Collusion and Competition

Firms in an oligopoly can increase their revenues through collusion, but collusive arrangements are naturally unstable.

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Learning Objectives

Assess the considerations affiliated in the oligopolist’s decision about whether to contend or cooperate

Key Takeaways

Key PointsFirms in one oligopoly may collude to collection a price or output level for a market in order to maximize market profits. In ~ an extreme, the colluding firms have the right to act together a monopoly.Oligopolists pursuing your individual self-interest would create a better quantity 보다 a monopolist, and also charge a reduced price.Collusive species are normally illegal. Moreover, that is complicated for that company to name: coordinates actions, and also there is a danger that firms may defect and also undermine the others in the arrangement.Price leadership, i m sorry occurs as soon as a dominant challenger sets the sector price and also others monitor suit, is an informal form of collusion i m sorry is normally legal.Key TermsPrice leadership: Occurs when one company, typically the dominant competitor amongst several, leads the way in identify prices, the others quickly following.collusion: A an enig agreement for an illegal purpose; conspiracy.price fixing: one agreement in between sellers to market a product just at a resolved price, or keep the market conditions such that the price is preserved at a offered level by managing supply.

Oligopoly is a market structure in which there room a couple of firms creating a product. As soon as there are few firms in the market, they may collude to collection a price or calculation level for the market in order to maximize sector profits. As a result, price will be greater than the market-clearing price, and output is likely to it is in lower. In ~ the extreme, the colluding firms might act as a monopoly, reducing their individual calculation so that their cumulative output would equal the of a monopolist, permitting them come earn higher profits.


OPEC: The oil-producing nations of OPEC have actually at time cooperated to raise human being oil prices in order to secure a steady income for themselves.

If oligopolists individually gone after their very own self-interest, climate they would produce a full quantity greater than the monopoly quantity, and also charge a lower price than the syndicate price, therefore earning a smaller sized profit. The promise of larger profits offers oligopolists an motivation to cooperate. However, collusive oligopoly is inherently unstable, since the most efficient firms will certainly be tempted to break ranks through cutting prices in bespeak to boost market share.

Several determinants deter collusion. First, price-fixing is illegal in the united States, and also antitrust regulations exist to protect against collusion between firms. Second, coordination among firms is difficult, and becomes much more so the better the variety of firms involved. Third, over there is a threat of defection. A firm may agree come collude and also then rest the agreement, undercutting the profits of the firms still holding to the agreement. Finally, a firm may be discouraged from collusion if that does no perceive chin to have the ability to effectively punishment firms that may break the agreement.

In comparison to price-fixing, price management is a type of informal collusion i beg your pardon is normally legal. Price leadership, which is likewise sometimes referred to as parallel pricing, occurs once the dominant contender publishes the price ahead of other firms in the market, and the various other firms then complement the announced price. The leader will certainly typically set the price to maximize that is profits, which might not be the price that maximized various other firms’ profits.

Game theory Applications come Oligopoly

Game theory gives a structure for understanding exactly how firms behave in one oligopoly.

Learning Objectives

Explain how video game theory applies to oligopolies

Key Takeaways

Key PointsIn an oligopoly, that company are influenced not just by their own production decisions, however by the production decisions of various other firms in the market as well. Video game theory models cases in which every actor, once deciding on a food of action, must likewise consider exactly how others could respond to that action.The prisoner’s dilemma is a type of video game that illustrates why collaboration is an overwhelming to keep for oligopolists also when the is support beneficial. In this game, the leading strategy of each actor is come defect. However, exhilaration in self-interest leader to a sub-optimal cumulative outcome.The Nash equilibrium is an essential concept in game theory. The is the set of techniques such that no player deserve to do better by unilaterally transforming his or she strategy.Game theory is generally not required to recognize competitive or monopolized markets.Key TermsPrisoner’s dilemma: A game that shows why 2 individuals can not cooperate, also if it shows up that it is in their best interests to carry out theory: A branch of applied mathematics that studies strategic situations in which people or organisations select various actions in an effort to maximize their returns.Nash equilibrium: The set of players’ tactics for i m sorry no player can advantage by transforming his or she strategy, assuming that the various other players save theirs unchanged.

In an oligopoly, firms space interdependent; lock are impacted not only by their very own decisions regarding how much to produce, yet by the decisions of various other firms in the sector as well. Video game theory offers a useful framework for thinking about how firms may act in the paper definition of this interdependence. More specifically, game theory can be offered to model cases in which every actor, as soon as deciding ~ above a course of action, must likewise consider exactly how others might respond to that action.

For example, game theory can explain why oligopolies have trouble preserving collusive arrangements come generate monopoly profits. While firms would be far better off jointly if castle cooperate, every individual firm has actually a strong incentive come cheat and undercut their competitors in bespeak to rise market share. Due to the fact that the motivation to defect is strong, firms might not even enter into a collusive agreement if lock don’t perceive there to be a way to successfully punish defectors.

The prisoner’s dilemma is a specific type of game in video game theory the illustrates why teamwork may be an overwhelming to preserve for oligopolists also when the is mutually beneficial. In the game, two members of a criminal gang space arrested and imprisoned. The detainees are separated and also left come contemplate their options. If both detainees confess, each will serve a two-year jail term. If one confesses, but the various other denies the crime, the one that confessed will walk free, if the one that denied the crime would gain a three-year sentence. If both refuse the crime, they will both serve only a one year sentence. Betraying the partner by confessing is the leading strategy; that is the better strategy because that each player nevertheless of just how the various other plays. This is known as a Nash equilibrium. The an outcome of the video game is that both prisoners pursue individual logic and also betray, when they would have collectively gotten a better outcome if they had actually both cooperated.

Prisoner’s Dilemma: In a prisoner’s dilemma game, the dominant strategy because that each player is come betray the other, also though teamwork would have led to a much better collective outcome.

The Nash equilibrium is an important concept in game theory. It is the collection of strategies such that no player can do much better by unilaterally changing his or she strategy. If a player knew the methods of the various other players (and those strategies might not change), and could not benefit by an altering his or her strategy, then that set of tactics represents a Nash equilibrium. If any kind of player would advantage by changing his or she strategy, then that collection of strategies is not a Nash equilibrium.

While video game theory is vital to expertise firm actions in oligopolies, that is usually not needed to know competitive or monopolized markets. In competitive markets, firms have such a little individual result on the market, the taking other firms right into account is just not necessary. A monopolized market has actually only one firm, and also thus strategy interactions perform not occur.

The Prisoner’s Dilemma and also Oligopoly

The prisoner’s dilemma reflects why two individuals could not cooperate, also if the is jointly in their best interest to do so.

Learning Objectives

Analyze the prisoner’s dilemma making use of the concepts of strategic dominance, Pareto optimality, and Nash equilibria

Key Takeaways

Key PointsIn the game, two criminals room arrested and also imprisoned. Each criminal have to decide whether he will cooperate v or betray his partner. The criminals cannot interact to coordinate your actions.Betrayal is the dominant strategy because that both football player in the game. Treason leads to ideal individual outcome regardless the what the other human does.Both players selecting betrayal is the Nash equilibrium of the game. However, this result is not Pareto-optimal. Both players would certainly have clearly been much better off if they had actually cooperated.Cooperation by firms in oligopolies is difficult to accomplish because defection is in the finest interest of each individual firm.Key TermsPareto optimal: explicate a instance in i beg your pardon the benefit of one party cannot be increased without reducing the profit of another.Nash equilibrium: The collection of players’ strategies for i beg your pardon no player can advantage by changing his or her strategy, assuming the the various other players keep theirs unchanged.Strategic dominance: Occurs as soon as one strategy is much better than one more strategy for one player, no matter just how that player’s adversaries may play.

Sometimes firms fail come cooperate with each other, also when teamwork would bring about a better collective outcome. The prisoner’s dilemma is a canonical instance of a video game analyzed in game theory that mirrors why two individuals can not cooperate, even if it shows up that it is in their ideal interest to do so.

In the game, two members that a criminal gang are arrested and imprisoned. Each prisoner is in solitary confinement v no way of speaking to or trading messages through the other. The police market each sinner a bargain:

Prisoner’s Dilemma: treason in the leading strategy for both players, as it provides for a much better individual outcome regardless that what the various other player does. However, the resulting result is not Pareto-optimal. Both football player would plainly have been much better off if they had actually cooperated.

If prisoner A and also Prisoner B both confess to the crime, each of them will certainly serve 2 years in prison.If A confesses however B denies the crime, A will certainly be set free, when B will certainly serve 3 years in jail (and angry versa).If both A and B refuse the crime, both of castle will just serve one year in prison.

For both players, the an option to betray the companion by confessing has actually strategic supremacy in this situation; it is the much better strategy because that each player nevertheless of what the various other player does. This set of techniques is thus a Nash equilibrium in the game–no player would certainly be much better off by an altering his or she strategy. Together a result, every purely self-interested prisoners would betray every other, resulting in a two year prison sentence for both. This outcome is not Pareto optimal; that is plainly possible to enhance the outcomes for both players through cooperation. If both players had actually denied the crime, they would each be serving just one year in prison.

Similarly to the prisoner’s dilemma scenario, cooperation is challenging to keep in an oligopoly since cooperation is no in the ideal interest that the individual players. However, the cumulative outcome would certainly be boosted if this firm cooperated, and were thus able to maintain low production, high prices, and syndicate profits.

One timeless example of video game theory and also the prisoner’s dilemma in practice requires soft drinks. Coca-Cola and also Pepsi compete in one oligopoly, and thus are extremely competitive against one one more (as lock have limited other compete threats). Considering the similarity that their commodities in the soft drink sector (i.e. Varying species of soda), any kind of price deviation on component of one contender is viewed as an act of non-conformity or betrayal of an created status quo.

In such a scenario, there space a number of plausible reactions and also outcomes. If Coca-Cola reduces their prices, Pepsi might follow to ensure they carry out not lose sector share. In this situation, defection outcomes in a lose-lose. I beg your pardon is come say that, due to the initial price palliation by Coca-Cola (betrayal of condition quo), both companies most likely see diminished profit margins. Top top the various other hand, Pepsi might uphold the price allude despite Coca-Cola’s deviation, sacrificing market share to Coca-Cola but maintaining the established price point. Prisoner dilemma scenarios are complicated strategic choices, as any deviation from developed competitive exercise may an outcome in less profits and/or sector share.

Duopoly Example

The Cournot model, in i m sorry firms compete on output, and also the Bertrand model, in i m sorry firms complete on price, explain duopoly dynamics.

Key Takeaways

Key PointsThe Cournot model focuses on the production output decision that a single firm. A firm determines its competitor’s calculation level and also the residual industry demand. It then determines its profit -maximizing output for that residual need as if it were the whole market, and also produces accordingly.In the Bertrand model, firms collection profit-maximizing prices in solution to what they suppose the challenger to charge. The model predicts that both this firm will lower prices until they with the marginal price limit, showing up at an outcome equivalent to what prevails under perfect competition.The accuracy that the Cournot or Bertrand model will vary from sector to industry, depending upon how easy it is to readjust output levels in the industry.Key TermsCournot duopoly: An financial model explicate an industry in i m sorry companies compete on the lot of calculation they will produce, i m sorry they decision on individually of each other and at the exact same time.Bertrand duopoly: A design that explains interactions amongst firms completing on price.

A true duopoly is a specific form of oligopoly where only two producer exist in a market. There room two rule duopoly models: Cournot duopoly and Bertrand duopoly.

Cournot Duopoly

Cournot duopoly is an financial model that describes an sector structure in i m sorry firms compete on calculation levels. The model makes the adhering to assumptions:

There room two firms, which produce a homogeneous product;The number of firms is fixed;Firms perform not cooperate (there is no collusion);Firms have market power, and each firm’s output decision affect the good’s price;Firms are economically rational and also act strategically, seeking to maximize profit offered their competitor’s decisions; andFirms contend on quantity, and also choose quantity simultaneously.

The Cournot model focuses on the production output decision that a single firm. The firm determines its rival’s calculation level, evaluates the residual market demand, and then changes its own output level to maximize profits. The is assumed that the firm’s calculation decision will not influence the calculation decision that its competitor.

For example, mean that there are two that company in the sector for toasters v a given demand function. For sure A will identify the calculation of for sure B, organize it constant, and then determine the remainder of the market demand for toasters. Certain A will then identify its profit-maximizing calculation for that residual need as if it to be the whole market, and produce accordingly. Certain B will be conducting comparable calculations with respect to Firm A in ~ the very same time.

Bertrand Duopoly

The Bertrand model defines interactions amongst firms that contend on price. Firms collection profit-maximizing prices in response to what they expect a competitor to charge. The design rests top top the complying with assumptions:

There are two firms developing homogeneous products;Firms execute not cooperate;Firms contend by setting prices simultaneously; andConsumers buy everything from a firm through a reduced price. If every firms fee the exact same price, consumers randomly select amongst them.

In the Bertrand model, for sure A’s optimum price counts on whereby it believes firm B will set its price. Pricing just listed below the various other firm will attain full market demand, though this choice is not optimal if the other firm is pricing listed below marginal cost, together this would an outcome in an unfavorable profits. If certain B is setup the price below marginal cost, certain A will set the price in ~ marginal cost. If firm B is setting the price above marginal cost however below syndicate price, then Firm A will collection the price just below that of firm B. If certain B sets the price above syndicate price, certain A will collection the price at monopoly level.

Bertrand Duopoly: The diagram shows the reaction function of a firm completing on price. Once P2 (the price set by firm 2) is much less than marginal cost, certain 1 price at marginal expense (P1=MC). As soon as Firm 2 prices above MC but below syndicate prices, certain 1 prices just below Firm 2. As soon as Firm 2 price above syndicate price (PM), firm 1 prices at monopoly level (P1=PM).

Imagine if both firms set equal prices above marginal cost. Each firm would certainly get fifty percent the sector at a greater than marginal cost price. However, by lowering prices simply slightly, a firm could gain the whole market. As a result, both firms room tempted to lower prices as much as they can. However, it would certainly be irrational come price below marginal cost, since the firm would make a loss. Therefore, both that company will reduced prices till they reach the marginal price limit. According to this model, a duopoly will an outcome in an outcome exactly indistinguishable to what prevails under perfect competition. The result of the firms’ strategies is a Nash equilibrium –a pair or strategies where no firm deserve to increase revenues by unilaterally an altering the price.

Colluding to fee the monopoly price and also supplying one half of the industry each is the finest that the firms can do in this scenario. However, not colluding and charging the marginal cost, i m sorry is the non-cooperative outcome, is the just Nash equilibrium that this model.

The accuracy of the Cournot or Bertrand model will differ from market to industry. If capacity and output deserve to be conveniently changed, Bertrand is typically a much better model that duopoly competition. If output and capacity are an overwhelming to adjust, climate Cournot is generally a far better model.

Cartel Example

A cartel is a formal collusive arrangement among firms with the score of boosting profits.

Key Takeaways

Key PointsCartel members cooperate to collection industry price and also output.Game theory suggests that cartels are naturally unstable. Each individual member has actually an impetus to cheat in order come make higher profits in the brief run.Cheating may result in the please of a cartel. Through the collapse, firms would revert to competing, which would certainly lead to lessened profits.OPEC, the organization of Petroleum Exporting Countries, provides an instance of a historically efficient cartel.Key TermsCartel: A group of businesses or nations that collude to border competition in ~ an industry or market.

A cartel is one agreement among competing firms come collude in order come attain higher profits. Cartels usually occur in one oligopolistic industry, where the variety of sellers is small and the products being traded space homogeneous. Cartel members might agree on such matters room price fixing, full industry output, market share, allocation that customers, allocation the territories, bid rigging, facility of usual sales agencies, and the department of profits.

Game theory says that cartels are inherently unstable, because the habits of cartel members to represent a prisoner’s dilemma. Every member that a cartel would have the ability to make a higher profit, at least in the short-run, by breaking the agreement (producing a higher quantity or marketing at a lower price) 보다 it would make by abiding by it. However, if the cartel collapses due to the fact that of defections, the firms would revert come competing, revenues would drop, and all would be worse off.

Whether members of a cartel pick to cheat on the commitment depends on whether the short-term returns to cheating outweigh the irreversible losses from the possible malfunction of the cartel. It likewise partly counts on how an overwhelming it is because that firms come monitor whether the agreement is being adhered to by other firms. If surveillance is difficult, a member is likely to gain away v cheating because that longer; members would then be much more likely to cheat, and also the cartel will certainly be more unstable.

Perhaps the most internationally recognizable and effective cartel is OPEC, the company of Petroleum Exporting Countries. In 1973 members of OPEC diminished their manufacturing of oil. Due to the fact that crude oil native the Middle east was well-known to have couple of substitutes, OPEC member’s revenues skyrocketed. Native 1973 to 1979, the price that oil increased by $70 per barrel, an unprecedented number at the time. In the mid 1980s, however, OPEC started to weaken. Exploration of brand-new oil areas in Alaska and also Canada introduced new alternatives to middle Eastern oil, leading to OPEC’s prices and also profits come fall. About the same time OPEC members likewise started cheating to try to rise individual profits.

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OPEC: In the 1970s, OPEC members properly colluded to mitigate the an international production that oil, leading to higher profits because that member countries.