Title: Collusive Oligopoly or Joint Profit Maximization
1Collusive 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.
2Consider 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.
3A 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.
4A 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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5The 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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6Joint 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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7One 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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8The 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.
9The 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.
10After 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.
11At 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.
12Nonetheless
- 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.
13The 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.
14The 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.
15Cheating 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.
16The 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.
17The 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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18Price 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.
19A 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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20Moreover
- 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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21The 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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22In 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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23The 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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24An 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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25A Kinked Demand Curve
P
Price
D1
MR
D2
Quantity
Q
- What does the firms demand curve look like?
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26P
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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27P
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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28P
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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29P
Price
c
d
Firms perceived demand curve
MR
Quantity
Q
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30Game 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.
31The 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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32Why 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.
33Second
- 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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34The Prisoners Dilemma
- Lets look at the Prisoners Dilemma, a
well-known game that demonstrates the difficulty
of cooperative behavior in certain circumstances.
35Bonnie 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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36Bonnie 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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37Why 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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38In 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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39Duopoly
- 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.
40Duopoly
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41Duopoly
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42Price
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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43Price
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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44Price
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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45Price
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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46So 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.
47Price
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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48Price
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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49Price
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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50The 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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51The Payoff Matrix Or Table
A Does not cheat A Cheats
B Does not cheat B Cheats
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52The 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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53The 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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54Nash 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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55Conclusion
- That completes our discussion of oligopoly.
- Well return to the broader topic of imperfect
competition in a later lecture on government
regulation and antitrust.
56End Of Lesson
Lecturer Peter Navarro Multimedia Designer Ron
Kahr Female Voiceover Ashley West Leonard