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

1. A2 Micro
Oligopoly – Collusion and
Game Theory
Tutor2u, Summer 2013

2. Tacit collusion

3. Overt collusion

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)

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