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Micro economics

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Microeconomics ­ECO402
VU
Lesson 41
Competition Versus Collusion:
The Prisoners' Dilemma
Why wouldn't each firm set the collusion price independently and earn the higher profits that
occur with explicit collusion?
Assume:
FC = $ 20 and VC = $ 0
Firm 1' s Demand : Q = 12 - 2 P1 + P2
Firm 2' s Demand : Q = 12 - 2 P2 + P1
ö = $ 12
: P = $4
Nash Equilibriu
m
ö = $ 16
P = $6
:
Collusion
Possible Pricing Outcomes:
ö = $16
Firm 1 : P = $6
Firm 2 : P = $6
P = $6
P = $4
ö  2 = P2Q2 - 20
= (4)[12 - (2)(4) + 6]  - 20 = $20
ö  1 = P1Q1 - 20
= (6)[12 - (2)(6) + 4]  - 20 = $4
Payoff Matrix for Pricing Game
Firm 2
Charge $4
Charge $6
Charge $4
$20,
$12,
Firm 1
Charge $6
$4,
$16,
These two firms are playing a non co-operative game.
­ Each firm independently does the best it can taking its competitor into account.
Question
­ Why will both firms both choose $4 when $6 will yield higher profits?
An example in game theory, called the Prisoners' Dilemma, illustrates the problem
oligopolistic firms face.
187
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Microeconomics ­ECO402
VU
Scenario
­ Two prisoners have been accused of collaborating in a crime.
­ They are in separate jail cells and cannot communicate.
­ Each has been asked to confess to the crime.
Payoff Matrix for Prisoners' Dilemma
Payoff Matrix for Pricing Game
Firm 2
Charge $4
Charge $6
Charge $4
$20,
$12,
Firm 1
Charge $6
$4,
$16,
Conclusions: Oligipolistic Markets
1) Collusion will lead to greater profits
2) Explicit and implicit collusion is possible
3) Once collusion exists, the profit motive to break and lower price is
significant
Implications of the Prisoners'
Dilemma for Oligipolistic Pricing
Observations of Oligopoly Behavior
1) In some oligopoly markets, pricing behavior in time can create a
predictable pricing environment and implied collusion may occur.
Observations of Oligopoly Behavior
2) In other oligopoly markets, the firms are very aggressive and collusion is not
possible.
 Firms are reluctant to change price because of the likely response of their
competitors.
 In this case prices tend to be relatively rigid.
188
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Microeconomics ­ECO402
VU
 The Kinked Demand Curve
If the producer raises price the
$/Q
competitors will not and the
demand will be elastic.
If the producer lowers price the
competitors will follow and the
demand will be inelastic.
D
Quantity
MR
So long as marginal cost is in the
$/Q
vertical region of the marginal
revenue curve, price and output
MC'
will remain constant.
P*
MC
D
Quantity
Q*
MR
PRICE SIGNALING & PRICE LEADERSHIP
­  Price Signaling
 Implicit collusion in which a firm announces a price increase in the hope that other
firms will follow suit
­  Price Leadership
 Pattern of pricing in which one firm regularly announces price changes that other
firms then match
The Dominant Firm Model
­ In some oligopolistic markets, one large firm has a major share of total sales, and a
group of smaller firms supplies the remainder of the market.
­ The large firm might then act as the dominant firm, setting a price that maximized its
own profits.
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Microeconomics ­ECO402
VU
Price Setting by a Dominant Firm
SF
The dominant firm's demand
Price
D
curve is the difference between
market demand (D) and the
supply of the fringe firms (SF).
P1
MC
P*
At this price, fringe
DD
firms sell QF, so that
total sales are QT.
P2
MR
Quantity
QF QD
QT
CARTELS
Characteristics
1) Explicit agreements to set output and price
2) May not include all firms
3) Most often international
­  Examples of successful cartels
 OPEC
 International Bauxite Association
­ Examples of unsuccessful cartels
 Copper
 Tin
 Coffee
 Tea
 Cocoa
4) Conditions for success
 Competitive alternative sufficiently deters cheating
 Potential of monopoly power--inelastic demand
190
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Microeconomics ­ECO402
VU
The OPEC Oil Cartel
TD
SC
Price
TD is the total world demand
curve for oil, and SC is the
Competitive supply. OPEC's
demand is the difference
between the two.
OPEC's profits maximizing
quantity is found at the
P*
intersection of its MR and
MC curves. At this quantity
OPEC charges price P*.
DOPEC
MCOPEC
MROPEC
QOPEC
Quantity
Cartels
About OPEC
­ Very low MC
­ TD is inelastic
­ Non-OPEC supply is inelastic
­ DOPEC is relatively inelastic
The OPEC Oil Cartel
TD
SC
Price
The price without the cartel:
Competitive price (P ) where
C
DOPEC = MCOPEC
P*
DOPEC
MCOPEC
Pc
MROPEC
QOPEC
QC
QT
Quantity
191
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Microeconomics ­ECO402
VU
The CIPEC Copper Cartel
TD and S are relatively elastic
C
Price
TD
D    is elastic
CIPEC
CIPEC has little monopoly power
S
MCCIPEC
DCIPEC
P*
PC
MRCIPEC
Quantity
QCIPEC
QC
QT
Cartels
Observations
­ To be successful:
 Total demand must not be very price elastic
 Either the cartel must control nearly all of the world's supply or the supply of
noncartel producers must not be price elastic.
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Table of Contents:
  1. ECONOMICS:Themes of Microeconomics, Theories and Models
  2. Economics: Another Perspective, Factors of Production
  3. REAL VERSUS NOMINAL PRICES:SUPPLY AND DEMAND, The Demand Curve
  4. Changes in Market Equilibrium:Market for College Education
  5. Elasticities of supply and demand:The Demand for Gasoline
  6. Consumer Behavior:Consumer Preferences, Indifference curves
  7. CONSUMER PREFERENCES:Budget Constraints, Consumer Choice
  8. Note it is repeated:Consumer Preferences, Revealed Preferences
  9. MARGINAL UTILITY AND CONSUMER CHOICE:COST-OF-LIVING INDEXES
  10. Review of Consumer Equilibrium:INDIVIDUAL DEMAND, An Inferior Good
  11. Income & Substitution Effects:Determining the Market Demand Curve
  12. The Aggregate Demand For Wheat:NETWORK EXTERNALITIES
  13. Describing Risk:Unequal Probability Outcomes
  14. PREFERENCES TOWARD RISK:Risk Premium, Indifference Curve
  15. PREFERENCES TOWARD RISK:Reducing Risk, The Demand for Risky Assets
  16. The Technology of Production:Production Function for Food
  17. Production with Two Variable Inputs:Returns to Scale
  18. Measuring Cost: Which Costs Matter?:Cost in the Short Run
  19. A Firmís Short-Run Costs ($):The Effect of Effluent Fees on Firmsí Input Choices
  20. Cost in the Long Run:Long-Run Cost with Economies & Diseconomies of Scale
  21. Production with Two Outputs--Economies of Scope:Cubic Cost Function
  22. Perfectly Competitive Markets:Choosing Output in Short Run
  23. A Competitive Firm Incurring Losses:Industry Supply in Short Run
  24. Elasticity of Market Supply:Producer Surplus for a Market
  25. Elasticity of Market Supply:Long-Run Competitive Equilibrium
  26. Elasticity of Market Supply:The Industryís Long-Run Supply Curve
  27. Elasticity of Market Supply:Welfare loss if price is held below market-clearing level
  28. Price Supports:Supply Restrictions, Import Quotas and Tariffs
  29. The Sugar Quota:The Impact of a Tax or Subsidy, Subsidy
  30. Perfect Competition:Total, Marginal, and Average Revenue
  31. Perfect Competition:Effect of Excise Tax on Monopolist
  32. Monopoly:Elasticity of Demand and Price Markup, Sources of Monopoly Power
  33. The Social Costs of Monopoly Power:Price Regulation, Monopsony
  34. Monopsony Power:Pricing With Market Power, Capturing Consumer Surplus
  35. Monopsony Power:THE ECONOMICS OF COUPONS AND REBATES
  36. Airline Fares:Elasticities of Demand for Air Travel, The Two-Part Tariff
  37. Bundling:Consumption Decisions When Products are Bundled
  38. Bundling:Mixed Versus Pure Bundling, Effects of Advertising
  39. MONOPOLISTIC COMPETITION:Monopolistic Competition in the Market for Colas and Coffee
  40. OLIGOPOLY:Duopoly Example, Price Competition
  41. Competition Versus Collusion:The Prisonersí Dilemma, Implications of the Prisoners
  42. COMPETITIVE FACTOR MARKETS:Marginal Revenue Product
  43. Competitive Factor Markets:The Demand for Jet Fuel
  44. Equilibrium in a Competitive Factor Market:Labor Market Equilibrium
  45. Factor Markets with Monopoly Power:Monopoly Power of Sellers of Labor