Archive for the 'Oligopoly' Category

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 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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Mar 04 2013

“Drinking games” – Why a Budweiser / Corona merger would seriously bum out, like, a ton of frat boys

Facts: 65% of all the beer bought in the United States is produced by one of two companies: Anheuser Busch / InBev or Miller. 7% is produced by a company called Grupo Modelo. 72% of all the beer bought comes from these three companies. Much of the remaining market is shared by thousands of “micro-breweries” of varying sizes.

While there are literally thousands of beer makers in the US, technically speaking, the market is oligopolistic, since such a large share of the market (72%) is dominated by just three firms. To be classified as an oligopoly, a market must be dominated by a few large firm selling a differentiated (and sometimes a homogeneous) product. Firms are interdependent on one another and they tend to compete for consumers using “non-price competition”, which may include improving the quality of their product and offering customers a wider variety to choose from, and especially through advertising. A final characteristic of oligopoly is that high barriers to entry exist.

In the case of the beer market,  there are minimal economies of scale, since anyone with a $200 home brewing kit can technically “enter the market”. But other barriers to entering the national market for beer are significant, which explains why the market is dominated by three huge firms. Notably, brand recognition poses a barrier to entry to the thousands of small brewers in America. The brands owned by the big three firms are well-established and liked among consumers, making it difficult for smaller brewers to gain share in the market.

In the Planet Money podcast below, we hear the story two of these “big three” beer makers. Anheuser Busch / InBev is attempting to merge with Grupo Modelo, a transaction that would reduce the “big three” to the “big two”, which would give the new single firm a truly dominant position in the market, and increase the two-firm concentration ratio from 65% to 72%. The podcast explains how competition in the market for beer benefits consumers, and how a decrease in competition will harm consumers. Below, I will provide a graphical analysis of the situation.

As the podcast explains, the competition between the big three beer producers has several benefits for consumers, not least of which is the huge variety of beers available across the three firms, each trying to capture a larger share of the market by offering consumers beers that appeal to their diverse tastes. In addition, however, the nature of competition in oligopolistic markets tends to result in stable prices over time. Here’s why:

Imagine Anheuser Busch / InBev, which wishes to raise its price from P1 to P2 in the graph below. If AB/InBev raises its prices, while Modelo and Miller keep theirs unchanged, the demand for AB/InBev’s beer is likely to be highly elastic, meaning that even a small price increase will cause the quantity demanded to fall dramatically (from Q1 to Q2). Due to the high elasticity of demand above P1, such a price hike will lead to lower revenues for AB/InBev. Conclusion? A price hike is a bad idea.

graph 1

So what if AB/InBev decides to lower its prices? The graph below shows that at any price below P1, demand will most likely be highly inelastic, because a price cut will most likely be matched by Modelo and Miller, who would have to cut their prices to avoid losing a significant number of consumers to AB/InBev. If all three firms lower their prices, then each firm will see hardly any increase at all in their total sales. A price decrease by AB/InBev will set off a “price war” and the firm will see its revenues fall.

graph 2

What we end up with is what is known as a “kinked” demand curve for AB/InBev’s beers.

graph 3

The firm has almost no incentive to raise or lower its prices, since a change in either direction will cause revenues to decline. Therefore, beer consumers enjoy stable prices, and the firms choose to compete through product differentiation, innovation and, of course, advertising!

So how would a merger between two of the big three beer makers change the situation in the market? What if just TWO firms controlled 72% of the market instead of three? The fear is that AB/InBev, once it owns Modelo, will be less interdependent on the actions of Miller. In other words, it will care less whether Miller ignores its price increases or matches its price decreases. Since there will be fewer substitutes for the gigantic firm’s dozens (or hundreds?!) of beer brands, demand for them overall will be more inelastic. This would give AB/InBev more price making power, and essentially make the market look more like a monopoly.

graph 4

When a firm has monopoly power, as we can see, a large increase in price (from P1 to P2) leads to a relatively smaller decrease in sales (from Qt to Q2). If AB/InBev and Modelo were to merge the firm would be able to get away with raising the price of all of its beer brands, as consumers are less likely to switch to the competition, since a big chunk of the competition would be owned by the firm itself!

The amount of competition that exists in a market has major bearings on the consumers, as this podcast demonstrates and our graphs illustrate. With just three big firms making 72% of the beer in the US, it may not seem like that big a deal if two of them merge. But even the loss of one firm in a highly concentrated market like beer could lead to higher prices for dozens of the top selling beers in the country; hence the US government’s hesitance to give AB/InBev a green light in its plan to acquire Grupo Modelo!

Discussion Questions:

  1. How can a market with thousands of individual sellers be considered oligopolistic?
  2. Why is “brand recognition” considered a barrier to entry into the beer market?
  3. Explain why prices in oligopolistic markets tend not to increase or decrease very often.
  4. Why is “non-price competition” so important for beer makers in the US? What are some forms of non-price competition that they practice?
  5. What is meant by the statement that “monopoly price is higher and output is lower than what is socially optimal.” Would this apply to the beer market if the AB/InBev and Modelo merger were to proceed?

One response so far

Apr 20 2012

UPDATE: Golden Balls, Game Theory, the Prisoner’s Dilemma, and the cold rationality of human behavior!

The excellent Radiolab has now done a story about Golden Balls. After watching the videos and reading the post below, listen to this story.


In my original “Golden Balls” blog post (see below), written almost three years ago after I saw a clip of the finale in an episode of the British game show, Golden Balls, I analyzed the actions of Sarah and Steve, who  had to decide whether they would split or steal a jackpot of 100,000 British pounds. The contestants had one minute to try to convince one another that they would split the money; but when it came down to it Sarah stole and Steve split, meaning Sarah got to keep the whole jackpot and Steve went home with nothing.

In that original post, I proposed that Steve’s best chances for going home with any money would have been “for him to use the one minute of discussion time to convince Sarah that he would choose SPLIT, yet be willing to go home with something LESS THAN $50,000 and accept that Sarah was going to choose STEAL. He could have threatened to chose steal if she did not agree to share her winnings with him to some extent.”

In a recent episode of the same game show, a contestant followed a similar strategy to that I suggested Steve should have taken. Watch the clip below, from a February 2012 episode of Golden Balls.

In this episode, Nick immediately takes control of the negotiations by insisting that he is going to steal, which is a very unorthodox approach to this game, in which the traditional strategy is to try and convince your opponent that you are going to split. By establishing a credible threat to steal, Nick puts all the pressure on Ibraham to decide only one of two things:

  1. Does Ibraham trust that Nick will split the money with him after he has stolen the full jackpot, and
  2. Would Ibraham rather both of them go home without any money at all than Nick win the jackpot and possibly not split it with him later on?
Nick’s strategy is brilliant. By the end of the negotiation, Nick has convinced Ibraham 100% that he is going to steal the money. Ibraham may only have had a confidence level of 50% that Nick was honest about splitting the money with him after the show, but with a 50% confidence level, Ibrahim’s possible payoffs are:
  • Choose steal and go home with nothing.
  • Choose split and have a 50/50 chance of going home with half the jackpot (based on his level of confidence in Nick’s promise to split the money after the show).
In other words, with a jackpot of 14,000 pounds, the payoffs for Ibrahim became:
  • If he splits: 0 pounds or 0.5(14,000) = 7,000 pounds
  • If he steals: 0 pounds or 0 pounds (assuming his confidence level in Nick’s intention to steal is 100%).
Clearly Ibraham now has a dominant strategy: to split. In the typical version of this game, a player’s dominant strategy is always to steal (as explained below), since the possible payoffs are:
  • If you split: 0 pounds or half the jackpot
  • If you steal: 0 pounds or the whole jackpot.
But because Nick has convinced his opponent that he will steal, and then split the winnings, Ibraham’s dominant strategy shifted to split, since the possible payoffs have changed. Ultimately, Ibraham does what is most rational given his confidence in Nick’s threat to steal, and that is to split. Ibraham then chooses split (as he should), but then to everyone’s surprise, Nick chooses split, not steal as he had threatened to do throughout the negotiation. This a surprising twist, since from Nick’s perspective stealing is clearly now a dominant strategy! Nick had convinved Ibraham to split, which means Nick faced a greater payoff by stealing. But by splitting, Nick shows that he had intended to split all along, but first needed to convince Ibraham otherwise to establish splitting as Ibraham’s dominant strategy.
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What a thrilling game! I won’t even bother getting into how this relates to economics today, I’m still shaking with excitement over the outcome!
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Original Golden Balls post:
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Teaching the Prisoners’ Dilemma Will Never Be the Same Again « Cheap Talk

Rarely does such a perfect illustration of the Prisoner’s Dilemma come along for Econ teachers to use in their classroom:

The payoffs are clear:

Each player has a weakly dominant strategy, which is to choose to steal. By choosing to steal, the player has a chance at maximizing his own payoff, but will do no worse than he would if his opponent also chooses to steal and at least will have the satisfaction of thwarting his opponent’s attempt to steal the money.

There are three Nash equilibria in the game, which are outcomes at which a player can not do better on his or her own by changing his or her strategy. The outcome Steve was hoping for by chosing “split” (50/50) was not a Nash equilibrium because Sarah knows she can do better if she chooses steal when Steve chooses split. Steve doomed himself by choosing split because he should know that Sarah’s dominant strategy is to choose steal. However, Sarah would also have doomed herself by choosing split because she should assume that Steve would also chose steal since steal is a dominant strategy for him too.

John Nash, who pioneered the field of Game Theory, assumed that humans were coldly rational, self-interested, deceptive creatures that would not hesitate to stab one another in the back to get what was best for themselves. His theory of human behavior is only partially proven correct in this game, in which Steve is shown to be the sucker and Sarah the coldly rational self-interested player. The best chance for Steve to go home with any money would have been for him to use the one minute of discussion time to convince Sarah that he would choose SPLIT, yet be willing to go home with something LESS THAN $50,000 and accept that Sarah was going to choose STEAL. He could have threatened to chose steal if she did not agree to share her winnings with him to some extent. Then again, any promise Sarah makes she could later break, thus further empowering the players to choose steal.

Discussion questions:

  1. What in the world is going on here? Why did Sarah choose steal rather than collaborate with Steve and share the $100,000?
  2. Was Steve totally wrong to choose split? What would you have done in his situation?
  3. How do the choices faced by Steve and Sarah relate to the choices faced by firms in oligopolitic markets? Now that you’ve seen this video, can you explain why collusive agreements between oligopolists often fall apart? Why do cartels such as OPEC often fail to achieve the high price targets agreed upon in meetings of their leaders?

110 responses so far

Mar 23 2012

Understanding Oligopoly Behavior – a Game Theory overview

What makes oligopolistic markets, which are characterized by a few large firms, so different from the other market structures we study in Microeconomics? Unlike in more competitive markets in which firms are of much smaller size and one firm’s behavior has little or no effect on its competitors, an oligopolist that decides to lower its prices, change its output, expand into a new market, offer new services, or adverstise, will have powerful and consequential effects on the profitability of its competitors. For this reason, firms in oligopolistic markets are always considering the behavior of their competitors when making their own economic decisions.

To understand the behavior of non-collusive oligopolists (non-collusive meaning a few firms that do NOT cooperate on output and price), economists have employed a mathematical tool called Game Theory. The assumption is that large firms in competition will behave similarly to individual players in a game such as poker. Firms, which are the “players” will make “moves” (referring to economic decisions such as whether or not to advertise, whether to offer discounts or certain services, make particular changes to their products, charge a high or low price, or any other of a number of economic actions) based on the predicted behavior of their competitors.

If a large firm competing with other large firms understands the various “payoffs” (referring to the profits or losses that will result from a particular economic decision made by itself and its competitors) then it will be better able to make a rational, profit-maximizing (or loss minimizing) decision based on the likely actions of its competitors. The outcome of such a situation, or game, can be predicted using payoff matrixes. Below is an illustration of a game between two coffee shops competing in a small town.

In the game above, both SF Coffee and Starbuck have what is called a dominant strategy. Regardless of what its competitor does, both companies would maximize their outcome by advertising. If SF coffee were to not advertise, Starbucks will earn more profits ($20 vs $10) by advertising. If SF coffee were to advertise, Starbucks will earn more profits ($12 vs $10) by advertising. The payoffs are the same given both options for SF Coffee. Since both firms will do best by advertising given the behavior of its competitor, both firms will advertise. Clearly, the total profits earned are less when both firms advertise than if they both did NOT advertise, but such an outcome is unstable because the incentive for both firms would be to advertise. We say that advertise/advertise is a “Nash Equilibrium since neither firm has an incentive to vary its strategy at this point, since less profits will be earned by the firm that stops advertising.

As illustrated above, the tools of Game Theory, including the “payoff matrix”, can prove helpful to firms deciding how to respond to particular actions by their competitors in oligopolistic markets. Of course, in the real world there are often more than two firms in competition in a particular market, and the decisions that they must make include more than simply to advertise or not. Much more complicated, multi-player games with several possible “moves” have also been developed and used to help make tough economic decisions a little easier in the world of competition.

Game theory as a mathematical tool can be applied in realms beyond oligopoly behavior in Economics.  In each of the videos below, game theory can be applied to predict the behavior of different “players”. None of the videos portray a Microeconomic scenario like the one above, but in each case a payoff matrix can be created and behavior can be predicted based on an analysis of the incentives given the player’s possible behaviors.

Assignment: Watch each of the five videos below. For each one, create a payoff matrix showing the possible “plays” and the possible “payoffs” of the game portrayed in the video. Predict the outcome of each game based on your understanding of incentives and the assumption that humans act rationally and in their own self-interest.

“Batman – the Dark Night” – the Joker’s ferry game:

“Princess Bride” – where’s the poison?:

“Golden Balls” – split or steal:

“The Trap” – the delicate balance of terror

“Murder by Numbers” – the interrogation

Discussion Questions:

  1. Why is oligopoly behavior more like a game of poker than the behavior of firms in more competitive markets?
  2. What does it mean that firms in oligopolistic markets are “inter-dependent” of one another?
  3. Among the videos above, which games ended in the way that your payoff matrix and understanding of human behavior and rational decision making would have predicted?
  4. How often did the equilibrium outcomes according to your analysis of the payoff matrices correspond with the socially optimal outcome (i.e. the one where total payoffs for all players are maximized or the total losses minimized)?

12 responses so far

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