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Oligopoly Collusion and Game Theory

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tutor2u
tutor2uDirector of Strategy

A2 micro, aspects of the key market structure of oligopoly and game theory

Oligopoly Collusion and Game Theory

1 of 29
A2 Micro
Oligopoly – Collusion and
Game Theory
Tutor2u, Summer 2013
Tacit collusion
Overt collusion
Aims of price fixing by firms
Businesses recognise their interdependence –
act together to maximise joint profits
Cut some of the costs of competition e.g.
wasteful advertising / marketing wars
Reduces uncertainty – higher profits increases
producer surplus / shareholder value
Aims of price fixing by firms
Businesses recognise their interdependence –
act together to maximise joint profits
Cut some of the costs of competition e.g.
marketing wars
Reduces uncertainty – higher profits increases
producer surplus / shareholder value
Aims of price fixing by firms
Businesses recognise their interdependence –
act together to maximise joint profits
Cut some of the costs of competition e.g.
marketing wars
Reduces uncertainty – higher profits increases
producer surplus / shareholder value
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Oligopoly Collusion and Game Theory

  • 1. A2 Micro Oligopoly – Collusion and Game Theory Tutor2u, Summer 2013
  • 4. Aims of price fixing by firms Businesses recognise their interdependence – act together to maximise joint profits Cut some of the costs of competition e.g. wasteful advertising / marketing wars Reduces uncertainty – higher profits increases producer surplus / shareholder value
  • 5. Aims of price fixing by firms Businesses recognise their interdependence – act together to maximise joint profits Cut some of the costs of competition e.g. marketing wars Reduces uncertainty – higher profits increases producer surplus / shareholder value
  • 6. Aims of price fixing by firms Businesses recognise their interdependence – act together to maximise joint profits Cut some of the costs of competition e.g. marketing wars Reduces uncertainty – higher profits increases producer surplus / shareholder value
  • 7. Cost & Price Output (Q) Price-Fixing Cartel in an Oligopoly Cost & Price Output (Q) Industry Demand and Costs Cartel Price and the Individual Member MC MR AR Q1 P1 P1 becomes cartel price When there are only a few dominant firms in a market, they can engage in RESTRICTIVE PRACTICES (such as cooperate to restrict output or fix higher prices)
  • 8. P1 Q1 Cost & Price Output (Q) Price-Fixing Cartel in an Oligopoly Cost & Price Output (Q) Industry Demand and Costs Cartel Price and the Individual Member MC MR AR MC Firm A AC Firm A P1 becomes cartel price P1
  • 9. P1 Q1 Cost & Price Output (Q) Price-Fixing Cartel in an Oligopoly Cost & Price Output (Q) Industry Demand and Costs Cartel Price and the Individual Member MC MR AR MC Firm A AC Firm A P1 becomes cartel price P1 Output quota for firm
  • 10. P1 Q1 Cost & Price Output (Q) Price-Fixing Cartel in an Oligopoly Cost & Price Output (Q) Industry Demand and Costs Cartel Price and the Individual Member MC MR AR MC Firm A AC Firm A P1 becomes cartel price P1 Output quota for firm C1 Super-normal profit for this firm in the cartel Profit at cartel price and staying within the quota
  • 11. P1 Q1 Cost & Price Output (Q) Price-Fixing Cartel in an Oligopoly Cost & Price Output (Q) Industry Demand and Costs Cartel Price and the Individual Member MC MR AR MC Firm A AC Firm A P1 becomes cartel price P1 Output quota for firm C2 Cheating – exceeding the quota Higher profit from producing in excess of the output quota Increasing output to achieve higher profits
  • 12. P1 Q1 Cost & Price Output (Q) Price-Fixing Cartel in an Oligopoly Cost & Price Output (Q) Industry Demand and Costs Cartel Price and the Individual Member MC MR AR MC Firm A AC Firm A P1 becomes cartel price P1 Output quota for firm C2 Cheating – exceeding the quota RISK! Over-supply threatens stability of cartel
  • 13. Why are many cartel agreements unstable and tend to collapse or break down? Falling market demand Over-production Exposure by authorities Entry of non-cartel firms
  • 14. Why are many cartel agreements unstable and tend to collapse or break down? Falling market demand Over-production Exposure by authorities Entry of non-cartel firms
  • 15. Why are many cartel agreements unstable and tend to collapse or break down? Falling market demand Over-production Exposure by authorities Entry of non-cartel firms
  • 16. Why are many cartel agreements unstable and tend to collapse or break down? Falling market demand Over-production Exposure by authorities Entry of non-cartel firms
  • 17. Oligopolistic Energy Market in the UK Three million EDF Energy customers will see their gas and electricity bills rise by nearly 11 per cent on average from December 7. The company, which is blaming high wholesale energy costs for the price rise, is the fifth major energy firm to announce an increase in recent months, following Scottish Power, nPower, British Gas and SSE. Tacit collusion? Price leader? Renewables obligations
  • 18. Oligopolistic Energy Market in the UK Three million EDF Energy customers will see their gas and electricity bills rise by nearly 11 per cent on average from December 7. The company, which is blaming high wholesale energy costs for the price rise, is the fifth major energy firm to announce an increase in recent months, following Scottish Power, nPower, British Gas and SSE. Tacit collusion? Price leader? Renewables obligations
  • 19. Oligopolistic Energy Market in the UK Three million EDF Energy customers will see their gas and electricity bills rise by nearly 11 per cent on average from December 7. The company, which is blaming high wholesale energy costs for the price rise, is the fifth major energy firm to announce an increase in recent months, following Scottish Power, nPower, British Gas and SSE. Tacit collusion? Price leader? Renewables obligations
  • 20. Oligopolistic Energy Market in the UK Three million EDF Energy customers will see their gas and electricity bills rise by nearly 11 per cent on average from December 7. The company, which is blaming high wholesale energy costs for the price rise, is the fifth major energy firm to announce an increase in recent months, following Scottish Power, nPower, British Gas and SSE. Tacit collusion? Price leader? Renewables obligations
  • 21. Game Theory and Collusion Game theory is the study of how people behave in strategic situations (i.e. when they must consider the effect of other people’s responses to their own actions). In an oligopoly, each company knows that its profits depend on actions of other firms. This gives rise to the "prisoners’ dilemma". Oligopoly theory makes heavy use of game theory to model the behaviour of oligopolies
  • 23. The Prisoners’ Dilemma Comment on the best strategies for each player and the likely outcome in this game Prisoner B Silent Betray Prisoner A Silent (6M,6M) (10Y,0) Betray (0,10Y) (5Y,5Y)
  • 24. The Prisoners’ Dilemma Prisoner B Silent Betray Prisoner A Silent (6M,6M) (10Y,0) Betray (0,10Y) (5Y,5Y) Comment on the best strategies for each player and the likely outcome in this game The prisoners' dilemma is a particular game that illustrated why it is difficult to cooperate, even when it is in the best interest of both parties. Both players select their own dominant strategies for short-sighted personal gain. Eventually, they reach an equilibrium in which they are both worse off than they would have been, if they could both agree to select an alternative (non- dominant) strategy.
  • 25. The Prisoners’ Dilemma – Decision Trees Prisoner B Silent Betray Prisoner A Silent (6M,6M) (10Y,0) Betray (0,10Y) (5Y,5Y)
  • 26. Pricing Game B Profit High Prices Low Prices A High Prices $3 bn; $3 bn $0 bn,$5 bn Low Prices $5 bn; $ 0bn $1 bn, $1 bn In this two firm game, they have to decide whether to set high or low prices The table shows the profits (pay-offs) that results from each set of choices
  • 27. Pricing Game B Profit High Prices Low Prices A High Prices $3 bn; $3 bn $0 bn,$5 bn Low Prices $5 bn; $ 0bn $1 bn, $1 bn Whilst both firms want to charge high prices, there is always the incentive to undercut the other to steal market share, but this leads to a mutually destructive price war (low price, low price gives a sub-optimal outcome)
  • 28. Game Theory Applications for Business • Interdependent pricing • Decisions on how much to spend on – Research and development – Marketing – New product launches • Co-operative and collaboration between businesses (Trust)
  • 29. Get help from fellow students, teachers and tutor2u on Twitter: @tutor2u_econ