As with any economy, local markets are extremely important in that they function well. This allows firms to compete and provide essential, better, and more cost-effective products/services to their consumers. In an even level playing field, competition is beneficial first and foremost to the consumer, as better choices, services, and lower prices are available. It also helps in many different ways such as in innovation and general efficiency to boost the local economy. Therefore, this article focuses on why competition authorities punish companies who restrict and often form cartels, to restrict competition from entering and operating in specific markets. It will use the price-fixing scandal of 2004 -2006 of the recruitment agencies, who colluded to form a cartel to restrict the entry of an intermediary into the market.
What is The Office of Fair Trading (OFT) and its function?
In The UK, the watchdog which oversees the interests of consumers against unfair consumer practices is called The Office of Fair Trading (OFT) 1Simonetti, R. (2013) ‘Chapter 13 – Perfect competition’, Running the Economy - p.95, (Book 2), Milton Keynes, The Open University. . The Office of Fair Trading essentially regulates the local UK market in all industries, making sure that firms uphold the rules of Perfect Competition.
These principles in markets allow the consumers to experience a wider variety of choices and better prices, as well as allowing new companies to enter markets freely and compete on an equal footing. It is often not the case that the markets and firms operate within these guidelines. This was especially the case in the recruitment industry between 2004 and 2006 when six companies decided to form a Cartel against a new intermediary who wished to enter the market and act between construction firms and recruitment agencies in supplying agency staff. The six recruitment companies formed an alliance to make sure that the new intermediary would not be able to enter the market and gain a share in their profits. Of course, the Office of Fair Trading wishes that all firms operate in a fair and open market, as far as services and product offerings are concerned.
If not every company upholds the same rules in the market, what type of competition exists, and what are the differences between them?
The Office of Fair Trading would most prefer every company consort to the same competition rules as everyone else, as mentioned earlier. Of course, this is not possible as each company has different ambitions and aims. The four main competition systems in operation would be perfect competition, monopoly, monopolistic competition, and oligopoly.
In an ideal world, local markets would like to operate within the framework of perfect competition. Perfect competition can be summed up as the model in which all firms and buyers are small relative to the size of the market. It also has perfect information in terms of price, service, and product description for buyers and sellers, while products are homogenous and there is freedom of entry and exit from the markets2Simonetti, R. (2013) ‘Chapter 13 – Perfect competition’, Running the Economy - p.97, (Book 2), Milton Keynes, The Open University. .
On the other hand, monopoly is the model that many markets and policymakers wish to avoid. There are two types of monopolies such as the natural monopoly (when a single firm can supply the market i.e. BT before privatization) and pure monopoly when a single firm has a sole market share3Stone, M. (2013) ‘Chapter 14 – Industrial structure, competition, and regulation’, Running the Economy, p.140, (Book 2), Milton Keynes, The Open University. . The latter seems to be the model which agencies such as The Office of Fair Trading wish to regulate and control. In this model, one seller has full control of prices and can earn supernormal profits 4Stone, M. (2013) ‘Chapter 14 – Industrial structure, competition, and regulation’, Running the Economy, p.153, (Book 2), Milton Keynes, The Open University. . Regarding monopolistic competition, the market is modeled on having many producers and consumers, and where the business has no real control over the prices in the market 4Stone, M. (2013) ‘Chapter 14 – Industrial structure, competition, and regulation’, Running the Economy, p.153, (Book 2), Milton Keynes, The Open University. . These are the main services and products which perform the same basic function but do differ in product differentiation 4Stone, M. (2013) ‘Chapter 14 – Industrial structure, competition, and regulation’, Running the Economy, p.153, (Book 2), Milton Keynes, The Open University. .
One of the more unusual models is the Oligopoly model. Oligopoly happens when firms in a particular industry form an alliance or partnership, to maintain market share through price, goods, and services through collusion5Stone, M. (2013) ‘Chapter 14 – Industrial structure, competition, and regulation’, Running the Economy, p.163, (Book 2), Milton Keynes, The Open University. . Through formal agreement, colluding is also known as Cartels, which refers to a group of firms that function as a monopolist to maintain total profits for its members5Stone, M. (2013) ‘Chapter 14 – Industrial structure, competition, and regulation’, Running the Economy, p.163, (Book 2), Milton Keynes, The Open University. . This is the stance which the six major recruitment firms adopted, in light of the competition from the intermediary (Parc UK). They collectively colluded in price-fixing, driving up staff costs (supply of workers) no freedom of entry or exit, while distorting the competition in making services not what they appear. By forming this Cartel, they were hoping to protect their market share as a monopolist, in the form of profit maximization and supernormal profits in the long run.
Profit maximization and supernormal profits
The following diagram will illustrate what is meant by profit maximization and super-normal profits in the long run:
FIGURE 1 – Profit maximization and super-normal profits Source: Norbert Lukacsi
Super-normal profits can be maintained in the long run, when businesses adopt the Monopoly form of market competition. In this instance, profits are maximized when MC=MR. The level of profit depends on the degree of competition within the market, which for a monopoly is zero. When profit occurs, maximization is MC=MR, while the output is Q and price P. Supernormal profits are possible (area PABC), as the price (AR) is above ATC at Q.
As there are no close substitutes, as is the case with the Cartels, their monopolist stance on the market is able to derive super-normal profits, area PABC. They would be able to derive the greatest monopoly (market power) if the competition (intermediary) would be totally eliminated as a substitute.
Recruitment firms adopt the Oligopoly market model
As the recruitment firms adopted the Oligopoly market model, they acted essentially as a monopoly5Stone, M. (2013) ‘Chapter 14 – Industrial structure, competition, and regulation’, Running the Economy, p.163, (Book 2), Milton Keynes, The Open University. . This meant that they were able to fix the price of workers being supplied to the construction business in the long run, protecting their profits. As the intermediary would have entered the market more fairly, that would have meant that pressure would have been placed on the profit margins of the various recruitment agencies involved in the Cartel. Obviously, the intermediary would have been taking their own commissions from each referred worker, essentially taking profit margins from agencies.
The intermediary company would have been able to supply from a wider pool of workforce, as it would have been able to dip into the pool of workers from all the recruitment agencies. This would have meant that the intermediary would have saved in input costs such as having to recruit its own workforce. Whereas, a single agency would only be able to offer staff that are only on their books. This would thus potentially make the intermediary company more successful in terms of long term profit maximization, without having to spend revenue on inputs such as recruiting its own supply of workers.
By hindering the intermediary from entering the market, the Cartels of recruitment firms were able to form a price alliance which construction companies would have to accept as there would be no alternative on offer within the market. This would have distorted the competition in the eyes of the consumers, meaning, they would have had a lack of information on what is truly available in terms of the supply of workers. By making further hindrance to entry to the market for the intermediary, the recruitment agencies were able to earn super-normal profits as described earlier.
This can be done by charging higher prices for each supplied worker, while also restricting the number of workers available in terms of numbers in the market. This would make the availability a commodity in the eyes of the market and the construction companies, due to the short supply of workers. Thus, allowing the Cartels to charge higher and set their own prices in the absence of the intermediary or competition in general.
What other ways can barriers beset by Cartels in order to restrict entry
There are also other ways in which barriers can beset by Cartels in order to restrict entry and allowing any new firm to compete freely. As the recruitment agencies restricted access to their pool of workers, the intermediary would have had to make large investments into recruiting its own pool of staff. There would have been a further hindrance in the entry, as also large investment would have to be made on advertising to attract new recruits to join the books of the intermediary since the intermediary would have needed a pool of workers to be able to supply the construction companies.
By boycotting the intermediary, the recruitment Cartel did not only hinder the general consumer (construction firms), but also the whole of the UK construction sector from going forward. This of course would be deemed as anti-competitive behaviour, and against the fair play of perfect competition. This case was of course particularly sensitive, as during and after the downturn in 2008, the construction industry had suffered a great deal. Government agencies such as The Office of Fair Trading were particularly concerned that the Cartel acted against the rules of perfect competition. This is especially so in an industry such as the construction sector, where it is mainly made up of much smaller private and the odd larger firm, who wish to compete on an equal footing when it comes to winning contracts and obtaining a staff.
Of course, it is rarely so that any market operates in a perfect environment. As mentioned earlier, the Cartels chose not to compete with each other on price and supply to create an equal market place (perfect competition), but by rather forming an alliance to hinder competition from entering. This way, they were able to manipulate the price and the industry supply of workers, meaning, their profits were up as the prices charged to supply the workers were greater than their marginal costs.