Modern Principles of Economics

Tyler Cowen

and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles of Economics • Cowen/Tabarrok

Chapter 13

Cartels, Games and Network Goods

Slide 2 of 36

Cartels and Games

• A Cartel is a group of suppliers that tries to act as if they were a monopoly.

• The goal of these suppliers is to coordinate in order to reduce supply, raise prices, and increase profits.

Slide 3 of 36

Cartels and Games

Competition

Pc

D

MC = ACS

Qc Qc

Pc

D

As if Controlled by a Monopolist

Qm

Pm

Profit

MRQ

P P

A Cartel Tries to Move a Market from “Competition” towards “As if Controlled by a Monopolist”

Q

Slide 4 of 36

Cartels and Games

• In reality few cartels effectively control the market price, and most tend to collapse over time.

• Reasons why cartels collapse:1. Cheating by cartel members.

2. New entrants and demand response.

3. Government prosecution.

Slide 5 of 36

Cheating by Cartel Members• In a successful cartel, each member earns high

profits on its goods.

• This same desire for high profits, however, also causes the cartel to fall apart as each member

will cheat on the cartel agreement. If everyone else keeps their promise, a member can

cheat and expand its production yielding greater profits.

As more members cheat, the less profitable it is to reduce production leading to every member cheating on the agreement.

Slide 6 of 36

Cheating by Cartel Members• Consider the world oil market where 10 countries

produce 10 million barrels of oil per day (mbd) for a total of 100 mbd.

• At that quantity suppose the world price of oil is $36 a barrel so that each country earns $360 million a day.

Slide 7 of 36

Cheating by Cartel Members• Now suppose that the countries form a cartel and

reduce production to 8 mbd for a total of 80 mbd.• At this lower quantity, the world price of oil rises

to $50 a barrel so that each country earns $400 million a day.

Slide 8 of 36

Cheating by Cartel Members• Imagine one cartel member cheats and expands

its production back to 10 mbd.• This increases world production to 82 mbd and

pushes the world price of oil to $47.50 a barrel.• Total revenue for the cheating country rises while

the total revenue for the other countries falls.

Slide 9 of 36

Cheating by Cartel Members• Every country in the oil cartel can earn more by

cheating than by maintaining the agreement. • So, everyone cheats, and the cartel collapses!• 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. As such, reducing production does not raise the world

price enough to make up for its lost sales.

Slide 10 of 36

Cheating by Cartel Members• Imagine that 9 countries cheat on the agreement

and produce 10 mbd while one country maintains production at 8 mbd for a total of 98 mbd.

• The market price falls to $37.50 per barrel.• At this price each cheater will earn revenues of

$375 million a day while the other country earns $300 million per day.

Cartel with Nine Cheaters and One Non-Cheater

CountriesOutput per

CountryTotal

OutputProfit per Country (per

day)

1 8 mbd 8 mbd $300 million

9 10 mbd 90 mbd $375 million

World Output 98 mbd

World Price $37.50

Slide 11 of 36

Cheating by Cartel Members• The example above indicates that cheating pays

when other firms keep their promise and cheating pays when other firms cheat.

• Note the distinction between the decisions of a monopolist and a cartel member. When a monopolist increases quantity above the profit-

maximizing level, the monopolist only hurts itself. But when a cartel cheater increases quantity above the

profit-maximizing level, the cheater benefits itself and hurts other cartel members.

Slide 12 of 36

Cheating by Cartel Members• Another approach to demonstrate the incentive to

cheat is to use a payoff matrix.• Consider a situation where 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.

Slide 13 of 36

Cheating by Cartel Members

The Cheating Dilemma

Russia’s Strategies

Cooperate Cheat

Saudi Arabia’s Strategies

Cooperate ($400, $400) ($200, $500)

Cheat ($500, $200) ($300, $300)

Slide 14 of 36

Cheating by Cartel Members• A Dominant Strategy is a strategy that has a

higher payoff than any other strategy no matter what the other player does.

• The dominant strategy for Saudi Arabia is to cheat. Saudi Arabia’s best strategy if Russia cooperates is to

cheat.• Cheating has a payoff of $500 while cooperating has a payoff

of $400.

Saudi Arabia’s best strategy if Russia cheats is to also cheat.

• Cheating has a $300 payoff while cooperating has a $200 payoff.

Slide 15 of 36

Cheating by Cartel Members• The dominant strategy for Russia is to cheat.

Russia’s best strategy if Saudi Arabia cooperates is to cheat.

• Cheating has a payoff of $500 while cooperating has a payoff of $400.

Russia’s best strategy if Saudi Arabia cheats is to also cheat.

• Cheating has a payoff of $300 while cooperating has a payoff of $200.

Slide 16 of 36

Cheating by Cartel Members• The equilibrium outcome of the game involves

both firms cheating 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.

• The Prisoner’s Dilemma describes situations where the pursuit of individual interest leads to a group outcome that is in the interest of no one.

Slide 17 of 36

New Entrants and Demand Response

• The high prices of a cartel attract new entrants not bound by the cartel agreement on production. As these new firms enter the market, supply

will increase, driving down the price of the good.

Slide 18 of 36

New Entrants and Demand Response• Over time consumers will alter their behavior in

response to the high cartel prices. More substitutes will be available in the long run. This ultimately makes demand curves more elastic and

limits the cartel’s pricing power.

• Cartels related to natural resources that are difficult to duplicate can avoid this problem and tend to be more successful.

Slide 19 of 36

Government Prosecution of Cartels

• Most cartels are illegal in the United States.

• The Sherman Antitrust Act of 1890. This legislation empowers the government to

prosecute and punish collusive behavior.

Slide 20 of 36

Government-Supported Cartels

• Governments do not always prosecute cartels, and often they support cartels.

• Many of the most successful cartels operate with the explicit support of the government because governments have the ability to effectively enforce cartel agreements.

Slide 21 of 36

CHECK YOURSELF In the OPEC cartel, what can Saudi Arabia do to

punish a cheater? (Hint: Will Saudi Arabia raising its output have an appreciable effect on the cheater?)

When Great Britain discovered large oil deposits in the North Sea, why didn’t it immediately join OPEC?

What is the surprising conclusion of the prisoner’s dilemma?

Slide 22 of 36

Network Goods• A Network Good is a good whose value to one

consumer increases the more that other consumers use the good.

• Features of network goods: Network goods are usually sold by monopolies or

oligopolies; When networks are important the “best” product may

not always win; Standard wars are common in establishing network

goods; Competition in the market for network goods occurs

“for the market” instead of “in the market.”

Slide 23 of 36

Network Goods• Network goods typically involve one firm

providing a dominant standard at a high price.• These markets, however, often include a number

of other firms offering a slightly different product. These firms tend to service niche areas in the market.

• An Oligopoly is a market dominated by a small number of firms.

Slide 24 of 36

Network Goods• The central issue of network goods is that

consumers derive a greater benefit when other consumers use the same good.

• Suppose Alex and Tyler are choosing whether to use Apple or Microsoft to write their textbook.

• Their choice can be expressed in a payoff matrix.

The Coordination Game

Tyler

Apple Microsoft

AlexApple (11, 11) (3, 3)

Microsoft (3, 3) (10, 10)

Slide 25 of 36

Network Goods• If Alex chooses Microsoft, and Tyler chooses

Apple, it will be difficult for them to work together and their payoffs will be low (3,3).

• Alex and Tyler receive the highest payoffs when both are using the same software. If Alex chooses Apple, then Tyler should choose Apple

as well since the payoffs are high (11,11).

• If Alex and Tyler both choose Apple, then neither will have an incentive to change their strategy. This is an equilibrium outcome of the game.

• A Nash Equilibrium is a situation in which no player has an incentive to change their strategy unilaterally.

Slide 26 of 36

Network Goods• Note that the choice of Microsoft is also a Nash

equilibrium. If Alex chooses Microsoft, then Tyler should choose

Microsoft as well.

• This equilibrium, however, yields lower payoffs (10,10) than the payoffs with Apple (11,11).

• It is thus possible for an inferior product to become the dominant standard in the market.

Slide 27 of 36

Network Goods• In a situation where two equilibria exist,

consumers often disagree which product is superior.

• When the players of a game differ over which equilibrium is best, a standard war may emerge.

• Recently, two groups of manufacturers have battled over the standard for high-definition DVD discs. Group 1, led by Toshiba, supported the HD-DVD. Group 2, led by Sony, supported the Blu-Ray.

Slide 28 of 36

Network Goods• The standard war between Sony and Toshiba can

be expressed in a payoff matrix.

The Standard War

Sony

HD-DVD Blu-Ray

ToshibaHD-DVD (10, 8) (0, 0)

Blu-Ray (0, 0) (8,10)

Slide 29 of 36

Network Goods• Toshiba is better off if the HD-DVD standard

emerges as the market standard.• Sony is better off if the Blu-Ray standard

emerges as the market standard.• Neither group does well with two competing

standards.• The Sony group ultimately won the standard war

when Blu-Ray technology was imbedded into the Sony PlayStation 3, thus building a bigger audience for that standard.*

Slide 30 of 36

Network Goods• Network goods tend to be sold by monopolies or

oligopolies.• What makes the markets for network goods

different than standard monopolies and oligopolies is the ease and speed at which the dominant standard can change.

• Competition for the market of these goods is strong and often leads to frequent changes in the dominant firm over time.

Slide 31 of 36

CHECK YOURSELFDoes a firm with an established network

good, such as Microsoft Office, face competition? Why or why not?

Consider the Blu-Ray versus HD-DVD competition. Why is it useful for you to wait before purchasing when standards are not set? What do you predict will happen to sales once standards are set?

Slide 32 of 36

Takeaway• A cartel is a group of suppliers that tries to act as

if they were a monopoly.• In 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.

Slide 33 of 36

Takeaway• A dominant strategy is a strategy that has a

higher payoff than any other strategy no matter what the other player does.

• The dominant strategy in a cartel is to cheat on the agreement.

• The prisoner’s dilemma describes situations where the pursuit of individual interest leads to a group outcome that is in the interest of no one.

Slide 34 of 36

Takeaway• The high prices of a cartel attract new entrants

which pushes down the high cartel price.• Over time consumers will alter their behavior in

response to the high cartel prices. More substitutes will be available in the long run. This ultimately makes demand curves more elastic and

limits the cartel’s pricing power.

• The Sherman Antitrust Act of 1890 makes most cartels illegal in the United States. This legislation empowers the government to

prosecute and punish collusive behavior.

Slide 35 of 36

Takeaway• A network good is a good whose value to one

consumer increases the more that other consumers use the good.

• Features of network goods: Network goods are usually sold by monopolies or

oligopolies; When networks are important the “best” product may

not always win; Standard wars are common in establishing network

goods; Competition in the market for network goods occurs

“for the market” instead of “in the market.”