Collusive Behaviour in the Ohio School Market

1. Introduction

In the U.S. state of Ohio, the contracts for supplying schools with milk are auctioned to the supplier with the lowest bid. This firm can supply the school with milk for one year. In a competitive market, auctioning would lead to firms submitting their lowest possible price from which the school can choose. However, if the firms are able to collude with each other, they can fix prices above the normal price of a competitive market. In Ohio, "thirteen dairies were charged with collusion in school milk auctions for the years 1980 through 1990 inclusive" (Porter & Zona, 1999, p.263). Collusion between firms is difficult to prove because there are ways to hide the characteristics and make it look like a competitive market. Nevertheless, in Ohio there is sufficient proof to support the charges for collusion. This paper will analyze the economic principles for the Ohio milk case and prove that the charges against the supplying firms were backed by sufficient evidence.

First, the market structure of Ohio school milk will be described, focusing on the auction system and the demanders and suppliers. Second, the theory behind collusion of cartels will be discussed. Finally, the collusion within the Ohio school milk market will be analyzed and the evidence will be evaluated, resulting in the conclusion that collusion did occur and why the firms were able to collude.

2. The Market

In Ohio there were approximately 600 school districts around at the time of the charges against milk suppliers were brought. The school districts demand a certain amount of milk for the following year. The demand for school milk was relatively inelastic because it was heavily subsidized (Porter & Zona, 1999). When the demand curve is inelastic the demand for the good is not affected by price change (Perloff, 2009). The reason for the inelastic demand in this market was because of a subsidy given to the schools, by the government. A subsidy is a financial aid given by the government to consumers who are active in a desirable activity (McDowell, Thom, Frank & Bernanke, 2006). Here, consumption of school milk was seen as a desirable activity since it was healthy for the students. Therefore, the consumer did not lower its consumption if the suppliers changed their prices. For the suppliers the subsidy was also profitable because they were able to demand higher prices without losing consumers (Porter & Zona, 1999).

The number of suppliers in the district was fixed in the short run because of the costs to supply the school districts. There were two types of suppliers: processors, they processed and packaged the milk themselves; and distributors, who purchased the milk ready for distribution from the processors and would resell it to the school districts (Porter and Zona, 1999). The costs of production would be similar for all suppliers, the difference was found in distribution and extra equipment. The processing plants had to be close to the school districts to minimize distribution costs. Close proximity to a school district thus resulted in the ability to submit a low bid. The school milk market made up less than ten percent of the revenue for the suppliers. This meant it was not worthwhile for the firms to build a new processing plant close to a school district in order to obtain new school milk contracts. Therefore the entry barrier into the market was high and thus the amount of suppliers fixed (Porter & Zona, 1999).

Most of the school districts auctioned their contracts for school milk. The type of auction used in this market was a procurement auction (Porter & Zona, 1999). A procurement auction is the reverse of a normal auction. Instead of the consumer bidding for a good or service, the suppliers need to submit bids on contracts that are posted by the consumers. All the bids are opened at a specific time and the best bid is chosen to supply the good or service. In the school milk case the bids are read at the school board meeting and "the contract is normally awarded to the dairy with the lowest bid" (Scott, 2000, p.327). However, because the demand was inelastic, suppliers incentive to collude was higher because they were able to keep the 'lowest bid' higher then it would be if the market was perfectly competitive.

3. Cartels

"A group of firms that explicitly agree (collude) to coordinate their activities is called a cartel" (Perloff, 2009, p.430). Cartels are illegal because they disrupt the natural competition, which results in welfare loss. As a result of firms coordinating their activities they function as monopolists. Consequently, all firms in the cartel will maximize their profit, as would happen in a situation where a monopoly existed. When a competitive market becomes a monopoly, welfare is lost due to a lower consumer surplus, while the cartel profits (Perloff, 2009).

A cartel only works if all firms do not defiate from the agreements to lower output and agree on the price demanded. In order for a cartel to work, all firms within the cartel need to lower their output to an agreed upon quantity, the same must be done for the price.

As a result the total output in the market decreases (Perloff, 2009). The price will change due to the decreased output as shown in the graph.

Fig. 1.: competition vs cartel (Perloff, 2009)

In a competitive market the output for each firm would be at qc. When the firms form a cartel the quantity produced is reduced to qm. This results in marginal revenue becoming equal to marginal cost for all firms involved. Therefore, achieving the same profit as in a monopoly. The firms need to stick to the new output even though if they alone would raise production to q* it would become the only supplier. This makes it important for the firms to trust each other on keeping production at qm. An important characteristic for cartels to work is that the market is an oligopoly. An oligopoly is a market with a small group of firms and a high barrier to entry, these conditions fit the Ohio milk case perfectly (Perloff, 2009).