ISET

ISET Economist Blog

A blog about economics in the South Caucasus.

Fine and Punishment

Imagine arriving at a provincial airport in an unnamed Central Asian country. You leave the terminal and go straight to row of waiting taxis. In your Lonely Planet you read that you should pay about $10 for what is a short taxi ride to the city center. You ask the first taxi driver and are quoted a fantasy price of $50. You try to bargain, to no avail. You go to the next taxi, and once again you are quoted $50. You finally go to the third taxi, and lo and behold, it’s the same price, $50. And you don’t even try to bargain anymore…

Now, imagine this to play out over and over again. When you want to buy gasoline. When you want to buy groceries. When you want to buy medication. Frustrating, wouldn’t it be? Or, to quote Brian Shepard, one of the FBI agents that helped break up the Lysine cartel in the United States in the 1990s: “Everyone in this country is a victim of corporate crime by the time they finish breakfast.” So how would you go about breaking up cartels? How does Georgia go about breaking up cartels?

A few days ago the Georgian parliament adopted the draft law “on the Amendments to the Law of Georgia on Free Trade and Competition”. As has been pointed out by Transparency Georgia, this new law introduces several novelties, and has the potential to finally have an impact and to result in the break-up of cartels.

So is all now well and good with this new law? Will cartels be broken up and involved firms be fined and punished? Will Georgian consumer enjoy lower prices for gasoline, pharmaceuticals, and food? On paper, the new law should give reason for optimism. The new law establishes an independent competition agency, it defines what is and what is not unfair competition, and it stipulates fines for anti-competitive practices. Importantly, these fines are defined as percentage of annual revenue and are supposed to be proportional to the damage, the duration, and the scope of the anti-competitive practice. The law is thus very much in line with EU competition law. Which is not surprising given that competition was and is a key point in the negotiations on the Deep and Comprehensive Free Trade Agreement between Georgia and the European Union.

In theory fines of up to five percent (up to ten percent for repeat offenders) of annual revenue provide a strong deterrent against anti-competitive behavior. But as usual the devil is in the details. Here are a few reasons why:

  1. Imagine two firms fixing prices in the retail gasoline market. One firm is well-diversified, not just selling gasoline but also providing other services – from fast food over grocery retail to car repair. The other firm is highly specialized, selling gasoline, and only gasoline. With fines being proportional to annual retail deterrence is strong for the former, but weaker for the latter. This is a problem as it distorts the decisions of firms to diversify or specialize.
  2. Imagine a pharmacy chain selling pharmaceuticals, and a pharmaceutical firm manufacturing said pharmaceuticals. Likely the profit/revenue ratio will be lower for the former, the downstream firm, and higher for the latter, the upstream firm. This also poses a problem for the competition agency as fines have to take into account market and firm characteristics, in order for the fine to be appropriate.
  3. Cartels increase their member’s profits by increasing prices and reducing market sales (or in other words, revenue). With fines being proportional to annual revenue competition policy gives an additional incentive for firms to increase prices and reduce market sales even further, thus increasing the damage to consumers.

In principle all these could be resolved by fine-tuning fines, not only taking into account the damage, the duration, and the scope of the anti-competitive practice, but also the characteristics of involved firms and markets. This certainly is a tall order. And requires experience and expertise from the new competition agency. Even worse, there is the following:

  1. Consider an extreme example – a cartel in the banking sector. Impose large fine and financial stability will be gone. Under these circumstances, can fines be a credible deterrent?
  2. Consider a less extreme example –a cartel in the grocery retail sector. Impose large fines, and not only the cartel, but also some retailers will go. Can we be sure that the market will be more competitive, not less?
  3. Fines imposed on cartels will be paid by consumers or shareholders, and not by those who are the real culprits: The managers who decided that it is ok to cheat consumers, and to reduce or eliminate competition with illegal practices.

What could be done instead? The competition agency could punish individuals and not firms, making anti-competitive practices a criminal offence. While certainly not without its own problems, criminal sanctions would provide a strong deterrent and would go a long way to alleviate distortions brought about by pecuniary fines.

There is of course a reason why criminal sanctions are not part of the new competition law. While criminal sanctions are common in the US, they are not in the European Union (except for some limited use in a few individual EU member countries). Quite simply, given the need and the intention to emulate EU competition law in Georgia they are not the best starting point for Georgia.

This leaves but one strategy to deal with the unintended consequences of fines: Invest not only into the legal but also the economic expertise of the new competition agency. For several reasons. One, trivially, to understand the anti-competitive practices employed by firms, and the damage caused. Second, to ensure that the economic consequences of fines, both ex-ante and ex-post, are properly understood. Third, to provide for transparent and predictable sanctions by developing guidelines and procedures for the determination of fines, to allow firms to anticipate the consequences of anti-competitive practices.


 

Recommended for further reading are Vasiliki Bageri, Yannis Katsoulacos and Giancarlo Spagnolo, “The Distortive Effects of Antitrust Fines Based on Revenue”, and the Fall 2010 issue of the Competition Policy International Journal with the colloquium “Who Should Be the Target of Cartel Sanctions?

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Guest - NP on Monday, 14 April 2014 16:09

Very interesting!

Very interesting!
Guest - Hans Gutbrod on Tuesday, 15 April 2014 01:48

agree, this is a very interesting post. Beyond the economics, I also wonder about the politics. Have you looked more into how the burden of proof works? If applied badly, this could become a mechanism for extracting revenue from profitable businesses ("hey, there is a profit, they must have cornered the market!"). Even just a shadow of fear on this issue would deter investors, especially for long-term ventures, who need to certain that there profits will not be raided.

agree, this is a very interesting post. Beyond the economics, I also wonder about the politics. Have you looked more into how the burden of proof works? If applied badly, this could become a mechanism for extracting revenue from profitable businesses ("hey, there is a profit, they must have cornered the market!"). Even just a shadow of fear on this issue would deter investors, especially for long-term ventures, who need to certain that there profits will not be raided.
Guest - MF on Tuesday, 15 April 2014 02:38

There is nothing really in the law about the burden of proof, it's something that will become evident only once we see how cases are handled by the competition agency. I would hope that they will rely on criminal evidence (whistleblowers, wiretaps etc.) only, and not succumb to the temptation of using economic analysis or statistical markers. Even if well-done (as for example the evidence against the Brazilian cement cartel) this kind of evidence is just too ambigious to rely on. On the other side, economic analysis and statistical markers should play a role in investigations. Investigations that combined with the leniency program will then hopefully convince some to come forward as whistleblowers. Of course criminal evidence might be problematic, too, given Georgia's track record....

There is nothing really in the law about the burden of proof, it's something that will become evident only once we see how cases are handled by the competition agency. I would hope that they will rely on criminal evidence (whistleblowers, wiretaps etc.) only, and not succumb to the temptation of using economic analysis or statistical markers. Even if well-done (as for example the evidence against the Brazilian cement cartel) this kind of evidence is just too ambigious to rely on. On the other side, economic analysis and statistical markers should play a role in investigations. Investigations that combined with the leniency program will then hopefully convince some to come forward as whistleblowers. Of course criminal evidence might be problematic, too, given Georgia's track record....
Guest - Hans Gutbrod on Tuesday, 15 April 2014 03:33

thanks for adding that detail. It's at least an opportunity to go in the right direction. In principle I like the libertarian argument on cartels, but my understanding was that the empirical case did not really bear out the result. I'd be curious, at some point, for more ISET analysis on cost-benefit.

thanks for adding that detail. It's at least an opportunity to go in the right direction. In principle I like the libertarian argument on cartels, but my understanding was that the empirical case did not really bear out the result. I'd be curious, at some point, for more ISET analysis on cost-benefit.
Guest - Rati Gabrichidze on Tuesday, 15 April 2014 07:46

I think that this low is very artificial. When we speak about this kind of issues, the political will is of the most importance. (For example, we had fantastic rating of doing business during Saakashvili's governance, but everyone knew that there was no political will to have competition and transparency in some industries and this problem could not have been solved with any amount of public servants in competition agency in case of it's existence...).
On the other hand, the cost of this law may be very high, it may become a weapon of the government... it will rise the government spending for sure (and broadly speaking, I think this government has a high risk of dramatically increasing administrative costs).
Besides, as it was already mentioned in this post, it will distort stimuli.
From my point of view, the maximum intervention that could be acceptable is to have small effective analytical group, that calculates simple and objective indices and indicators and using these tools determines the lack of competition on a particular market (which on the other hand may create good investing potential for the new entrant) and then presents it to potential investors... this action has double positive effect (capital attraction and increasing competition on the local market).
Other clearly manipulative actions of the firms may be subject of punishment, but criteria of manipulative action assessment should be quite simple. (Some may even argue that this kind of punishment measures is unnecessary and in true competitive environment there is no need of intervention at all).
Broadly speaking every new law and barrier creates new adverse effects and possibilities - peltzman effect (By the way, following link may appear interesting if someone is interested what this effect stands for: http://hotair.com/headlines/archives/2012/06/05/the-peltzman-effect-why-its-hard-for-government-to-force-people-to-be-healthy/) and should be analysed carefully.

I think that this low is very artificial. When we speak about this kind of issues, the political will is of the most importance. (For example, we had fantastic rating of doing business during Saakashvili's governance, but everyone knew that there was no political will to have competition and transparency in some industries and this problem could not have been solved with any amount of public servants in competition agency in case of it's existence...). On the other hand, the cost of this law may be very high, it may become a weapon of the government... it will rise the government spending for sure (and broadly speaking, I think this government has a high risk of dramatically increasing administrative costs). Besides, as it was already mentioned in this post, it will distort stimuli. From my point of view, the maximum intervention that could be acceptable is to have small effective analytical group, that calculates simple and objective indices and indicators and using these tools determines the lack of competition on a particular market (which on the other hand may create good investing potential for the new entrant) and then presents it to potential investors... this action has double positive effect (capital attraction and increasing competition on the local market). Other clearly manipulative actions of the firms may be subject of punishment, but criteria of manipulative action assessment should be quite simple. (Some may even argue that this kind of punishment measures is unnecessary and in true competitive environment there is no need of intervention at all). Broadly speaking every new law and barrier creates new adverse effects and possibilities - peltzman effect (By the way, following link may appear interesting if someone is interested what this effect stands for: http://hotair.com/headlines/archives/2012/06/05/the-peltzman-effect-why-its-hard-for-government-to-force-people-to-be-healthy/) and should be analysed carefully.
Guest - Steph Comsa on Tuesday, 15 April 2014 13:33

(1) I see fines as only one means to address this among others. One example that was successful in Georgia was removing the extensive bureaucratic and long process to import pharmaceuticals. Removing this barrier allowed new importers in Georgia to pop up and introduced competition. (2) Use of fines could be a deterrent, but how do regulators determine what is price fixing and what is not? (3) I think much of the cartel activity is not centered around price fixing, but keeping others out of the industry through intimidation. In one industry i dabbled in (not pharmaceuticals but something else), the dominating player/cartel would tell retail outlets if you buy new entrant X's product, we will cut off your supply from us, which will leave you in a bad situation since we are the main supplier with more product variety etc. (4) Saw something the other day about the large amounts of sums Comcast donated to individual Senator/Congressman campaigns, and it is quite correlated with their view on the Comcast merger. Example of cartel/monopolistic activity by Comcast that they mentioned is keeping Bloomberg station far away (in terms of channel numbers) from other news stations, done likely because Comcast owns a competing financial news channel. Same stuff in the US as in Georgia I guess - one just one more formal and institutionalized i guess...!

(1) I see fines as only one means to address this among others. One example that was successful in Georgia was removing the extensive bureaucratic and long process to import pharmaceuticals. Removing this barrier allowed new importers in Georgia to pop up and introduced competition. (2) Use of fines could be a deterrent, but how do regulators determine what is price fixing and what is not? (3) I think much of the cartel activity is not centered around price fixing, but keeping others out of the industry through intimidation. In one industry i dabbled in (not pharmaceuticals but something else), the dominating player/cartel would tell retail outlets if you buy new entrant X's product, we will cut off your supply from us, which will leave you in a bad situation since we are the main supplier with more product variety etc. (4) Saw something the other day about the large amounts of sums Comcast donated to individual Senator/Congressman campaigns, and it is quite correlated with their view on the Comcast merger. Example of cartel/monopolistic activity by Comcast that they mentioned is keeping Bloomberg station far away (in terms of channel numbers) from other news stations, done likely because Comcast owns a competing financial news channel. Same stuff in the US as in Georgia I guess - one just one more formal and institutionalized i guess...!
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