Question

e) by referirng to previous questions b) and c) This game shows that a collusive agreement over prices will be needed to reach the most desirable outcome for the firms where they both price high. Explain?

Answer 1

You didn't mention the previous questions. So I am assuming the answer.

Collusion and Competition

Firms in an oligopoly can increase their profits through collusion, but collusive arrangements are inherently unstable.

KEY TAKEAWAYS

Key Points

Firms in an oligopoly may collude to set a price or output level for a market in order to maximize industry profits. At an extreme, the colluding firms can act as a monopoly.

Oligopolists pursuing their individual self-interest would produce a greater quantity than a monopolist, and charge a lower price.

Collusive arrangements are generally illegal. Moreover, it is difficult for firms to coordinate actions, and there is a threat that firms may defect and undermine the others in the arrangement.

Price leadership, which occurs when a dominant competitor sets the industry price and others follow suit, is an informal type of collusion which is generally legal.

Key Terms

Price leadership: Occurs when one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following.

collusion: A secret agreement for an illegal purpose; conspiracy.

price fixing: An agreement between sellers to sell a product only at a fixed price, or maintain the market conditions such that the price is maintained at a given level by controlling supply.

Oligopoly is a market structure in which there are a few firms producing a product. When there are few firms in the market, they may collude to set a price or output level for the market in order to maximize industry profits. As a result, price will be higher than the market-clearing price, and output is likely to be lower. At the extreme, the colluding firms may act as a monopoly, reducing their individual output so that their collective output would equal that of a monopolist, allowing them to earn higher profits.

OPEC: The oil-producing countries of OPEC have at times cooperated to raise world oil prices in order to secure a steady income for themselves.

If oligopolists individually pursued their own self-interest, then they would produce a total quantity greater than the monopoly quantity, and charge a lower price than the monopoly price, thus earning a smaller profit. The promise of bigger profits gives oligopolists an incentive to cooperate. However, collusive oligopoly is inherently unstable, because the most efficient firms will be tempted to break ranks by cutting prices in order to increase market share.

Several factors deter collusion. First, price-fixing is illegal in the United States, and antitrust laws exist to prevent collusion between firms. Second, coordination among firms is difficult, and becomes more so the greater the number of firms involved. Third, there is a threat of defection. A firm may agree to collude and then break the agreement, undercutting the profits of the firms still holding to the agreement. Finally, a firm may be discouraged from collusion if it does not perceive itself to be able to effectively punish firms that may break the agreement.

In contrast to price-fixing, price leadership is a type of informal collusion which is generally legal. Price leadership, which is also sometimes called parallel pricing, occurs when the dominant competitor publishes its price ahead of other firms in the market, and the other firms then match the announced price. The leader will typically set the price to maximize its profits, which may not be the price that maximized other firms’ profits.

Game Theory Applications to Oligopoly

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

Key Points

In an oligopoly, firms are affected not only by their own production decisions, but by the production decisions of other firms in the market as well. Game theory models situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action.

The prisoner’s dilemma is a type of game that illustrates why cooperation is difficult to maintain for oligopolists even when it is mutually beneficial. In this game, the dominant strategy of each actor is to defect. However, acting in self-interest leads to a sub-optimal collective outcome.

The Nash equilibrium is an important concept in game theory. It is the set of strategies such that no player can do better by unilaterally changing his or her strategy.

Game theory is generally not needed to understand competitive or monopolized markets.

Key Terms

Prisoner’s dilemma: A game that shows why two individuals might not cooperate, even if it appears that it is in their best interests to do so.

game theory: A branch of applied mathematics that studies strategic situations in which individuals or organisations choose various actions in an attempt to maximize their returns.

Nash equilibrium: The set of players’ strategies for which no player can benefit by changing his or her strategy, assuming that the other players keep theirs unchanged.

In an oligopoly, firms are interdependent; they are affected not only by their own decisions regarding how much to produce, but by the decisions of other firms in the market as well. Game theory offers a useful framework for thinking about how firms may act in the context of this interdependence. More specifically, game theory can be used to model situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action.

For example, game theory can explain why oligopolies have trouble maintaining collusive arrangements to generate monopoly profits. While firms would be better off collectively if they cooperate, each individual firm has a strong incentive to cheat and undercut their competitors in order to increase market share. Because the incentive to defect is strong, firms may not even enter into a collusive agreement if they don’t perceive there to be a way to effectively punish defectors.

The prisoner’s dilemma is a specific type of game in game theory that illustrates why cooperation may be difficult to maintain for oligopolists even when it is mutually beneficial. In the game, two members of a criminal gang are arrested and imprisoned. The prisoners are separated and left to contemplate their options. If both prisoners confess, each will serve a two-year prison term. If one confesses, but the other denies the crime, the one that confessed will walk free, while the one that denied the crime would get a three-year sentence. If both deny the crime, they will both serve only a one year sentence. Betraying the partner by confessing is the dominant strategy; it is the better strategy for each player regardless of how the other plays. This is known as a Nash equilibrium. The result of the game is that both prisoners pursue individual logic and betray, when they would have collectively gotten a better outcome if they had both cooperated.

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

The Nash equilibrium is an important concept in game theory. It is the set of strategies such that no player can do better by unilaterally changing his or her strategy. If a player knew the strategies of the other players (and those strategies could not change), and could not benefit by changing his or her strategy, then that set of strategies represents a Nash equilibrium. If any player would benefit by changing his or her strategy, then that set of strategies is not a Nash equilibrium.

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