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Cartel versus monopoly: The German nitrogen industry in the interwar years

Claudia Riani PhD student Dept of History and Civilization European University Institute, Florence

Abstract During the interwar years, the German nitrogen cartel included several small producers of agricultural fertilizers and a very large firm, BASF, later IG Farben. The cartel lasted from 1919 until the end of WWII. The proposed paper aims to show two facts that seem to contradict each other: that BASF was a potential monopolist, and that the cartel in which it accepted to stay set prices that were considerably lower than the monopoly price. This poses the question of why this firm stayed in the cartel, instead of establishing a true monopoly.

Introduction This paper explores one striking aspect of the economic performance and behaviour of the chemical giant BASF - IG Farben that has not been studied yet. In doing so, it casts some doubts on the rationality of some choices made by its senior management. In particular, the focus is on nitrogen fertilizers, which represented a substantial part of the firms turnover, and the market for which was entirely and legally cartelized in Germany in the interwar years.

Fixed nitrogen is a key fertilizer that allows farmers to significantly increase total agricultural productivity. After WWI, thanks to a major process innovation implemented in Germany for military purposes, the availability of this substance increased enormously. As a result, the production of nitrogen soared rapidly, as did concens about its profitability and it came as no surprise, therefore, that the German nitrogen producers soon joined the Stickstoffsyndikat, a legal cartel in which the state played an important role, at least in the first years of its existence.1 The German nitrogen cartel survived for 26 years, from 1919 to 1945. It functioned mainly as a single-sales agency, with virtually no output restrictions for the majority of its members, with the significant exception of BASF. The cartel assured domestic sales and exports according to pre-determined quotas, and controlled 98% of the domestic market. The cartel comprised the DAVV, a consortium of coke and gas producers that sold ammonia as a by-product; Bayerische Stickstoffwerke, the producers of Cyanamid; and BASF (later included in IG Farben), the company that used the most efficient process with the highest capital intensity. One of the broader questions of my research is how the cartel survived, having such a heterogeneous membership.

Total sales Market share BASF-IG 840 68.8% DAVV 250 20.5% Bayerische Stickstoffwerke 90 7.4% Other firms 40 3.3% Total 1220 100.0
Figure 1: Sales of N fertilizers in 1930, in 1000tN. Source: Janze 2000

In this context, the present paper aims to test two basic assumptions: the first is that in its nitrogen production, BASF showed the features of a potential monopoly.2 The second, is that the price set by the cartel was considerably lower than the monopoly price that the dominant firm could have charged. If these two assumptions are correct, we need to understand the circumstances which allowed the German cartel to survive.3 In particular, it will be necessary to explain why the potential monopolist choose to remain in the cartel, allowing other firms to survive, instead of free-running and pushing other producers out of business, increasing its market share and earning monopoly profits, as one would expect from a potential monopolist. The history of the cartel is very long and encompasses a complex historical period, during which circumstances changed considerably, and I have therefore divided it into three phases. The first goes from 1919 to 1924: Here, the German economy was under the control of the state because of the needs of post-war reconstruction. The direction of the cartel was subjected to government control, especially concerning price setting. In those years, German nitrogen production was destined only for the domestic market and the share of exports was trivial. The second phase goes from 1924-25 to 1933, and is characterized by (i) a freer economic environment,(ii) the cartels engagement in exports, (iii) the inclusion of its principal member, BASF, in the giant concern IG Farben, and (iv) a mounting international cartelization. The third phase, that of the Nazi regime, is one of increasing state control on prices and the entire economy. The focus of this paper is mainly on the second phase.

This paper is developed around three main parts: in the first, I will deal with the monopoly position of BASF-IG; in the second I will discuss the price level in the context of the German nitrogen fertilizers market, while the third section concludes.

1. A potential monopoly? If we examine the German domestic market in the interwar years, BASF shows the features of a potential monopoly. This firms capacity made it able to entirely meet the domestic demand at very low marginal costs. In addition, its plants were very expensive, i.e. its fixed costs were extremely high and represented a substantial barrier to entry. Indeed, no other firm in Germany showed a performance similar to that of BASF.4 Before going any further with the analysis of the costs, it is useful to set out a preliminary premise: because, in the chemical industry, the same operation often yields several products and byproducts, in price setting the costs of many chemicals are often determined arbitrarily.5 This is particularly true for most of the ammonia processes. It is therefore very difficult to determine and compare the cost curves of the different processes, although this would be the best way to show whether BASF enjoyed a monopoly position or not. Here, then, it is only possible to give an idea of the fixed costs of BASF, to consider capacity and consumption, and to compare its marginal costs to actual price. Let us start the survey with the fixed costs. From 1912 to 1919, the plants of Oppau and Leuna-Merseburg together required a total investment of 914mln RM to be set up.6 This huge financial operation, set up as a result of the pressure of the government because of the war, was partially covered through state loans (465mln RM). The loan was

extraordinarily large, and therefore unique, but was in fact never repaid because it was cancelled on account of the hyperinflation. When Merseburg became an independent GmbH (although it continued to be managed by BASF) at the end of 1920, BASF estimated its three nitrogen plants to be worth 1,125ml RM. Such a large investment was thus possible thanks only to state support and facing war necessities as a result of the war.7 Moving on to the description of capacity and domestic demand, in 1919 BASF reached a capacity of 300,000 tons of pure nitrogen, compared to 115,000 tons of domestic consumption (Figure 3). However, until 1924 its actual output was much lower than capacity and, following the agreement set up by the cartel, was also inferior to the domestic demand. After a short period of crisis in 1922-23, the domestic and world market for fertilizers expanded, and, moreover, the German cartel entered the foreign markets. As a result, BASF (from 1925 on, IG Farben) was able to raise capacity accordingly: In 1929, with the expansion of the plant of Merseburg, it reached 700,000 tons of pure nitrogen,8 compared to 385,000 tons of domestic consumption in the same year. However, due to its membership in the domestic cartel, BASF-IG was allowed to cover only a part of the domestic demand, the rest being reserved for the other producers which did not engage in export. Therefore, after 1924, much of BASFs output was destined for export. 9 By comparison, in 1930 all other German producers in the cartel had together a capacity of 415,500 tN, compared to BASFs 962,000 tN. The capacity of Cyanamid plants was limited by the supply (and cost) of electrical power, and the capacity of the sources of byproduct nitrogen was extremely inelastic and tied to the coke and gas output.10

1400

1200

1000

800

1000 tN
600 400

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BASF-IG N fertilizers Output BASF-IG synthesis Capacity Sales N fertilizers in Germany

1918 1919 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939

Figure 2: Capacity, output, and sales of BASF-IG nitrogen fertilizer production.

For the reasons mentioned above, data regarding the variable and average costs are very poor. The available data regarding IG average costs of sulfate of ammonia and saltpeter between 1928 and 1932 show that they were between 0.40 and 0.51 RM/KgN for saltpeter and 0.36 and 0.42 for sulfate of ammonia. Other firms cost structure is not known, but the literature regarding the nitrogen cartel states that the average cost of Cyanamid was circa 40% higher than that of synthetic nitrogen.11 Another set of data makes it possible to calculate the marginal cost of nitrogen in the two plants of Oppau and Merseburg, starting from quarterly figures regarding the variable cost and output (unfortunately, these are available only for 1925). Consistently with the very high fixed costs, that allow us to predict wide economies of scale, the MC result to be very low. The interesting fact is that they were significantly lower than the market price, as shown in the table below.

Marginal costs Actual price (RM/KgN) (RM/KgN) Oppau, Sulfate of ammonia 0.1694 0.98 Oppau, Sulfate of ammonia 0.0922 1.04 Merseburg, Sulfate of ammonia 0.4288 1.135 Merseburg, Sulfate of ammonia 0.079 0.98 Figure 3: Marginal costs and actual price (own calculation)

The extent of BASF-IG capacity, together with the high fixed costs and the very low marginal cost, highlight that this firm was a potential monopolist inside the domestic market.

2. Price level If BASF-IG was a potential monopolist, then the following question is: Was the price of German nitrogen fertilizers near to monopoly price for BASF-IG? In order to answer this question, the first step is to calculate the implicit monopoly price, PM , through the usual formula:
PM = MC 1 1! e

Marginal costs are known, even though only for the year 1925: It is therefore necessary to obtain the price elasticity of demand. The model adopted here hypothesizes an income effect, where the consumption of fertilizers is a function not only of relative prices, but also of the real agricultural output of the previous year, which will be included in the model:

logCA = " 3 + # RP log Pn / a + $ log Ra t %1 + &3

Here, CA is the consumption of nitrogen in agriculture (in metric tons/year), the price index Pn/a represents the price of nitrogen in terms of agricultural prices, and is obtained by dividing the index of nitrogen prices by the index of agricultural prices.12 Finally, Ra is the agricultural output expressed in real prices, and the model uses the lagged value as farmers are assumed to spend in fertilizers the available resources, i.e. the income of the previous year.13 Both series are co-integrated and the base year (as they are indexes) is 1928. The dataset is a time-series, which is not the most appropriate tool to obtain the price elasticity of demand, as other factors changing over time might affect the results. However, the lack of other data makes it impossible to perform a more appropriate panel data analysis. And, in addition, the statistical tests are acceptable (see below), so that the noise due to factors changing over time can be considered as having a minor impact. Regarding the results of the regression, the coefficient RP is the relative price elasticity (-1.069), and is the income elasticity (0.288). The figure obtained for the relative price elasticity, which is the most interesting figure for the present paper, is highly significant (see appendix), the entire regression has good statistical tests, and the model proves highly significant as a whole. The results show that the lagged total agricultural output plays a small role in the decision to purchase fertilizers, as the sale of fertilizer seems to positively react to its increase, i.e. in the resources available for the purchase of this input.

In order to make the model more accurate, it would be appropriate to hypothesize a substitution effect of fertilizers for labor and other inputs, but this would require a larger number of observations (unavailable at the moment) in order to run the regressions. Therefore, these effects have been neglected, waiting for the results of further research to enlarge the set of data. For the same reason, borrowings are assumed to be equal to savings.

The coefficient indicating the relative price elasticity of demand, together with the few observations about marginal costs, have been used to obtain an idea of the implicit monopoly price (expressed in RM 1928). The results are shown in Figure 4 below. All of them refer to the year 1925.

Output per Actual price Monopoly price quarter year (RM/KgN) (RM/KgN) 14 (KgN) Oppau, Sulfate of ammonia 15 825 000 0.98 2.62 Oppau, Sulfate of ammonia 21 503 000 1.04 1.42 Merseburg, Sulfate of ammonia 40 529 902 1.135 6.63 Merseburg, Sulfate of ammonia 42 325 572 0.98 1.22 Figure 4: Marginal costs and monopoly prices (own calculations)

These results show that the marginal costs of the nitrogen produced by BASF-IG were very low compared to actual prices. On average, marginal costs represented 18% of actual price. In addition, an almost unitary elasticity distanced the monopoly price from marginal costs. On average, the actual price was 52% of monopoly price.15

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3. Conclusion and further research If the actual price in 1925 was 52% of monopoly price, does this mean that BASFIG was accepting earnings of only 52% of monopoly profits? Obviously not. If BASF-IG had decided to exit the cartel, begin a price war and become a domestic monopolist, the consequences would have been the following:

During the price war: Low prices in order to undercut competitors Decrease of profits (but probably no losses) Once monopoly established: Increase in prices up to monopoly level Increase in output, in order to met the demand curve Demand decreases due to increase in prices Change in average costs due to increase in output (the sign depends on the cost curve)

How much would the monopoly profit have been? At this stage of the research, it is not possible to draw any conclusions about this, as the cost curves cannot be calculated for the lack of data. It is clear that, even ignoring the losses due to the price war phase, in the case of monopoly the increase in profits would have been smaller than the increase in prices. However, a substantial increase in profits is not excluded. This leads to three further questions:

a. What role did exports play in the BASF-IG nitrogen profits?

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b. Did the existence of the cartel reduce BASF-IG costs, so that it compensated for the lower-than-monopoly price? c. To what extent did each of these two factors help compensate for lower-thanmonopoly prices?

Finally, it is possible that the survival of the cartel was based on an economic rationale, but because of the political environment that surrounded it, an attempt to give answers to the question of its survival cannot exclude non-economic explanations. When IG Farben was created, it was a polycentric firm, more similar to the juxtaposition of the former independent firms than to a new body. 16 Many of its directors were tied to other interests than those of the firm as a whole; among them, political concerns also played a role. Therefore, some choices could have not been fully oriented to the maximization of profits. To stay in the cartel was probably, in some moments, one of these choices.

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Appendix: Regression

Dependent Variable: Log TOTAL N-FERTILIZER SALES IN GERMANY Method: Least Squares Sample (adjusted): 1925 1938 Included observations: 14 after adjustments Variable Coefficient Std. Error t-Statistic C 3.474758 2.686916 1.293214 Log RELATIVE PRICES NITROGEN/AGRICULTURE -1.069206 0.167768 -6.373109 Log AGRARIAN PRODUCTION 0.288313 0.296416 0.972664 REAL PRICES FED-MAD(-1) R-squared 0.845844 Mean dependent var Adjusted R-squared 0.817815 S.D. dependent var S.E. of regression 0.111882 Akaike info criterion Sum squared resid 0.137695 Schwarz criterion Log likelihood 12.48728 F-statistic Durbin-Watson stat 1.715800 Prob(F-statistic)

Prob. 0.2224 0.0001 0.3516 6.016688 0.262123 -1.355326 -1.218385 30.17804 0.000034

Regression Relative price and income elasticity of demand

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Notes
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The involvement of the state in the cartel had many reasons: the existence of a national interest in the nitrogen industry a sensible argument, since the nitrogen industry had played a major role during the war in supplying both fertilizers for boosting agricultural production, and raw materials for production of explosives, and the financial commitment of the state in the largest Cyanamid firm. 2 International trade in nitrogen was possible, and theoretically could have exposed BASF to foreign competition. However, it is more likely that international producers suffered the dominant position of BASF, as this firm was by far the biggest producer in the world, and its production costs remained for long time among the lowest. Then, when international competition became threatening because of the increase in worlds capacity, the international market underwent a heavy cartelization, and the international cartel was established under the supervision of the German industry. 3 An explanation for this is necessary especially if one does not consider the years of the Nazi regime, 1933 to 1945, when membership in the cartel became virtually compulsory, and therefore its survival had probably no longer a purely economic rationale. 4 In the world BASF was the largest producer, even if several other firms had adopted similar high-pressure processes. 5 George W. Stocking and Myron W. Watkins, Cartels in action. Case studies in International Business Diplomacy, New York, The Twentieth Century Fund, 1946, p. 400-401. 6 Gottfried Plumpe, Die IG Farbenindustrie AG. Wirtschaft, Technik and Politik 1904-1945, Berlin, Dunckler & Humblot, 1990, p. 214-215. The plant in Oppau cost to BASF 50ml RM before the outbreak of WW1, but the biggest part of the investment for the enlargement of the plant and the building of the plant of Merseburg came during the war (465mln RM government loan up to end 1918) and immediately after the war (another 135mln during 1919 and 32mln in September 1919): These figures add up to 682mln RM. Moreover, in October 1919 BASF was allowed to borrow another 232mln RM from the Reich in order to complete Merseburg and Oppau, reaching the amount of 914mln RM, of which 464 borrowed from the state. 7 Fritz L. Haber, The chemical industry 1900-1930. International growth and technological change, Oxford, Clarendon, 1971, p. 88-89. 8 Helmuth Tammen, Die I.G. Farbenindustrie Aktiengesellschaft (1925-1933). Ein Chemiekonzern in der Weimarer Republik, Berlin, Helmuth Tammen Verlag, 1978, p. 42. 9 Burkhardt Roeper, Die Geschichte des Ruhr-Stickstoffs. Vom aeltesten Nebenprodukten-Verband des RuhrBergbaus, Manuscript, 1964, chap. XIII, p. 1. 10 About the rigidity of supply of byproduct nitrogen, see Stocking and Watkins, Cit., p. 127, ref. 13, and Gian S. Sahota, Fertilizer in economic development. An econometric analysis, Praeger, New York, 1968, p. 97. 11 Monika Friedrich, Die Aktivitten des Deutschen Stickstoff-Syndikats in gypten, in Zeitschrift fr Unternehmensgeschichte, 1993, n. 38, p. 28-29. 12 The nitrogen price index used here is an average of four indexes: that of the German Nitrogen Syndicate, that of the Statistisches Jahrbuch vom Deutschen Reich, a BASF-IG index, and one by Burkhardt Roeper, Cit., 1965, this latter produced on the basis of data collected by Rudolf Lachmann Mosse, Die Stickstoffindustrie und ihre internationale Kartellisierung, Dissertation, Zrich, 1940. The agricultural price index is that of the Statistisches Jahrbuch vom Deutschen Reich. 13 The German agricultural gross output has been estimated by Giovanni Federico, The growth of world agricultural production, 1800-1938, Research in economic history, 22, 2004, pp.125-182, and corrected by the Consumer Price Index calculated by Angus Maddison, Dynamic forces in capitalist development. A longrun comparative view. Oxford, Oxford University Press, 1991. 14 Monopoly price is obtained through the standard formula, using marginal cost corrected by nitrogen price index 1928, relative price elasticity of demand, and the result has been expressed again in nominal prices. 15 Unfortunately, there are still no data available to compare the marginal costs of synthetic nitrogen to those of nitrogen as a byproduct or in form of Cyanamid, and further research is required in order to draw conclusions about the equilibrium of price and costs in the cartel. 16 Werner Abelshauser et al., German industry and global enterprise, Cambridge, CUP, 2004, p.212, 217 and ff.