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Collusive Oligopoly or Joint Profit Maximization

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Title: Collusive Oligopoly or Joint Profit Maximization


1
Collusive Oligopoly orJoint Profit Maximization
  • The cartel model provides insight into the price
    and quantity that oligopolists are likely to set
    when they can collude successfully.

2
Consider A Four-Firm Industry
  • Each firm has grown tired of ruinous price wars.
  • During the industrys annual trade show in Las
    Vegas, the Chief Executive Officers of all four
    companies ignore antitrust laws against explicit
    collusion and risk a possible jail sentence as
    they slip off to a secret rendezvous.

3
A Negotiated Price
  • They then negotiate what price should be charged
    for the product.
  • And, of course, as part of their secret cartel
    agreement, each firm will also have to agree to
    restrict its output so the price can be
    maintained in the market.

4
A Question
  • So where do you think these oligopolists will set
    price?
  • a) The oligopoly will set price equal to marginal
    cost.
  • b) The oligopoly will set marginal revenue equal
    to marginal cost.
  • c) This is an incredibly obscure question.

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5
The Answer
  • So where do you think these oligopolists will set
    price?
  • a) The oligopoly will set price equal to marginal
    cost.
  • b) The oligopoly will set marginal revenue equal
    to marginal cost.
  • c) This is an incredibly obscure question.
  • If the oligopolists can truly coordinate their
    activities, the obvious price to set is the same
    as that which would be set by a monopolist.

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6
Joint Profit Maximization Model
  • Price will be set by the profit-maximizing rule
    of marginal revenue equals marginal cost.
  • If price is set at that point, the oligopolists
    will jointly maximize their profits, which is why
    this model is often called the joint profit
    maximization model.

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7
One Other Point
  • In order for the monopoly price to hold in the
    marketplace, total industry output must equal the
    monopoly output.
  • This is where problems with the cartel are likely
    to emerge because if any one firm in the
    oligopoly decides to cheat by producing more than
    its agreed upon share of output, it can make
    higher profits than if it adheres to the cartel
    agreement.

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8
The OPEC Cheating Example
  • In the days of 1973 and 1974, few, if any
    economists, believed OPEC would turn out to be
    such a paper tiger.
  • During those years, the members of OPEC banded
    together, slapped an oil embargo on the U.S for
    its support of Israel, and more than quadrupled
    prices.

9
The Result
  • Was long gas lines and a strong negative shock to
    the American economy.
  • Under international law, OPECs cartel behavior
    was quite legal even if cartels are illegal
    within the U.S.

10
After The 1970s
  • The OPEC cartel has been unable to keep the price
    of oil high, and at least part of the problem has
    been on the demand side.
  • After the 1970s oil price shocks, motorists
    started driving smaller, more fuel efficient
    cars, homeowners more fully insulated their
    homes, businesses adopted new technologies to
    dramatically cut energy use, and the world, in
    general, adopted wide ranging energy conservation
    measures.

11
At The Same Time
  • On the supply side, higher oil prices stimulated
    the search for new oil reserves, and many
    non-OPEC members like Norway and Mexico entered
    the global oil market.

12
Nonetheless
  • The biggest problem was not these forces of
    supply and demand but rather that OPEC has faced
    wide scale cheating within its ranks.
  • This is due largely to the economic and political
    diversity of members as well as the large number
    of members -- 13 in the cartel.

13
The Wealthier Countries
  • The sparsely populated and fabulously wealthy
    members of the cartel like Saudi Arabia, Kuwait,
    and Qatar have been perfectly content to restrict
    output and enjoy monopoly profits.

14
The Poorer Countries
  • Other much more populous and poorer nations like
    Venezuela and Nigeria havent been able to resist
    the urge to cheat on their production quotas
    because of large external debts to be paid and
    growing needs for cash.

15
Cheating Occurs
  • Cheating has arisen with other nations like Iran,
    Iraq, and Libya.
  • They have used their oil wealth to fund military
    operations against their neighbors.

16
The End Result
  • After adjusting for inflation, the price of oil
    in the 1990s is actually less than it was at the
    beginning of the 1970s before OPEC raised the
    price.

17
The Broader Problem
  • OPEC has no effective enforcement mechanism to
    police its agreements.
  • It has little effective way to punish any members
    who do cheat on the collusive bargain.

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18
Price Leadership
  • Provides insight into how firms in an industry
    might tacitly collude as well as how firms which
    refuse to collude might be punished.
  • In the price leadership model, the policing or
    enforcement mechanism used is often punishment by
    the price leader usually the biggest or
    dominant firm in the industry.

19
A Dominant Firm
  • With price leadership, executives within the
    industry dont have to slip off to a secret
    rendezvous in Vegas to set prices.
  • Rather, a practice evolves where the dominant
    firm --usually the largest firm-- initiates a
    price change and all other firms more or less
    automatically follow that price change.

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20
Moreover
  • If one or more firms refuse to follow suit, the
    price leader may choose to back down.
  • Alternatively, it may punish the
    non-cooperative firms by significantly lowering
    prices for a while, forcing the followers to
    incur losses.
  • In this way, the oligopoly can maintain price
    discipline.

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21
The Cigarette Industry
  • The Big Three firms Reynolds, American, and
    Liggett and Meyer evolved a highly profitable
    practice of price leadership which resulted in
    virtually identical prices over the entire period
    between 1923 and 1941.
  • During that period, the companies averaged a
    whopping 18 percent rate of return after taxes
    roughly double the rate earned by American
    manufacturing as a whole.

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22
In More Recent Times
  • Other industries such as farm machinery,
    anthracite coal, cement, copper, gasoline,
    newsprint, tin cans, lead, sulfur, rayon,
    fertilizer, glass containers, steel, automobiles
    and nonferrous metals have likewise practiced
    some type of price leadership.

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23
The Kinked Demand Curve
  • This model helps to explain why prices are
    sticky in oligopolistic industries, that is,
    why prices dont rapidly adjust to changes in
    supply and demand.
  • The model also helps explain why prices may be
    high relative to the perfect competition outcome
    -- even if there is no collusion.

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24
An Example
  • Imagine an oligopolistic industry with three
    firms, A, B, and C, each of which have one-third
    of the total market.
  • Further assume that each firm sets its price
    independently, meaning that there is no
    collusion, and that the going price for Firm As
    product is P times Q with current sales of Q.

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25
A Kinked Demand Curve
P
Price
D1
MR
D2
Quantity
Q
  • What does the firms demand curve look like?

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26
P
Price
D1
MR
D2
Quantity
Q
  • If Firm A raises its price, and the firm believes
    that the other firms wont go along, its
    perceived demand curve for increasing price will
    be very elastic.

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27
P
Price
D1
MR
D2
Quantity
Q
  • Alternatively, suppose Firm A decides to lower
    its price. What might it most logically expect
    its rivals to do?
  • a) Ignore the price decrease and lose market
    share to Firm A.
  • b) Match the price decrease and maintain their
    market shares relative to Firm A.
  • c) Invite the CEO of Firm A to Vegas for a little
    secret chat.

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28
P
Price
D1
D2
MR
Quantity
Q
  • Alternatively, suppose Firm A decides to lower
    its price. What might it most logically expect
    its rivals to do?
  • a) Ignore the price decrease and lose market
    share to Firm A.
  • b) Match the price decrease and maintain their
    market shares relative to Firm A.
  • c) Invite the CEO of Firm A to Vegas for a little
    secret chat.

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29
P
Price
c
d
Firms perceived demand curve
MR
Quantity
Q
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30
Game Theory
  • You can see from these three traditional models
    of oligopoly behavior how important the strategic
    behavior of rivals can be in determining the
    eventual outcome in an industry.
  • Lets take a deeper look at these strategic
    interactions through the lens of game theory.

31
The Guiding Philosophy
  • You will pick your strategy by asking what makes
    most sense assuming that your rival is analyzing
    your strategy and acting in his or her own best
    interest.

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32
Why It Is Important
  • First, the many different possible games
    articulated by the theory help capture the
    essence and complexity of oligopoly conduct.
  • With mutual interdependence recognized between
    firms, oligopoly conduct becomes a game of
    strategy such as poker, chess or bridge.
  • The best way to play your hand in a poker game
    depends on the way rivals play theirs.

33
Second
  • The insights of game theory thereby help to
    underscore why such collusion is often made
    illegal in a given economic system.

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34
The Prisoners Dilemma
  • Lets look at the Prisoners Dilemma, a
    well-known game that demonstrates the difficulty
    of cooperative behavior in certain circumstances.

35
Bonnie And Clyde
  • Two suspects in a bank robbery Bonnie and Clyde
    are arrested and interrogated in separate
    rooms.
  • Each of the prisoners is offered the following
    options
  • 1) If one prisoner confesses and the other does
    not, the one who confesses will go free and the
    other will be given a 20-year sentence.
  • 2) If both confess, each will receive a 5-year
    sentence.
  • 3) If neither confesses, each will be given a
    6-month sentence on a minor charge.

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36
Bonnie And Clyde
  • Each of the prisoners is offered the following
    options
  • a) If one prisoner confesses and the other does
    not, the one who confesses will go free and the
    other will be given a 20-year sentence.
  • b) If both confess, each will receive a 5-year
    sentence.
  • c) If neither confesses, each will be given a
    6-month sentence on a minor charge.

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37
Why Both Confess
  • If both prisoners could talk to one another after
    they are arrested, they could collusively agree
    not to confess and both would get light sentences
    if they kept the bargain.
  • In the absence of collusion, however, there is
    great pressure on each prisoner to confess
    because he or she knows that if he doesnt
    confess and his partner does, hell get a very
    long sentence.

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38
In The Absence Of Collusion
  • The typical result is that both prisoners confess
    and get medium sentences.
  • This is because the only other way out of the
    Prisoners Dilemma is trust.
  • But trust is something that is very hard to come
    by unless there is an explicit enforcement
    mechanism.

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39
Duopoly
  • The Prisoners Dilemma has its simplest
    application to oligopoly when the oligopoly is a
    duopoly, that is, when the industry consists of
    only two firms.
  • A duopoly might emerge in an industry when the
    minimum efficient scale of production is about
    half that of the total industry sales.

40
Duopoly
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41
Duopoly
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42
Price
Price
MC
SMC
ATC
600
575
ATC
A
500
MR
D
4000
8000
6000
Quantity
Quantity
  • What is the likely strategic pricing decision to
    be, how much will each produce, and what will be
    their total economic profits?
  • a) Price will be set at 500, each will produce
    4000 tons, and economic profits will be zero.
  • b) Price will be set at 600, each will produce
    3000 tons, and economic profits will be 75,000
    per firm.
  • c) Im still thinking about that trip to Vegas.

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43
Price
Price
MC
SMC
ATC
600
575
ATC
A
500
MR
D
4000
8000
6000
Quantity
Quantity
  • What is the likely strategic pricing decision to
    be, how much will each produce, and what will be
    their total economic profits?
  • a) Price will be set at 500, each will produce
    4000 tons, and economic profits will be zero.
  • b) Price will be set at 600, each will produce
    3000 tons, and economic profits will be 75,000
    per firm.
  • c) Im still thinking about that trip to Vegas.

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44
Price
Price
MC
SMC
ATC
600
575
ATC
A
500
MR
D
4000
8000
6000
Quantity
Quantity
  • What is the likely market price, output, and
    profit and which of the three traditional
    oligopoly models does this outcome most resemble?
  • a) Price will be set at 500, each will produce
    4000 tons, and economic profits will be zero.
    This resembles the kinked demand model.
  • b) Price will be set at 600, each will produce
    3000 tons, and economic profits will be 75,000
    per firm. This resembles the cartel or joint
    profit maximization model.
  • c) Ive stopped thinking about my trip to Vegas
    but now must confront the bleak possibility that
    I will get this question wrong and never become a
    titan of industry.

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45
Price
Price
MC
SMC
ATC
600
600
575
ATC
575
A
500
MR
D
4000
8000
6000
3000
Quantity
Quantity
  • What is the likely market price, output, and
    profit and which of the three traditional
    oligopoly models does this outcome most resemble?
  • a) Price will be set at 500, each will produce
    4000 tons, and economic profits will be zero.
    This resembles the kinked demand model.
  • b) Price will be set at 600, each will produce
    3000 tons, and economic profits will be 75,000
    per firm. This resembles the cartel or joint
    profit maximization model.
  • c) Ive stopped thinking about my trip to Vegas
    but now must confront the bleak possibility that
    I will get this question wrong and never become a
    titan of industry.

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46
So Far So Good
  • Now lets entertain the possibility that while
    the two duopolists fully collude and shake hands
    on the deal, one of them is a no-good,
    back-stabbing, four-flushing, varmint who decides
    to cheat.

47
Price
Price
MC
SMC
ATC
600
575
575
ATC
A
550
550
500
MR
D
4000
8000
6000
Quantity
Quantity
7000
  • What happens now to the market price, output, and
    profit?
  • a) Price falls to 550, industry output increases
    to 7000 tons, the non-cheating firm loses
    75,000, and the cheating duopolist makes a
    200,000 economic profit.
  • b) Price falls to 500, industry output increases
    to 8000 tons, and both firms earn zero economic
    profits.
  • c) The CEO of the non-cheating firm starts
    listening to country music and his favorite song
    becomes Your Cheating Heart.

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48
Price
Price
MC
SMC
ATC
600
575
575
ATC
A
550
550
500
MR
D
4000
8000
6000
3000
Quantity
Quantity
3000
7000
  • What happens now to the market price, output, and
    profit?
  • a) Price falls to 550, industry output increases
    to 7000 tons, the non-cheating firm loses
    75,000, and the cheating duopolist makes a
    200,000 economic profit.
  • b) Price falls to 500, industry output increases
    to 8000 tons, and both firms earn zero economic
    profits.
  • c) The CEO of the non-cheating firm starts
    listening to country music and his favorite song
    becomes Your Cheating Heart.

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49
Price
Price
MC
SMC
ATC
600
575
ATC
A
550
500
MR
D
4000
8000
6000
Quantity
Quantity
7000
  • This example should demonstrate clearly the often
    huge incentives to cheat that colluding
    oligopolists face.
  • In this case, the successful cheater can more
    than double his profits from 75,000 to 200,000.

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50
The Payoff Matrix
  • Now it is precisely to provide insight into this
    type of strategic situation that game theory was
    developed.
  • It does so by analyzing the strategies of both
    firms under all circumstances and placing the
    combinations in a so-called payoff matrix or
    payoff table.

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51
The Payoff Matrix Or Table
A Does not cheat A Cheats
B Does not cheat B Cheats
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52
The Payoff Matrix Or Table
A Does not cheat A Cheats
A 75,000
A 200,000
B Does not cheat B Cheats
B -75,000
B 75,000
A -75,000
A 0
B 200,000
B 0
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53
The Payoff Matrix Or Table
A Does not cheat A Cheats
A 75,000
A 200,000
B Does not cheat B Cheats
B -75,000
B 75,000
A -75,000
A 0
Nash Equilibrium
B 200,000
B 0
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54
Nash Equilibrium
  • Describes a situation in which no player can
    improve his or her payoff given the other
    player's strategy.
  • This often describes a noncooperative
    equilibrium.
  • In the absence of collusion, each part chooses
    that strategy which is best for itself.

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55
Conclusion
  • That completes our discussion of oligopoly.
  • Well return to the broader topic of imperfect
    competition in a later lecture on government
    regulation and antitrust.

56
End Of Lesson
Lecturer Peter Navarro Multimedia Designer Ron
Kahr Female Voiceover Ashley West Leonard
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