Feb 25 2015

Ways firms may collude in Oligopolistic markets

Oligopolistic markets are unique among the four market structures we have studied. Unlike perfect and monopolistic competition and pure monopoly,the individual firms in an oligopoly are heavily interdependent of one another with regards to business decisions relating to price, service, location, advertising, product differentiation, and so on. The actions of one firm will impact heavily the profitability of its major competitors.

This sometimes gives oligopolies an incentive to collude with one another. Collusion, as defined by Investopedia is A non-competitive agreement between rivals that attempts to disrupt the market’s equilibrium. By collaborating with each other, rival firms look to alter the price of a good to their advantage.”

Collusion can take many forms, and is not always overt in nature (in other words, it may be going on without any actual discussions between the firms colluding). Below are three ways firms may collude:

Overt, formal collusion – the cartel model: A cartel, as defined by Investopedia, is “An organization created from a formal agreement between a group of producers of a good or service, to regulate supply in an effort to regulate or manipulate prices.” An example of a cartel is California’s Raisin Administrative Committee. Listen to this story to learn more.

  • California’s raisin producers meet annually to determine the quantity of raisins that should be released to the market
  • In years where the crop is very good, they will “divert” raisins to the “reserve” and reduce the supply
  • This keeps the price high.
  • By colluding through the cartel, the raisin growers get to sell their output for a higher price and the total quantity released to the market is less than would be released without the cartel. The cartel makes the raisin market look more like a monopoly (higher price, lower quantity, less consumer surplus).

Tacit, informal collusion – the price leadership model: Not all collusion is formal and overt. In fact, because of the negative impact collusion has on consumers (higher price, lower quantity), it is actually illegal in many countries and government will investigate and possibly prosecute firms that attempt to collude to raise prices (see this story about the US Justice Department investigating the a proposed merger between two food wholesale companies). In order to avoid investigation by the government, firms often engage in tacit collusion, when firms agree to keep prices high without explicitly saying so.

Beer market in the US: The story about the US beer market indicates that a form of tacit collusion may be taking place between the two largest beer producers.

  • When Anheuser Busch/InBev raises the prices for its beers, its main competitor (Miller/Coors), tends to do so too.
  • The two firms control 65% of America’s beer market. When both raise their prices, demand tends to be relatively inelastic, allowing both firms to enjoy higher revenues.
  • If the two firms were acting competitively, the smaller firm (Miller/Coors), would most likely ignore price increases by Anheuser Busch/Inbev, and enjoy the greater demand resulting from the larger firm’s consumers switching beers.
  • The “price leadership” model of tacit collusion is when one firm (typically the largest in the market) raises prices and competitors willingly follow suit, leading to a smaller decrease in quantity demanded for the larger firm and increased revenues for all firms in the market.

Grocery stores in the United Kingdom: Another example of tacit collusion can be seen in the UK grocery market. The big grocery chains offer “price-match guarantees” that promise their consumers that they will never pay less for their groceries at another supermarket.

  • Sellers have no incentive to lower their prices because they will be less likely to steal the competition’s customers when the competition has a price-match guarantee.
  • Through such a scheme, all grocery chains are likely to keep their prices HIGH and “price-wars” (which benefit consumers), are much less likely to occur.
  • The price-match guarantee (which on the surface appears to be good for consumers) acts as a form of tacit collusion and results in consistently higher prices for groceries in the UK.

Graphing collusive oligopolies: Under competition, oligopolists that lower their prices may initiation a “price war” due to the strong incentive any price cut creates for competitors to also cut prices. Likewise, price increases are less likely under competition because price increases tend to be ignored as the competition gains market share when the first firm raises its price. These assumptions of competitive oligopolies are reflected in the “kinked demand curve” model.

noncollusive

Under a collusive oligopoly, price increases is greater and the chance of price wars is much smaller. Demand for an individual firm’s output when it is colluding with its competitors looks more like the demand for a monopolist’s output; it is relatively inelastic, even when the firm raises its prices (since price increases are more likely to be matched rather than ignored). The collusive oligopolists demand curve looks like this.

collusion

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Feb 25 2015

Art, meet Economics

Here’s a great story about the importance of getting an education in both Art and Economics: ArtNet News – New York Times Exposes Peter Lik Photography SchemeGive it a read before reading the rest of this post.

Lik

There’s a lot of interesting Microeconomic applications of this story. Lik makes 995 prints of a photograph, sells them for cheap at first, but as they become more “scarce” the price rises. If the prints were, in fact, becoming “scarcer” then there might be a justification for their prices rising, and it is this illusion of increasing scarcity that tricks his (apparently un-art-educated and un-economics-educated) buyers into being willing to pay a much higher price for the final few prints than was paid for the first several prints sold.

In fact, the prints don’t become scarcer as more are sold, rather, the quantity supplied remains constant at 995. In most markets, to sell additional units of a product, the price typically has to decrease (since those who are willing to pay the most will buy first), but in the market for Lik’s photographs, those willing to pay most are the LAST buyers of the good. He has managed to reverse the rationale behind consumer behavior by creating an artificial sense of increasing scarcity, and thereby tricking his buyers into believing they are investing in an asset that increases in value over time rather purchasing a good that only loses value once it leaves the gallery.

Assuming demand for a particular print is fixed in a period of time, there really should be a single price as long as the quantity supplied does not change (which it doesn’t!!). But by making his buyers think the scarcity is increasing (by implying that the more are sold, the fewer the there are available to buy), demand actually rises as more prints are sold and the the price correspondingly increases. There is no actual change in the quantity supplied, only demand, and the reason demand is increasing is the belief that the rising price signals increasing scarcity, thus the ability to sell the art for an even higher price in the future. Art can be an investment, like gold, which people demand more of when the price is rising, because of the anticipation of future price increases (and thus the ability to make a profit on the purchase and future sale of the asset). As it turns out, the secondary market for Lik’s prints is tiny and few buyers have ever turned a profit on their purchase of a Lik print.

The fact that the prints’ prices are rising is evidence only of Lik’s monopolistic, price-making power, not a real increase in the market value of a Peter Lik print. Lik himself reveals this ruse when he says about his art, “”It’s like a Mercedes-Benz, you drive it off the lot, it loses half its value.”

The moral of this story: If you don’t study both ART and ECONOMICS in school, never pretend to be a skilled art collector, because you’re only being tricked by scam artists (and savvy businessmen!) like Peter Lik!

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Feb 24 2015

The Raisin Cartel – collusive agreements and why they fall apart

Planet Money – The Raisin Outlaw

When a competitive industry acts like a monopoly, the consumers are the losers, the producers are the winners, and a market that may have been efficient is made less so. But how can this type of collusion be possible, and what happens when collusive agreements fall apart?

NPR’s Planet Money tells the story of a collusive agreement, and what happened when one producer betrayed the agreement.

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Nov 27 2014

A mathematical proof of the Marshall Lerner Condition

One of the toughest topics to teach in IB higher level Economics is the Marshall Lerner Condition, which is an International Economics concept which states the following:

If the combined price elasticities of demand of a nation’s imports and exports is greater than one (PEDx + PEDm > 1), then a depreciation or a devaluation of the nation’s currency will move its current account balance towards surplus.

This is a concept I have been teaching for eight years now, and I have even written about it in my textbook and produced a YouTube video lecture explaining it to students, but one thing I’ve never done is attempted a mathematical proof of the concept (needless to say, I avoid using math as much as possible, and the prospect of “proving” the MLC was always too daunting).

But this evening I received an email from an Economics teacher in Paris asking for just such a proof. So I buckled down and worked it out. In her email, the teacher said:

The Marshall Lerner Condition states that if the PEDx + PEDm > 1 then a depreciation in a country’s currency will reduce a current account deficit.

Suppose the PED for exports = .6 and the PED for imports = .5. The sum is greater than 1, therefore the MLC is met. A depreciation of this country’s currency should therefore improve its current account balance.

But based on my analysis, this country’s current account should be getting worse, not better.

For Exports: price is decreasing but the quantity demanded is increasing by proportionally  less (since PEDx = 0.6) so the country’s total export revenue is decreasing

For Imports: price is increasing and quantity demanded is decreasing by proportionally less (since PEDm = 0.5) so the country’s total spending on imports is increasing

The country’s revenues from exports are decreasing while the country’s spending on imports are increasing, so overall the trade balance is getting worse (moving deeper into deficit) not improving.

What am I doing wrong?

This teacher’s email really stumped me at first, because her logic is totally sound. I figured the only way I was going to be satisfied was if I worked it mathematically. So here’s the result and the reply I sent to the teacher:

Hello,

Your email really got me thinking about this. Your logic stumped me at first, but then inspired me to go work it out with numbers. So, hopefully my “proof” of the MLC below will clarify your confusion.

To simplify the analysis we will use easy numbers. I will use your values of PEDx = 0.6 and PEDm = 0.5

Assumptions:

  • The US and Canada are trading partners
  • Current exchange rate: $1 US = $1 CA
  • US exports 10 widgets at $1 US apiece for a total export revenue of $10 US
  • US imports 10 wingdings at $1 CA apiece for a total import expenditure of $10 US
  • US trade balance: $10 – $10 = 0
  • PEDx = 0.6 and PEDm = 0.5

Next, assume the US $ depreciates by 10% against the CA $. Now,

  • $1 US = $0.90 CA
  • $1 CA = $1.11 US

Impact on imports:

  • Price to Americans of Canadian wingdings rises to $1.11 US
  • Quantity demanded falls by 5.5% to 9.45
  • Total expenditures on Canadian imports expressed in US $: $1.11 x 9.45 = $10.49

In order for the US trade balance to improve US export revenues must increase by more than $0.49 US.

Impact on exports:

  • Price to Canadians of US widgets falls by 10% to $0.90 CA
  • Quantity demanded increases by 6% to 10.6
  • Total revenue from exports to Canada expressed in CA $: $0.90 x 10.6 = $9.54 CA.
  • Since $1 CA = $1.11 US, the value of US exports to Canada expressed in US $ is $9.54 x $1.11 = $10.59

Expressed in US $, exports increased by $0.59 and imports increased by $0.49.

Therefore, US net exports are now $10.59 – $10.49 = $0.1. The MLC is met and the US trade balance moves into surplus.

I think the only mistake with the logic you applied in your email was that you were not considering that a country’s balance of trade is measured in its own home currency. As you can see, if we measured the value of US exports in Canadian dollars, then following the depreciation of the US dollar American export revenues actually appear to decrease, moving the US into a current account deficit. But even though Canadians are spending less of their own dollars on US goods, the Canadian dollar has now appreciated by 11%, therefore the value of US exports expressed in US $ actually increases (due to the now weaker US dollar)!

I hope this all makes sense! Thanks for inspiring me to buckle down and tackle this analysis! I’ve been teaching this concept for eight years and have never actually taken the time to walk through a proof like this.

Best,
Jason

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Nov 19 2014

Efficiency and Market Failure in “Anchorman”

As a follow up to my recent post, A Video and Audio Introduction to Market Failure, I plan to introduce the diagrams we use to illustrate and analyze negative and positive externalities and the inefficiency arising in the markets for certain goods. My fellow Econ Video Lecturer, Mr. Clifford, provides a great introduction to these diagrams in his video, EconMovies 7: Anchorman. We’ll watch the video below before beginning our notes on the subject today! Enjoy!

YouTube Preview Image

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