MODERN PRINCIPLES OF ECONOMICSThird Edition

Oligopoly and Game Theory Oligopoly and Game Theory

Chapter 15

Outline

� Cartels

� The Prisoner’s Dilemma

� Oligopolies

� When Are Cartels and Oligopolies Most Successful?

� Government Policy toward Cartels and Oligopolies

� Business Strategy and Changing the Game

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Introduction

� An oligopoly is an industry that is dominated by a small number of firms.

� A cartel is an oligopoly that tries to act together to reduce supply, raise prices, and increase profits.

� Even when an oligopoly is not able to collude, prices are likely to be higher than in a competitive market.

� Game theory is used to model decisions in

situations where the players interact.

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Definition

Oligopoly:

a market that is dominated by a small number of firms.

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Cartel:

a group of suppliers who try to act as if they were a monopoly.

Definition

Strategic decision making:

decision making in situations that are interactive.

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Self-Check

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An oligopoly is a market that is:

a. Dominated by one firm.

b. Dominated by cartels.

c. Dominated by a few firms.

Answer: c – an oligopoly is a market that is dominated by a few firms.

Cartels

� The Organization of Petroleum Exporting Countries (OPEC) is a cartel of oil-exporting countries.

� Between 1970 and 1974 OPEC cut back on their production of oil.

� The price of oil shot up from $7 per barrel to almost $38 a barrel.

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Cartels

The Price of Oil 1960 – 2012 8

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Cartels

Price Price

DD

Competitive Market(constant cost)

As if controlled by a monopolist

MC = ACSupply

PM

QuantityQuantity QMQC QC

PC

MR

Profit shared by

members of cartel

A cartel tries to move a market from “Competitive” toward “As If Controlled By a Monopolist”.

Self-Check

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Cartels try to increase their profits by:

a. Reducing costs.

b. Reducing quantity.

c. Increasing quantity.

Answer: b – cartels try to increase profits by reducing quantity and therefore increasing price.

Cartels

� Cartels tend to collapse and lose their power for three reasons:

1. Cheating by the cartel members.

2. New entrants and demand response.

3. Government prosecution and regulation.

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The Incentive to Cheat

� If a cartel succeeds, each member makes high profits.

� These profits create an incentive to cheat

� When everyone reduces production and price rises, some members will then cheat by producing more.

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Venezuelan President Hugo Chavez

hugs Saudi Crown Prince Abdullah

bin Abdul Aziz Al Saud during

an OPEC summit in 2000.

REUTERS/CORBIS

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The Incentive to Cheat

Price Price

DD

Monopoly Four-Firm Cartel

P1

QuantityQuantity QO Q1

PO

QO

PO

P1

Q1

� Monopoly ↑ quantity: it bears all of the loss due to the lower price.� Cartel member ↑ quantity: losses are shared with the other members.� Conclusion: A member of a cartel has a greater incentive to cheat.

Revenue

lost

Revenue

gained Revenue

gained

Revenue

lost

Other members

Self-Check

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One of the ways cartels lose their market power is through:

a. Competing with each other for customers.

b. Going bankrupt.

c. Members cheating on the agreement.

Answer: c – a member of a cartel can increase profits even further by cheating and producing more than they had originally agreed on.

Prisoner’s Dilemma

� A cartel cheating is one version of a game called the prisoner’s dilemma.

� It suggests that cooperation is difficult to maintain.

� Political scientist Elinor Ostrom showed that members of communities with repeated interaction generally find rules or norms that limit the prisoner’s dilemma.

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Definition

Prisoner’s dilemma:

a situation where the pursuit of individual interest leads to a group outcome that is in the interest of no one;

the negative counterpart to the invisible hand.

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Prisoner’s Dilemma

In this game, Cheat is a better strategy for each player no matter what the other player’s strategy.

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A Payoff Table

Definition

Dominant strategy:

a strategy that has a higher payoff than any other strategy no matter what the other player does.

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Self-Check

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A game where pursuing one’s own interest leads to an outcome that is in no one’s interest is called the:

a. Oligopoly outcome.

b. Dominant strategy.

c. Prisoner’s dilemma.

Answer: c – this is called the prisoner’s dilemma.

Collusion

� When only a handful of firms can realistically bid on a contract, it becomes profitable to collude.

� Firms can agree to take turns being the “low” bidder.

� Collusive outcomes may evolve even without explicit agreement.

� Collusion/cartels are illegal in the US except for…

� Government sanctioned cartels (agriculture, professional sports, taxi cab companies, etc)

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Definition

Tacit collusion:

when firms limit competition with one another but they do so without explicit agreement or communication.

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Oligopolies

� Oligopolies are markets dominated by a small number of firms.

� A firm in an oligopoly has some influence over price and therefore has an incentive to reduce output and increase price.

� Price in an oligopoly is likely to be below monopoly levels but above competitive levels.

� The more firms in an industry, the closer price will be to competitive levels.

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Oligopolies

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Price

Quantity

Demand

MC = AC

Four firm oligopoly:� Firm 4 ↓Q → ↑ price to P1 → Profit� Other firms ↑P → ↑ their profits

P1

P0

Q1 Q0

Profit increase firm 4

Profit increaseother firms.

Self-Check

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Oligopoly prices tend to be:

a. Lower than monopoly but higher than competitive prices.

b. Lower than monopoly or competitive prices.

c. Higher than monopoly but lower than competitive prices.

Answer: a – oligopoly prices tend to be lower than monopoly but higher than competitive prices.

Definition

Barriers to entry:

factors that increase the cost to new firms of entering an industry.

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Oligopolies

� Cartels and oligopolies tend to be most successful when there are barriers to entry.

� Important barriers to entry include:

1. Control over a key resource or input.

2. Economies of scale.

3. Network effects.

4. Government barriers.

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Government Policy

� Most cartels have been illegal in the United States since the Sherman Antitrust Act of 1890.

� Antitrust laws are used to prosecute cartels, block mergers, and break up very large firms.

� Sometimes governments reduce competition and create barriers to entry by supporting cartels.

� For example, the U.S. government raises the price of milk through subsidies and quotas.

� Government encouraged creation of cartels (price fixing) during the Great Depression.

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Government Policy

� Are cartels strictly a form of crony capitalism?

� Government-enforced monopolies and cartels are a serious problem facing poor nations.

� Government-supported cartels usually mean higher prices, lower-quality service, and less innovation.

� People spend their energies trying to get monopoly or cartel privileges from governments.

� Government becomes more corrupt.

� The most successful cartels operate with the

explicit support of (and enforcement by) the

government.

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Government Cartels

Government sponsored Cartel examples:

• Raisins (Raisin Administrative Committee)

• Raisin growers required to keep some portion of crop off market in a “raisin reserve”

• Growers who don’t collude are fined and/or penalized

• WHY DO THIS???

• Who pays? Who benefits?

• The free market is a dangerous idea apparently

• Crony capitalism29

Government Cartels

� Government sponsored Cartel examples:

• Milk Cartels – price fixing by region

• Created in 1930s to keep prices from falling (via Keynesian aggregate demand arguments even though people were going hungry)

• Cartels created for political reasons, not economic, producers abhor competition

• Yet people think that the government protects them from this sort of behavior

• Who pays? Who benefits?

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Government Cartels

� Government sponsored Cartel examples:

• Other examples:

• Credit rating agencies

• Certain labor unions, occupational licensing

• Sugar

• TBTF banks

• Numerous state and local laws or licensing requirements that protect politically favored businesses

• Taxi cartels (local government)

• Louisiana casket cartel31

Government Cartels

� "We never face a choice between regulation and no regulation. We face a choice between kinds of regulation: regulation by legislatures and bureaucracies, or regulation by market forces —regulation by restriction of choice, or regulation by the exercise of choice.“

� – Howard Baetjer

� http://fee.org/freeman/detail/theres-no-such-thing-as-an-unregulated-market

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There’s No Such Thing as an “Unregulated” Market

When market failure occurs, the presumption is that regulation will solve the problem:

Nirvana Fallacy is a name given to the informal fallacy of comparing actual things with unrealistic, idealized alternatives. It can also refer to the tendency to assume that there is a perfect solution to a particular problem.(perfectly)

Many regulatory agencies are subject to “regulatory capture”

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Business Strategy

� Suppose that Lowe’s and Home Depot are locked into a price war over refrigerator sales.

� Each firm could set a high price of $1,000 or a low price of $800.

� Assume that costs are zero and that there are 1,000 consumers.

� If both firms set a high price, each gets 500 consumers and makes a profit of $500,000 ($1,000 × 500).

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Business Strategy

� If one firm sets a low price ($800) while the other firm continues to set a high price then the low-price firm gets all the customers (1,000) and makes more money, $800,000.

� If both firms set a low price, then they again split the market and each makes $400,000.

� They both have the incentive to set low prices but would be better off (more $ profit) if they both set high profits

� i.e. they are in a “prisoner’s dilemma”

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Business Strategy

Lowe’s and Home Depot face the Prisoner’s Dilemma. The dominant

strategy is to set low prices.

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Business Strategy

Price Matching

� Suppose competing firms offer to match lower prices and give customers 10% of the difference.

� Rather than being a sign of a competitive market, this strategy encourages higher prices

� If one sets price at $1000 and the other at $800, customers can buy from the higher-priced firm at $800 – (10% x 800) = $780.

� The price match guarantee changes the payoffs and that changes the game.

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Price Matching

� A firm has no incentive to drop price, because its competitor will get all the customers.

� Lowe’s strategic decisions:

(1) Home Depot chooses High Price

Lowe’s earns $500,000 by choosing High Price

Lowe’s earns $0 by choosing Low Price.

(2) Home Deport Chooses Low Price

Lowe’s earns $780,000 by choosing High Price

Lowes earns $400,000 by choosing Low Price

� Same decisions are symmetric by Home Depot38

Price Matching

� Whatever choice Home Depot makes, it’s better for Lowe’s to choose High Price

� Note: When Lowe’s chooses to post a Low Price, consumers run to buy from Home Depot, which despite a high posted price offers to match the Lowe’s price and give consumers 10% of the difference in prices.

� The dominant strategy is to choose High Price

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Price Matching

A price match guarantee that looks pro-consumer changes the equilibrium strategies from:

{Low Price, Low Price} to {High Price, High Price}.

The price match guarantee plus the promise to pay 10% of the difference in price turns out to be a clever strategy that reduces the incentive of firms to compete with lower prices!

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Business Strategy

Lowe’s and Home Depot face the Prisoner’s Dilemma.

41The price matching game.

Business Strategy - Loyalty Plans

� Loyalty plans reward regular customers with special treatment or a better price.

� Once customers are locked in, firms don’t have to compete as much.

� If a firm raises price, its customers will remain loyal; if it lowers price, other firms’ customers will also remain loyal.

� Loyalty plans reduce competition: make customers more demand inelastic

� Loyalty plans increase monopoly power and results in higher prices.

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Self-Check

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Loyalty plans lead to:

a. Higher prices.

b. Lower prices.

c. More competition.

Answer: a – by encouraging lock-in, loyalty plans lead to monopoly power and thus higher prices.

Business Strategy

Innovation

� Pursuit of market power can lead to innovation and product differentiation.

� One reason firms innovate is to produce a product with fewer substitutes.

� Fewer substitutes mean more inelastic demand, leading to higher prices and profits.

� Firms also compete by differentiating their products with different styles or features.

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Innovation - Uber

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� Traditional taxi cab companies (TCC) – regulated by local governments

� Local cartel – must have license (or medallion) issued by government

� NYC medallions sold for over $1 million

� Limit and control supply raised cab prices and profits

� Who pays?

� Problem: TCC’s very inefficient, high search costs

• Why do cabs conglomerate around airports, hotels?

Innovation - Uber

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� Problem: TCC’s very inefficient, high search costs

• Why do cabs conglomerate around airports, hotels?

• TCCs have no way of gauging or responding to real time changes in demand

• Lots of idle resources

� Uber and other firms solved the “Search” & cost problems via technology

• The TCC’s had every opportunity to do this many years ago but didn’t

Innovation - Uber

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� Uber has eradicated search costs:

• Riders don’t have difficulty finding empty cabs

• Cars dispatched on real time demand

• No waiting around at highly probable locations

� Helps consumers who don’t like long waits or uncertainty (more value)

� Uber can dispatch more drivers during higher demand periods

Innovation - Uber

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� Uber’s social benefits:

� Allows far more efficient use of capital

� Enhances consumer welfare

� Consumers may buy fewer cars leading to savings and reducing environmental harms

� Less cars, more space for other things

Innovation - Uber

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� Does Uber have significant market power?

� Uber is a technology company

� Developed super efficient dispatch technology/software

� Direct spillover from smartphone tech

� What prevents entry/competition against Uber?

• Drivers drive their own vehicle, self-driving cars?

� Uber an idea that created immense value

� Will Uber be around in 10 years? (“Myspace”)

Innovation - Uber

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� AEI article on Uber:

� https://www.aei.org/publication/the-beauty-of-uber-and-why-it-represents-the-future-of-transportation-it-has-basically-eradicated-search-costs/

� Uber and the Great Taxicab Collapse (7:43)

� https://www.youtube.com/watch?v=n0yLhlQ6kCQ

Takeaway

� An oligopoly is a market dominated by a small number of firm.

� Oligopolies form when there are significant barriers to entry.

� Prices in an oligopoly tend to be below monopoly prices but above competitive prices.

� A cartel is an oligopoly that maximizes profits by limiting competition and producing the monopoly quantity.

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Takeaway

� Most cartels are not stable; either members cheat or new competitors enter the market.

� Governments break up some cartels, but enforce many others.

� Game theory is the study of strategic interaction.

� The prisoner’s dilemma game explains why cheating is common in cartels.

� Firms can reduce competitive pressures through price matching, loyalty programs, and innovation.

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