Collusive Oligopoly or Joint Profit Maximization

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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.

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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.

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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.

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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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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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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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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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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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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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.

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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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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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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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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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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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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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A Kinked Demand Curve
P
Price
D1
MR
D2
Quantity
Q

• What does the firms demand curve look like?

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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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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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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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P
Price
c
d
Firms perceived demand curve
MR
Quantity
Q
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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.

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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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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.

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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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The Prisoners Dilemma

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

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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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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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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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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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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.

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Duopoly
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Duopoly
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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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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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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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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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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.

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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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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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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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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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The Payoff Matrix Or Table
A Does not cheat A Cheats
B Does not cheat B Cheats
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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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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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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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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.

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