Cartels, Oligopolies, and Monopolistic Competition

1. Cartels, Oligopolies, and Monopolistic Competition

2. Oligopolies Cartels Game Theory Monopolistic Competition The Economics of Advertising For applications, click here To Try it! questions To Video

4. “Our neck is stretched over the fence and OPEC has a knife” U.S. President Jimmy Carter, 1979

5. Oligopoly and Monopolistic Competition • An oligopoly is a market that is dominated by a small number of firms. • (Cola) • Monopolistic competition is a market with a large number of firms selling similar but not identical products. • (Restaurants)

6. The Landscape of Firms YOU ARE HERE Competition Monopolistic Competition Oligopoly Monopoly More Competition Less Competition (less price control) (more price control)

7. Studying Oligopoly Behavior • Is complicated- because it’s not a single firm considering its costs and pricing in a vacuum (like competitive firms and monopolies) • The profits of a large firm depend heavily on the actions taken by other large firms. • Strategic Decision-Making = decision making in situations that are interactive. • Poker, Chess

8. Studying Strategic Decision-Making • We’ll introduce Game Theory as a way of predicting outcomes in strategic situations like oligopolies.

9. Cartels • Some oligopoly firms are competitive with each other, some are cooperative with each other. We’ll focus on the cooperative ones (since all firms would rather not compete!) • A Cartel = a group of suppliers that tries to act as if they were a monopoly. • The goal of these suppliers? To coordinate in order to reduce supply, raise prices, and increase profits.

10. Mariachi Plaza is a sort of day-labor center for musicians, and the mariachis will quickly gather around passers-by, a horde of them jostling to get their business card into the hand of the would-be customer. Now, roughly 200 mariachis have joined the United Mariachi Organization of Los Angeles, a group that formed to set a minimum price in the plaza.

11. OPEC Cartel • OPEC (the Organization of Petroleum Exporting Countries) limits production for each member nation- to raise oil prices and profits- a cartel.

12. The Price of Oil, 1960-2005

13. Cartels and Profit Maximization A Cartel Tries to Move a Market from “Competition” towards “As if Controlled by a Monopolist” Competition As if Controlled by a Monopolist P P Profit Pm Pc S Pc MC = AC D D Q Q MR Qc Qc Qm

14. Cartels and Cheating • Reality? Few cartels effectively control the market price, and most tend to collapse over time. • Reasons why cartels collapse: • Cheating by cartel members. • New entrants and demand response. • Government prosecution.

15. Cheating on the OPEC Cartel • Every country in OPEC can earn more by cheating than by keeping to their allotment. • So, everyone cheats, and the cartel collapses! Don’t let me down: Venezuelan President Hugo Chavez and Saudi Crown Prince Abdullah bin Abdul Aziz Al Saud at an OPEC summit

16. Cheating on the OPEC Cartel • Cheating is also profitable when other members do not keep their promise to reduce production. • A single cartel member does not have significant monopoly power. • So reducing production does not raise the world price enough to make up for its lost sales.

17. The Incentive to Cheat As a single seller, you alone bear the gains (green) and losses (red) from lowering price. But if there are four firms, the losses are split- each firm bears ¼ the loss.

18. The Cheating Dilemma • A payoff matrix can show us the incentive to cheat: • Example: assume the world oil market is dominated by two large countries, Saudi Arabia and Russia. • Each country has two choices or strategies: • Cooperate by reducing output and acting like a monopolist. • Cheat and expand production.

19. The Cheating Dilemma • If both countries cooperate, they each earn $400. • If one cheats while the other doesn’t, the cheater earns $500 and the non-cheater earns $200. • If they both cheat, they each earn $300.

20. To next Try it! If Sundance keeps quiet, what’s the best choice (highest payoff) for Butch: keep quiet or testify? (Butch’s payoffs are on the left) Keep quiet Testify

21. The Cheating Dilemma • ADominant Strategyis a strategy that has a higher payoff than any other strategy no matter what the other player does. • The dominant strategy for Saudi Arabia? Cheat. • If Russia cooperates? Best to cheat. • Cheating pays $500 while cooperating pays $400. • If Russia cheats? Also best to cheat. • Cheating pays $300 while cooperating pays $200.

22. To next Try it! what is Butch's “dominant strategy”? What is Sundance's? Butch's dominant strategy is to testify; Sundance's dominant strategy is to testify. Butch has no dominant strategy; Sundance's dominant strategy is to keep quiet. Butch's dominant strategy is to testify; Sundance's dominant strategy is to keep quiet. Butch's dominant strategy is testify; Sundance has no dominant strategy.

23. The Cheating Dilemma • The dominant strategy for Russia? You decide… • If Saudi Arabia cooperates? Cheat. • Cheating pays $500 while cooperating pays $400. • If Saudi Arabia cheats? Cheat. • Cheating pays $300 while cooperating pays $200. • No matter what the other player does, each player is better off cheating.

24. The Prisoner’s Dilemma • The Prisoner’s Dilemmadescribes situations where the pursuit of individual interest leads to a group outcome that is in the interest of no one. • The equilibrium outcome: both firms cheat on the agreement. • Each firm’s strategy is based on its own self-interest, but the outcome is in the interest of neither firm. • Cooperation would give both firms a bigger payoff.

25. New Entrants and Demand Response Break Down Cartels • Cheating is not the only reason for cartels to fail. • Thehigh prices of a cartel attract new entrants. • Supply will increase and push down the price. • Consumers will favor the new firms with lower prices. • More substitutes will be available in the long run.

26. How to Sustain a Cartel • Possess access to natural resources that are difficult to duplicate • can avoid this problem of new entrants. • E.g. Oil, diamonds, nutmeg Is the diamond cartel forever?

27. How to Sustain a Cartel • Control access to some key input that can’t be easily duplicated • E.g. the NBA buyer’s cartel uses a salary cap is enforced by kicking out teams that don’t comply. • No substitutes exist for the NBA league. • Who wins and who loses under this structure? Home of the Indiana Pacers

28. To next Try it! Do you support the idea of salary caps for sports teams in general? Yes No

29. To next Try it! In game theory, the strategy that has a higher payoff than any other strategy, no matter what the other player does, is also known as the superior strategy. Nash equilibrium. dominant strategy. best possible outcome.

30. Back to Bill and Ted are assigned to do a group project. Ted does excellent work. Bill struggles. Suppose that each of the students can choose two levels of work: work hard or take it easy. They will get the same group grade and therefore they have the same payoff for each strategy combination. Ted does not have a dominant strategy. Ted's dominant strategy is to Work Hard. Ted's dominant strategy is to Take It Easy. both are dominant strategies for Ted.

31. Government Prosecution and Regulation • Most cartels are illegal in the United States since the Sherman Antitrust Act of 1890. • Antitrust Laws give the government the power to regulate or prohibit business practices that may be anti-competitive. • empowers the government to prosecute and punish collusive behavior.

32. Watch the international Lysine cartel discuss their conspiracy to raise prices by clicking below. ( 3:23 minutes) http://www.youtube.com/watch?v=E21YYoxRs5g&feature=player_embedded To next Video Back to

33. Government-Supported Cartels • Surprisingly, governments do not always prosecute cartels, and often they support cartels. • In the U.S.: many cartels are supported by the government, including milk. • In many poor nations, governments regularly enrich themselves through cartels. • The most successful cartels operate with the explicit support of (and enforcement by) the government.

34. Think-pair-share: • What are the effects of cartels on a nation? • How do you think economic growth and cartel prevalence are related? Why?

35. Summary: Successful Cartels • Cartels are more likely to be stable and successful if they can prevent new entrants through: • Control of natural resources or • Control of access to some key input that can’t be easily duplicated • Weak enforcement of antitrust laws (or lack of laws) • Achieving government support

36. Oligopolies • Cartels may be tough to keep together… BUT oligopoly can still maintain prices (and profits) that are higher than competitive firms.

37. The Incentive and Ability to Raise Price in Oligopoly • A firm in oligopoly who reduces quantity by the amount Q0–Q1 increases the market price to P1 (which is greater than MC.) • The increase in price increases the profits of the firm that cuts output (the green area),as well as increasing the profits of the other firms in the industry.

38. Oligopoly Pricing • Can we be more specific? Economists have developed many models of oligopolistic pricing. • A lot depends on factors specific to the industry; We leave further discussion for intermediate and advanced microeconomics studies. • Let’s turn now to a different form of market structure, monopolistic competition.

39. Monopolistic Competition • Monopolistic Competition is a market structure that’s a little like monopoly and a little like competition. Specifically: • many competitors • products are similar but not identical • downward-sloping demand curve • each firm earns zero profit Restaurants: Monopolistic Competitors

40. Monopolistic Competition andProfit Maximization • Same profit maximizing rule as competitive and monopoly firms: produce where MR = MC Price MC But…. This profit will attract new entrants. P Profit AC Demand Q Quantity MR

41. Zero Profit in the Long Run • If firms are earning economic profits, new firms will want to enter the industry. • This will reduce the demand curve facing each individual producer. • In the long run, each supplier will earn normal profits, and price will equal ATC.

42. Monopolistic Competition andProfit Maximization • Entrance of new firms reduces demand for existing firms… • Until profits erode to zero in the Long Run (Economic profits, remember!) Price MC Profit AC P P Demand Q QLR Quantity MR

43. Comparing Monopolistic Competition with Competition • Firms in both industries produce where P = AC and earn zero profits. • However, firms under monopolistic competition charge prices above marginal cost, they produce a smaller quantity, and Q* is not at minimum average cost.

44. The Economics of Advertising • Oligopolies and Monopolistically Competitive Firms advertise…. • Is advertising good or bad? It’s Complicated. • (There are different types of advertising)

45. Types of Advertising • “Informative” Advertising: • price, quality and availability information

46. Types of Advertising • Advertising as Signaling “If they’re spending so much $$$ on advertising for this product, they must expect it to be profitable and around a long time. Must be good.”

47. Types of Advertising • Advertising as Part of the Product: • Even if NO information is given, does “Branding” make the product more enjoyable? • Tasters enjoy the cola more if it’s labeled as “Coke”…

48. Click below for a peek at some of the funniest Superbowl commercials of the past several years. You decide: did they do more than entertain? (8:00 minutes) http://www.youtube.com/watch?v=caZTCDTif_I Back to

49. In your opinion, is advertising “worth it” for society? Yes No