Strategic competition and collusion

Oligopolists need to ensure that they all restrict output – collusion is sustained

AND (in the same way as monopolists)

they also need to deter entry of new firms

Sustaining collusion – not so easy in a prisoners’ dilemma Revision of prisoners’ dilemma

generally and in an oligopoly context

The prisoners’ dilemma

Prisoner B confess don’t

confess Prisoner confess -5 -5 -1 -10

A don’t confess

-10 -1 -2 -2

•The payoffs are years in prison•Use the underlining method to find the Nash Equilibrium

The Nash equilibrium

Prisoner B confess don’t

confess Prisoner confess -5 -5 -1 -10

A don’t confess

-10 -1 -2 -2

The Nash equilibrium is also a dominant strategy equilibrium. So game theorists believe that the predicted outcome is very convincing; confession is a dominant strategy for both players and yet…..

The equilibrium of the prisoners’ dilemma The equilibrium is {confess, confess}

But both would be better off if neither confessed The dilemma for the prisoners’ is that they

would both be better off if they co-operated with each other (by not confessing) but it is individually rational for them both to confess in any other strategy combination there is an

incentive for one of the prisoners to deviate

A more general interpretation of the prisoners’ dilemma

Confess implies cheating on (or defection from) some mutually beneficial, but not necessarily explicit agreement (to deny): non-cooperation

To deny implies some kind of working together or collusion or cooperation between the players

The generalised PD problem

Player B co-operate not

cooperate

Player co-operate a, a b, c

A not coopnot cooperate c, b d, d

c > a > d > bWhat is the dominant strategy equilibrium (DSE)?

The generalised PD problem

Player B co-operate not

cooperate

Player co-operate a, a b, c

A not coopnot cooperate c, b d, d

Since c> a and d > b the DSE is: {not cooperate, not cooperate}

But both players would be better off cooperating since a > d

Remember that c > a > d > b

GENERALISATION

Any game with this payoff structure is a Prisoners’ Dilemma

The players do not have to be prisoners

• SMALL GROUP WORK• Discussion questions on the Prisoners’

Dilemma  • Why does the group think so much attention has

been given to the prisoners’ dilemma in (i) economics and (ii) the social sciences more generally?

 • Describe three or more examples of a prisoners’

dilemma that is faced by real people (acting individually or in groups) in real life.

 • How, if at all, are the prisoners’ dilemma

problems described in (2) above resolved? If they are not resolved in practices how might they be resolved?

The prisoners’ dilemma and cooperation/collusion between 2-firms in an

Oligopoly (Duopoly)

Alpha and Beta are two oil producers who share the market.

Each firm has two possible strategies:

1. High output –Lower price

2. Low output – higher price

Each chooses its strategy without knowing what strategy the other has chosen(equivalent to simultaneous or hidden moves)

four possible outcomes:

1. Both produce a high output

• OK profits (1 billion)

2. Both produce a low output – collusive agreement.

• E.g. by forming a cartel: Arrangements entered into

voluntarily which restrict firms’ future actions (Alpha and

Beta each agree to restrict output to keep prices high).

• High profits (2 billion)

3. Beta produces low output but Alpha produces high

output.

• Beta has very low profits (0), Alpha very high profits (3)

4. Alpha produces low output but Beta produces high

output.

• Beta has very high profits (3), Alpha very low profits (0)

Prisoners’ dilemma and oligopoly

Alpha’sStrategy

Beta’sStrategy

Compete on price: high

output

Don’t compete on price: low output

Compete on price: high output

Don’t compete on price: lowOutput

The Prisoners’ Dilemma and oligopoly collusion

1 0

3 2

1 3

0 2

Both firms would improve profits if they colluded to form a cartel in which each agreed to limit price competition and restrict output. But what is the likely outcome (the Nash Equilibrium) of this strategic game?

Alpha’sStrategy

Beta’sStrategy

Compete on price: high output

Don’t compete on price: lowOutput

The Prisoners’ Dilemma and oligopoly collusion

1 0

3 2

1 3

0 2

Although both firms would have higher profits if they colluded to restrict output there is an incentive for each to cheat because each firm could increase its profits by increasing its output as long as the other firm keeps to the agreement and keeps its own output low. The likely outcome is that they both produce high output.

Don’t compete on price: low output

Compete on price: high

output

Implications Collusion between oligopolists is undesirable

but it is also unlikely to be stable firms are likely to be involved in a ‘prisoners’

dilemma’ – especially given that collusion is illegal and subject to punishment they can agree to collude BUT this still leaves

problem of enforcement. So regulators don’t have to worry?

Depends - how realistic is the analysis?

Test your understanding

Collusion: Explain why game theorists predict that collusion between oligopolists is likely to be fragile

1.(a)Explain how and why firms in oligopoly markets might collude. Illustrate your answer with reference to the 07/12/07 OFT Press Release on supermarket collusion.

(b) Use game theoretic analysis and Payoff Matrix 1 (below) to explain why collusion between firms could be fragile in some circumstances. Payoff Matrix 1 TESCO

Restrict supply

Increase supply

ASDA Restrict supply

300, 300 150, 400

Increase supply

400, 150 200, 200

Payoff Matrix 1 illustrates the situation facing two supermarkets, ASDA and TESCO. They each choose between either restricting supply or increasing supply of a specific range of products. By restricting their combined supply the supermarkets are able to maintain higher prices. In the payoff matrix the payoffs of the supermarkets represent profits and in each cell the payoffs of ASDA are written first.

1(c) Explain how the OFT’s offer of leniency to firms involved in collusion could

help to break up collusive agreements (see OFT guidance in the OFT Press Release 144/08).

1(d) Under what circumstances is collusion between firms more likely to be

sustained? Illustrate your answer with reference to the FT article on cooperation between DVD makers

Hints: you need to consider the independent nature of firms’ behaviour in oligopoly

markets and the consequences of collusion

Exercise on oligopoly

Investigations continue against other supermarkets and a dairy processor

OFT Press release 170/07 7 December 2007

OFT welcomes early resolution agreements and agrees over £116m penalties

Following the OFT's Statement of Objections (SO) of 20 September 2007 which provisionally found evidence of collusion between certain large supermarkets (Asda, Morrisons, Safeway, Sainsbury's and Tesco) and dairy processors (Arla, Dairy Crest, Lactalis McLelland, The Cheese Company (formerly Glanbia Foods Limited) and Wiseman) on the retail prices of some dairy products, certain of these parties have now admitted involvement in anti-competitive practices and have agreed to pay individual penalties which, combined, come to a maximum of over £116 million.

With a view to maintaining strong and effective competition law, the OFT will continue with its case against the remaining parties. The SO set out the OFT's provisional findings that certain large supermarkets and dairy processors have colluded to increase the retail prices of one or more of liquid milk, value butter and UK produced cheese. The OFT's provisional findings were that the collusion took place through the sharing of commercially sensitive information in 2002 and, in some cases, in 2003.

The OFT has now concluded early resolution agreements with Asda, Dairy Crest, Safeway (in relation to conduct prior to its acquisition by Morrisons), Sainsbury's, The Cheese Company and Wiseman based upon the provisional findings made in the SO. These parties have accepted a liability in principle, and will pay penalties which amount to a maximum of over £116 million. However each party will receive a significant reduction in the financial penalty that would otherwise have been imposed on it, on condition that it continues to provide full co-operation.

Arla had previously applied to the OFT for leniency and will receive complete immunity from financial penalty if it continues to fully co-operate. The OFT will continue with its case against Lactalis McLelland, Morrisons and Tesco. These parties have an opportunity to make representations on the OFT's provisional findings. The OFT will carefully consider any representations, and the evidence in the case as a whole before reaching any final decision.

OFT publishes revised guidance on leniency OFT Press Release 144/08 11 December 2008 The OFT has today published revised leniency guidance for businesses and individuals that come forward with information about their involvement in a cartel. Under the OFT leniency programme members of cartels who provide evidence of such involvement may qualify for criminal immunity and may avoid any fine or receive a reduced penalty provided they fully co-operate with an investigation. The clarified and expanded guidance is intended to give maximum predictability and transparency for leniency applicants and their advisers. Simon Williams, OFT Senior Director of Cartels and Criminal Enforcement, said: 'Cartels cheat consumers by restricting competition. The leniency programme continues to be a simple and powerful tool to expose such conduct and the revisions to the OFT's guidance will help ensure that the programme continues to provide a powerful incentive to seek leniency before it is too late.'

DVD makers decide on co-operation, not damaging competition

By Michiyo Nakamoto in Tokyo and Maija Pesola in London Published: April 22 2005 03:00

The recent history of the consumer electronics industry has been fraught with format wars that have confused consumers, wasted valuable resources and left the losing camps with redundant technologies. The transition to next-generation high-definition DVDs - which started another round of fierce competition with divisions not only among manufacturers but also among software content producers - was expected to go the same way.

But in the past several weeks, Sony, which leads the camp supporting Blu-ray disc technology, and Toshiba, which is promoting HD-DVD, have come to the negotiating table to try to agree on a common platform. The decision highlights growing concerns about the damaging impact a divided market could have on consumer sentiment towards the new technology and ultimately on industry growth.

It was a classic example of the Prisoner's Dilemma from game theory: the gains would be higher for the winner if one standard succeeded outright, but both could make modest gains from co-operating. More importantly, by continuing at loggerheads, both stood to make considerable losses.

Evenly matched, the camps would have faced a lengthy battle in the marketplace for dominance. However, with the Japanese electronics sector plagued by plunging prices, increasingly short product cycles and tumbling profitability, companies can ill afford pain as the prices of digital products, from flat-panel TVs to DVD recorders and digital cameras, remain weak, further squeezing profits. Many Japanese electronics manufacturers, including Sony, have had to revise down their forecasts for the year just ended. Against this background, there have been concerns that any confusion surrounding next- generation DVDs could discourage consumers from adopting the new technology.

The industry, which has seen how quickly price erosion hit the DVD recorder market, must be aware that "if they continue to fight over the format, it would take too long to recoup their costs - if they could at all. I think that has been the catalyst [for the agreement]," says one analyst.

"Price erosion in the next generation will be worse, so the companies probably decided that it would be better to co-operate in development, reduce their own cost burden and facilitate penetration of next-generation DVDs." Copyright The Financial Times Limited 2005

Exercise on oligopoly: Answers 1 (a) Oligopolists have an incentive to act together (as a monopolist) to restrict supply. Their

motivation for acting in this way is to raise prices and thereby make higher combined profits on the products concerned. However, such behaviour is detrimental to consumers since they pay higher prices than if there is no collusion.The OFT found that the supermarkets named in the press release colluded with each other and their suppliers (the dairy processors) to keep prices high. According to the OFT, the collusion was managed through the sharing of commercially sensitive information (b) The game theoretic analysis of the prisoners’ dilemma suggests that oligopoly collusion (e.g. through the formation of cartels or through implicit collusion) is likely to be fragile because the incentives to break any collusive agreement are too high . Payoff Matrix 1 illustrates this. The matrix illustrates the situation facing two supermarkets, ASDA and TESCO, and the payoffs imply that if the supermarkets collude by restricting supply to keep prices high they both make high profits (300 each). But if one of the supermarkets e.g. ASDA breaks the agreement by increasing supply (resulting in a lower market price overall) while TESCO continues to restrict supply, ASDA would make relatively high profits of 400 (e.g. by increasing sales to its own customers and poaching some of ASCO’s customers) while TESCO would see a reduction in its profits to 150. However, if both increased supply, price would fall even further and they would both make relatively low profits (200 each). In Payoff Matrix 1 both firms have a dominant strategy which is to break the collusive agreement by charging a lower price. To see this, consider the options of ASDA in response to each of TESCO’s two possible strategies. First, If ASCO chooses to maintain the agreement by restricting supply then ASDA makes profits of 300 if it also restricts supply but ASDA makes profits of 400 by increasing supply (breaking the agreement with TESCO). Therefore, ASDA’s best option (its best response to TESCO restricting supply) is to increase supply. Second, if TESCO increases its supply, then ASDA makes profits of 200 by also increasing its supply and only makes profits of 150 if it continues to restrict supply. Therefore, ASDA’s best option in response to an increase in supply by TESCO is to also to increase its supply. This shows that ASDA is better off increasing its supply whatever TESCO does. In other words, increasing supply is a dominant strategy for ASDA (whatever TESCO does, ASDA is better off choosing to restrict sales). Since the game is symmetric, the same is true for TESCO. Thus both firms have a dominant strategy which is to increase supply. Therefore, the expected outcome is that neither firm will stick to the collusive agreement, both will increase supply. Both firms would therefore end up with profits of 200. The prisoners’ dilemma for the supermarkets is that if they could somehow maintain the collusive agreement they would both make higher profits (300 each) but the incentive to break the agreement is too strong.

(c) The OFT policy of leniency is discussed in the 11/12/08 Press Release. The offer of leniency to firms involved in collusion should help to break up collusive agreements since it gives firms even more incentive to break up any such agreement. In terms of the payoff matrix in Figure 7 the payoff to either supermarket from maintaining the collusive agreement, if the other were to break it by increasing supply, would be even lower (i.e. less than 150) since the OFT would impose high penalties on the firm that did not break the agreement by confessing.

(d) Collusion is more likely to be sustained if it can be enforced over the long term i.e. through repetition. In this case, the one-off gains from breaking the agreement (followed by repeated non-agreement) could be outweighed by longer-term (repeated) gains from commitment to the agreement. This appears to be the determining factor that induced Sony and Toshiba to agree on a common platform for DVDs; the potential gains from becoming the market leader were outweighed by the losses that would be sustained by maintaining a market divide. In the long-term, collusion is also more likely to be maintained if the participants can make credible threats of punishment that will be enforced against any party that breaks the collusive agreement (e.g. by imposing penalties for default). A collusive agreement may also be sustained if the parties to the agreement share norms of commitment.