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

Prices and Markets Sessions 14 & 15 Imperfect Competition and Collusion Prof. Amine Ouazad Road Map for Prices and Markets: Pricing under Different Market Structures 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 Done so far • Simultaneous and Sequential Games • Predictions → Nash equilibrium and backward induction • Tension between Individual Rationality and Group Rationality Today Oligopoly • Price games and Capacity games Done so far • Leader-Follower games and First Mover Advantage • Implicit Collusion with Repeated Games • Entry Deterrence through Reputation Done so far • Strategic Irrationality Auctions Done so far • English auctions and eBay.

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: EB � s 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: P 1 > P 2 P 1 = P 2 > MC P 1 = P 2 = MC

Looks like a Prisoner � s Dilemma Encarta P mon P – ε 5 10 P mon 5 0 Britannica 0 3 P – ε 10 3 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

Cournot Game in the Lysine market (no collusion; imperfect competition) 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 market � s 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. ADM � s profit as a function of the quantity produced by each firm: Π ADM = (P-MC) Q ADM � = (1.5-Q TOTAL /2500) Q ADM � Each firm � s reaction or best-response function: Differentiate Π ADM w.r.t. Q ADM and get Q ADM = 1875-Q Aji /2 �

� � � � � Cournot Game Q aji 3750% 1875% 1250% Q ADM 1250% 1875% 3750% Cournot equilibrium capacities: Firms have same cost and profit: Q ADM =Q Aji � Q = 1875-Q/2 leads to Q = 1250 M lbs of lysine per firm ! � World production?? � Cournot equilibrium market price and the profit for each firm: Total production is Q = 2500 M lbs of lysine. � Price is P = 2 – 2500/2500 = $1 per lbs !! � Profit of each firm: � Π ADM = (P-MC) Q ADM = $0.50 x 1250 = $625M �

Recall: MC ADM = MC Ajinomoto = 0.50 q Aji% P = 2 – Q /2500 3750% q ADM = 1875 – 0.5 q Aji Cournot-Nash 1875% 1250% q Aji = 1875 – 0.5 q ADM Collusion q ADM% 1250% 1875% 3750% 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

Cournot Nash Equilibrium q Aji% 3750% q ADM = 1875 – 0.5 q Aji Cournot-Nash 1875% 1250% q Aji = 1875 – 0.5 q ADM Collusion q ADM% 1250% 1875% 3750% Quantity Competition Redux Dominant Strategy Ajinomoto Low Production High Production ADM 781.25 703.125 Low Production 586 703.125 Dominant Strategy 625 586 High Production 625 781.25 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 703.125 + 1 (1 + r ) 2 703.125 + ... = 703.125 + 703.125 1 PV (collude) = 1 + r 703.125 + r 781.25 + 1 (1 + r ) 2 625 + ... = 781.25 + 625 1 PV (cheat) = 1 + r 625 + r Profit $781.25M $703.125M collude cheat $625M Time t t+1 t+2 t+3 “ 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!

Cheating or not Cheating? How many punishment periods? • 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; Ajinomoto CEO : “ cheating punishes uncooperative opponents. was frequent but the range of cheating was not too • It is forgiving & easy to understand . big ... they kept their promise about 90 percent. • A trigger strategy : Something like that. ” • 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 ?? How Did This All End? 1992% • Collusion between ADM and Ajinomoto. • Mark Whitacre (Matt Damon) is the Informant. U.S. Attorney General 1995% Janet Reno: • FBI raid at ADM’s offices. "This $100 million criminal fine should send a message to the entire world.” Price declines to the Cournot equilibrium price. Really?? Lost consumer surplus? Incentives to collude? 1996% • December : ADM & Ajinomoto executives indicted. • Fined $100M! Extra Profit of collusion ?? 78.125+78.125/0.05 > $1b if done forever !!

Collusion Profits & Cost for Consumers Lost consumer surplus? Cartel’s Cartel profits? Marginal Revenue P Cartel Variable Profits Variable Profit with competition P m =$1.25 P * =$1 MC Market Demand Q m Q * Q =1875 =2500 Takeaways on Price and Quantity Competition ! 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 !!

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