Transcript Strategic competition and collusion

Strategic competition and collusion
Oligopolists need to ensure that they all
restrict output – collusion is sustained
AND (in the same way as monopolists)
they also need to deter entry of new
firms
Sustaining collusion – not so
easy in a prisoners’ dilemma

Revision of prisoners’ dilemma generally
and in an oligopoly context
The prisoners’ dilemma
Prisoner confess
A
don’t
confess
Prisoner B
confess
don’t
confess
-5
-5 -1 -10
-10 -1 -2
-2
•The payoffs are years in prison
•Use the underlining method to find the
Nash Equilibrium
The Nash equilibrium
Prisoner B
confess
don’t
confess
Prisoner confess
A
don’t
confess
-5
-10
-5
-1
-1
-2
-10
-2
The Nash equilibrium is also a dominant strategy equilibrium.
So game theorists believe that the predicted outcome is
very convincing; confession is a dominant strategy for both
players and yet…..
The equilibrium
of the prisoners’ dilemma

The equilibrium is {confess, confess}
 But

both would be better off if neither confessed
The dilemma for the prisoners’ is that they
would both be better off if they co-operated
with each other (by not confessing) but it is
individually rational for them both to confess

in any other strategy combination there is an
incentive for one of the prisoners to deviate
A more general interpretation of the
prisoners’ dilemma
Confess implies cheating on (or
defection from) some mutually
beneficial, but not necessarily explicit
agreement (to deny): non-cooperation
 To deny implies some kind of working
together or collusion or cooperation
between the players

The generalised PD problem
Player B
co-operate
co-operate
Player
notAcoopnot cooperate
a,
a
c,
b
not
cooperate
b,
c
d,
d
c>a>d>b
What is the dominant strategy equilibrium (DSE)?
The generalised PD problem
Player B
co-operate
co-operate
Player
notAcoopnot cooperate
a,
a
c,
b
not
cooperate
b,
c
d,
d
Since c> a and d > b the DSE is: {not cooperate, not cooperate}
But both players would be better off cooperating since a > d
Remember that c > a > d > b
GENERALISATION
 Any
game with this payoff
structure is a Prisoners’ Dilemma
 The players do not have to be
prisoners
• SMALL GROUP WORK
• Discussion questions on the Prisoners’ Dilemma
• Why does the group think so much attention has
been given to the prisoners’ dilemma in (i) economics
and (ii) the social sciences more generally?
• Describe three or more examples of a prisoners’
dilemma that is faced by real people (acting
individually or in groups) in real life.
• How, if at all, are the prisoners’ dilemma problems
described in (2) above resolved? If they are not
resolved in practices how might they be resolved?
The prisoners’ dilemma and cooperation/collusion
between 2-firms in an Oligopoly (Duopoly)
Alpha and Beta are two oil producers who share the
market.
Each firm has two possible strategies:
1.
High output –Lower price
2.
Low output – higher price
Each chooses its strategy without knowing what
strategy the other has chosen
(equivalent to simultaneous or hidden moves)
Prisoners’ dilemma and oligopoly
four possible outcomes:
1.
Both produce a high output
OK profits (1 billion)
•
2.
Both produce a low output – collusive agreement.
•
E.g. by forming a cartel: Arrangements entered into voluntarily
which restrict firms’ future actions (Alpha and Beta each agree
to restrict output to keep prices high).
•
3.
High profits (2 billion)
Beta produces low output but Alpha produces high output.
•
4.
Beta has very low profits (0), Alpha very high profits (3)
Alpha produces low output but Beta produces high output.
•
Beta has very high profits (3), Alpha very low profits (0)
The Prisoners’ Dilemma and oligopoly
collusion
Beta’s
Strategy
Alpha’s
Strategy
Compete on price: Don’t compete on
high output
price: low output
Compete on
price: high
output
Don’t compete
on price: low
Output
1
1
3
0
0
3
2
2
Both firms would improve profits if they colluded to form a cartel in which
each agreed to limit price competition and restrict output. But what is the
likely outcome (the Nash Equilibrium) of this strategic game?
The Prisoners’ Dilemma and oligopoly
collusion
Beta’s
Strategy
Alpha’s
Strategy
Compete on price:
high output
Compete on
price: high
output
Don’t compete
on price: low
Output
1
0
Don’t compete on
price: low output
1
3
0
3
2
2
Although both firms would have higher profits if they colluded to restrict
output there is an incentive for each to cheat because each firm could
increase its profits by increasing its output as long as the other firm keeps
to the agreement and keeps its own output low. The likely outcome is that
they both produce high output.
Implications


Collusion between oligopolists is undesirable
but it is also unlikely to be stable
firms are likely to be involved in a ‘prisoners’ dilemma’
– especially given that collusion is illegal and subject
to punishment
 they
can agree to collude BUT this still leaves
problem of enforcement.

So regulators don’t have to worry?
 Depends
- how realistic is the analysis?
Test your understanding

Collusion: Explain why game theorists
predict that collusion between
oligopolists is likely to be fragile
Exercise on oligopoly
1.(a)Explain how and why firms in oligopoly markets might collude. Illustrate your
answer with reference to the 07/12/07 OFT Press Release on supermarket collusion.
(b) Use game theoretic analysis and Payoff Matrix 1 (below) to explain why collusion
between firms could be fragile in some circumstances.
Payoff Matrix 1
ASDA
Restrict
supply
Increase
supply
TESCO
Restrict
supply
300, 300
Increase
supply
150, 400
400, 150
200, 200
Payoff Matrix 1 illustrates the situation facing two supermarkets, ASDA and
TESCO. They each choose between either restricting supply or increasing
supply of a specific range of products. By restricting their combined supply
the supermarkets are able to maintain higher prices. In the payoff matrix the
payoffs of the supermarkets represent profits and in each cell the payoffs of
ASDA are written first.
1(c) Explain how the OFT’s offer of leniency to firms involved in collusion could
help to break up collusive agreements (see OFT guidance in the OFT Press
Release 144/08).
1(d) Under what circumstances is collusion between firms more likely to be
sustained? Illustrate your answer with reference to the FT article on cooperation
between DVD makers
Hints: you need to consider the independent nature of firms’ behaviour in oligopoly
markets and the consequences of collusion
Investigations continue against other
supermarkets and a dairy processor
OFT Press release 170/07
7 December 2007
OFT welcomes early resolution agreements and agrees over
£116m penalties
Following the OFT's Statement of Objections (SO) of 20 September 2007 which provisionally
found evidence of collusion between certain large supermarkets (Asda, Morrisons, Safeway,
Sainsbury's and Tesco) and dairy processors (Arla, Dairy Crest, Lactalis McLelland, The Cheese
Company (formerly Glanbia Foods Limited) and Wiseman) on the retail prices of some dairy
products, certain of these parties have now admitted involvement in anti-competitive practices and
have agreed to pay individual penalties which, combined, come to a maximum of over £116
million.
With a view to maintaining strong and effective competition law, the OFT will continue with its
case against the remaining parties. The SO set out the OFT's provisional findings that certain large
supermarkets and dairy processors have colluded to increase the retail prices of one or more of
liquid milk, value butter and UK produced cheese. The OFT's provisional findings were that the
collusion took place through the sharing of commercially sensitive information in 2002 and, in
some cases, in 2003.
The OFT has now concluded early resolution agreements with Asda, Dairy Crest, Safeway (in
relation to conduct prior to its acquisition by Morrisons), Sainsbury's, The Cheese Company and
Wiseman based upon the provisional findings made in the SO. These parties have accepted a
liability in principle, and will pay penalties which amount to a maximum of over £116 million.
However each party will receive a significant reduction in the financial penalty that would
otherwise have been imposed on it, on condition that it continues to provide full co-operation.
Arla had previously applied to the OFT for leniency and will receive complete immunity from
financial penalty if it continues to fully co-operate. The OFT will continue with its case against
Lactalis McLelland, Morrisons and Tesco. These parties have an opportunity to make
representations on the OFT's provisional findings. The OFT will carefully consider any
representations, and the evidence in the case as a whole before reaching any final decision.
OFT publishes revised guidance on leniency
OFT Press Release 144/08 11 December 2008
The OFT has today published revised leniency guidance for businesses and
individuals that come forward with information about their involvement in a cartel.
Under the OFT leniency programme members of cartels who provide evidence of
such involvement may qualify for criminal immunity and may avoid any fine or
receive a reduced penalty provided they fully co-operate with an investigation. The
clarified and expanded guidance is intended to give maximum predictability and
transparency for leniency applicants and their advisers.
Simon Williams, OFT Senior Director of Cartels and Criminal Enforcement, said:
'Cartels cheat consumers by restricting competition. The leniency programme
continues to be a simple and powerful tool to expose such conduct and the revisions
to the OFT's guidance will help ensure that the programme continues to provide a
powerful incentive to seek leniency before it is too late.'
DVD makers decide on cooperation, not damaging
competition
By Michiyo Nakamoto in Tokyo and Maija
Pesola in London Published: April 22 2005
03:00
The recent history of the consumer electronics
industry has been fraught with format wars
that have confused consumers, wasted
valuable resources and left the losing camps
with redundant technologies. The transition to
next-generation high-definition DVDs - which
started another round of fierce competition
with divisions not only among manufacturers
but also among software content producers was expected to go the same way.
But in the past several weeks, Sony, which
leads the camp supporting Blu-ray disc
technology, and Toshiba, which is promoting
HD-DVD, have come to the negotiating table
to try to agree on a common platform. The
decision highlights growing concerns about the
damaging impact a divided market could have
on consumer sentiment towards the new
technology and ultimately on industry growth.
It was a classic example of the Prisoner's
Dilemma from game theory: the gains would
be higher for the winner if one standard
succeeded outright, but both could make
modest gains from co-operating. More
importantly, by continuing at loggerheads, both
stood to make considerable losses.
Evenly matched, the camps would have faced a
lengthy battle in the marketplace for dominance.
However, with the Japanese electronics sector
plagued by plunging prices, increasingly short
product cycles and tumbling profitability, companies
can ill afford pain as the prices of digital products,
from flat-panel TVs to DVD recorders and digital
cameras, remain weak, further squeezing profits.
Many Japanese electronics manufacturers,
including Sony, have had to revise down their
forecasts for the year just ended. Against this
background, there have been concerns that any
confusion surrounding next- generation DVDs
could discourage consumers from adopting the new
technology.
The industry, which has seen how quickly price
erosion hit the DVD recorder market, must be aware
that "if they continue to fight over the format, it
would take too long to recoup their costs - if they
could at all. I think that has been the catalyst [for the
agreement]," says one analyst.
"Price erosion in the next generation will be worse,
so the companies probably decided that it would be
better to co-operate in development, reduce their
own cost burden and facilitate penetration of nextgeneration DVDs."
Copyright The Financial Times Limited 2005
Exercise on oligopoly: Answers
1 (a) Oligopolists have an incentive to act together (as a monopolist) to restrict supply. Their
motivation for acting in this way is to raise prices and thereby make higher combined profits on the
products concerned. However, such behaviour is detrimental to consumers since they pay higher
prices than if there is no collusion.The OFT found that the supermarkets named in the press release
colluded with each other and their suppliers (the dairy processors) to keep prices high. According to
the OFT, the collusion was managed through the sharing of commercially sensitive information
(b) The game theoretic analysis of the prisoners’ dilemma suggests that oligopoly collusion (e.g.
through the formation of cartels or through implicit collusion) is likely to be fragile because the
incentives to break any collusive agreement are too high . Payoff Matrix 1 illustrates this. The matrix
illustrates the situation facing two supermarkets, ASDA and TESCO, and the payoffs imply that if
the supermarkets collude by restricting supply to keep prices high they both make high profits (300
each). But if one of the supermarkets e.g. ASDA breaks the agreement by increasing supply
(resulting in a lower market price overall) while TESCO continues to restrict supply, ASDA would
make relatively high profits of 400 (e.g. by increasing sales to its own customers and poaching some
of ASCO’s customers) while TESCO would see a reduction in its profits to 150. However, if both
increased supply, price would fall even further and they would both make relatively low profits (200
each).
In Payoff Matrix 1 both firms have a dominant strategy which is to break the collusive agreement by
charging a lower price. To see this, consider the options of ASDA in response to each of TESCO’s
two possible strategies. First, If ASCO chooses to maintain the agreement by restricting supply then
ASDA makes profits of 300 if it also restricts supply but ASDA makes profits of 400 by increasing
supply (breaking the agreement with TESCO). Therefore, ASDA’s best option (its best response to
TESCO restricting supply) is to increase supply. Second, if TESCO increases its supply, then ASDA
makes profits of 200 by also increasing its supply and only makes profits of 150 if it continues to
restrict supply. Therefore, ASDA’s best option in response to an increase in supply by TESCO is to
also to increase its supply. This shows that ASDA is better off increasing its supply whatever
TESCO does. In other words, increasing supply is a dominant strategy for ASDA (whatever TESCO
does, ASDA is better off choosing to restrict sales). Since the game is symmetric, the same is true for
TESCO.
Thus both firms have a dominant strategy which is to increase supply. Therefore, the expected
outcome is that neither firm will stick to the collusive agreement, both will increase supply. Both
firms would therefore end up with profits of 200. The prisoners’ dilemma for the supermarkets is that
if they could somehow maintain the collusive agreement they would both make higher profits (300
each) but the incentive to break the agreement is too strong.
(c) The OFT policy of leniency is discussed in the 11/12/08 Press Release. The offer of leniency to
firms involved in collusion should help to break up collusive agreements since it gives firms even
more incentive to break up any such agreement. In terms of the payoff matrix in Figure 7 the payoff
to either supermarket from maintaining the collusive agreement, if the other were to break it by
increasing supply, would be even lower (i.e. less than 150) since the OFT would impose high
penalties on the firm that did not break the agreement by confessing.
(d) Collusion is more likely to be sustained if it can be enforced over the long term i.e. through
repetition. In this case, the one-off gains from breaking the agreement (followed by repeated nonagreement) could be outweighed by longer-term (repeated) gains from commitment to the agreement.
This appears to be the determining factor that induced Sony and Toshiba to agree on a common
platform for DVDs; the potential gains from becoming the market leader were outweighed by the
losses that would be sustained by maintaining a market divide. In the long-term, collusion is also
more likely to be maintained if the participants can make credible threats of punishment that will be
enforced against any party that breaks the collusive agreement (e.g. by imposing penalties for
default). A collusive agreement may also be sustained if the parties to the agreement share norms of
commitment.