CURRENT ISSUES IN AGRIBUSINESS

Compiled by:

Dr. Robert AidooDept. of Agric. Economics, Agribusiness & Extension, KNUST, Kumasi-Ghana

LECTURE MATERIALS FOR BSc. AGRIBUSINESS MGT IV

Course outlineCourse Objective:• The objective of this course is to expose students to current trends in the field of

agribusiness in international circles.• Content:

 The origin and principal features of the World Trade Organization (WTO), its role and mandated ISO. The need for an ISO content variation and applicability to developed and developing countries, international trade and international commodity organizations. Alternatives and consequences of public policy in the agri-food system.

What we will cover:

• The global agri-food system and structural Changes/evolution

• Linkages/Integration in Businesses (Vertical and Horizontal Integration)

• Vertical Coordination in the agribusiness industry

• Game Theory and Economics of Cooperation

• WTO issues

• ISO issues

• Agricultural Insurance Issues 2

THE AGRI-FOOD SYSTEM AND STRUCTURAL CHANGES

Lecture 1

Food chain- A reflection from SCM

Input suppliers

Farmers

Processors

Retailers

Consumers

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The Evolving Food and Agriculture System

• In the past, food was viewed strictly in terms of commodities produced in bulk and meant to be plentiful and affordable.

• But, in the decades of prosperity in the last half century, the concept of food and our expectations have changed and taken on a new significance.

• Consumers today have come to expect a great deal more of the food system.

• The food system now delivers more nutritious food with wider variety; improved safety, with less environmental impacts; and greater convenience than at any time in the history of the world.

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• Over the last century, the global food system requires that in addition to providing the physical food commodity; we:

– Ensure food safety– Promote nutritious and convenient foods and products,– Protect environmental quality,– Protect workforce, and – Keep markets functioning efficiently.

• The key challenge is the ongoing transformation of agriculture into the a global, consumer-driven food system.

• How do countries (especially less developed economies) make a paradigm shift from the largely commodity-oriented agriculture to a more function focus and consumer oriented agriculture?

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Agricultural Diversity• Farming today consists of enormously different farms, growing numerous

crop and livestock products for sale in markets that range from their immediate neighbours to consumers worldwide.

• Farms differ in size, type and value of commodities produced, technology used, resource endowment, and many other attributes.

• Farmers differ in commitment of time, management abilities, business goals, and financial resources.

• The result is a sector that cannot be accurately characterized by any single measure or indicator.

• It is, therefore, important to recognize and understand this diversity that makes up today’s agriculture if we are to adequately prepare for its future.

• The developed world (especially US) saw a concentration of resources into fewer and larger farms throughout the 20th century.

• While production doubled over the last 50 years, farm numbers dropped by more than two-thirds. 7

Consumer-Driven Agriculture

• Historically, farmers’ main objective was to keep up with the food demand generated by a growing population.

• Over time, people wanted not only to ensure that their basic energy requirements were met, but also to eat better through access to a wider variety of nutritious foods.

• The number of foods labeled “low-fat” or “healthy food” shows how the food system has evolved to address consumer demand.

• Food marketing is also changing in other ways. Mass merchandisers, warehouse club stores, specialty stores, and restaurants are becoming increasingly favored over traditional supermarkets.

• Meanwhile, consumers are increasingly eating away from home, reflecting the premium on convenience.

• The competitive job market and urbanization have changed the traditional role of women in the home, thereby creating demand for convenient foods.

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• Consequently, the structural change well underway in commercial agriculture is characterized by:

– Larger farm sizes;

– Specialization;

– More efficient production methods; and

– Greater coordination.

• For these farms, a decided change in their role in the overall food system is occurring.

• Farmers once purchased inputs and sold products in arms-length transactions and largely were price takers in both markets.

• But, those lines are fast blurring, with differentiated products, bundled systems, and greater system coordination.

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• Buyers and sellers of agricultural commodities and producers rely less on cash markets and more on dozens of kinds of contractual arrangements.

• New production methods, a variety of joint venture/marketing arrangements, and information technology are lowering the total costs of doing business by introducing size economies and reducing transaction costs.

 

• While this structural change clearly is advantageous for some, it also prompts concerns about competition, market access, and the use of market power by some participants to the disadvantage of others.

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The main drivers of change• Today, a small number of very powerful forces are

propelling the fast-paced change occurring in every single component of the food system.

• They include:

a) Globalization of markets and culture,

b) Technology,

c) Fundamental changes in our family structure, life style and workforce, and

d) Environmental and safety concerns 11

a. Globalization• Today, much more agricultural trade is market driven because of the

collapse of the Soviet Union, the end of the U.S.- European Union (EU) subsidy wars, and China’s shift to more market-oriented agricultural policies.

• International trade agreements, reforms in domestic agricultural policies, financial market liberalization, and a constellation of other policy changes that boost competition have further hastened globalization.

• Growth in international trade and investment illustrates the impact of globalization on the food system.

• Foreign-owned firms had foodservice sales in the United States of $6.4 billion in 1998.

• McDonald’s has become the largest overseas foodservice operator, with more than 28,000 restaurants in 121 countries.

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• Globalization of markets pressurizes firms to be more competitive, to “shorten the supply chain,” streamlining the system (eliminating transactions and their associated costs) to efficiently meet rapidly changing consumer demand.

• Businesses in the food system around the world compete against each other to provide high-quality products at the best price.

• Globalization makes it imperative for companies to diversify their sources of raw materials and buy from the farmer, wholesaler, or food processing company that provides the best product for the lowest price at any given time.

• Available evidence points to increasingly fierce competition in the agricultural system, suggesting that the innovative, cost-effective producers will prosper.

• Mergers, acquisitions, and further globalization of the food system can be expected to continue.

• Helping consumers to eventually get what they want can be good business, and– businesses that can do this quickly and efficiently tend to succeed while those who are slow to

understand key trends face rapid erosion of competitive position.

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b. Technology• Technological change in agriculture focused traditionally on tools and

techniques to lower farmer production costs and increase yields.

• Such technologies, which have added greatly to production efficiency, increased profit margins of early adopters, and ultimately lower consumer prices, still have a role in today’s agricultural economy.

• Increasingly, though, the market today is pushing technological progress in new directions, for new purposes, using new tools - all with different implications for business and policy decision making.

• Bio-based technologies promise opportunities never before imagined.– Production and processing technologies are opening entirely new energy, industrial, and

pharmacological markets for today’s farmers.

• Technology is shifting at every level in the production and marketing chain towards satisfying consumer demand for quality, safety, nutrition, and choice.

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• Production Technology: Recent advances in agricultural production technology have both reduced producer costs and conserved natural resources.

• Consumer-Oriented Technology:

Consumers’ demands for food safety, freshness, quality, convenience, and even attractiveness have led to brand new industries, each relying on new and unique avenues of technological advance.

• Information Technology:

– Information technology (IT) contributes to the faster flow of information among potential buyers and sellers of food and agricultural products.

– It thus affects the speed at which markets operate, and it shortens the timeframe in which purchase, inventory, and pricing decisions must be made.

– Adoption of information technology by farmers in the USA, particularly the Internet, has occurred at the same or greater rate than in the general population or among small businesses.

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• Agricultural Biotechnology:– Biotechnology is a collection of powerful tools that can be used to

increase production or cut costs, develop product attributes desired by consumers, or enhance environmental quality.

– It is a technology that has application in not just one, but every segment of the food supply chain (i.e. input supply, production, processing, consumption).

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c. Fundamental changes in family structure, life style and workforce

• Drive for more convenience and added value foods: – Demographic and lifestyle changes– Eating away from home (due to work pressures and

urbanization)– Women working outside the home (limited time to

prepare time-consuming traditional diets (e.g. Fufu)

• Nutrition and health issues:– Food labels and packaging– Sugar, Fat and cholesterol in foods– Chemical residues in foods (organic foods)

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d. Environmental and safety concerns

• Environmental protection (river bodies, biodiversity –flora and fauna)

– There is a call for Sustainable agriculture/Green agriculture/Organic farming

– Socio-environmental Certification of agric products

• Safety of workforce has become very important and the type of labour used in agriculture– Child labour issues

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Motivation for these structural changes

• The desire to capture economies of scale and economies of scope (horizontal)

• Reducing uncertainty and controlling quality in the supply chain (vertical)

• Competition in the food industry in future will be more between alternative supply chains than individual firms

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Summary• Consumers’ demands for food safety, freshness, quality, convenience,

and even attractiveness have brought about a revolution in the agri-food system.

 

• The food system has entered a consumer-driven era and diversity within the farm sector is enormous.

• New waves of new technology are sweeping through the entire food system.

• Agribusinesses must now operate in a globally competitive economic environment.

• A diversifying agricultural system, based more on end products and less on raw commodities, brings new challenges along with broad benefits.

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Lecture 2

LINKAGES/INTEGRATION IN BUSINESSES

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Business integration?• Business integration is the process of attaining

close linkage or coordination among several departments, groups, organizations, systems, etc. to ensure efficient business operations.

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What is Vertical Integration?

• Vertical integration is the process in which several steps in the production and/or distribution of a product or service are controlled by a single company or entity, in order to increase that company’s power in the marketplace.

• Vertical integration occurs when one company owns outright two or more stages of production as a way to seek greater economic value.

• Vertically integrated companies in a supply chain are united through a common owner.

• Usually each member of the supply chain produces a different product or (market-specific) service, and the products combine to satisfy a common need.

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Example of vertical integration

• While you are relaxing on the beach sipping chilled cold drink, the brand that you see on the bottle is the producer of the drink but not necessarily the maker of the bottles that carry these drinks.

• This task of creating bottles is outsourced to someone who can do it better and at a cheaper cost.

• But once the company achieves significant scale it might plan to produce the bottles itself as it might have its own advantages.

• This is what is called vertical integration:– The company tries to get more things under its reign to gain more control over the

profits the product / service delivers.

• A monopoly produced through vertical integration is called a vertical monopoly.

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Types of Vertical IntegrationThere are three basic classifications of Vertical Integration:

• Backward integration – This is where the firm/company tries to own an input product company as a subsidiary.

Examples include:– Soft drink company owning a bottle manufacturing firm– A car company owning a company which makes tires. – Poultry farm owning a feed mill, maize farm, hatchery, etc.– Cocobod owning a jute sac manufacturing company– Cassava processing firm owning a cassava farm

• Forward integration – Where the business tries to control the post production areas, namely the distribution network.

Examples include: – Poultry farm owning a distribution firm to sell its eggs or owning a meat processing plant (e.g. Santinos)– A fertilizer producing company owning a distribution firm to sell the product– A licensed cocoa buying company owning a haulage company to cart its cocoa to the port (e.g.

Adwumapa buyers Ltd)– Like a mobile company opening its own Mobile retail chain.

• Balanced integration – It is a mix of the above two. A balanced strategy to take advantage of both worlds. 25

What is Horizontal Integration?

• Horizontal integration (or lateral integration) simply means a strategy to increase a firm’s market share by taking over a similar company.

• Horizontal integration occurs when a firm is being taken over by, or merged with, another firm which is in the same industry and in the same stage of production as the merged firm.

• This take-over / merger / buyout can be done in the same geographic area or probably in other countries to increase your reach.

• Horizontal integration is a strategy used by a company/firm that seeks to sell a type of product in numerous markets.

• Horizontal integration in marketing is much more common than vertical integration is in production.

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• Examples include:

– A car manufacturer merging with another car manufacturer. • In this case both the companies are in the same stage of production and also in the same industry. • This process is also known as a "buy out" or "take-over".

– A feed company in Kumasi buying out a similar feed company in Techiman

– If Benso Oil Mills (BOP) or Twifo Oils Mills buys or merges with Juaben Oil Mills

– The merger between Intercontinental Bank and Access Bank

• The goal of horizontal integration is to consolidate ‘like’ companies and monopolize an industry.

• A monopoly created through horizontal integration is called a horizontal monopoly.

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Advantages associated with business integration• Have economies of scale and scope

• Expand your knowledge and capabilities

• Increase market (and profits)

• Own the whole life cycle so that you can change it the way you want ( it avoids the hold-up problem)

• Reduce competition (by merging with them rather than competing)

• Increased control over product quality and consistency (helping meet consumer demand)

• Flexibility in operations--Greater control over the timing of production (You are able to adjust to the ebb and flow of market demand).

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Hold-up problem ?•  In economics, the hold-up problem is a situation where two parties

(such as a supplier and a manufacturer or the owner of capital and workers) may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits.

• For example, imagine a scenario where profit can be made if agents X and Y work together, so they form an agreement to do so, after X buys the necessary equipment.

• The hold-up problem occurs when X might not be willing to accept that agreement, even though the outcome would be Pareto efficient, because after X buys the necessary equipment, Y would have bargaining power and might decide to demand a larger proportion of the profits than before (free rider problem!).

• One way to avoid the hold-up problem is for the firms to merge, a tactic known as vertical integration.

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Economies of scale?

• Economies of scale are the cost advantages that an enterprise obtains due to expansion.

• There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased.

• "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a facility and the usage levels of other inputs increase.

• Diseconomies of scale is the opposite.

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Economies of scope?• Economies of scope are conceptually similar to economies of scale. Whereas 'economies

of scale' for a firm primarily refers to reductions in average cost (cost per unit) associated with increasing the scale of production for a single product type, 'economies of scope' refers to lowering average cost for a firm in producing two or more products.

• Economies of scope makes product diversification efficient if they are based on the common and recurrent use of proprietary know-how or on an indivisible physical asset.

– For example as the number of products promoted is increased, more people can be reached per dollar spent.

– If a sales force is selling several products they can often do so more efficiently than if they are selling only one product.

– The cost of their travel time is distributed over a greater revenue base, so cost efficiency improves.

• Economies of scope can also operate through distribution efficiencies: – It will be more efficient to ship a range of products to any given location than to ship a single type of

product to that location.

– Selling in different geographic market will be more efficient than selling in a single market location.

• So a company which sells many product lines, sells the same product in many countries, or sells many product lines in many countries will benefit from reduced risk levels as a result of its economies of scope.

• If one of its product lines falls out of fashion or one country has an economic slowdown, the company will, most likely, be able to continue trading. 31

Limitations of business integration

1. One challenge to vertical integration is statutory. – In the US, several states have laws in place designed to protect the role of the

independent producer, preventing corporations from engaging in certain agricultural activities.

– Nine states currently have some form of anti-corporate farming law in effect, including South Dakota, Minnesota, Nebraska and Kansas. Typically, they restrict a company’s ability to engage in farming or to acquire, purchase, or otherwise obtain land for agricultural production. Many have an exception for certain types of family-owned corporations.

– Mergers have seen increased scrutiny from federal regulators and approvals are becoming more difficult to obtain.

2. Production and market risk. Farming is a risky business. Yet for vertically integrated companies involved in production agriculture, programs such as federal crop insurance and federal farm programs are less likely to be available to help manage the associated risks.

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3. Public and community perception (negative). – In developed economies, proposed mergers involving vertical integration are seeing

increased resistance within the public sector as well.

– Independent producers often encounter much less resistance when developing a new venture than a proposed vertically integrated project.

– When it comes to marketing, the public’s perception and support, for independent producers can also be a benefit, as opposed to the public’s possible antipathy toward vertically integrated companies in one sector.

4. One challenge that those looking at vertical integration may find is the perception that the independent producer, with his connection to the land, is a better steward of the land and the environment.

5. Differences in organizational cultures (in the case of mergers)

6. Liabilities of the organizations are all taken on board (in mergers and acquisition)

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VERTICAL COORDINATION

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• Vertical coordination includes “any type of formal or informal arrangement that has the effect of more closely relating successive steps in the production and/or processing of food and fiber” (Davis 1957).

• Vertical coordination includes a continuum of possibilities—from spot market transactions to full vertical integration.

• The middle ground encompasses various hybrid forms including contracts, strategic alliances and quasi-integration (joint ventures).

• In spot markets, goods are exchanged between multiple buyers and sellers in the current time period, and price is often the sole determinant of the sale, e.g., auction markets, food commodity sales in an open market.

• Spot markets are efficient for the distribution of homogenous commodities. 35

• However, as agricultural products become more differentiated and buyers prefer more heterogeneous products, there is a need for improved information flow along the supply chain.

– Thus, methods of vertical coordination which allows closer buyer-seller relationships are emerging, such as contracts, strategic alliances and quasi-vertical integration.

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Contracts• contracts can be classified into three broad groups.

• Market specification contracts represent an agreement by a buyer to provide a market for a seller's output. The buyer may assume some risk and the right to make decisions over the timing of marketing. The farmer retains control over production.

• Production-management contracts entail more buyer control, allowing the buyer to specify and/or to monitor production practices, input usage, etc.

• Resource-providing contracts represent the greatest level of control for buyers who provide a market outlet, supervise production practices and supply key inputs.

• In doing so, the buyer usually assumes a greater proportion of the risk and may retain ownership of the product, with the farmer, in effect, being paid a management fee.

• In all these, there is increased coordination level in the supply chain (why do you think this is necessary??...... To ensure that you get what you have asked for so you can satisfy your customers…) 37

quasi-vertical integration• Typically, quasi-vertical integration (a joint venture) is a long-term

contractual obligation in which both the buyer and seller have invested resources in the relationship.

• It differs from full vertical integration because the relationship ceases at the end of an agreed period of time and the firms remain independent entities afterwards.

• An example would be a joint venture in which participants share the costs, risks, profits and losses of a venture.

– An agreement for a cassava farmers’ group to supply cassava roots to a gari processing firm for five years

– Blue skies and mango farmers

• Franchises and licenses are other examples but are not common in the agricultural sector.

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strategic alliance• A strategic alliance is characterized by parties sharing an objective, resulting risks and

mutual control over decision making (Amanor-Boadu and Martin, 1992).

• Typically, it is more flexible than a contract and requires that the parties recognize their mutual goals and work together to achieve them.

• Trust is implicit in a successful strategic alliance.

• An example might be a strategic alliance between a group of producers who follow specified production practices and a pork processor who receives hogs of a specified quality.

• The processor may also have a strategic alliance with a food retailer to introduce a high-quality packaged pork product developed jointly and another strategic alliance with a hog breeding firm to introduce specific genetics/breeds into the supply chain.

• In this case, the strategic alliance involves all four parties, spanning the supply chain from producer to retailer.

• We can also look at Ghana COCOBOD, LBCs and cocoa farmer associations or chocolate manufacturer, certification firms, cocoa supplier, LBCs and Farmers.

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Full vertical integration

• Full vertical integration occurs when one firm owns two or more stages of the production-processing-distribution process.

• Everything occurs under one management.

• At this point, there is very little or no need for coordination.

• However, because of some problems associated with full integration (e.g. huge capital outlay and limited specialization, etc.), organizations tend to focus on specific aspects of production and rather coordinate with other firms at other stages in the supply chain.

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Some things to note about VC

•The search for quality is a key engine of VC•Traders, agribusinesses, and food companies contract or coordinate with farms and provide inputs and assistance in return for guaranteed and quality supplies.

•Enforcement is an important problem: Enforcement is problematic when public enforcement institutions are absent

– Trust is often lacking as a base for business exchanges in many developing and transition countries.

– Companies try to create self-enforcing contracts by designing the terms of the contracts such that nobody has an incentive to breach the contract.

– They also try to enforce contracts by interlinking markets e.g. The enforcement of credit transaction

• Not all examples of VC are successful:– In particular, where governments are heavily and actively involved in the

management of the integration, the effects are dubious at best.

– In cotton supply chains in Central Asia where the government has allowed private gins to develop and to compete, such as in Kyrgyzstan and Kazakhstan, farms have benefited from VC, with relatively high prices and strong cotton growth.

– In Tajikistan and Uzbekistan, where governments actively control input supplies, production, processing, and marketing of cotton, VC resulted in major fee extraction from cotton farmers, with depressed prices and stagnating cotton production.

– Cocobod and mass spraying exercise in Ghana

TRADE ASSOCIATIONS• An organization that represents the interests of the member firms of an

industry

• A trade association, also known as an industry trade group, business association or sector association, is an organization founded and funded by businesses that operate in a specific industry.

• An industry trade association participates in public relations activities such as advertising, education, political donations, lobbying and publishing, but its main focus is collaboration between companies, or standardization.

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• One of the primary purposes of trade groups/associations is to attempt to influence public policy in a direction favorable to the group's members.

• In the USA, this can take the form of contributions to the campaigns of political candidates and parties through Political Action Committees (PACs); contributions to "issue" campaigns not tied to a candidate or party; and lobbying legislators to support or oppose particular legislation.

• In addition, trade groups attempt to influence the activities of regulatory bodies

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A critique• A common criticism of trade associations is that, while they

are ‘non-profit making’ organisations that claim to do valuable work which is ultimately for the public benefit, they are in reality fronts for price fixing cartels and other, more subtle, anti-competitive activities that are not in the public interest.

– The potentially anti-competitive nature of some trade association activities has been a matter of public concern. For instance, under the guise of ‘standard setting’ trade associations representing the established players in an industry can set rules that make it harder for new companies to enter a market.

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Examples of Trade Associations in Ghana

• Association of Ghana Industries (AGI)

• Peasant Farmers Association of Ghana

• General Agricultural Workers Union (GAWU)

• Ghana National Association of Poultry Farmers

• Brong Ahafo Regional Association of Poultry Farmers

• Feed Millers Association of Ghana

• Co-operation Alata Samina Manufacturing & Marketing Association

• Federation of Association of Ghanaian Exporters (FAGE)

• Ghana Cocoa, Coffee and Sheanut Farmers Association

• Yam exporters Association of Ghana

• etc.

Question:

In your opinion, what can be done to strengthen agricultural trade associations in Ghana to be effective at lobbying Government to formulate favourable agricultural policies?

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Summary on Market structures

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Features of the four market structuresFeatures of the four market structures

Features of the four market structuresFeatures of the four market structures

Features of the four market structuresFeatures of the four market structures

Features of the four market structuresFeatures of the four market structures

Features of the four market structuresFeatures of the four market structures

Summary of the Features of the four market structuresSummary of the Features of the four market structures

GAME THEORY AND THE ECONOMICS OF COOPERATION• Game theory – the study of multi-person decision problems

(the reactions of a few interdependent decision makers).

• It is the study of how people behave in strategic situations.

• Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

• Game - any situation that involves well-defined rules and outcomes, where outcomes are dependent on players’ strategic decisions.

Game theory and Oligopoly

• Because the number of firms in an oligopolistic market is small, each firm must act strategically.

• Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce.

The Prisoners’ Dilemma

• The prisoners’ dilemma is a game that provides insight into the difficulty in maintaining cooperation.

• Often people (firms) fail to cooperate with one another even when cooperation would make them better off.

• The prisoners’ dilemma is a particular “game” between two captured prisoners that illustrates why cooperation is difficult to maintain even when it is mutually beneficial.

The dilemmaTwo suspects, Kofi and Kwame, are arrested by the police.

The police have insufficient evidence for a conviction, and, having separated both prisoners, visit each of them to offer the same deal:

– if one testifies for the prosecution against the other and the other remains silent, the betrayer gets 3 months and the silent accomplice receives the full 10-year sentence.

– If both stay silent, both prisoners are sentenced to only 1 year in jail for a minor charge.

– If each betrays the other, each receives a three-year sentence.

– Each prisoner must make the choice of whether to betray the other or to remain silent.

– However, neither prisoner knows for sure what choice the other prisoner will make.

– So this dilemma poses the question: How should the prisoners act?

The Prisoners’ dilemma The Prisoners’ dilemma

Does not confess Confesses

Does not confess

Confesses

Kofi’s alternatives

Kwame’s alternatives

Everyone gets1 year

Everyone gets 3 years

Kwame - 3 months

Kofi- 10 years

Kwame - 10 years

Kofi -3 months

The Prisoners’ dilemma is the duopoly’s dilemma.

• Prisoners cannot coordinate their confessions.

• Even though they both would get less if they do not confess, they betray one another, because of the greater payoff.

• No matter what the other player does, one player will always gain a greater payoff by playing defect.

• Since in any situation playing defect is more beneficial than cooperating, all rational players will play defect.

The Prisoners’ Dilemma -Another combination

Bonnie’ s Decision

Confess

Confess

Bonnie gets 8 years

Clyde gets 8 years

Bonnie gets 20 years

Clyde goes free

Bonnie goes free

Clyde gets 20 years

gets 1 yearBonnie

Clyde gets 1 year

Remain Silent

RemainSilent

Clyde’sDecision

Can you predict what these two perps will do?

Dominant strategy

• The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.

• In the Prisoners’ Dilemma game, each player’s dominant strategy is to confess.

• And yet, they would both be better off if they remained silent

• The pursuit of self interest leads to misery for all.

• Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

• The Prisoners’ Dilemma is an apt metaphor for many social situations in which we’d all be better off if we cooperated, but we don’t

Payoffs for firms A и B under different pricing policiesPayoffs for firms A и B under different pricing policies

2.00 1.80

2.00

1.80

A’s Price

B’s Price

10mil. for each

8m for each12m for В5m for А

5m for В12m for А

Collusive behavior

• How could the firms overcome the How could the firms overcome the prisoners’ dilemma?prisoners’ dilemma?

– Collusion!!!Collusion!!!

• Collusive behavior will set higher prices for the buyers!

An Oligopoly Game – Another example

Iraq’s Decision

High Production

High Production

Iraq gets $40 billion

Iran gets $40 billion

Iraq gets $30 billion

Iran gets $60 billion

Iraq gets $60 billion

Iran gets $30 billion

Iraq gets $50 billion

Iran gets $50 billion

Low Production

LowProduction

Iran’sDecision

• From the above game:

• Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits.

Another example: An Arms-Race Game

Decision of the United States (U.S.)

Arm

Arm

U.S. at risk

USSR at risk

U.S. at risk and weak

USSR safe and powerful

U.S. safe and powerful

USSR at risk and weak

U.S. safe

USSR safe

Disarm

Disarm

Decision

of the

Soviet Union

(USSR)

An Advertising Game

Marlboro’ s Decision

Advertise

Advertise

Marlboro gets $3billion profit

Camel gets $3billion profit

Camel gets $5billion profit

Marlboro gets $2billion profit

Camel gets $2billion profit

Marlboro gets $5billion profit

Camel gets $4billion profit

Marlboro gets $4billion profit

Don’t Advertise

Don’tAdvertise

Camel’sDecision

Why do People Sometimes Cooperate?

• Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain.

PUBLIC POLICY TOWARD OLIGOPOLIES

• Cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to:

– production that is too low, and – prices that are too high.

• Antitrust laws make it illegal to restrain trade or attempt to monopolize a market.