Transcript Cartels

Modern Principles:
Microeconomics
Tyler Cowen
and Alex Tabarrok
Chapter 13
Cartels, Games and
Network Goods
Copyright © 2010 Worth Publishers • Modern Principles: Microeconomics • Cowen/Tabarrok
Cartels and Games
• A Cartel is a group of suppliers that tries to
act as if they were a monopoly.
• The goal of these suppliers is to coordinate
in order to reduce supply, raise prices, and
increase profits.
Slide 2 of 36
Cartels and Games
A Cartel Tries to Move a Market from “Competition”
towards “As if Controlled by a Monopolist”
Competition
As if Controlled by a Monopolist
P
P
Profit
Pm
Pc
S
Pc
MC = AC
MR
D
Q
Qc
D
Q
Qm
Qc
Slide 3 of 36
Cartels and Games
• In reality few cartels effectively control the
market price, and most tend to collapse
over time.
• Reasons why cartels collapse:
1. Cheating by cartel members.
2. New entrants and demand response.
3. Government prosecution.
Slide 4 of 36
Cheating by Cartel Members
• In a successful cartel, each member earns high
profits on its goods.
• This same desire for high profits, however, also
causes the cartel to fall apart as each member
will cheat on the cartel agreement.
 If everyone else keeps their promise, a member can
cheat and expand its production yielding greater
profits.
 As more members cheat, the less profitable it is to
reduce production leading to every member cheating
on the agreement.
Slide 5 of 36
Cheating by Cartel Members
• Consider the world oil market where 10 countries
produce 10 million barrels of oil per day (mbd) for
a total of 100 mbd.
• At that quantity suppose the world price of oil is
$36 a barrel so that each country earns $360
million a day.
Slide 6 of 36
Cheating by Cartel Members
• Now suppose that the countries form a cartel and
reduce production to 8 mbd for a total of 80 mbd.
• At this lower quantity, the world price of oil rises
to $50 a barrel so that each country earns $400
million a day.
Slide 7 of 36
Cheating by Cartel Members
• Imagine one cartel member cheats and expands
its production back to 10 mbd.
• This increases world production to 82 mbd and
pushes the world price of oil to $47.50 a barrel.
• Total revenue for the cheating country rises while
the total revenue for the other countries falls.
Slide 8 of 36
Cheating by Cartel Members
• Every country in the oil cartel can earn more by
cheating than by maintaining the agreement.
• So, everyone cheats, and the cartel collapses!
• Cheating is also profitable when other members
do not keep their promise to reduce production.
 A single cartel member does not have significant
monopoly power.
 As such, reducing production does not raise the world
price enough to make up for its lost sales.
Slide 9 of 36
Cheating by Cartel Members
• Imagine that 9 countries cheat on the agreement
and produce 10 mbd while one country maintains
production at 8 mbd for a total of 98 mbd.
• The market price falls to $37.50 per barrel.
• At this price each cheater will earn revenues of
$375 million a day while the other country earns
$300 million per day.
Cartel with Nine Cheaters and One Non-Cheater
Countries
Output per
Country
Total
Output
Profit per Country (per
day)
1
8 mbd
8 mbd
$300 million
9
10 mbd
90 mbd
$375 million
World Output
98 mbd
World Price
$37.50
Slide 10 of 36
Cheating by Cartel Members
• The example above indicates that cheating pays
when other firms keep their promise and cheating
pays when other firms cheat.
• Note the distinction between the decisions of a
monopolist and a cartel member.
 When a monopolist increases quantity above the profitmaximizing level, the monopolist only hurts itself.
 But when a cartel cheater increases quantity above the
profit-maximizing level, the cheater benefits itself and
hurts other cartel members.
Slide 11 of 36
Cheating by Cartel Members
• Another approach to demonstrate the incentive to
cheat is to use a payoff matrix.
• Consider a situation where the world oil market is
dominated by two large countries, Saudi Arabia
and Russia.
• Each country has two choices or strategies:
 Cooperate by reducing output and acting like a
monopolist.
 Cheat and expand production.
Slide 12 of 36
Cheating by Cartel Members
The Cheating Dilemma
Russia’s Strategies
Saudi Arabia’s
Strategies
Cooperate
Cheat
Cooperate
($400, $400)
($200, $500)
Cheat
($500, $200)
($300, $300)
Slide 13 of 36
Cheating by Cartel Members
• A Dominant Strategy is a strategy that has a
higher payoff than any other strategy no matter
what the other player does.
• The dominant strategy for Saudi Arabia is to
cheat.
 Saudi Arabia’s best strategy if Russia cooperates is to
cheat.
• Cheating has a payoff of $500 while cooperating has a payoff
of $400.
 Saudi Arabia’s best strategy if Russia cheats is to also
cheat.
• Cheating has a $300 payoff while cooperating has a $200
payoff.
Slide 14 of 36
Cheating by Cartel Members
• The dominant strategy for Russia is to cheat.
 Russia’s best strategy if Saudi Arabia cooperates is to
cheat.
• Cheating has a payoff of $500 while cooperating has a payoff
of $400.
 Russia’s best strategy if Saudi Arabia cheats is to also
cheat.
• Cheating has a payoff of $300 while cooperating has a payoff
of $200.
Slide 15 of 36
Cheating by Cartel Members
• The equilibrium outcome of the game involves
both firms cheating on the agreement.
• Each firm’s strategy is based on its own selfinterest, but the outcome is in the interest of
neither firm.
 Cooperation would give both firms a bigger payoff.
• The Prisoner’s Dilemma describes situations
where the pursuit of individual interest leads to a
group outcome that is in the interest of no one.
Slide 16 of 36
New Entrants and Demand Response
• The high prices of a cartel attract new
entrants not bound by the cartel agreement
on production.
 As these new firms enter the market, supply
will increase, driving down the price of the
good.
Slide 17 of 36
New Entrants and Demand Response
• Over time consumers will alter their behavior in
response to the high cartel prices.
 More substitutes will be available in the long run.
 This ultimately makes demand curves more elastic and
limits the cartel’s pricing power.
• Cartels related to natural resources that are
difficult to duplicate can avoid this problem and
tend to be more successful.
Slide 18 of 36
Government Prosecution of Cartels
• Most cartels are illegal in the United States.
• The Sherman Antitrust Act of 1890.
 This legislation empowers the government to
prosecute and punish collusive behavior.
Slide 19 of 36
Government-Supported Cartels
• Governments do not always prosecute
cartels, and often they support cartels.
• Many of the most successful cartels
operate with the explicit support of the
government because governments have
the ability to effectively enforce cartel
agreements.
Slide 20 of 36
CHECK YOURSELF
 In the OPEC cartel, what can Saudi Arabia do to
punish a cheater? (Hint: Will Saudi Arabia raising
its output have an appreciable effect on the
cheater?)
 When Great Britain discovered large oil deposits
in the North Sea, why didn’t it immediately join
OPEC?
 What is the surprising conclusion of the prisoner’s
dilemma?
Slide 21 of 36
Network Goods
• A Network Good is a good whose value to one
consumer increases the more that other
consumers use the good.
• Features of network goods:
 Network goods are usually sold by monopolies or
oligopolies;
 When networks are important the “best” product may
not always win;
 Standard wars are common in establishing network
goods;
 Competition in the market for network goods occurs
“for the market” instead of “in the market.”
Slide 22 of 36
Network Goods
• Network goods typically involve one firm
providing a dominant standard at a high price.
• These markets, however, often include a number
of other firms offering a slightly different product.
 These firms tend to service niche areas in the market.
• An Oligopoly is a market dominated by a small
number of firms.
Slide 23 of 36
Network Goods
• The central issue of network goods is that
consumers derive a greater benefit when other
consumers use the same good.
• Suppose Alex and Tyler are choosing whether to
use Apple or Microsoft to write their textbook.
• Their choice can be expressed in a payoff matrix.
The Coordination Game
Tyler
Alex
Apple
Microsoft
Apple
(11, 11)
(3, 3)
Microsoft
(3, 3)
(10, 10)
Slide 24 of 36
Network Goods
• If Alex chooses Microsoft, and Tyler chooses
Apple, it will be difficult for them to work together
and their payoffs will be low (3,3).
• Alex and Tyler receive the highest payoffs when
both are using the same software.
 If Alex chooses Apple, then Tyler should choose Apple
as well since the payoffs are high (11,11).
• If Alex and Tyler both choose Apple, then neither
will have an incentive to change their strategy.
 This is an equilibrium outcome of the game.
• A Nash Equilibrium is a situation in which no
player has an incentive to change their strategy
unilaterally.
Slide 25 of 36
Network Goods
• Note that the choice of Microsoft is also a Nash
equilibrium.
 If Alex chooses Microsoft, then Tyler should choose
Microsoft as well.
• This equilibrium, however, yields lower payoffs
(10,10) than the payoffs with Apple (11,11).
• It is thus possible for an inferior product to
become the dominant standard in the market.
Slide 26 of 36
Network Goods
• In a situation where two equilibria exist,
consumers often disagree which product is
superior.
• When the players of a game differ over which
equilibrium is best, a standard war may emerge.
• Recently, two groups of manufacturers have
battled over the standard for high-definition DVD
discs.
 Group 1, led by Toshiba, supported the HD-DVD.
 Group 2, led by Sony, supported the Blu-Ray.
Slide 27 of 36
Network Goods
• The standard war between Sony and Toshiba
can be expressed in a payoff matrix.
The Standard War
Sony
Toshiba
HD-DVD
Blu-Ray
HD-DVD
(10, 8)
(0, 0)
Blu-Ray
(0, 0)
(8,10)
Slide 28 of 36
Network Goods
• Toshiba is better off if the HD-DVD standard
emerges as the market standard.
• Sony is better off if the Blu-Ray standard
emerges as the market standard.
• Neither group does well with two competing
standards.
• The Sony group ultimately won the standard war
when Blu-Ray technology was imbedded into the
Sony PlayStation 3, thus building a bigger
audience for that standard.*
Slide 29 of 36
Network Goods
• Network goods tend to be sold by monopolies or
oligopolies.
• What makes the markets for network goods
different than standard monopolies and
oligopolies is the ease and speed at which the
dominant standard can change.
• Competition for the market of these goods is
strong and often leads to frequent changes in the
dominant firm over time.
Slide 30 of 36
CHECK YOURSELF
Does a firm with an established network
good, such as Microsoft Office, face
competition? Why or why not?
Consider the Blu-Ray versus HD-DVD
competition. Why is it useful for you to wait
before purchasing when standards are not
set? What do you predict will happen to
sales once standards are set?
Slide 31 of 36
Takeaway
• A cartel is a group of suppliers that tries to act as
if they were a monopoly.
• In reality few cartels effectively control the market
price, and most tend to collapse over time.
• Reasons why cartels collapse:
 Cheating by cartel members.
 New entrants and demand response.
 Government prosecution.
Slide 32 of 36
Takeaway
• A dominant strategy is a strategy that has a
higher payoff than any other strategy no matter
what the other player does.
• The dominant strategy in a cartel is to cheat on
the agreement.
• The prisoner’s dilemma describes situations
where the pursuit of individual interest leads to a
group outcome that is in the interest of no one.
Slide 33 of 36
Takeaway
• The high prices of a cartel attract new entrants
which pushes down the high cartel price.
• Over time consumers will alter their behavior in
response to the high cartel prices.
 More substitutes will be available in the long run.
 This ultimately makes demand curves more elastic and
limits the cartel’s pricing power.
• The Sherman Antitrust Act of 1890 makes most
cartels illegal in the United States.
 This legislation empowers the government to
prosecute and punish collusive behavior.
Slide 34 of 36
Takeaway
• A network good is a good whose value to one
consumer increases the more that other
consumers use the good.
• Features of network goods:
 Network goods are usually sold by monopolies or
oligopolies;
 When networks are important the “best” product may
not always win;
 Standard wars are common in establishing network
goods;
 Competition in the market for network goods occurs
“for the market” instead of “in the market.”
Slide 35 of 36