Prices and Markets Sessions 14 & 15 Imperfect Competition and - - PDF document

Prices and Markets

Sessions 14 & 15 Imperfect Competition and Collusion

• Prof. Amine Ouazad

Real world somewhere between the polar cases of monopoly and perfect

• competition. Unfortunately, this is a much harder problem to solve and

requires the techniques of GAME THEORY More Tools: Game Theory

• Importance of Strategic Thinking
• Simultaneous and Sequential Games
• Predictions → Nash equilibrium and backward induction
• Tension between Individual Rationality and Group Rationality

Oligopoly

• Price games and Capacity games
• Leader-Follower games and First Mover Advantage
• Implicit Collusion with Repeated Games
• Entry Deterrence through Reputation
• Strategic Irrationality

Road Map for Prices and Markets: Pricing under Different Market Structures

Auctions

• English auctions and eBay.

Done so far Done so far Done so far Done so far Today

This Session: Imperfect Competition & Collusion

• 1. Price Competition
• 2. Quantity Competition
• 3. Collusion on the Lysine Market

Next Session Exam Guidance, Econ Electives, Solution to Market Power Games

Why is Price Competition Dangerous?

Competitive industry: P = MC = AC → π = 0 Oligopoly: P = MC? Example 1: Electronic phonebooks

• 1986: Nynex charged $10,000 per disk for NY directory
• ProCD and Digital Directory Assistance
• Chinese workers at $3.50 daily wage
• Bertrand or Price Competition → Free

Example 2: Encyclopedia Britannica vs. Encarta

1991: EB sold @ $1,600 1992: Microsoft introduced Encarta, sold @ $49.95 1995: EBs sales have halved 1995: EB offers online subscription for $120 p.a. or CD for $200 1996: EB lowers cost of subscription to $85 1999: EB offers FREE on-line service (www.britannica.com) Today: <$20 for DVD; $100 for online subscription

Bertrand or Price Competition with Identical Products

E-commerce: First-copy costs dominate Significant economies of scale – Marginal cost less than average cost – MC usually constant (close to zero) Standard Implication: Cannot be "perfectly competitive 2 firms with identical products and identical cost structures; no capacity constraints. Nash equilibrium: P1 > P2 P1 = P2 > MC P1 = P2 = MC

Looks like a Prisoners Dilemma

Pmon P – ε Pmon

5 5 10

P – ε

10 3 3

Britannica Encarta This is the Bertrand trap. Avoid this game if you can! How to avoid price wars?? Profitable price wars?? Role of capacity constraints??

This Session: Imperfect Competition & Collusion

• 1. Price Competition
• 2. Quantity Competition
• 3. Collusion on the Lysine Market

Next Session Exam Guidance, Econ Electives, Solution to Market Power Games

ADM and Ajinomoto are producing lysine, a perfectly homogeneous product, in plants in the US (ADM) and Japan (Ajinomoto). The cost per unit of capacity is $0.50. The markets inverse demand curve, with price in $ and quantity in millions of pounds of lysine, is P = 2 − Q / 2500 ! This is a Cournot model of quantity competition. ADMs profit as a function of the quantity produced by each firm: Each firms reaction or best-response function:

Cournot Game in the Lysine market (no collusion; imperfect competition) ΠADM = (P-MC) QADM

= (1.5-QTOTAL/2500) QADM

Differentiate ΠADM w.r.t. QADM and get QADM = 1875-QAji/2

Cournot Game

QADM Qaji

3750% 1250% 1875% 3750% 1250% 1875%

Cournot equilibrium capacities: Cournot equilibrium market price and the profit for each firm:

Firms have same cost and profit: QADM=QAji

• Q = 1875-Q/2 leads to Q = 1250 M lbs of lysine per firm !
• World production??

Total production is Q = 2500 M lbs of lysine.

• Price is P = 2 – 2500/2500 = $1 per lbs !!
• Profit of each firm:
• ΠADM = (P-MC) QADM = $0.50 x 1250 = $625M

qAji = 1875 – 0.5qADM Collusion Cournot-Nash qADM% qAji%

3750% 1250% 1875% 3750% 1250% 1875%

qADM = 1875 – 0.5qAji

Recall: MCADM = MCAjinomoto = 0.50 P = 2 – Q/2500

Quantity Competition or Cournot Game

2 firms ADM and Ajinomoto Increased production by ADM → Increased production very soon → Prices are expected to fall → Lower return on production for ADM → ADM is less likely to invest Actions/strategies: Capacity Choice If ADM invests more Ajinomoto invests less If Ajinomoto invests more ADM invests less

Collusion Cournot-Nash qADM% qAji%

Cournot Nash Equilibrium

3750% 1250% 1875% 3750% 1250% 1875%

qAji = 1875 – 0.5qADM qADM = 1875 – 0.5qAji

Quantity Competition Redux

Dominant Strategy Dominant Strategy ADM Ajinomoto Low Production High Production Low Production High Production 703.125 703.125 781.25 586 781.25 586 625 625 Low production leads to higher profits, but it is not the Nash equilibrium of the game!!

This Session: Imperfect Competition & Collusion

• 1. Price Competition
• 2. Quantity Competition
• 3. Collusion on the Lysine market

Next Session Exam Guidance, Econ Electives, Solution to Market Power Games

Trigger Strategies to Enforce Collusive Outcome

! Begin by cooperating. I assume equal split of the production in the collusive agreement. ! Cooperate as long as the rivals do. ! Upon observing a defection: immediately revert to a period of punishment of specified length in which everyone plays non-cooperatively

• Example
• Grim Trigger Strategy (GTS)
• Start off setting production at the low production level

and continue to do so until the other firm cheats by producing more.

• If the other firm cheats, set high output per year forever.

Payoff Stream from Grim Trigger Strategy

$781.25M $703.125M $625M

t t+1 t+2 t+3 collude cheat Time

Profit PV (collude) = PV (cheat) =

781.25+ 1 1+r 625+ 1 (1+r)2 625+... = 781.25+ 625 r 703.125+ 1 1+r 703.125+ 1 (1+r)2 703.125+... = 703.125+ 703.125 r

“Monthly scorecards were prepared and discussed at quarterly meetings, based on reported sales volumes of each firm. To verify reported sales volumes, international trade statistics were available.”

Implicit Collusion: Weighing Costs and Benefits

• For implicit collusion to work:
• Gains from cooperation must exceed net gain from cheating and being

punished

• That is:
• You would collude if PV of colluding > PV of cheating

703.125+703.125/r > 781.25+625/r → r < 1 (100%)

• This condition always holds.
• Key take-away point: If detection is certain and punishment is quick…
• “Grim Trigger Strategy” can effectively deter cheating and ensure collusion
• AND: Conditions on the Lysine market (e.g. only a few major players,

frequent meetings, international trade statistics) were very conducive to trigger strategies working!

• The Grim Trigger Strategy is unforgiving.
• Tit-for-Tat Strategy
• Start off by cooperating (its nice!)
• Cooperate if your rival cooperated in the previous period
• Cheat for X periods if your rival cheated in the previous period
• Back to collusion after X periods.
• Tit for tat cooperates with cooperative opponents;

punishes uncooperative opponents.

• It is forgiving & easy to understand.
• A trigger strategy:
• If your partner cheats, cheat for X periods.

How long do you need to punish your partner to make him or her cooperate all the time?? Very impatient partner ??

Cheating or not Cheating? How many punishment periods?

Ajinomoto CEO: “cheating was frequent but the range

• f cheating was not too

big ... they kept their promise about 90 percent. Something like that.”

How Did This All End?

• Collusion between ADM and Ajinomoto.
• Mark Whitacre (Matt Damon) is the Informant.
• FBI raid at ADM’s offices.

Price declines to the Cournot equilibrium price.

• December : ADM & Ajinomoto executives indicted.
• Fined $100M!

Extra Profit of collusion ?? 78.125+78.125/0.05 > $1b if done forever !!

1995% 1996% 1992%

U.S. Attorney General Janet Reno: "This $100 million criminal fine should send a message to the entire world.” Really?? Lost consumer surplus? Incentives to collude?

Pm=$1.25 Qm =1875 P*=$1 Q* =2500

Collusion Profits & Cost for Consumers

P Q MC Market Demand Cartel’s Marginal Revenue Variable Profit with competition Cartel Variable Profits Lost consumer surplus? Cartel profits?

!

In quantity games, the price stays above MC even though goods are perfect substitutes.

!

Quantity game is not as dangerous as price game.

!

But still there is over-production. Firms have higher output than a merged firm (monopolist) would.

!

Implicit collusion/cartels are beneficial (for firms) but hard to sustain.

!

… Explicit collusion leads you straight to jail !!

Takeaways on Price and Quantity Competition

This Session: Imperfect Competition & Collusion

• 1. Price Competition
• 2. Quantity Competition
• 3. Collusion on the Lysine Market

Next Session Exam Guidance, Econ Electives, Solution to Market Power Games