was indeed on average at 8 percent within the EEA. To summarize this original model it is important to see that at the equilibrium price and quantity producers earn zero economic profit in the long run.

If, now the companies decide to collude upon a target price that is higher than the equilibrium price many things change. Most importantly, a cartel enjoys market power through coordinating actions. This means the companies act together as monopoly, so that the optimum output is achieved where marginal cost equals marginal revenue. This is the reason why producers suddenly make additional economic profit, on behalf of the consumers. Through the increase in price the consumer surplus is reduced, so that the difference of what the consumers are willing to pay and what the goods cost shrinks. For total welfare this effect also has negative consequences. The altering of the market creates a so called deadweight loss (DWL), which is the net reduction in welfare from a loss of surplus, in this case by the consumers, that is not offset by a gain to the producers (Perloff, 2009). This makes logical sense because the increase in the price also reduces the quantity supplied. To visualize the whole scenario, Figure 1 illustrates a blue triangle between the new quantity supplied Q2 and the new and old equilibrium, which is than the welfare loss for the entire economy.

According to Duncan Reekie the second agreement about price discrimination should not be seen too pejorative, because generally, the conditions for welfare might even improve. This is due to the fact that more price sensitive buyers might be drawn into the market. This last assumption is based on a theoretical model, however, the actual demand curve of the customers is not clear, so that the total effect of the price discrimination cannot be examined more explicitly. Nevertheless, it is indisputable that price discrimination favors the effect of increased target pricing. In fact, if the prices are too high, retailers will be driven out of the market, so that overall competition shrinks. This economic analysis states clearly that a cartel formation is anticompetitive. It harms consumers, total welfare and competition. It is now time to examine what the European Commission decided and what actions it used to punish this anticompetitive behavior.

4. The European Commission´s decision
4.1 The decision

After evaluating the anticompetitive behavior, the Commission decided that Article 81 of the Antitrust Law was violated by all three cartels. Since the upper bound for the fines is given by law it is usually defined as a percentage of gross annual revenue per firm in the last year of the cartel’s existence (Hinloopen, 2004), the fine payments were adjusted to each individual firm. In this specific case elven companies practiced price-fixing over a period from one up to eleven years and were fined 43.5 million € in total, with two companies already judgmental receiving 65 percent of the total amount of fines. These two, Coats Ltd and Amann und Söhne GmbH were in fact the biggest companies involved with the longest duration of eleven years, but surprisingly individual employers that were responsible for the anticompetitive behavior did not receive criminal sanctions at all. Furthermore, with respect to the remaining companies, the fines seem not high enough to discourage future cartel formation or at least do not give the incentive to competitive trade within the market. This raises the question why the EC seems to understate the damage that was created by the cartel agreements.

To answer this question it is necessary to look at the case itself. The Journal of the European Union (2005) states that the fine payments were set upon the gravity and duration as well as the existence of aggravating and/or mitigating circumstances. Obviously, the antitrust authorities must have made the use of mitigating circumstances, which hypothetically could be leniency programs. Leniency programs reduce the fines for cartel members that bring evidence to the antitrust authority. A further step could also be to extend this mechanism to reward individuals in a certain company, so that managers that reveal information would avoid criminal sanctions, such as jail. Both techniques work perfectly in the combination with the cheating and deregulate structure of cartels. Their impact can be seen in the recent increase in successfully prosecuted cartels (Aubert, Rey & Kovacic, 2003). Thus, the fines seem to low at first but with respect to leniency programs the antitrust authorities achieved to break the cartels much quicker and to encourage fair trade in the future.

5. Conclusion

The industrial thread market within the EEA contains some characteristics of a perfectly competitive market and in in this way is very efficient. Nevertheless, some companies decided to collude and to price discriminate for a period between one and eleven years. A welfare analysis demonstrated how consumers, total welfare and competition suffered significant losses over that time through the collusive behavior. To prevent such market failures the antitrust authorities have two possibilities to act. First they could make use of hard instruments to serve as a deterrent. Therefore criminal sanctions for individual people or high money fines would discourage the companies to collude in the future. Next, they can also make use of the cheating nature of a cartel in combination with a leniency program. On the one hand the last possibility has the advantage that cartel structure can be revealed much quicker with less investigation costs and on the other hand the lower fines will not necessarily drive out some of the investigated companies, so that competition is guaranteed. This demonstrates that the last possibility is more effective, so that the European Commission decided correctly to punish the thread market with appropriate fines to encourage efficient trading in the future.

References:

Aubert, C., Rey, P. & Kovacic, W. (2004, October). The Impact of Leniency Programs on
Cartels. Paper presented at 13th WZB Conference on Markets and Political Economy, Berlin, Germany. Abstract retrieved from: http://www.wzb.eu/mp/conf/pastconfs/io04/papers/rey.pdf

Athukorala, P. (2007). The Rise of China and East Asia Export Performance: Is the Crowding- out Fear Warranted?. Division of Economics, Research School of Pacific and Asian Studies Working Paper, No. 2007/10.Retrieved from: http://rspas.anu.edu.au/economics/publish/papers/wp2007/wp-econ-2007-10.pdf

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European Commission (2005). Summary of Commission Decision of 14 September 2005 relating to a proceeding under Article 81 of the EC Treaty and Article 53 of the EEA Agreement. Official Journal of the European Union, document number C (2005) 3452 and C (2005) 3765. Retrieved from: http://eurlex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2008:021:0010:0014:EN:PDF

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Universtiy of Amsterdam & Economics Network for Competition and Regulation, The Netherlands. Retrieved from: http://www.encore.nl/documents/Hinloopen_Internalcartelstabilitywithtime-dependentdetectionprobabilities.pdf

Oliveira Martins, J., Scarpetta, S. & Pilat, P. (1996). Mark-Up Ratios in Manufacturing
Industries: Estimates for 14 OECD Countries. OECD Economics Department Working Papers, No. 162, OECD Publishing, DOI: 10.1787/007750682315

Perloff, J. M. (2009). Microeconomics (5th internat. ed.). Boston: Pearson Addison Wesley

YLI Corporation (2010). A Thread of Truth- A factual look at sewing thread. Retrieved from:
http://www.ylicorp.com/pdf/tot-brochure.pdf