How can cartels lead to market failure?

Cartels can lead to market failure by reducing competition, leading to higher prices and lower output.

Cartels are agreements between firms in the same industry to limit competition and increase profits. They can take various forms, such as price fixing, market sharing, and bid rigging. By colluding, firms can effectively act as a monopoly, setting prices and output levels that maximise their joint profits. However, this can lead to market failure, as it results in a misallocation of resources and a reduction in consumer welfare.

Firstly, cartels can lead to higher prices. In a competitive market, firms compete on price, which benefits consumers as it drives prices down to the level of costs. However, when firms collude, they can set prices above the competitive level. This results in consumers paying more for goods and services than they would in a competitive market, reducing consumer surplus and leading to a loss of welfare.

Secondly, cartels can lead to lower output. In a competitive market, firms produce where marginal cost equals marginal revenue, which is the socially optimal level of output. However, in a cartel, firms restrict output in order to raise prices and increase profits. This results in a lower quantity of goods and services being produced and consumed, leading to a deadweight loss of welfare.

Thirdly, cartels can lead to a reduction in product quality. In a competitive market, firms not only compete on price, but also on quality. However, when firms collude, they have less incentive to improve the quality of their products, as they face less competition. This can result in consumers receiving lower quality goods and services, further reducing consumer welfare.

Finally, cartels can lead to a lack of innovation. In a competitive market, firms have a strong incentive to innovate in order to gain a competitive advantage. However, when firms collude, they have less incentive to innovate, as they can maintain high profits without needing to improve their products or processes. This can result in a slower pace of technological progress, reducing long-term economic growth.

In conclusion, cartels can lead to market failure by reducing competition, leading to higher prices, lower output, reduced product quality, and a lack of innovation. This results in a misallocation of resources and a reduction in consumer welfare, which are key indicators of market failure. Therefore, competition authorities play a crucial role in detecting and preventing cartels in order to ensure the efficient functioning of markets.