We haven’t talked a lot about corporate manipulations these last few blog entries. Let’s fix that, shall we?

If you’re a corporation in the US, or Europe, or even China these days, you’re operating in a capitalistic, market-driven economy. The goal is to innovate, outmaneuver, and generally outwit your competition, and earn the commensurate rewards. For the winners, high stock prices and share options. For the losers, bankruptcy and failure. It’s, in many ways, a reality show on steroids.

But with slightly more dignity. Slightly.

If you’re a corporation, though, all that competing and outmaneuvering sounds hard. Especially since everyone else is trying to do it at the same time. Wouldn’t it be easier if everyone could just get along?

That is, in fact, the definition of a cartel. Under a cartel, a number of corporations get together and basically agree not to compete with each other. As a result, it becomes a lot easier to raise prices, lower service levels, or both. The fun part of being in a cartel is that you can make major profits without all that competing activity. The downside is that, under most jurisdictions, forming a cartel is illegal. But with all that sweet, sweet upside, many corporations decide to risk annoying regulators and form cartels with their one-time competitors.

Cartels have a long and storied history. Back in 1929, for example, the hot commodity that everyone wanted was… light bulbs.

America and the world in general was being electrified, literally, and everyone wanted light bulbs. GE , Philips, and many others started to compete to offer light bulbs, slowly driving down prices and making light bulbs last longer. Osram was a Swiss manufacturer of bulbs, too, and decided that the industry needed less competition, not more, if it was going to yield significant profits for the manufacturers. So Osram created a Swiss company, “Phoebus S.A. Compagnie Industrielle pour le Développement de l’Éclairage”. Each large manufacturer took shares in Phoebus proportional to their sales, and Phoebus became the de facto institution to regulate competition amongst the manufacturers. Those participating in the group, from GE and Philips to the smaller players, became known as the Phoebus Cartel.

The Phoebus cartel had a good thing going. It decided to split the world up, and to give each manufacturer his home territory (so, for example, Philips would face very little competition in its home country and surrounding areas). The rest of the world it divided into zones, and each manufacturer was allocated a certain number of zones. Since there was no more effective competition, manufacturers could and did raise prices, and also lower their costs, since they could now push suppliers hard on costs (where else would they go?). This is one reason that all light bulbs became standardized, especially the base below the bulb, since that meant that manufacturers could order them in bulk and save some money. The Phoebus cartel is why you can buy a bulb by any manufacturer and plug into a socket by any other manufacturer!

The cartel also realized that the manufacturers had been competing on life expectancy. Light bulbs were fickle back then, and manufacturers knew that consumers wanted long-lasting bulbs, and so one of the key ways in which they competed was the innovation of longer-lasting light bulbs. This was expensive, and so the cartel decided to ‘cap’ light bulbs at 1,000 hours. Any manufacturer that made light bulbs that lasted more than 1,000 hours was fined by the cartel, which meant that manufacturers no longer needed to compete or innovate on that dimension.

The cartel meant that manufacturers could now enjoy increased profits, lower costs, and a fairly ‘safe’ environment without too much disruptive innovation. But all cartels eventually must come to an end, and the Pheobus cartel met its match in a few years later, when some smaller manufacturers who had been excluded from the cartel created their own mini-cartel, and began selling bulbs a lot cheaper than the Phoebus cartel’s. The cartel fought back, with intimidation and threats, and might have been able to eventually cow the upstarts into submission, had World War II not intervened. In the chaos of the war, the cartel disbanded, and the members went back to slowly competing with each other. And we got light bulbs that could exceed 1,000 hours.

The Phoebus cartel was a great manipulation of the market, and other corporations learned quite a bit from it. Many more cartels were formed, some of which became known (and broken) over time, and some that did not. Some were quite successful. For example, have you ever bought some vitamins?

Sweet, sweet vitamins...

If so, you probably paid about 30% more than you needed to. It turns out that most of the manufacturers of bulk vitamins learned the lessons of Phoebus, and decided in 1990 to band together and control the price of vitamins. For 8 years, the manufacturers in the  Vitamin Cartel managed to control the price of vitamins (except the price of vitamin C, which was produced by Chinese manufacturers who had been excluded from the cartel). This is the reason that most vitamins cost significantly more than vitamin C, by the way.

In 1998, various regulatory agencies in the US and Europe started to get suspicious, and one of the French members of the cartel decided to live up to stereotype and surrender, in exchange for amnesty. During the subsequent investigation, fines of more than $1.5B were levied against the manufacturers (which was still quite a bit less than the profit made from nearly a decade of price fixing).

Again, companies saw this, and learned from it. The problem with a formal cartel is that there are meetings, agendas, and the like. A formal structure can be exposed, and that creates problem. What if you collaborate, but in stealth mode?

In 1995, the FCC decided to auction off one of the last piece of spectrum in the US. It was a major transaction, with different parts of the spectrum, in different geographies, being bid on by most of the large telecom companies.

The FCC was determined to get as much revenue for the government as it could, and thus created a system which was like Ebay on steroids. Each geography had its own auction, and companies could bid on any geography. The bids were made public, but not the bidders. Every few days, the FCC would declare a new round of bidding, and the auction ended when no new high bid was entered. The FCC spent months crafting this process to make sure that companies could not collude to create a cartel (since no one knew who was bidding on what, and all bids were transparent).

It's a foolproof plan!

Bids started to come in, and the FCC was happy. At first. They were puzzled, however, because the bids just were not as high as they expected. The bids would come in, many at first, and then… just stop. Auctions were going for a lot less than the FCC expected.

The other odd thing about the bids is that they were oddly… specific. Companies were bidding $3,483,013 for a specific area, for example. Why bother with such an exotic number? Why not just $3,500,000?

Well, it turns out that the bids themselves were encoding a lot of information. Since the bids were public, companies knew that the other bidders would see their bids. Since each company had some territories that they wanted more than others, they decided to encode that information within the bid. The bid above, for example, was for Lubbock, Texas, and it was really for $3M. The 483 part, though, was code for GTE, one of the bidders, since typing 483 on a telephone keypad creates GTE. The last digits were the most important ones: they encoded the cartel information. For example, by ending the bid by 013, the code for Amarillo, Texas, the bidder was basically telling the other bidder that if they continued to bid on Lubbock, then they would be punished by a reciprocal bid on Amarillo.

What??

Okay, let’s make it clearer. This is roughly how things worked:

A few bidders would bid on Lubbock. The bids would be made public, and then each company would decide on whether or not they wanted to bid higher on it. If the region was of real interest to someone, over the course of the next few rounds, the companies would start to tag their bids. Eventually, a couple of bidders would emerge, and GTE would then decide that it really, really wanted Lubbock. So it encoded its bid with a warning to the other bidder: “continue bidding on Lubbock, and I’ll start to bid on Amarillo, on which you are currently the high bidder. Let Lubbock go, and I won’t screw up your little gig in Amarillo.” If the other bidder pulled out, GTE would go on to win. If not, GTE would bid on Amarillo, with a special number to make sure that the bid was understood to be retaliation for Lubbock.

And the system worked. Bids came in, companies staked out their territories, and the cartel divided the nation, using nothing more than numbered bids. It was a complex manipulation, made all the more impressive by the fact that the system was not discussed before the auction – it emerged as the companies learned of the rules of the FCC and figured out, mostly on their own, how to manipulate them.

The cartels mentioned above were discovered, and eventually fined (although with fairly limited fines, in context). There are many more that yet elude broad discovery, especially in the health care industry. For example, all of the companies in one section of the pharmaceutical industry use one particular consultant for all their pricing / market studies. Is the consultant that good? Well, maybe, but more importantly, the consultant is very consistent: the consulting firm uses a proprietary methodology to recommend prices for drugs for their clients, and the formula takes into account previous recommendations to try to maximize the market for everyone, not just the firm’s current client. If a pharmaceutical company used another consultant, he could recommend a price that could be great for the client, but bad for the industry as a whole (a low price, for example, that could trigger a price war). But, as long as everyone in the industry uses the same consultant, the results are optimal for the whole industry – everyone prices according to the formula, and as a result prices stay high. It is a cartel without any communication whatsoever between the participants, pretty close to an ideal cartel – the stealth cartel, with all of the advantages of a cartel and none of the exposure.

Like this, but for cartels.

Cartels are one of the most profitable business manipulations. Even beyond these manipulations, though, are a few companies that have gone beyond even cartels, and have achieved the next step in manipulation: the creation of legal, long-lasting, stable monopolies. These companies – Monsanto, De Beers, and others – deserve their own entry, and we will get to them eventually…