Collusion and Competition

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

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Learning Objectives

Assess the considerations associated in the oligopolist’s decision around whether to contend or cooperate

Key Takeaways

Key PointsFirms in an oligopoly may collude to collection a price or output level because that a sector in order come maximize industry profits. At an extreme, the colluding firms have the right to act together a monopoly.Oligopolists pursuing their individual self-interest would produce a greater quantity 보다 a monopolist, and charge a lower price.Collusive species are usually illegal. Moreover, the is daunting for that company to coordinate actions, and there is a risk that firms might defect and also undermine the others in the arrangement.Price leadership, i m sorry occurs once a dominant challenger sets the sector price and others follow suit, is one informal form of collusion i beg your pardon is typically legal.Key TermsPrice leadership: Occurs when one company, normally the dominant competitor among several, leads the way in determining prices, the others soon following.collusion: A an enig agreement because that an illegal purpose; conspiracy.price fixing: one agreement between sellers to sell a product only at a resolved price, or preserve the market conditions such that the price is kept at a provided level by managing supply.

Oligopoly is a sector structure in i beg your pardon there room a few firms producing a product. When there are few firms in the market, they might collude to collection a price or output level because that the industry in order come maximize sector profits. As a result, price will certainly be greater than the market-clearing price, and output is most likely to be lower. At the extreme, the colluding firms might act together a monopoly, reducing their individual output so that their collective output would equal that of a monopolist, enabling them come earn greater profits.


OPEC: The oil-producing countries of OPEC have at times cooperated to raise human being oil price in order to secure a steady revenue for themselves.

If oligopolists individually pursued their very own self-interest, climate they would create a complete quantity greater than the monopoly quantity, and also charge a lower price 보다 the syndicate price, hence earning a smaller profit. The promise of bigger profits offers oligopolists an incentive to cooperate. However, collusive oligopoly is naturally unstable, because the most reliable firms will certainly be tempted to rest ranks by cutting prices in bespeak to boost market share.

Several determinants deter collusion. First, price-fixing is illegal in the united States, and antitrust legislations exist to stop collusion between firms. Second, coordination among firms is difficult, and becomes much more so the higher the variety of firms involved. Third, over there is a risk of defection. A firm might agree to collude and also then break the agreement, undercutting the earnings of the firms tho holding to the agreement. Finally, a firm may be discouraged from collusion if it does not perceive itself to be able to effectively punishment firms that may break the agreement.

In contrast to price-fixing, price leadership is a form of informal collusion which is normally legal. Price leadership, i beg your pardon is also sometimes referred to as parallel pricing, occurs when the dominant challenger publishes the price ahead of other firms in the market, and also the other firms then complement the announced price. The leader will certainly typically collection the price come maximize the profits, which might not it is in the price that maximized various other firms’ profits.

Game theory Applications come Oligopoly

Game theory gives a framework for understanding exactly how firms behave in an oligopoly.

Learning Objectives

Explain how video game theory uses to oligopolies

Key Takeaways

Key PointsIn one oligopoly, firms are impacted not only by their own production decisions, but by the manufacturing decisions of other firms in the industry as well. Game theory models situations in which each actor, as soon as deciding top top a food of action, must likewise consider just how others could respond to the action.The prisoner’s dilemma is a type of video game that illustrates why collaboration is daunting to keep for oligopolists even when that is support beneficial. In this game, the dominant strategy of every actor is to defect. However, acting in self-interest leads to a sub-optimal collective outcome.The Nash equilibrium is vital concept in game theory. It is the set of methods such the no player have the right to do better by unilaterally an altering his or she strategy.Game concept is typically not required to recognize competitive or monopolized markets.Key TermsPrisoner’s dilemma: A video game that mirrors why 2 individuals could not cooperate, even if it shows up that the is in their best interests to do theory: A branch of used mathematics that researches strategic situations in which people or organisations select various action in an effort to maximize their returns.Nash equilibrium: The set of players’ techniques for which no player can benefit by changing his or her strategy, assuming that the various other players keep theirs unchanged.

In one oligopoly, firms room interdependent; castle are impacted not just by their own decisions concerning how lot to produce, yet by the decision of other firms in the sector as well. Game theory provides a valuable framework for thinking about how firms may act in the context of this interdependence. Much more specifically, video game theory have the right to be provided to model cases in which each actor, once deciding top top a food of action, must likewise consider how others might respond to that action.

For example, game theory can explain why oligopolies have trouble preserving collusive arrangements to generate monopoly profits. While firms would certainly be better off collectively if they cooperate, each individual firm has a solid incentive to cheat and undercut their competitors in stimulate to boost market share. Since the incentive to defect is strong, firms may not even enter into a collusive commitment if they don’t perceive over there to it is in a method to efficiently punish defectors.

The prisoner’s dilemma is a specific kind of game in video game theory that illustrates why collaboration may be daunting to keep for oligopolists even when that is mutually beneficial. In the game, 2 members that a criminal gang space arrested and also imprisoned. The prisoners are separated and also left to contemplate their options. If both detainees confess, each will certainly serve a two-year jail term. If one confesses, however the various other denies the crime, the one that confessed will certainly walk free, if the one that denied the crime would get a three-year sentence. If both refuse the crime, they will certainly both serve only a one year sentence. Betraying the companion by confessing is the leading strategy; it is the much better strategy because that each player nevertheless of exactly how the various other plays. This is known as a Nash equilibrium. The result of the game is the both prisoners pursue individual logic and betray, as soon as they would certainly have jointly gotten a better outcome if they had actually both cooperated.

Prisoner’s Dilemma: In a prisoner’s dilemma game, the leading strategy for each player is to betray the other, even though participation would have led to a far better collective outcome.

The Nash equilibrium is vital concept in game theory. That is the collection of tactics such the no player deserve to do better by unilaterally changing his or her strategy. If a player knew the tactics of the various other players (and those strategies could not change), and could not advantage by an altering his or her strategy, climate that collection of tactics represents a Nash equilibrium. If any kind of player would advantage by changing his or her strategy, climate that set of strategies is not a Nash equilibrium.

While game theory is vital to knowledge firm habits in oligopolies, that is usually not necessary to understand competitive or monopolized markets. In compete markets, firms have such a little individual result on the market, the taking various other firms right into account is just not necessary. A monopolized market has only one firm, and thus strategy interactions carry out not occur.

The Prisoner’s Dilemma and Oligopoly

The prisoner’s dilemma shows why 2 individuals can not cooperate, also if the is jointly in their best interest to execute so.

Learning Objectives

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

Key Takeaways

Key PointsIn the game, 2 criminals space arrested and also imprisoned. Every criminal have to decide even if it is he will cooperate v or betray his partner. The criminals cannot communicate to coordinate their actions.Betrayal is the leading strategy because that both players in the game. Betrayal leads to finest individual outcome regardless the what the other human being does.Both players choosing betrayal is the Nash equilibrium the the game. However, this result is no Pareto-optimal. Both players would certainly have plainly been much better off if they had actually cooperated.Cooperation by that company in oligopolies is daunting to accomplish because defection is in the best interest of every individual firm.Key TermsPareto optimal: describing a situation in i m sorry the profit of one party can not be raised without reducing the profit of another.Nash equilibrium: The collection of players’ strategies for which no player can advantage by an altering his or she strategy, assuming that the various other players store theirs unchanged.Strategic dominance: Occurs once one strategy is much better than an additional strategy because that one player, no matter just how that player’s enemies may play.

Sometimes firms fail to cooperate with each other, even when participation would bring around a much better collective outcome. The prisoner’s dilemma is a canonical instance of a video game analyzed in game theory that shows why 2 individuals can not cooperate, also if it shows up that the is in their ideal interest to carry out so.

In the game, two members the a criminal gang room arrested and imprisoned. Each prisoner is in solitary confinement through no way of speak to or trading messages with the other. The police offer each prisoner a bargain:

Prisoner’s Dilemma: treason in the dominant strategy because that both players, as it offers for a much better individual result regardless that what the other player does. However, the resulting outcome is no Pareto-optimal. Both players would clearly have been far better off if they had cooperated.

If prisoner A and Prisoner B both confess to the crime, each of them will certainly serve two years in prison.If A confesses however B denies the crime, A will certainly be collection free, if B will serve three years in prison (and evil versa).If both A and B refuse the crime, both of them will just serve one year in prison.

For both players, the choice to betray the companion by confessing has actually strategic dominance in this situation; that is the far better strategy for each player regardless of what the various other player does. This collection of tactics is thus a Nash equilibrium in the game–no player would certainly be much better off by transforming his or her strategy. Together a result, all purely self-interested detainees would betray every other, causing a 2 year jail sentence for both. This outcome is not Pareto optimal; the is clearly possible to improve the outcomes for both players through cooperation. If both players had actually denied the crime, they would each it is in serving only one year in prison.

Similarly to the prisoner’s dilemma scenario, teamwork is difficult to maintain in an oligopoly due to the fact that cooperation is not in the finest interest of the separation, personal, instance players. However, the collective outcome would be enhanced if firms cooperated, and were therefore able to keep low production, high prices, and syndicate profits.

One classic example of video game theory and the prisoner’s dilemma in practice entails soft drinks. Coca-Cola and Pepsi complete in an oligopoly, and also thus are very competitive versus one an additional (as lock have limited other compete threats). Considering the similarity the their assets in the soft drink market (i.e. Varying species of soda), any type of price deviation on component of one challenger is viewed as an act of non-conformity or betrayal of an established status quo.

In together a scenario, there room a number of plausible reactions and outcomes. If Coca-Cola reduces their prices, Pepsi might follow to ensure they perform not lose sector share. In this situation, defection results in a lose-lose. I m sorry is come say that, due to the early stage price reduction by Coca-Cola (betrayal of standing quo), both companies most likely see diminished profit margins. ~ above the other hand, Pepsi might uphold the price allude despite Coca-Cola’s deviation, sacrificing market share to Coca-Cola but maintaining the developed price point. Prisoner dilemma scenarios are difficult strategic choices, as any kind of deviation from established competitive exercise may an outcome in much less profits and/or sector share.

Duopoly Example

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

Key Takeaways

Key PointsThe Cournot model focuses on the production output decision the a solitary firm. A firm identify its competitor’s calculation level and the residual sector demand. It climate determines its profit -maximizing calculation for that residual demand as if it were the entire market, and produces accordingly.In the Bertrand model, firms collection profit-maximizing prices in solution to what they suppose the competitor to charge. The design predicts that both firms will lower prices until they with the marginal price limit, getting here at an end result equivalent to what prevails under perfect competition.The accuracy that the Cournot or Bertrand design will differ from sector to industry, depending on how straightforward it is to readjust output levels in the industry.Key TermsCournot duopoly: An economic model describing an market in i beg your pardon companies contend on the quantity of calculation they will certainly produce, i m sorry they decision on individually of each other and at the very same time.Bertrand duopoly: A design that defines interactions amongst firms contending on price.

A true duopoly is a specific form of oligopoly where just two producers exist in a market. There room two principle duopoly models: Cournot duopoly and Bertrand duopoly.

Cournot Duopoly

Cournot duopoly is an economic model that defines an sector structure in which firms contend on calculation levels. The design makes the following assumptions:

There space two firms, which create a homogeneous product;The number of firms is fixed;Firms execute not cooperate (there is no collusion);Firms have market power, and also each firm’s output decision influence the good’s price;Firms are financially rational and also act strategically, seeking come maximize profit provided their competitor’s decisions; andFirms compete on quantity, and also choose quantity simultaneously.

The Cournot model concentrates on the production output decision the a single firm. The firm determines its rival’s output level, evaluate the residual sector demand, and then transforms its very own output level come maximize profits. It is assumed the the firm’s output decision will certainly not affect the output decision the its competitor.

For example, suppose that there space two that company in the industry for toasters with a given demand function. Firm A will identify the output of certain B, hold it constant, and also then determine the remainder that the market demand for toasters. For sure A will certainly then identify its profit-maximizing calculation for that residual need as if it were the entire market, and also produce accordingly. Firm B will certainly be conducting similar calculations v respect come Firm A in ~ the exact same time.

Bertrand Duopoly

The Bertrand model describes interactions amongst firms that contend on price. Firms set profit-maximizing price in an answer to what they intend a challenger to charge. The model rests ~ above the adhering to assumptions:

There room two firms producing homogeneous products;Firms execute not cooperate;Firms compete by setup prices simultaneously; andConsumers buy everything from a firm with a reduced price. If every firms charge the very same price, consumers randomly select among them.

In the Bertrand model, firm A’s optimum price depends on whereby it believes for sure B will set its price. Pricing just listed below the various other firm will achieve full industry demand, though this an option is no optimal if the other firm is pricing below marginal cost, together this would result in an unfavorable profits. If firm B is setup the price below marginal cost, certain A will collection the price at marginal cost. If for sure B is setup the price above marginal cost yet below monopoly price, climate Firm A will set the price just listed below that of certain B. If for sure B set the price above syndicate price, firm A will collection the price at monopoly level.

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

Imagine if both firms collection equal prices above marginal cost. Each firm would certainly get half the industry at a higher than marginal price price. However, by lowering prices just slightly, a firm could gain the totality 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 certainly make a loss. Therefore, both this firm will reduced prices till they with the marginal expense limit. Follow to this model, a duopoly will result in result exactly equivalent to what prevails under perfect competition. The an outcome of the firms’ techniques is a Nash equilibrium –a pair or tactics where no firm have the right to increase profits by unilaterally transforming the price.

Colluding to fee the monopoly price and also supplying one fifty percent of the sector each is the best that the firms might do in this scenario. However, no colluding and charging the marginal cost, which is the non-cooperative outcome, is the only Nash equilibrium of this model.

The accuracy of the Cournot or Bertrand model will differ from industry to industry. If capacity and also output can be easily changed, Bertrand is typically a far better model of duopoly competition. If output and capacity are daunting to adjust, then Cournot is typically a better model.

Cartel Example

A cartel is a officially collusive arrangement among firms with the goal of increasing profits.

Key Takeaways

Key PointsCartel members cooperate to collection industry price and output.Game theory shows that cartels are naturally unstable. Each individual member has actually an incentive to cheat in order come make greater profits in the brief run.Cheating may bring about the collapse of a cartel. With 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 effective cartel.Key TermsCartel: A group of companies or nations that collude to limit competition in ~ an market or market.

A cartel is an agreement among competing firms come collude in order to attain higher profits. Cartels usually take place in an oligopolistic industry, whereby the variety of sellers is small and the assets being traded room homogeneous. Cartel members may agree on together matters space price fixing, complete industry output, sector share, allocation that customers, allocation of territories, bid rigging, facility of common sales agencies, and the division of profits.

Game theory says that cartels are inherently unstable, because the habits of cartel members represents a prisoner’s dilemma. Every member that a cartel would have the ability to make a greater profit, at least in the short-run, by breaking the agreement (producing a better quantity or offering at a reduced price) than it would make through abiding through it. However, if the cartel collapses because of defections, the firms would certainly revert to competing, revenues would drop, and all would be worse off.

Whether members the a cartel choose to cheat on the commitment depends on whether the short-term returns to cheating outweigh the long-term losses indigenous the possible failure of the cartel. It additionally partly counts on how complicated it is because that firms come monitor whether the covenant is gift adhered come by various other firms. If monitoring is difficult, a member is likely to obtain away v cheating because that longer; members would then be an ext likely to cheat, and also the cartel will certainly be more unstable.

Perhaps the most worldwide recognizable and also effective cartel is OPEC, the organization of Petroleum Exporting Countries. In 1973 members of OPEC diminished their manufacturing of oil. Because crude oil indigenous the Middle eastern was known to have few substitutes, OPEC member’s profits skyrocketed. Native 1973 to 1979, the price the oil raised by $70 per barrel, an unprecedented number at the time. In the mid 1980s, however, OPEC began to weaken. Exploration of brand-new oil fields in Alaska and Canada introduced new alternatives to middle Eastern oil, bring about OPEC’s prices and also profits come fall. Approximately the very same time OPEC members additionally started cheating to try to rise individual profits.

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OPEC: In the 1970s, OPEC members efficiently colluded to alleviate the global production of oil, leading to greater profits because that member countries.