International Journal of Industrial Organization 10 (1992) l-13.

North-Holland

Cartel stability and product

differentiation
Thomas W. ROSS*
Carleton University, Ottawa, KIS 5B6

Final version received July 1991

This paper employs a supergame-theoretic model of collusion to analyze the effects of different
levels of product diNerentiation on cartel stability. In contrast tc earlier work, the ability of the
parties to reach an agreement is assumed. Here the focus is on how greater product
homogeneity increases both the gain to cheating on a collusive agreement and the magnitude of
the punishments that follow a defection. The total effect on the likelihood a cartel is stable is
therefore unclear. Two particular ditTerentiated products models are then used to demonstrate
that, contrary to the conventional view, greater homogeneity can reduce cartel stability.

1. Introduction

In his seminal article on oligopoly theory, Stigler (1964) studied the ability
of oligopolists to hold collusive agreements together when there are some
inherently unobservable elements to individual firm (and perhaps market)
demands. Building upon his insights and applying results from the theory of
supergames, more recent work has looked for ‘cooperative’ equilibria in these
noncooperative games.l
My purpose here is to use the theory of supergames to explore a related
idea of Stigler’s. As part of a discussion of factors that contribute to the ease

*Much of this research was done while the author held the T.D. MacDonald Chair in
Industrial Economics in the Canadian Bureau of Competition Policy, but the views expressed
here are solely his and are not necessarily those of the Bureau of Competition Policy. The
author is grateful to Paul Anglin, Dan Bernhardt, Myong-Huan Chang, Paul Crampton,
Philippe Cyrenne, Nancy Gallini, Paul Geroski, Joseph Harrington, Shyam Khemani, Ralph
Winter, seminar participants at the Universities of Waterloo and Toronto and two anonymous
referees for useful discussions and comments and to the Bureau of Competition Policy, the
Carleton Industrial Organization Research Unit and the Social Sciences and Humanities
Research Council of Canada for financial support.
‘See, for example, Green and Porter (1984), Porter (1983a, 1983b and 1985), Rotemberg and
Saloner (1986), and Rees (1985). The idea that cooperation may be sustained in supergames goes
back to Lute and Raiffa (1966). A formal treatment was provided by Friedman (1977). For a
general discussion of the supergame approach to the study of collusion, see Tirole (1988, pp.
245-253).

0167-7187/92/$05.50 0 1992-Elsevier Science Publishers B.V. All rights reserved

2 Th.W. Ross, Cartel stability and product differentiation

or difficulty of coming to a collusive agreement, Stigler suggested that such

agreements would be easier to negotiate when the product was relatively
homogeneous.2 This is the question addressed here: does greater product
homogeneity in fact enhance cartel stability?
While Stigler was concerned principally with the difficulties firms can have
in reaching an agreement on price, I focus on a different aspect of the
problem. My interest is in the relationship between the degree of differentia-
tion and the incentive to cheat on a negotiated agreement.
Supergame models of collusion have been used to study product differen-
tiation in related work. Most significantly, Deneckere (1983) and Majerus
(1988) study the relative efficiency of price vs. quantity competition in cartels
composed of firms selling differentiated products. Deneckere, in fact, contains
a very brief introduction to the question explored in more detail here.3
The next section presents a simple model of supergame cooperation with
differentiated products and illustrates the potential effects of changing
degrees of heterogeneity. Since the gains to cheating are reduced when
products are differentiated it is not clear that cartels involving differentiated
products will be less stable.4 Precise predictions about whether hetero-
geneous product cartels are more or less stable require the application of a
more specific model. This is offered in section 3.

2. Supergame collusion with differentiated products

By now the notion of supporting collusion in infinitely repeated games is
quite familiar, so this section will be brief. Consider the problem of
duopolists producing differentiated products. For simplicity I assume a large
amount of symmetry. While selling different products, the firms face identical
demands in the sense that if they charged the same price they would sell
identical quantities. I also assume the firms have identical costs.
Let this be an infinitely repeated game between price setting firms. As
Telser (1972) and Friedman (1983) have demonstrated, it is possible for firms
to sustain cooperation in a repeated setting that would not be possible were
their interaction to be once and for all. While each player faces some
strategic uncertainty about his rival’s play, there is no other uncertainty in
this model. Specifically, there is no random element to demand as in Green

*See also Posner (1976, pp. 59-60) and Stigler (1966, pp. 219-220).
sin recent work (discovered after the tirst draft of this paper had been completed and before it
had been published) Chang (1991) covers some of the same ground as this paper. His specific
model of differentiation is derived from the Hotelling spatial model and is similar to the spatial
model studied as part of the section 3 here.
“Bemhardt (1991), in a spatial two-period model of costly price adjustment in oligopoly,
establishes that collusive opportunities can improve with product differentiation.
 Th. W. Ross, Cartel stability and product differentiation 3

Firm 2’s price

Firm l’s
price P* PC PN

P* IT*, n* I?, 7f _
PC n=,nv _ -
PN _ _ nN,nN
Fig. 1

and Porter (1984). There are really just three prices for each firm that are
important to this model. Let p* be the price that, when charged by both
firms, maximizes joint profits. 5 This is the price to which firms would like
to commit in the long run. Noncooperative play in the stage game would
result in Bertrand-Nash prices, (p”, pN). Finally, a player expecting his rival
to play cooperatively (i.e. to charge p*) might consider cheating by setting a
lower price, pc.
A condensed normal form of the stage game is depicted in fig. 1. Since
(p”, p”) is an equilibrium to the stage game, both playing pN forever is an
equilibrium to the infinitely repeated game as well. As a noncooperative
equilibrium this can also represent a credible punishment for cheaters in a
collusive agreement.
In fig. 1, rc* represents the profits per firm under collusion, rcN the profits
in the Nash equilibrium of the stage game, rcc the one period protit of a
cheater and Z” the profit of a firm being cheated (i.e. the ‘victim’). The
important properties of this matrix are: (i) n’>rc* (i.e. cheating is profitable
in a one-shot setting), (ii) rc* >nN (i.e. cooperation is more profitable than
noncooperation), and (iii) (pN, pN) is the Nash equilibrium to the stage game
(by assumption it is unique).
Cooperation will be supportable in the repeated setting if the punishment
from defection is sufficient to deter cheating. Suppose each adopts the
following strategy: play p* until the other player cheats, then play pN forever.
This ‘grim’ strategy provides a simple but (potentially) substantial punish-
ment consistent with Nash equilibrium behaviour. Will it be enough?
A firm contemplating cheating in some period t must weigh the gain from
cheating, 7~‘- rc*, which comes entirely in period t, against the lower profits
earned thereafter. From period t + 1 on profits will be lower by an amount

‘Depending upon costs it may not be joint payoff maximizing for both firms to charge the
same price. For example, it may be the case that due to large fixed costs, one firm should shut
down. I will assume these conditions do not hold or that an inability to policy sidepayments
makes an asymmetric optimum infeasible.
4 Th. W. Ross, Cartel stability and product differentiation

n* - rcN per period. The condition for the gains to exceed the present value of
the losses, and therefore for the cartel to be stable is easily seen to imply a
critical discount rate, D*?

Thus, the critical discount rate is seen to be simply the ratio of the per
period loss during the punishment phase to the one-time gain to cheating.’
If the actual discount rate exceeds CJ*, the cartel will not be stable because
punishments are discounted too heavily relative to the immediate gains from
cheating.
In what follows I will use the critical value of the discount rate as a
measure of cartel stability. Higher levels of rr* correspond to more (or more
likely) stability. Though hardly the perfect measure it does have some
intuitive appeal, and it has been used this way in the past.8 At the very
least, C* can be seen to represent a short-hand description of the relationship
between the one-time gain to cheating and the cost of the ensuing
punishment.’
When the products are identical and two firms have constant marginal
costs it is easy to see that rcc= 27c* and rcN= 0, yielding a critical discount rate
of a*=1.
As we introduce product differentiation we can see it having two opposing
effects on cartel stability. First, the segmentation of the markets through
differentiation means that the gains from cheating are less. Now a cheater
cannot capture the entire market with a trivial price cut. This reduces the
denominator in (1). However, the Bertrand-Nash punishments are less severe
with differentiation; the Nash equilibrium will leave all firms with positive

6Recent work has shown that cartels might be sustainable under weaker conditions if
‘optimal’ punishments are employed. See, for example, Abreu, Pearce and Stachetti (1985). These
punishments can, under certain circumstances, be more severe than the punishments imposed by
the grim strategies used here. A possible direction for future research would involve assessing the
effects of differentiation on the stability of cartels able to make use of optimal punishments.
‘Those familiar with supergame models and the Folk theorem will be aware of the fact that
this is not the only possible equilibrium to the supergame. For discount rates below the critical
discount rate, o*, however, this equilibrium is not Pareto-dominated by any other. I would
argue then, that it is a likely outcome, particularly if the firms can use preplay communication
to focus beliefs on the best self-enforcing agreement.
*See. for example, the applications discussed in Tirole (1988, pp. 247-251), and see also,
Shapiro (1989, pp. 361-381). In some ways (r* may not seem related to what we think of as
stability, that is the probability that a cartel will break down, since in this model cartels are
either perfectly stable or completely unstable. However, adding some stochastic elements to the
model, in demands or costs [as in Green and Porter (1984)] or even in the actual levels of firms’
levels of o would permit this kind of interpretation for u*.
91f there is a lixed cost per lirm of maintaining the cartel, the numerator of (1) is decreased
and the denominator increased, making the critical value CJ* lower and the cartel less stable.
Such a cost will not qualitatively affect the results on differentiation that follow.
 Th. W. Ross, Cartel stability and product dlferentiation 5

profits in this case. With punishments less significant, the numerator in (1)
falls as well.
Which of these effects dominates: will the cartel be more or less stable
when products are differentiated? To answer this question we need to know
more about the relative magnitudes of these profits and about how they
change as we move toward greater differentiation. This requires a more
detailed model of product differentiation; two such models are employed to
this end in the next section.

3. Two simple models of differentiation

3.1. Quadratic utility model

The first model, which employs a quadratic utility function for a represen-
tative consumer, has been used by Dixit (1979) and Singh and Vives (1984).
The consumer derives utility from the consumption of the two goods and a
third, numeraire good, Y, according to the function:

U=aq,+aq,-(1/2)(bqf+2cq,q,+bq:)+ Y. (2)

This utility function has the convenient property that it yields linear demand
curves, in inverse form (and given pr= 1):

p1 =a-&, -cq2,
(3)
p2=a-bq,-cq,,

in the regions in which both prices and quantities are positive. The ratio
r =c/b, which lies in the range [0, l] as long as c 5 b, serves as a measure of
the degree of differentiation with r= 1 denoting perfect substitutes and r =0
representing goods with independent demands. Without any further loss of
generality firms’ identical constant marginal costs are set equal to zero.
The task ahead is to solve for rc*, n’ and rcN for this model, and to use this
information to construct an expression for 6*.
The cooperative solution involves the maximization of joint profits,
rcr + rc2=plql +p2q2. Solving the first-order conditions for profit maximizing
prices reveals that the cooperative prices and profits per firm will be given
by:

p*=pr=pT=a/2,
(4)
n* = a*/[4(b + c)].
6 Th.W. Ross, Cartel stability and product differentiation

The Bertrand-Nash prices and profits will come from the simultaneous
solution of individual profit maximization problems in the standard way:

p: = p; = a(b - c)/(2b -c),

(5)
7cN=a%(b-c)/[(b+c)(2b-c)2].

To determine the gains from cheating we must solve for the cheater’s best
response to his rival’s play of p*. This involves substituting p* from (4) into
the cheater’s reaction function. If firm 1 was to cheat it would choose price p’
and obtain profits r-t’:

p’= a(2b - c)/4b, (6a)

Notice that if the products are identical so that c = b the value of expression
(6b) goes to infinity. This unreasonable result is due to the fact that the
asymmetric outcome associated with one firm cheating will drive us outside
the range in which all quantities are positive. In this case the model at high
levels of r will overstate the gains from cheating.
We need to add a constraint that the victim’s quantity and profits cannot
become negative. When this constraint is binding it can be shown that the
cheater’s price and profit will be (the superscript cc refers to ‘constrained
cheating):

py = a( 2c - b)/2c, (7a)

zy = a2(2c - b)/4c2. (7W

Notice that if c= b, these profits are
ing in any given period. The value
binding is determined simply as the
turns out to be about r = 0.73.
Now we have only to plug the
indeed twice those earned by cooperat-
of r at which this constraint becomes
value of r that equates p; and py. This
derived values of rt*, rrN and rcc into
 Th. W. Ross, Cartel stability and product dljkentiation 7

expression (1) defining the critical discount rate, cr*. After some manipula-
tion, and substituting for c/b using r, this becomes

a*=4(-r)/(2-r)’ (8)

for the unconstrained region in which (6a) describes the cheater’s price. For
cases in which r is greater than the value at which the victim’s quantity is
zero, we must solve for O* using x?:

o*=r4/[(2-r)‘(r2+r-l)]. (9)

Notice that in both (8) and (9), the critical discount rate is completely
determined by the ratio r, and there is no independent influence exerted by
either the size of the market (as given by the magnitude of the parameter a),
or by the absolute size of parameters b and c.
Fig. 2 illustrates the relationship between r and CJ*from (8) and (9). Notice
that it is a negative monotonic relationship in the unconstrained region (i.e.
up to r=0.73): in this range, the more homogeneous the products are, the
less likely the cartel is to be stable. At a point (approximately r=0.77)
beyond the point at which the nonnegativity constraint on q2 becomes
binding, the relationship becomes positive, with g* rising toward 1.
This analysis allows us to make two points about the relationship between
product heterogeneity and the stability of cartels. First, it is true here too
that homogeneous product (i.e. r= 1) cartels are more stable than hetero-
geneous product cartels: all the critical values of O* for r < 1 are less than
one. However, the stability here is from a source different from that
considered by Stigler; there is no cost of finding an agreement in this model.
Second, within the world of nonhomogeneous products (i.e. r< l), greater
homogeneity does not necessarily imply greater stability.
Finally, a question naturally arises regarding the welfare costs of collusion
for different degrees of differentiation. What is the relationship between r and
the welfare loss from cartel pricing monotonic? To answer this question
consider as a measure of welfare the ratio of the sum of consumer’s surplus
and profits under collusion (IV*) to the same sum in Bertrand-Nash
competition (IV”). Given the symmetric nature of these outcomes we have

W* = 2aq: -(b + c)qy2,

WN = 24’ -(b + c)qy2.

It is straightforward to show that the ratio of these quantities

 Th.W. Ross, Cartel stability and product d@rentiation

D.95

0.S

0.6%

0.e

n 75

0.7

0.65

0.6

is a decreasing function of Y as long as r< 1. Thus, cartels of more

differentiated products are less socially harmful.

3.2. A spatial model

Because of their different orientation, it is of interest to pose the question
of cartel stability with differentiation in the context of an address model of
differentiation.” These models admit the existence of localized competition
which is not possible in representative consumer models.
I consider a particularly simple model. Assume consumers are distributed
uniformly along a line of infinite length with density z.‘l Products or brands
are located along this line as well, but at distinct points. I will assume a

‘“FOF a discussion and defense of address models of product differentiation see Archibald,
Eaton and Lipsey (1986).
l”The line is thought to be of intinite length so as to avoid problems with differences at the
ends. Having consumers distributed around a circle, as in Salop (1979), would do as well.
 Th. W. Ross, Cartel stability and product differentiation 9

symmetric distribution so that brands are evenly spaced along the line.
Without loss of generality let this distance between products be 2.‘*
Consumers, who each purchase zero or one unit, will buy the product with
the lowest full price, which is the price charged by the firm plus any
transport or disutility cost suffered as a result of the consumer being located
some distance from the firm. This constant per unit (of distance) transport
cost, t, functions as a measure of product differentiation. Consumers’
reservation price is u; if no full price is lower than u the consumer will drop
out.
In this model a variety of equilibria are possible. I will consider the
competitive equilibrium in which firms compete on their margins for
customers. Further, I will assume that the collusive outcome is such that all
customers do buy the product, so that there is some gain to cheating on the
margin.
Finally, though I allow firms to own multiple brands, it will facilitate the
exposition if we assume that no firm owns adjacent brands. Thus, every
brand is competing on both ends of its market area. Production will be
subject to constant marginal costs which we can gain, without further loss of
generality, set to zero.
In this setting the collusive outcome is easily derived. We know that
customers exactly midway between two brands will have to pay a full price
equal to their reservation price u, so the collusive price must be this amount
less the transport cost to reach that customer. The transport cost, given that
the marginal consumer is one unit away will be equal to t. Thus, we have

p*=v-t. (104

As there is a density of consumers of z, and each brand has a market area of

two units length, total sales for each will be q* = 22 and profits will be

n* = 2z(u - t). UW

The Nash equilibrium prices and profits will be,

pN= 2t, (114

(lib)

I assume that cheating on the cartel agreement is profitable in the short

term, that is that the collusive solution is not a noncooperative equilibrium.
12This generality is slightly overstated. If brands are too close (or t too low) it is possible that
the equilibrium to be described would not exist. Brands would lower price sufficiently to remove
neighbours from the market.
 10 Th. W. Ross, Cartel stability and product differentiation

The reader can easily verify by differentiating a brand’s profit with respect to
its price at the collusive outcome that this requires u to be sufficiently large
relative to t; to be precise o 2 3t.
In terms of optimal cheating strategies there will be two local optima,
either of which could be the global maximum. It is possible that the optimal
cheating strategy will involve a price so low that the cheater takes over all
his neighbours’ market areas. This would happen at a price of p* - 2t.13 I
will explore the other optimum here in which such dramatic price cutting is
not profitable, but some more restrained cheating is prolitable.i4
In this case the cheater’s optimal price and profits will be

pc = (0 + t)/2, (12a)

7cc=(z/4t)(u + t)2. (12b)

We are now ready to solve for the critical discount rate. If the cartel
arrangement is such that any cheating is met with Bertrand-Nash pricing
everywhere forever, it will not matter if firms own more than one brand.i5 In
such a case it will certainly cheat everywhere at once so all the relevant
profit levels defined above will simply be multiplied by the number of brands
owned by the firm. This will not affect our definition of G*. Inserting the
profit expressions from (lo), (11) and (12) into the definition of o* given in
(1) yields

0*=8t/(v-3t). (13)

In this case, the critical discount rate is again independent of the size of the
market in terms of the density of consumers, however it depend upon the
value of the outside option. In fact, U* will depend only upon the ratio u/t.
For values of v approaching 3t from above, we see that G* goes to infinity,
so that higher levels of differentiation involve lower levels of the critical
discount rate than the homogeneous products case. Therefore here, unlike
the previous model, there are conditions under which heterogeneous cartels
are more likely to be stable than cartels involving identical products,
To study the effect of increasing differentiation on this critical value, we

raThis must be the optimum if products are identical (t=O) or nearly so. With differentiated
products it is also possible that an even llower price will allow the cheater to profitably steal
customers from brands located two (or more) positions to his right or left.
r4The case in which price cutting transfers all sales to the cheating brand is a straightforward
extension left to the interested reader.
IsThis assumes that no firm owns adjacent brands. To the extent that this is not true, the
gains to cheating are reduced because the cheater steals customers on fewer margins. Of course,
it is also true that the punishments will be less severe in this case.
 Th. W. Ross, Cartel stability and product differentiation 11

have only to differentiate the expression in (13) with respect to the

transportation cost parameter t:

da*Jdt=o/(v-3t)‘>O. (14)

Thus we again observe that increased differentiation could enhance cartel

stability. l6

4. Summary and conclusions

In this paper I have presented two models in which cartels supply

differentiated products. The results of the supergame analysis indicate that
differentiation need not hamper cartel stability when finding an agreement is
not problematic. This has implications for public policies regarding cartels.
In screening mergers, for example, authorities in Canada and the United
States have often looked to the degree of differentiation as an indication of
the likelihood of cartel pricing should the merger proceed.” The analysis
above suggests, however, that differentiation itself is not sufficient to warrant
this approach; there must be some asymmetry between firms that makes
defining a cartel agreement difficult.
This is not the first paper to suggest we rethink the conventional wisdom
regarding collusion in differentiated products markets. In an interesting
critique of the 1982 U.S. Department of Justice Merger Guidelines’ treatment
of such markets, Davidson (1983) recognized that cheating will be less
profitable when products are differentiated. Therefore, he reasoned, cartels
might be more stable. I8 He also suggested that the very segmentation that
makes products differentiated might itself provide stable market allocation
mechanisms.’ 9

‘% the spatial model in which customers have cl type demands, there is no welfare loss
from cartel pricing as long as every consumer buys from the nearest seller (which is true here).
Therefore, changing the degree of differentiation cannot alter the welfare loss in this case.
“The U.S. Department of Justice Merger Guidelines (1984) claim that collusion is less likely
when products are differentiated because of the difficulty in establishing and enforcing ‘a
complex schedule of prices corresponding to gradations in actual or perceived quality attributes
. ’ (p. S-7).
“This is the first of the effects described above. Davidson did not have a formal model of
collusion, nor did he discuss punishment strategies. Chang’s (1991) results also support the
proposition that collusion between makers of more differentiated products might be easier to
sustain. His spatial model diNers from that presented here in at least two important respects.
First, he assumes that the transportation costs are quadratic in distance and second, his measure
of differentiation is the distance between products. He also considers the possibility that the
cheater will cut price sufficiently that his neighbours are eliminated, though this does not change
the general result that greater differentiation makes for enhanced stability.
“For example, he constructs a hypothetical market for a beverage that is available in three
grades: regular, premium and special. A successful cartel arrangement might just enjoin the
parties from offering each others’ grades and need not specify price at all. Davidson also reviews
some of the case evidence on the stability of homogeneous and heterogeneous product cartels.
 12 Th. W. Ross, Cartel stability and product d~~rentiation

In light of the results presented here and Davidson’s arguments, a valuable

project for future research would involve a review of collusion cases to assess
the role of product differentiation. There is theoretical work to be done as
well. The ambiguity of the results available to date suggest a need for a way
to guide antitrust agencies needing to know the conditions under which
differentiation helps collusion. There is clearly also room for further work on
the game-theoretic underpinnings of this super-game based model addressing
questions such as the effects of introducing alternative punishment strategies
and restricting attention to renegotiation-proof equilibria.20

Z”As an example, suppose optimal punishments were available that guaranteed a potential
cheater zero profits (the lowest profits consistent with individual rationality) forever in the event
he defects. Then one of the two effects of differentiation discussed in section 2 is missing. While
the gains from cheating are still smaller with differentiation, the costs in terms of this
punishment need not change. Thus, it appears again that cartels will be less vulnerable to
cheating when the products are differentiated.

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