Game Theory!

Cartels A group of suppliers who try to act together in order to reduce supply, raise prices, and increase profits. A group of supplied who try to act as AS IF they were a monopolist Example: OPEC Question to answer: When will cartels be able to achieve their goal of being a monopolist?

Game Theory A study of strategic decision-making A decision in making situations that are interactive Example: Craps players make decisions, pokers players make strategic decisions Game theory is used to analyze cartels because the best decision of one cartel member depends on the decisions of every other cartel member which in turn depends on the decisions of every other cartel member

Game Theory Also used to study war, romance, business decisions, evolution, voting and other situations involving interactions Game theory is applied to the economics of network of goods A network of goods is a good who value to one consumer increases the more that other consumers use the good Ex. Cell phones

Cartels and Game Theory Why did the price of oil more than triple in 1973-1974? Saudi Arabia, a cartel of oil exporting countries cut back on their production of oil

Cartels and Game Theory Very few cartels can move in an industry from competition to pure monopoly OPEC seems to be all powerful but in reality, very few cartels are UNLESS…..they have strong government support Would have much control over market price for a very long time

Cartels and Game Theory Cartels tend to collapse due to three reasons: Cheating by cartel members New entrants and demand response Government prosecution

1. Cheating by cartel members For oil-exporting nations, if they worked together to reduce production and raise prices, it would succeed Cartel members earn high profits on each barrel of oil that comes out of the ground BUT……members will cheat on the cartel agreement They promise to reduce production but when everyone else reduces production and the price of oil rises…….some cartel members can and will cheat to increase their profits

Logic of Cheating….. No Cartel Countries Output per Country Output Profit per Country (per day) 10 10 MBD 100 MBD $360 million World Output World Price $36

Logic of Cheating….. Cartel Countries Output per Country Output Profit per Country (per day) 10 8 MBD 80 MBD $400 million World Output World Price $50

Logic of Cheating….. Cartel with One Cheater Countries Output per Country Output Profit per Country (per day) 9 8 MBD 72 MBD $380 million 1 10 MBD $475 million World Output 82 MBD World Price $47.50

1. Cheating by cartel members The logic is simple, a single cartel member does not have extensive monopoly power, so cutting back production doesn’t raise the world price enough to make up for its loss of sales What happens when nine countries cheat and only one country keeps its promise?

Logic of Cheating….. Cartel with Nine Cheaters and One Non-Cheater Countries Output per Country Output Profit per Country (per day) 1 8 MBD $300 million 9 10 MBD 90 MBD $375 million World Output 98 MBD World Price $37.50

1. Cheating by cartel members Cheating pays when other firms keep their promise and cheating pays when other firms cheat When a monopolist increases quantity beyond the profit-maximizing quantity, the monopolist hurts itself When a cartel cheater increases quantity beyond the profit-maximizing quantity, the cheater benefits itself and hurts other cartel members

1. Cheating by cartel members When the decisions of two or more firms significantly affect each others’ profits, they are in a situation of interdependence. The study of behavior in situations of interdependence is known as game theory. The reward received by a player in a game—such as the profit earned by an oligopolist—is that player’s payoff. A payoff matrix shows how the payoff to each of the participants in a two player game depends on the actions of both. Such a matrix helps us analyze interdependence.

Saudi Arabia’s Strategies The Payoff Table Russia’s Strategies Cooperate Cheat Saudi Arabia’s Strategies ($400, $400) ($200, $500) ($500, $200) ($300, $300) Saudi Arabia’s Payoff Russia’s Payoff

Saudi Arabia’s Strategies The Payoff Table Russia’s Strategies Cooperate Cheat Saudi Arabia’s Strategies ($400, $400) ($200, $500) ($500, $200) ($300, $300) Two numbers in each both of the table are the payoffs to the players Dominant Strategy – is a Strategy that has a higher payoff than any other Strategy no matter what the other player does When Russia acts in their own interest and Saudi Arabia acts in their own interest, the result is an outcome that is in the interest of neither

The Prisoner’s Dilemma If both players cooperate, fishing revenues can be maximized and the stock of fish will be maintained for future generations BUT….if one player cheats, the other has an incentive to cheat and this will reduce the stock of fish below the best possible outcome and will eventually deplete the product This describes situations where the pursuit of individual interest leads to a group outcome that is in the interest of no one Ex: Japan’s Strategies Cooperate Cheat United States’ Strategies ($400, $400) ($200, $500) ($500, $200) ($300, $300)

Prisoner’s Dilemma & Nash Equilibrium An action is a dominant strategy when it is a player’s best action regardless of the action taken by the other player. Depending on the payoffs, a player may or may not have a dominant strategy. A Nash equilibrium, also known as a non-cooperative equilibrium, is the result when each player in a game chooses the action that maximizes his or her payoff given the actions of other players, ignoring the effects of his or her action on the payoffs received by those other players

Repeated Interaction and Tacit Collusion Players who don’t take their interdependence into account arrive at a Nash, or non-cooperative, equilibrium. But if a game is played repeatedly, players may engage in strategic behavior, sacrificing short-run profit to influence future behavior. In repeated prisoners’ dilemma games, tit for tat is often a good strategy, leading to successful tacit collusion. Tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period. When firms limit production and raise prices in a way that raises each others’ profits, even though they have not made any formal agreement, they are engaged in tacit collusion

2. New entrants and demand response High prices of a cartel will attract new entrants These entrants do not feel bound by previous agreements Cartels are more successful when there are fewer substitutes for the cartelized good – implies less elastic demand More subs are typically available in the long run than in the short run, do demand curves tend to become more elastic over time, thus limited a cartel’s power

2. New entrants and demand response With the ease of new entrants, it is easier to maintain a cartel in a natural resource than in a manufactured good Two successful cartels – oil and diamonds

2. New entrants and demand response Natural resources are not the only “thing” in limited supply A cartel may control access to some key inputs that cannot be easily duplicated Ex. Major League Sports – NBA, NFL, MLB, MLS

2. New entrants and demand response NBA consists of 30 teams Teams compete on the court but “collude” off the court They use the NBA league structure to keep down player salaries – “salary cap” If they do, face “the luxury tax” Each team, when joining the NBA, agrees to limit how much spent on players Example of a buyer’s cartel – result is that professional basketball salaries are lower than they should be

3. Government prosecution Cartels have been illegal since the Sherman Antitrust Act of 1890 Governments don’t always prosecute cartels and sometimes even support them Most cartels operate with clear legal and governmental backing Examples: OPEC, milk cartels, coal mining, agriculture, medicine

3. Government prosecution Government-enforced monopolies and cartels are one of the most serious problems faxing poor nations such as Mexico, Russia, Indonesia and Africa Entrepreneurs who start new businesses sometimes find that the law force them out of competition with the small number of so-called untouchable big men who have cartelized the major sectors of the government

3. Government prosecution A government-supported cartel also means higher prices, lower quality of service and less innovation

Game Theory!

Cartels A group of supplied who try to act as AS IF they were a monopolist Example:

Game Theory Example: Craps players make decisions, pokers players make strategic decisions Game theory is used to analyze cartels because the best decision of one cartel member depends on the decisions of every other cartel member which in turn depends on the decisions of every other cartel member

Game Theory Also used to study war, romance, business decisions, evolution, voting and other situations involving interactions Game theory is applied to the economics of network of goods

Cartels and Game Theory Why did the price of oil more than triple in 1973-1974?

Cartels and Game Theory Very few cartels can move in an industry from competition to pure monopoly OPEC seems to be all powerful but in reality, very few cartels are

Cartels and Game Theory Cartels tend to collapse due to three reasons:

1. Cheating by cartel members They promise to reduce production but when everyone else reduces production and the price of oil rises…….some cartel members can and will cheat to increase their profits

Logic of Cheating….. No Cartel Countries Output per Country Output Profit per Country (per day) 10 10 MBD 100 MBD $360 million World Output World Price $36

Logic of Cheating….. Cartel Countries Output per Country Output Profit per Country (per day) 10 8 MBD 80 MBD $400 million World Output World Price $50

Logic of Cheating….. Cartel with One Cheater Countries Output per Country Output Profit per Country (per day) 9 8 MBD 72 MBD $380 million 1 10 MBD $475 million World Output 82 MBD World Price $47.50

1. Cheating by cartel members The logic is simple, What happens when nine countries cheat and only one country keeps its promise?

Logic of Cheating….. Cartel with Nine Cheaters and One Non-Cheater Countries Output per Country Output Profit per Country (per day) 1 8 MBD $300 million 9 10 MBD 90 MBD $375 million World Output 98 MBD World Price $37.50

1. Cheating by cartel members Cheating pays when other firms keep their promise and cheating pays when other firms cheat When a monopolist increases quantity beyond the profit-maximizing quantity, the monopolist hurts itself

Saudi Arabia’s Strategies The Payoff Table Russia’s Strategies Cooperate Cheat Saudi Arabia’s Strategies ($400, $400) ($200, $500) ($500, $200) ($300, $300)

Saudi Arabia’s Strategies The Payoff Table Russia’s Strategies Cooperate Cheat Saudi Arabia’s Strategies ($400, $400) ($200, $500) ($500, $200) ($300, $300) Dominant Strategy –

The Prisoner’s Dilemma Ex: Japan’s Strategies Cooperate Cheat United States’ Strategies ($400, $400) ($200, $500) ($500, $200) ($300, $300)

2. New entrants and demand response High prices of a cartel will attract new entrants These entrants do not feel bound by previous agreements Cartels are more successful when there are fewer substitutes for the cartelized good – implies less elastic demand

2. New entrants and demand response With the ease of new entrants, it is easier to maintain a cartel in a natural resource than in a manufactured good

2. New entrants and demand response Natural resources are not the only “thing” in limited supply A cartel may control access to some key inputs that cannot be easily duplicated Ex.

2. New entrants and demand response NBA consists of 30 teams Teams compete on the court but “collude” off the court They use the NBA league structure to keep down player salaries – “salary cap” If they do, face “the luxury tax” Each team, when joining the NBA, agrees to limit how much spent on players Example of a buyer’s cartel –

3. Government prosecution Cartels have been illegal since ____________ ________________________ Governments don’t always prosecute cartels and sometimes even support them Most cartels operate with clear legal and governmental backing Examples:

3. Government prosecution Government-enforced monopolies and cartels are one of the most serious problems faxing poor nations such as Mexico, Russia, Indonesia and Africa Entrepreneurs who start new businesses sometimes find that the law force them out of competition with the small number of so-called untouchable big men who have cartelized the major sectors of the government

3. Government prosecution