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Oligopoly Collusion and Game Theory

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

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Oligopoly Collusion and Game Theory

  1. 1. A2 MicroOligopoly – Collusion andGame TheoryTutor2u, Summer 2013
  2. 2. Tacit collusion
  3. 3. Overt collusion
  4. 4. Aims of price fixing by firmsBusinesses recognise their interdependence –act together to maximise joint profitsCut some of the costs of competition e.g.wasteful advertising / marketing warsReduces uncertainty – higher profits increasesproducer surplus / shareholder value
  5. 5. Aims of price fixing by firmsBusinesses recognise their interdependence –act together to maximise joint profitsCut some of the costs of competition e.g.marketing warsReduces uncertainty – higher profits increasesproducer surplus / shareholder value
  6. 6. Aims of price fixing by firmsBusinesses recognise their interdependence –act together to maximise joint profitsCut some of the costs of competition e.g.marketing warsReduces uncertainty – higher profits increasesproducer surplus / shareholder value
  7. 7. Cost & PriceOutput (Q)Price-Fixing Cartel in an OligopolyCost & PriceOutput (Q)Industry Demand and Costs Cartel Price and the Individual MemberMCMR ARQ1P1P1 becomes cartel priceWhen there are only a few dominant firms in a market, they can engage inRESTRICTIVE PRACTICES (such as cooperate to restrict output or fix higher prices)
  8. 8. P1Q1Cost & PriceOutput (Q)Price-Fixing Cartel in an OligopolyCost & PriceOutput (Q)Industry Demand and Costs Cartel Price and the Individual MemberMCMR ARMC Firm AAC Firm AP1 becomes cartel priceP1
  9. 9. P1Q1Cost & PriceOutput (Q)Price-Fixing Cartel in an OligopolyCost & PriceOutput (Q)Industry Demand and Costs Cartel Price and the Individual MemberMCMR ARMC Firm AAC Firm AP1 becomes cartel priceP1Outputquota forfirm
  10. 10. P1Q1Cost & PriceOutput (Q)Price-Fixing Cartel in an OligopolyCost & PriceOutput (Q)Industry Demand and Costs Cartel Price and the Individual MemberMCMR ARMC Firm AAC Firm AP1 becomes cartel priceP1Outputquota forfirmC1Super-normalprofit for thisfirm in the cartelProfit atcartel priceand stayingwithin thequota
  11. 11. P1Q1Cost & PriceOutput (Q)Price-Fixing Cartel in an OligopolyCost & PriceOutput (Q)Industry Demand and Costs Cartel Price and the Individual MemberMCMR ARMC Firm AAC Firm AP1 becomes cartel priceP1Outputquota forfirmC2Cheating –exceedingthe quotaHigher profitfrom producingin excess of theoutput quotaIncreasingoutput toachievehigherprofits
  12. 12. P1Q1Cost & PriceOutput (Q)Price-Fixing Cartel in an OligopolyCost & PriceOutput (Q)Industry Demand and Costs Cartel Price and the Individual MemberMCMR ARMC Firm AAC Firm AP1 becomes cartel priceP1Outputquota forfirmC2Cheating –exceedingthe quotaRISK!Over-supplythreatensstability ofcartel
  13. 13. Why are many cartel agreements unstable andtend to collapse or break down?Falling market demand Over-productionExposure by authorities Entry of non-cartel firms
  14. 14. Why are many cartel agreements unstable andtend to collapse or break down?Falling market demand Over-productionExposure by authorities Entry of non-cartel firms
  15. 15. Why are many cartel agreements unstable andtend to collapse or break down?Falling market demand Over-productionExposure by authorities Entry of non-cartel firms
  16. 16. Why are many cartel agreements unstable andtend to collapse or break down?Falling market demand Over-productionExposure by authorities Entry of non-cartel firms
  17. 17. Oligopolistic Energy Market in the UKThree million EDF Energy customerswill see their gas and electricity billsrise by nearly 11 per cent on averagefrom December 7. The company, whichis blaming high wholesale energy costsfor the price rise, is the fifth majorenergy firm to announce an increase inrecent months, following ScottishPower, nPower, British Gas and SSE.Tacitcollusion?Price leader?Renewablesobligations
  18. 18. Oligopolistic Energy Market in the UKThree million EDF Energy customerswill see their gas and electricity billsrise by nearly 11 per cent on averagefrom December 7. The company, whichis blaming high wholesale energy costsfor the price rise, is the fifth majorenergy firm to announce an increase inrecent months, following ScottishPower, nPower, British Gas and SSE.Tacitcollusion?Price leader?Renewablesobligations
  19. 19. Oligopolistic Energy Market in the UKThree million EDF Energy customerswill see their gas and electricity billsrise by nearly 11 per cent on averagefrom December 7. The company, whichis blaming high wholesale energy costsfor the price rise, is the fifth majorenergy firm to announce an increase inrecent months, following ScottishPower, nPower, British Gas and SSE.Tacitcollusion?Price leader?Renewablesobligations
  20. 20. Oligopolistic Energy Market in the UKThree million EDF Energy customerswill see their gas and electricity billsrise by nearly 11 per cent on averagefrom December 7. The company, whichis blaming high wholesale energy costsfor the price rise, is the fifth majorenergy firm to announce an increase inrecent months, following ScottishPower, nPower, British Gas and SSE.Tacitcollusion?Price leader?Renewablesobligations
  21. 21. Game Theory and CollusionGame theory is the study of howpeople behave in strategicsituations (i.e. when they mustconsider the effect of otherpeople’s responses to their ownactions).In an oligopoly, each companyknows that its profits depend onactions of other firms.This gives rise to the "prisoners’dilemma".Oligopoly theory makesheavy use of game theoryto model the behaviour ofoligopolies
  22. 22. The Prisoners’ DilemmaComment on the best strategies for eachplayer and the likely outcome in this gamePrisoner BSilent BetrayPrisonerASilent (6M,6M) (10Y,0)Betray (0,10Y) (5Y,5Y)
  23. 23. The Prisoners’ DilemmaPrisoner BSilent BetrayPrisonerASilent (6M,6M) (10Y,0)Betray (0,10Y) (5Y,5Y)Comment on the best strategies for each player and the likelyoutcome in this gameThe prisoners dilemma isa particular game thatillustrated why it isdifficult to cooperate,even when it is in the bestinterest of both parties.Both players select theirown dominant strategiesfor short-sighted personalgain. Eventually, theyreach an equilibrium inwhich they are both worseoff than they would havebeen, if they could bothagree to select analternative (non-dominant) strategy.
  24. 24. The Prisoners’ Dilemma – Decision TreesPrisoner BSilent BetrayPrisonerASilent (6M,6M) (10Y,0)Betray (0,10Y) (5Y,5Y)
  25. 25. Pricing GameBProfit High Prices Low PricesAHighPrices$3 bn; $3 bn $0 bn,$5 bnLowPrices$5 bn; $ 0bn $1 bn, $1 bnIn this two firm game, they have to decide whether to set high or low pricesThe table shows the profits (pay-offs) that results from each set of choices
  26. 26. Pricing GameBProfit High Prices Low PricesAHighPrices$3 bn; $3 bn $0 bn,$5 bnLowPrices$5 bn; $ 0bn $1 bn, $1 bnWhilst both firms want to charge high prices, there is always the incentive toundercut the other to steal market share, but this leads to a mutuallydestructive price war (low price, low price gives a sub-optimal outcome)
  27. 27. 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 betweenbusinesses (Trust)
  28. 28. Get help from fellowstudents, teachers andtutor2u on Twitter:@tutor2u_econ

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