Kartells and Cartel Theory: Evidence from Early 20th Century German Coal, Iron, and Steel Industries

Janice Rye Kinghorn, Washington University

[PLEASE NOTE THAT FIGURES 1 - 3 ARE NOT INCLUDED IN THIS VERSION OF THE SUMMARY AT THIS TIME--THE CLIOMETRIC SOCIETY]

Abstract

This paper argues that cartels of the type seen in late 19th century Germany may have been an efficient means of industrial organization given the conditions of German markets and the existing institutional environment. Surprisingly, stable cartels in the coal, iron, and steel industries were not associated with monopoly power. Cartelization, rather than having the generally assumed effects of raising price and restricting quantity, actually increased output and lowered price. Further, the cartels stabilized demand faced by the firms within the cartel, allowing them to use more efficient production technologies.

It is well known that during the years 1870-1913 the German economy grew rapidly, surpassing Britain in industrial output, and capturing a large share of the export market. This presents a paradox for neoclassical monopoly and oligopoly theory. Large firms and the vigorous attempt to preclude collusion characterized the U.S. economy, thought to be the model of success. The German economy, however, was dominated by powerful cartels, and can be characterized by relatively small scale production. Existing theory has difficulties explaining how a country with small firms and ubiquitous collusion should have been so successful.

In this paper I compare the implications of standard cartel theory with the effects of cartelization of a group of leading German industries. The facts are inconsistent with standard theory. This suggests that the seeming contradiction of strong economic performance corresponding to ubiquitous interfirm cooperation might be resolved through a broader perspective on the motives and effects of such organizational behavior.

I The German Coal, Iron and Steel Industries

The coal, iron, and steel industries were at the forefront of German industrialization. The products of these industries fueled the production of capital goods, leading observers to regard them as the leading sectors of the economy. The pattern of exports also demonstrates the tremendous growth in these industries. Before 1870 Germany's iron and steel exports were negligible. German exports grew to 1 million tons in the 1880s and 5 million by 1913.

It is widely perceived that the strongest of the German cartels were in the coal, iron and steel industries. The coal syndicate controlled 85% of the output in the Ruhr, and 40% of the total coal output in Germany. The steel cartel controlled 90% of domestic steel production. These cartels most closely match the neoclassical ideal of cartels - collusion among producers of a homogeneous good controlling a large share of output. Thus they are a natural place to examine the effects of cartelization on German industrial performance and the relevance of standard cartel theory to historical examples.

II Neoclassical Oligopoly Theory

The neoclassical association of cartels with monopoly is a recent phenomenon in the history of economic thought. The first German economic work on kartells was written by Fredrich Kleinwachter in 1883. He argued that the kartells were an extension of medieval guilds, and applied the same theory to the kartells as was previously applied to guilds. Other scholars argued kartells evolved from the guild system in response to a growing market, and the associated increase in risk. They suggested that two important functions were served by the guilds, and later by the kartells: the adjustment of supply and demand to stabilize an industry, and the hindrance of monopolistic (single-producer) tendencies. The view that collusion among producers would serve to restrain, rather than promote monopolistic tendencies seems antithetical to the modern reader. The concern in this literature regarding monopoly power was a concern that one large producer would monopolize an industry in a given market, not that horizontal cooperation would foster a monopolistic outcome.

As the German term "kartell" was borrowed by American economists, the idea that there might be benefits associated with cartelization was lost, and cartels were a priori branded monopolistic. The English word cartel seems to have first come into common use by mainstream economists through Alfred Marshall's Principles of Economics. He wrote that "the first step towards this combination (of giant business) was generally an association, or "cartel," to use a German term, of a rather loose kind." The term became increasingly popular with U.S. economists, as evidenced by later work of Marshall. "Monopolistic federations, which are increasingly described by the German name "cartels," have their roots deep in the past, where the spirit of comradeship was often as potent as the desire for the monopolistic regulation of prices." Economists borrowed the German term and ascribed to cartels behavior that was antithetical to efficient competition. By the time Stigler wrote his "A Theory of Oligopoly," cooperation among firms was equated with monopoly power.

Associating cartels with monopoly power is a powerful use of rhetoric by those critical of interfirm cooperation. The strong negative associations of monopoly shift the debate from the relative costs and benefits of alternative contracting arrangements to the identification and elimination of cartels.

Modern neoclassical cartel theory, beginning with Stigler, assumes the sole purpose of cooperation among producers is monopoly profits. Cartel theory has thus concentrated on how changes in industry structure affect the ability of firms to successfully collude to raise price by restricting output. As monitoring and enforcement of the cartel agreement become more costly, the incentive for individual firms to cheat rises. Stigler's theory, and later formalizations explain why, given the assumption firms wish to collude in order to achieve monopoly profits, the facts suggest that in the United States successful collusion has rarely occurred. The explanation is that in general the agreements can not be enforced. The illegality of collusive relationships raises the costs of negotiating and enforcing agreements. Firms will succumb to the incentives to cheat on collusive agreements. Price cuts are assumed to be the device for cheating, and the cheating eventually dissolves the cartel. The focus is thus on the "enforcement" of agreements, which is assumed to basically consist of detecting and punishing violations.

The nature of cartel theory, which was developed chiefly by Americans, stems from two sources: the unique U.S. cartel history, and the basic assumptions of neoclassical economics. Since collusion in the U.S. has been illegal since the Sherman Act, explicit cartel contracts as existed in Germany are not available. Thus prices are often seen as the best, and often only signals for detecting collusion. The dominance of the neoclassical model has also contributed to the evolution of thought. The fundamental assumption of the absence of transaction costs allows no motive for "non-standard" contracting methods except monopoly gains through the restriction of output.

III Evidence

Price

The main implication of standard cartel theory is that price will be raised above the competitive level. Simply contrasting pre and post cartelized prices is inadequate, as it may incorrectly assume "all else is equal". A higher post cartelization price due to rising demand might not be distinguished from successfully monopolizing cartel behavior. To clearly examine the consequences of cartelization on price we need to estimate how price would have behaved absent cartelization.

I use a "predictor" good which was not cartelized to proxy for the cartelized good. This technique has been used in studies by Stigler and Kindahl, and Sproul. A good predictor should have two characteristics. First, it should be closely correlated with what it is predicting prior to cartelization. To assess the closeness of correlation, the price of the predictor is regressed on the price of the variable in question during the pre-cartelized period. The higher the R2, all else equal, the better the predictor. The second characteristic is that the predictor good must not be effected by the German cartelization. This excludes some likely candidates, such as the price of non-cartelized output in Germany, and the price of imported goods in Germany. Based on these criteria, British domestic prices were selected as the predictor for German coal, pig iron, and rail prices.

Once selected, the predictor good was used to estimate a relationship between the price of the predictor and the commodity in question during the pre-cartel period. For example, in the case of coal, the price of German coal was regressed on the British price and time using yearly price observations from 1881 to 1892. The estimates of the parameters along with the British price data post 1892 were then used to generate "predicted" German coal prices. The predicted price is thus an estimate of what the price time series would have been in the absence of cartelization.

The actual and predicted price of German coal is displayed in figure 1. The British domestic price is clearly a good predictor of the German price in the pre-cartelized years (pre-1893). Following cartelization, however, the two series diverge. Beginning with 1896, the actual price is in every year lower than the predicted price, suggesting that the actual price of German coal after cartelization of the industry was lower than what it would have been had the cartel not formed.

Similar results are presented in figures 2 and 3 for pig iron and steel rails. The British domestic price is a good predictor of German pig iron prices before 1904, the first year the cartel existed. After the formation of the cartel, a wide gap develops between the predicted and actual price. This suggests that the price of pig iron in Germany was much lower than it would have been in the absence of the iron and steel cartel. Figure 3 indicates that German steel rail prices follow the same pattern, although less dramatically. A similar result is seen in table 1 which shows a decrease in the real price of merchant bars following cartelization in 1904. Comparable data is not available for other countries, but a fall in the price of merchant bars does seem to be associated with cartelization of the industry.

Output

The paper examines evidence regarding the potential causes of the price behavior reported in the previous section. The evidence strengthens the conclusions drawn above in that the lower cartel prices seem not to have been the result of decreases in German demand. To the extent that the evidence regarding output indicates an increase in demand, the general reduction of prices is even more remarkable.

The paper presents evidence on the average annual output of coal in Germany, France, the U.S., and Britain for a pre-German-cartel period, 1878-1892, and a cartelized period, 1893-1907. Coal output is higher in the cartelized period in all four countries. Importantly, the change in German average output over the two periods is higher in absolute and percentage terms than in France, Britain, and the U.S.. Rather than restricting output the German coal industry under the domination of cartels expanded output at a much higher rate than her rivals. The paper presents evidence that this results is not driven by new entrants, but increased output of cartel members.

The implications of the monopoly based theory regarding the quantity of output is also examined using pig iron production data. Pig iron production is higher in all four countries in the period of German cartelization. It increases by 69% in Germany, which is a much greater percentage change than in Britain, and slightly greater than in France. Under the domination of the steel cartel, Germany overtakes Britain, producing almost 20% more pig iron. Only the U.S. has a higher percentage change in production in this period. As with coal, the output is shown to be driven by increases in output by the cartel members.

In all four countries the output of steel is larger in the cartelized years than in the period before cartelization. In absolute terms the German output increase was greater than the increase in France and Britain. German industry went from producing 50% less steel than Britain, to 100% more annually. The percentage change in output is greater in Germany than in Britain, similar to France, but below the U.S. Although the German steel industry was not as spectacular as the U.S., it clearly led its European rivals.

IV DEMAND STABILIZATION

Toward an Efficiency Rational for Cartel Organization

Coase observed that "if an economist finds something--a business practice of one sort or another--that he does not understand, he looks for a monopoly explanation." Williamson wrote that "many other issues which at the outset appear to lack a contracting aspect turn out, upon scrutiny, to have an implicit contracting quality (the cartel problem is an example)." The results shown in Section III and in other recent work suggest the need to broaden the standard theory of oligopoly to include stable cartels absent monopoly pricing.

In the tradition of Kartell theory, what follows is an explanation for the existence and persistence of cartels in the German coal, iron, and steel industries that does not rely on monopoly motives, but instead posits an efficiency gain from cartelization. Specifically, the cartels in these industries stabilized demand, allowing increased production efficiencies.

Theory

Neoclassical industrial organization models generally assume that identical firms face stationary demand. Demand, however, is rarely stationary. Stigler was one of the first to note that a firm's choice of cost structures depends on anticipated demand fluctuations over the time period the firm is bound by that choice. That is, flexibility is an element of a firm's choice set. He describes flexibility as an attribute of production technology that accommodates output fluctuations. Hart echoes Stigler's view, and argues that flexibility is a firm's response to uncertainty both from demand fluctuations and market imperfections. Marxchak and Nelson suggest that Stigler's flexibility can be represented by the inverse of the slope of the marginal cost curve of a quadratic cost function. Put simply, more flexible firms have flatter average cost functions. There is a trade-off, however, between static efficiency and dynamic efficiency. As Stigler argues, "flexibility will not be a 'free good': a plant certain to operate x units of output per week will surely have lower costs at that output than will a plant designed to be passably efficient from x/2 to 2x units per week." More recent extensions of this theory and a formal model are presented in the paper.

The potential efficiency gains to cartelization are clear. If a cartel stabilizes demand, member firms will move to a lower average total cost curve, and produce at a higher output at a lower unit cost. Several testable implications distinguish this from monopoly based cartel theory. They regard industry output, output per firm, and price. If the demand stabilization theory is correct, we should observe industry output growing with cartelization, contrary to the predictions of monopoly-based theory. This increase should come through increased output per firm, not the entry of new, small firms practicing hit-and-run entry. The evidence in Section III indicates that this was the case in Germany. Industry output rose as output per firm in the coal and steel industries rose. Finally, the price should not rise, as it would if the cartel was behaving monopolistically. The behavior of price is also important in establishing if any increased output is coming from increased demand. If so, we should observe a higher price. If, however, the increased output is driven by a supply shift only, we should observe a lower price.

Evidence of Stability

Many scholars have remarked on the unusual stability in the early 20th century German economy particularly in the coal, iron and steel industries.

The paper compares average absolute errors calculated from a regression of time and time squared on the log of output using yearly data. The results indicate that stability in the German coal industry was increased during the cartelized period. That the increased stability resulted from cartelization is suggested by data on the stability of growth of production of coal in syndicated compared to non-syndicated mines in the Ruhr from 1903-1914. Syndicated production was much less volatile, having a standard deviation of 9.3 compared to 12.1 for non-syndicated mines. Similar results are demonstrated for pig iron, crude steel, half-rolled steel, rolled wire, bars and beams, and sheet.

The standard deviations of yearly coal prices may be compared, since the strong positive trend which is observed in the output data is absent from the price data. The standard deviation of yearly German coal prices in the pre-cartelized period is 2.44, compared to 1.01 during the cartelized years. There is not a similar rise in the stability of British imported, British domestic, or U.S. coal prices, in fact both British domestic and U.S. price fluctuations rise.

The paper continues by detailing the mechanisms the cartels used to stabilize demand.

V Conclusion

This paper contrasts implications of neoclassical cartel theory with an efficiency explanation for cartels using data from turn of the century Germany. The evidence suggests that stable cartels in the coal, iron, and steel industries did not result in monopoly power. Cartelization, rather than having the generally assumed effects of raising price and restricting quantity, actually increased output and lowered price - behavior consistent with demand-stabilizing cartels.

It should be noted that the monopoly and efficiency theories are not mutually exclusive. It is possible that a cartel that is organized with monopoly motives could be associated with efficiency gains. Evidence supporting an efficiency theory does not imply the complete lack of monopoly power or monopoly rents, only that the efficiency effects dominate the monopoly effects, and thus perhaps understate the true efficiency gains. Daemes wrote that ". . if hierarchical integration is necessary for production economies and for the stabilization of capacity utilization, it may well be that the resulting lower unit costs improve allocative efficiency. If product differentiation and hierarchical integration lead to market power, as is commonly assumed, it may well be the other way around." Daemes was writing about the choice between market and firm organization, but the same analysis can be applied to the choice between market and cartel organization. The point is that it is an empirical issue, not one that can be addressed with ever more complex game theoretical formulations.

More detailed investigation is needed in order to more exactly determine productivity differences and the extent to which cartelization of German industry was the causal factor in German productivity gains. However, the initial results presented in this paper strongly suggest that received cartel theory has been constrained to the point of irrelevance by its singular focus on monopoly motives and the implicit assumption of the U.S. institutional environment. Horizontal cooperation may have been a cost reducing means of industrial organization given the conditions of German markets and the existing institutional environment.

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