• ◦ This case study illustrates how a particular auction design, used for public procurement, can unintentionally provide fertile ground for bidding rings.

• ◦ Essentially, the average bid auction format awards the contract to the bidder whose bid is nearest to the average bid. The average bid auction format has been advocated in order to prevent contracts being awarded to bidders with unrealistically low bids that might result in low quality or ex post renegotiation.

• ◦ This case study shows how it facilitates collusion. The setting is the tendering of public work projects in Turin, Italy over 2000–2003 where subgroups of construction firms formed cartels and coordinated their bids to enhance their chance of winning the contract at an inflated price.

• ◦ To understand the ease with which bidders can collude when participating in an average bid auction, suppose the current expectation (in the absence of coordination) is that firms bid aggressively. In order to have a chance to win, a firm would have to submit a relatively low bid in order for it to be close to the average bid. Now consider firms forming a cartel. All they need to do is agree to submit high prices. That will reap higher profits and without the temptation to deviate as is present with the usual auction design where the contract is awarded to the lowest bidder. A firm that thinks about submitting a lower bid will move its bid farther away from the average bid and thus reduce its chances of winning. Once firms agree to submit high bids, such an agreement is self-enforcing. The average bid auction format thus makes collusion more likely because cartel stability is so easy to maintain.

• ◦ The case study also explores an incentive for a subset of firms to form its own coalition in order to increase their chances of winning. If it comprises enough firms, they can move the average bid up or down in a manner to cause their bids to be closer to the average bid than the bids of firms outside of their coalition. As a result, a collection of bidders can respond to a coalition by forming its own coalition. The proliferation of these coalitions is well documented for the Turin case.

• ◦ This understanding of cartel conduct is used to develop a marker for collusion based on the frequency of joint participation.

In The Wealth of Nations, Adam Smith observed that “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” As we will see, Smith’s warning has stood the test of time. Over 240 years later, we find such conspiracies among physicians, hospitals, pharmaceutical manufacturers, medical device producers, and health insurers. Their contrivances to raise prices add billions of dollars to our expenditures on health care. In this chapter, we introduce an economic model of a price-fixing cartel and discuss the deleterious effects on price, quantity, and social welfare. Using health care examples, we discuss collusion among physicians to deny staff privileges, noncompete agreements among hospitals, and market division schemes in the health insurance sector.

When a patent on a pharmaceutical product expires, therapeutically equivalent generic versions of the drug rapidly enter the market. Competition among the generic producers ordinarily causes the price of drugs to plummet. This, of course, is socially beneficial since consumers are considerably better off. Health insurers are also better off because the costs of insurance claims fall. Nearly everyone gains – except for the pioneer firm whose patent monopoly has expired. For many generic drugs, however, this scenario has failed to materialize because the generic producers allegedly decided to collude rather than compete. Various state attorneys general have filed complaints against 30 well-known generic drug manufacturers for their alleged collusion of more than 160 pharmaceutical drugs. The complaints allege that a large-scale cartel engaged in price fixing, customer allocation, and bid rigging in the market for generic drugs, leading to higher prices and lower sales.