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Game Theory! Cartels • A group of suppliers who try to act together in order to reduce supply, raise prices, and increase profits. • A group of supplied who try to act as AS IF they were a monopolist • Example: OPEC • Question to answer: When will cartels be able to achieve their goal of being a monopolist? Game Theory • A study of strategic decision-making – A decision in making situations that are interactive • Example: Craps players make decisions, pokers players make strategic decisions • Game theory is used to analyze cartels because the best decision of one cartel member depends on the decisions of every other cartel member which in turn depends on the decisions of every other cartel member Game Theory • Also used to study war, romance, business decisions, evolution, voting and other situations involving interactions • Game theory is applied to the economics of network of goods • A network of goods is a good who value to one consumer increases the more that other consumers use the good • Ex. Cell phones Cartels and Game Theory • Why did the price of oil more than triple in 1973-1974? • Saudi Arabia, a cartel of oil exporting countries cut back on their production of oil Cartels and Game Theory • Very few cartels can move in an industry from competition to pure monopoly • OPEC seems to be all powerful but in reality, very few cartels are – UNLESS…..they have strong government support – Would have much control over market price for a very long time Cartels and Game Theory • Cartels tend to collapse due to three reasons: 1. Cheating by cartel members 2. New entrants and demand response 3. Government prosecution 1. Cheating by cartel members • For oil-exporting nations, if they worked together to reduce production and raise prices, it would succeed • Cartel members earn high profits on each barrel of oil that comes out of the ground • BUT……members will cheat on the cartel agreement • They promise to reduce production but when everyone else reduces production and the price of oil rises…….some cartel members can and will cheat to increase their profits Logic of Cheating….. No Cartel Countries Output per Country Output Profit per Country (per day) 10 10 MBD 100 MBD $360 million World 100 MBD Output World Price $36 Logic of Cheating….. Cartel Countries Output per Country Output Profit per Country (per day) 10 8 MBD 80 MBD $400 million World Output World Price 80 MBD $50 Logic of Cheating….. Cartel with One Cheater Countries Output per Country Output Profit per Country (per day) 9 8 MBD 72 MBD 1 10 MBD 10 MBD $380 million $475 million World Output World Price 82 MBD $47.50 1. Cheating by cartel members • The logic is simple, a single cartel member does not have extensive monopoly power, so cutting back production doesn’t raise the world price enough to make up for its loss of sales • What happens when nine countries cheat and only one country keeps its promise? Logic of Cheating….. Cartel with Nine Cheaters and One NonCheater Countries Output per Country Output Profit per Country (per day) 1 8 MBD 8 MBD 9 10 MBD 90 MBD $300 million $375 million World Output World Price 98 MBD $37.50 1. Cheating by cartel members • Cheating pays when other firms keep their promise and cheating pays when other firms cheat • When a monopolist increases quantity beyond the profit-maximizing quantity, the monopolist hurts itself • When a cartel cheater increases quantity beyond the profit-maximizing quantity, the cheater benefits itself and hurts other cartel members 1. Cheating by cartel members • When the decisions of two or more firms significantly affect each others’ profits, they are in a situation of interdependence. • The study of behavior in situations of interdependence is known as game theory. • The reward received by a player in a game—such as the profit earned by an oligopolist—is that player’s payoff. • A payoff matrix shows how the payoff to each of the participants in a two player game depends on the actions of both. Such a matrix helps us analyze interdependence. The Payoff Table Russia’s Strategies Cooperate Saudi Arabia’s Strategies Cheat Cooperate ($400, $400) ($200, $500) Cheat ($500, $200) ($300, $300) Saudi Arabia’s Payoff Russia’s Payoff The Payoff Table Russia’s Strategies • Two numbers in each both of the table are the payoffs to the players • Dominant Strategy – is a Strategy that has a higher payoff than any other Strategy no matter what the other player does • When Russia acts in their own interest and Saudi Arabia acts in their own interest, the result is an outcome that is in the interest of neither Saudi Arabia’s Strategies Cooperate Cheat Cooperate ($400, $400) ($200, $500) Cheat ($500, $200) ($300, $300) The Prisoner’s Dilemma • • If both players cooperate, fishing revenues can be maximized and the stock of fish will be the maintained for of This describes situations where pursuit future generations individual interest leadsthetoother a group BUT….if one player cheats, has anoutcome incentive thattoischeat in the of no and interest this will reduce theone stock of fish below the best possible outcome and Japan’s will eventually deplete Strategies Ex: the product United States’ Strategies Cooperate Cheat Cooperate ($400, $400) ($200, $500) Cheat ($500, $200) ($300, $300) Prisoner’s Dilemma & Nash Equilibrium • An action is a dominant strategy when it is a player’s best action regardless of the action taken by the other player. Depending on the payoffs, a player may or may not have a dominant strategy. • A Nash equilibrium, also known as a noncooperative equilibrium, is the result when each player in a game chooses the action that maximizes his or her payoff given the actions of other players, ignoring the effects of his or her action on the payoffs received by those other players Repeated Interaction and Tacit Collusion Players who don’t take their interdependence into account arrive at a Nash, or non-cooperative, equilibrium. But if a game is played repeatedly, players may engage in strategic behavior, sacrificing short-run profit to influence future behavior. In repeated prisoners’ dilemma games, tit for tat is often a good strategy, leading to successful tacit collusion. Tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period. When firms limit production and raise prices in a way that raises each others’ profits, even though they have not made any formal agreement, they are engaged in tacit collusion 2. New entrants and demand response • High prices of a cartel will attract new entrants • These entrants do not feel bound by previous agreements • Cartels are more successful when there are fewer substitutes for the cartelized good – implies less elastic demand – More subs are typically available in the long run than in the short run, do demand curves tend to become more elastic over time, thus limited a cartel’s power 2. New entrants and demand response • With the ease of new entrants, it is easier to maintain a cartel in a natural resource than in a manufactured good • Two successful cartels – oil and diamonds 2. New entrants and demand response • Natural resources are not the only “thing” in limited supply • A cartel may control access to some key inputs that cannot be easily duplicated • Ex. Major League Sports – NBA, NFL, MLB, MLS 2. New entrants and demand response • NBA consists of 30 teams • Teams compete on the court but “collude” off the court • They use the NBA league structure to keep down player salaries – “salary cap” – If they do, face “the luxury tax” • Each team, when joining the NBA, agrees to limit how much spent on players • Example of a buyer’s cartel – result is that professional basketball salaries are lower than they should be 3. Government prosecution • Cartels have been illegal since the Sherman Antitrust Act of 1890 • Governments don’t always prosecute cartels and sometimes even support them • Most cartels operate with clear legal and governmental backing • Examples: OPEC, milk cartels, coal mining, agriculture, medicine 3. Government prosecution • Government-enforced monopolies and cartels are one of the most serious problems faxing poor nations such as Mexico, Russia, Indonesia and Africa • Entrepreneurs who start new businesses sometimes find that the law force them out of competition with the small number of socalled untouchable big men who have cartelized the major sectors of the government 3. Government prosecution • A government-supported cartel also means higher prices, lower quality of service and less innovation Game Theory! Cartels • A group of supplied who try to act as AS IF they were a monopolist • Example: Game Theory • Example: Craps players make decisions, pokers players make strategic decisions • Game theory is used to analyze cartels because the best decision of one cartel member depends on the decisions of every other cartel member which in turn depends on the decisions of every other cartel member Game Theory • Also used to study war, romance, business decisions, evolution, voting and other situations involving interactions • Game theory is applied to the economics of network of goods Cartels and Game Theory • Why did the price of oil more than triple in 1973-1974? Cartels and Game Theory • Very few cartels can move in an industry from competition to pure monopoly • OPEC seems to be all powerful but in reality, very few cartels are Cartels and Game Theory • Cartels tend to collapse due to three reasons: 1. Cheating by cartel members • They promise to reduce production but when everyone else reduces production and the price of oil rises…….some cartel members can and will cheat to increase their profits Logic of Cheating….. No Cartel Countries Output per Country Output Profit per Country (per day) 10 10 MBD 100 MBD $360 million World 100 MBD Output World Price $36 Logic of Cheating….. Cartel Countries Output per Country Output Profit per Country (per day) 10 8 MBD 80 MBD $400 million World Output World Price 80 MBD $50 Logic of Cheating….. Cartel with One Cheater Countries Output per Country Output Profit per Country (per day) 9 8 MBD 72 MBD 1 10 MBD 10 MBD $380 million $475 million World Output World Price 82 MBD $47.50 1. Cheating by cartel members • The logic is simple, • What happens when nine countries cheat and only one country keeps its promise? Logic of Cheating….. Cartel with Nine Cheaters and One NonCheater Countries Output per Country Output Profit per Country (per day) 1 8 MBD 8 MBD 9 10 MBD 90 MBD $300 million $375 million World Output World Price 98 MBD $37.50 1. Cheating by cartel members • Cheating pays when other firms keep their promise and cheating pays when other firms cheat • When a monopolist increases quantity beyond the profit-maximizing quantity, the monopolist hurts itself The Payoff Table Russia’s Strategies Cooperate Saudi Arabia’s Strategies Cheat Cooperate ($400, $400) ($200, $500) Cheat ($500, $200) ($300, $300) The Payoff Table Russia’s Strategies Saudi Arabia’s Strategies • Dominant Strategy – Cooperate Cheat Cooperate ($400, $400) ($200, $500) Cheat ($500, $200) ($300, $300) The Prisoner’s Dilemma Japan’s Strategies • Ex: United States’ Strategies Cooperate Cheat Cooperate ($400, $400) ($200, $500) Cheat ($500, $200) ($300, $300) 2. New entrants and demand response • High prices of a cartel will attract new entrants • These entrants do not feel bound by previous agreements • Cartels are more successful when there are fewer substitutes for the cartelized good – implies less elastic demand 2. New entrants and demand response • With the ease of new entrants, it is easier to maintain a cartel in a natural resource than in a manufactured good 2. New entrants and demand response • Natural resources are not the only “thing” in limited supply • A cartel may control access to some key inputs that cannot be easily duplicated • Ex. 2. New entrants and demand response • NBA consists of 30 teams • Teams compete on the court but “collude” off the court • They use the NBA league structure to keep down player salaries – “salary cap” – If they do, face “the luxury tax” • Each team, when joining the NBA, agrees to limit how much spent on players • Example of a buyer’s cartel – 3. Government prosecution • Cartels have been illegal since ____________ ________________________ • Governments don’t always prosecute cartels and sometimes even support them • Most cartels operate with clear legal and governmental backing • Examples: 3. Government prosecution • Government-enforced monopolies and cartels are one of the most serious problems faxing poor nations such as Mexico, Russia, Indonesia and Africa • Entrepreneurs who start new businesses sometimes find that the law force them out of competition with the small number of socalled untouchable big men who have cartelized the major sectors of the government 3. Government prosecution