Collusion in the Developing World

Trade and social change

Why is food so expensive in Kenya, if the price received by the farmers is so low? It’s collusion. The intermediaries, the traders who bring corn from farmers to market, are charging prices well above what earnest competition would imply. This is not the only place where market power, sustained by collusion, is important in the developing world. It indicates an important role for trade and infrastructure improvements, above and beyond what simplified models of trade would indicate.

I should substantiate the claims about traders in Kenya, lest I be accused of libel. In Kenya, as with much of East Africa, corn is a staple crop. It is sold to the consumer in bulk with the kernels removed from the cob and dried, to be ground into flour when needed (flour does not keep as long as the kernels do), or simply boiled and served in another dish. Farmers do not sell directly to the consumer, but to intermediaries, who then bring the corn to market. Entry is constrained by the high cost of trucks – buying one takes 21 times annual per capita GDP, and simply renting one for a day would set you back $250, or 18% of annual income. Everybody knows everyone else, even when they might visit multiple markets.

The conditions are certainly ripe for collusion. There are no publicly posted prices, and everything is done via negotiation. Nevertheless, these negotiations are public, and everyone can hear what the prices you offer are. The ability to secretly deviate and undercut your rivals is anathema to collusive cartels. They would prefer everything out in the open. Read Genesove and Mullin (2001) on the sugar cartel – what held it together was not explicit collusion on prices and quantities, but obsessive rules on standardizing the product and making it impossible to give secret discounts.

We face a difficulty, however: estimating “conduct” is normally very difficult with observational data. Most studies in industrial organization do not attempt it. Suppose that you have estimated the demand curve, at considerable effort. In order to recover the degree of market power which firms have, one needs the marginal cost of producing an additional unit. The marginal cost and the mode of conduct are not separately identified – for every mode of conduct, I can give you a marginal cost which justifies it. The normal method, then, is to assume the mode of conduct, and spit out the marginal costs and markups that way.

In principle, however, the form of conduct can be identified with an additional exogenous variable. You have one exogenous variable shift the supply curve along the demand curve, which traces out its shape; and the other exogenous variable rotates the demand curve. You might get this from something like the entry of an alternative good which makes demand more elastic now that there is a close substitute available. With the demand curve rotating, firms which are colluding or otherwise charging a markup will increase the amount they supply, while firms charging at marginal cost will see no change in output.

The original implementation, due to Timothy Bresnahan, doesn’t quite work if firms are colluding on a price which is not the joint profit maximizing price. This can be reached quite easily, if the firms are colluding through a Green and Porter (1984) style strategy where they revert back to competition whenever they detect a decrease in their demand. This muddles matters, and biases the conduct parameter to perfect competition.

The modern method is due to Berry and Haile (2014). Rather than estimate a single conduct parameter, you can test particular models of conduct, and see if they deliver the behavior necessary for them to be correct. If your model of conduct is correct, then after subtracting out markups, the marginal costs must be uncorrelated with another set of instrumental variables which you did not use in estimating demand, like demographics. To see it put in action, read Backus, Conlon, and Sinkinson (2021).

Lauren Falcao Bergquist and Michael Dinerstein (2020) run a beautiful series of experiments to systematically pin down everything you would need to know about the markets. First, we are going to estimate passthrough by giving traders a per unit subsidy. There are three groups, corresponding to no subsidy, a low subsidy, and a high subsidy. Only around 20% of the subsidy is passed on to the consumer, and perhaps remarkably, this holds no matter the size of the subsidy, the number of traders in the market, or the degree of market access (proxied for by things like whether the roads are paved).

We can rule out pure price competition (Bertrand competition), which would imply 100% passthrough of the subsidy. We can’t separate out the type of imperfect competition without knowing the demand curve, though. For any given passthrough under a monopoly, increasing the curvature of the demand curve to make it more concave could replicate it under partial competition.

So Bergquist and Dinerstein have a second experiment, where they manipulate the price that consumers face directly. Consumers negotiate a quantity at a given price, then the enumerators of the experiment come along and draw a random subsidy. The consumer is then free to choose a new quantity at the new price (with the seller having agreed in advance to not revoke the agreement and try to renegotiate). Tracing out the demand curve, competition where traders choose the quantities they will bring to market, and then choose price (Cournot competition) would imply a pass through of 46%, comfortably outside the 95% confidence intervals. Instead, the pricing behavior is essentially indistinguishable from a perfect monopoly.

So what can we do about it? The obvious thing would be to encourage entry. Perhaps someone who is not privy to the collusive arrangement would cause the whole thing to break down. We are also uncertain whether the markups represent something necessary to make back the genuinely high fixed costs, or whether they represent excess profits extracted from the consumer.

So Bergquist and Dinerstein test this. They offer traders money to go to new markets. The take up rate – which is altogether low – allows us to infer the fixed cost to entering a new market. Then, we can look at how prices change. Strikingly, if the traders were already familiar with the new entrant, there is no change in prices. It is only when the traders were unfamiliar to the existing traders that prices are impacted.

We know that intermediaries possess considerable market power in Africa. Atkin and Donaldson (2015), in an extraordinary feat of data collection, collect detailed prices on homogenous branded goods as one gets further away from distribution hubs. When prices fall at the port, that doesn’t mean people inland see the gains. It’s getting absorbed by the intermediaries. What Bergquist and Dinerstein are able to do is finally understand why.

We sadly lack a lot of evidence on collusion, as opposed to more generic sources of market power. I know of only one other study credibly measuring conduct – Garima Sharma’s working paper on Indian textile mills, who proposes some heuristic methods of determining collusion along the lines of Bresnahan, and then validates it with the “full-IO” approach.

She is working with data from Indian textile mills, where she has uncovered a startling regularity. Members of the Tirupur Exporters’ Association pay their workers exactly the minimum wage. Not around the minimum wage – because deviations below what is legal are ubiquitous, this is possible – exactly the minimum wage. She argues that this is due to the members of the association exerting pressure on each other to hold the line on the wages. Like with intermediaries in Africa, this is a place where entry is constrained. It is notoriously difficult to hire and fire workers in India – for example, if you have more than 100 employees, you need to get government permission to change hours, wages, or employment status. It is difficult, then, to profitably defect from existing arrangements.

Sharma has a simple test. Under any form of earnest competition, a shock to the demand for a competitor’s products will increase their demand for labor, reducing the number of people that you are able to hire and forcing you to increase wages. If you were previously in a collusive agreement, however, wages rise, but so too does employment. Because these textile plants are generally producing for one single major firm, like Nike or Zara, a change in the demand for those particular brands creates a demand shock that is genuinely idiosyncratic.

Naturally, the firms are colluding with each other. Positive demand shocks increase employment and wages, before the wages eventually settle back down around the minimum wage as the collusive agreement is re-established.

I suspect that this sort of collusion is common. Humans are social creatures, who are capable of sustaining cooperative agreements within their community. Many contracts are not enforced through law, but through social pressure and norms. What breaks it down is “capitalism” – trade, globalization, market access, anonymous profit-seeking by alienated individuals. All this is good.

It leads one to believe that the gains from trade are understated. The normal way to quickly estimate the gains from trade can be borrowed from Arkolakis, Costinot, and Rodriguez-Clare (2012) – all of the standard models, whether Eaton-Kortum (gains from comparative advantage) or Melitz (gains from reallocating to more efficient firms) can be summarized by the share of domestic expenditures, raised to the elasticity of trade with respect to costs. The key to their equivalence is that markups are a constant proportion of marginal costs. Having trade make collusive agreements unsustainable breaks the ACR equivalence. The gains from trade can be much larger than they would appear, because they are really the gains from modernity.