1. Chapter 13 Cartels, Games and Network Goods

2. 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.
Instructor Notes:

3. Cartels and Games Q P
A Cartel Tries to Move a Market from “Competition” towards “As if Controlled by a Monopolist”
Competition Pc D
MC = AC S Qc
As if Controlled by a Monopolist Qm Pm
Profit MR
Instructor Notes: Figure 13.2: A Cartel Tries to Move a Market from “Competition” towards “As if Controlled by a Monopolist”
Few cartels are able to move from competition to a pure monopoly, but that is the goal.

4. Reasons why cartels collapse:
Cartels and Games
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.
Instructor Notes:

5. 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.
Instructor Notes:

6. 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.
Instructor Notes: Table 13.1 No Cartel

7. 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.
Instructor Notes: Table 13.2 Cartel

8. 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.
Instructor Notes: Table 13.3 Cartel with One Cheater

9. 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.
Instructor Notes: It could be useful here to remind students of the discussion of marginal revenue for a monopolist presented in Chapter 11.

10. 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
Countries
Output per Country
Total 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
Instructor Notes: Table 13.4 Cartel with Nine Cheaters and One Non-Cheater

11. 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.
Instructor Notes:

12. 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.
Instructor Notes:

13. Cheating by Cartel Members
The Cheating Dilemma
Russia’s Strategies
Cooperate
Cheat
Saudi Arabia’s Strategies
($400, $400)
($200, $500)
($500, $200)
($300, $300)
Instructor Notes: Figure 13.3 The Cheating Dilemma
The payoff matrix show revenues for each country under every strategy pairs. The first number in each cell represents the payoff to Saudi Arabia while the second figure is the payoff to Russia for the particular strategy pairing. If both countries cooperate they both receive $400. If Saudi Arabia cooperates but Russia cheats, the payoff to Saudi Arabia is $200 while the payoff to Russia is $500. If Saudi Arabia cheats but Russia cooperates, then Saudi Arabia receives $500 while the payoff to Russia is $200. If both countries cheat, then they both receive $300. Both countries have a strong incentive to cheat. The equilibrium of the game is for both countries to cheat as is highlighted.

14. 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.
Instructor Notes:

15. 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.
Instructor Notes:

16. 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.
Instructor Notes:

17. 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.
Instructor Notes:

18. 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.
Instructor Notes:

19. 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.
Instructor Notes:

20. 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.
Instructor Notes:

21. What is the surprising conclusion of the prisoner’s dilemma?
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?
Instructor Notes:

22. 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.”
Instructor Notes:

23. 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.
Instructor Notes:

24. 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
Alex
(11, 11)
(3, 3)
(10, 10)
Instructor Notes: Figure 13.4 The Coordination Game
The payoff matrix show revenues for each country under every strategy pairs. The first number in each cell represents the payoff to Alex while the second figure is the payoff to Tyler for the particular strategy pairing. If both choose Apple they both receive a payoff of 11. If Alex chooses Apple, but Tyler chooses Microsoft, they both receive a payoff of 3. If Alex and Tyler both choose Microsoft, they both receive a payoff of 10. Each player has a strong incentive to choose the same software as the other player. The equilibria of the game is for both players to choose the same software. These are highlighted.

25. 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.
Instructor Notes:

26. 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.
Instructor Notes:

27. 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.
Instructor Notes:

28. Network Goods
The standard war between Sony and Toshiba can be expressed in a payoff matrix.
The Standard War
Sony
HD-DVD
Blu-Ray
Toshiba
(10, 8)
(0, 0)
(8,10)
Instructor Notes: Figure 13.5 The Standard War
The payoff matrix show revenues for each country under every strategy pairs. The first number in each cell represents the payoff to Toshiba while the second figure is the payoff to Sony for the particular strategy pairing. The both firms produce HD-DVD, then Toshiba receives a payout of 10 while Sony receives a payoff of 8. If both firms produce Blu-Ray, then Sony receives a payoff of 10 while Toshiba receives a payoff of 8 Each firm prefers its technology standard, but each firm prefers one standard over multiple standards. The equilibria of the game are highlighted.

29. 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.*
*Sony’s ability to secure an exclusive distribution contract with Warner Bros. also played a large role in their victory.

30. 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.
Instructor Notes:

31. Does 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?
Instructor Notes:

32. Reasons why cartels collapse:
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.
Instructor Notes:

33. The dominant strategy in a cartel is to cheat on the agreement.
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.
Instructor Notes:

34. 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.
Instructor Notes:

35. Features of 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.”
Instructor Notes: