Micro Lecture 17: Oligopoly and Cheating

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1 Micro Lecture 17: Oligopoly and Cheating Oligopolies Many important industries in the U.S. include a few moderately sized firms. For example, the automobile industry, the cell phone industry, the airline industry, etc. These industries are not monopolies because they have more than one large firm, but on the other hand they are not perfectly competitive because they are not composed of a large number of small independent firms. These industries are called oligopolies. Perfect Competition Oligopoly Monopoly Large number of small independent firms. Few moderately sized firms. One large firm. Question: Will industries that are oligopolies they act like a monopoly or will they act like a perfectly competitive industry? Answer: In general we cannot tell. It depends on how the firms interact with each other. Why is the answer important? The answer is important from a public policy perspective. If such an industry acts like a monopoly, inefficiency would result providing justification for government intervention. In fact, anti-trust legislation is designed to prevent oligopolies from acting as though they were a monopoly. Alternatively, if the firms act like a perfectly competitive industry, intervention based on efficiency grounds would be undesirable. Perfect Competition Oligopoly Monopoly Large number of small independent firms. Few moderately sized firms. One large firm. Efficient Inefficient Preview: Challenge of Oligopoly If an industry is perfectly competitive we can straightforwardly describe the resulting price and quantity. The market demand and supply curves permit us to do this. If an industry is a monopoly, we can also straightforwardly describe the resulting price and quantity. The market demand, the monopoly s marginal revenue, and the monopoly s marginal cost curves permit us to do this. If an industry is an oligopoly, the situation is not as straightforward. The resulting price and quantity depend on how the firms interact with each other. Project: Explaining OPEC s Vacillating Behavior. We can also motivate our study of oligopoly by considering the vacillating behavior of OPEC, the Organization of Petroleum Exporting Countries. When the firms in an industry attempt to act as though they were a monopoly we say that they are acting as a cartel. OPEC is an excellent example of a cartel because the member nations meet regularly to set production quota in an effort to affect the price of petroleum. September 27, 1993: Wall Street Journal article, Bahree and Tanner report that OPEC was meeting: in an urgent attempt to regain the initiative in its effort to prop up petroleum prices Prices have fallen sharply, by about $3 a barrel this year, largely because OPEC has been producing about one million barrels a day more than its widely ignored ceiling The fall in prices has left the OPEC benchmark about $6 a barrel under the $21 target

2 2 September 30, 1993: Within a few days, the members of OPEC agreed upon production quotas and oil prices rose. Tanner and Bahree report in the Wall Street Journal: OPEC members agreed on how to divide their new production level and, surprisingly, extended the output arrangement to six months rather than the expected three. The accord sets a ceiling of 24.5 million barrels a day for OPEC. It is intended to reduce actual output by some 200,000 barrels a day and raise world oil prices as a result. [In London,] Brent crude rose 68 cents a barrel [In New York,] crude soared 71 cents a barrel The oil minister hailed the agreement as one of the best ever October 11, 1993: Tanner reported that World oil prices are likely to rise further over the next few weeks if the Organization of Petroleum Exporting Countries stick to its new production quotas. October 12, 1993: The New York Times reported a chink in OPEC s resolve appeared, however. An extra 300,000 or 400,000 barrels of crude oil were being produced every day: The weekly Middle East Economic Survey estimated that production by members of the Organization of Petroleum Exporting Countries rebounded to 24.8 million barrels a day The daily Platt s Oilgram News [estimated] production at nearly 24.9 million barrels a day. [Both estimates exceeded] the output ceiling of 24.5 million barrels October 26, 1993: In of the Wall Street Journal, Tanner reported oil prices quickly responded: petroleum prices [dropped] to the lowest levels since the September meeting of the Organization of Petroleum Exporting Countries. Prices of crude oil fell 50 cents a barrel or more, Summary In late September, the members of OPEC negotiated quotas to restrict the quantity of oil produced. The agreement was applauded by OPEC oil ministers. Oil prices promptly rose. The increase in oil prices proved to be short lived, however. OPEC members violated their agreement within two weeks of consummating it. Within a few weeks, the price of oil fell. Question: How can we explain the behavior of OPEC members? Preview: Conflicting Interests of an Oligopolies and Cartels: Collective Interests versus Individual Interests It is in the collective interests of the firms in an industry to establish a cartel. By colluding to reduce production below the competitive level, the firms can act like a monopoly to maximize their joint profits. Alternatively, if a cartel is established it may be in the individual interests of a firm to cheat on the cartel agreement. If the cartel agreement is in place, it may be in an individual firm s interests to produce more than the agreement allows thereby pushing production toward the competitive level. Strategy: Begin with a multi-plant monopoly and then convert it to an oligopoly.

3 3 Review: Multi-Plant Monopoly Recall that in the last lecture we consider a monopoly with two plants: Plant A and Plant B. Figure 17.1 depicts the profit maximizing state of affairs for the two-plaint monopoly. As we showed, to maximize profits, two conditions must be satisfied: Marginal costs of each plant must be equal: MC A = MC B Marginal revenue must equal each plant s marginal cost: MR = MC A = MC B When Plant A produces 200 units and Plant B 400 units, firm s profits will be maximized. Plant A Plant B Total Production q A = 50 q B = 100 Q = 150 MC A = $60 MC B = $60 MR = $60 Plant A Plant B Demand and Marginal Revenue MC A MC A MC B MC B D 20 MR q A q B Q (units per day) (units per day) (units per day) Figure 17.1: Multi-plant monopoly Today Firm A Firm B Monopoly Quantity Price Total Revenue 4,500 9,000 Total Cost 3,000 5,000 Profit 1,500 4,000 5,500 Marginal Revenue 60 Marginal Cost Preview: Conflicting Interests of an Oligopolies and Cartels: Collective Interests versus Individual Interests It is in the collective interests of the firms in an industry to establish a cartel. By colluding to reduce production below the competitive level, the firms can act like a monopoly to maximize their joint profits. Alternatively, if a cartel is established it may be in the individual interests of a firm to cheat on the cartel agreement. If the cartel agreement is in place, it may be in an individual firm s interests to produce more than the agreement allows thereby pushing production toward the competitive level. Strategy: Begin with a multi-plant monopoly and then convert it to an oligopoly.

4 4 Oligopolies and Cartels Suppose that the owner of the monopoly firm retires and gives his two plants to his two children. The owner gives Plant A to his son, Adam, and Plant B to his daughter, Beth. Now there are two separate firms, Firm A and Firm B. Initially, Adam and Beth agree to operate the plants just like their father did. By doing so, they will be maximizing their joint profits. They will be acting as though they are simply two different plants of a single monopoly firm. As we have learned, this situation is called a cartel; their agreement is called a cartel agreement. Cartel Agreement: Adam s Firm Beth s Firm Total Production q A = 50 q B = 100 Q = 150 Price = $90 MC A = $60 MC B = $60 MR = $60 Let us calculate the total revenues of the siblings today, when the cartel agreement is in place: Today: Adam s Firm Beth s Firm TR A = Pq A TR B = Pq B = = = 4, = 9, Micro Lab 17.1 illustrates the joint profit maximizing state of affairs: Micro Lab 17.1: Joint Profit Maximization Today Firm A Firm B Joint Quantity Price Total Revenue 4,500 9,000 Total Cost 3,000 5,000 Profit 1,500 4,000 5,500 Marginal Cost Question: Will the siblings agreement persist or will the siblings have an incentive to cheat on the agreement? Claim: The stability of the agreement depends on how each sibling would react to the actions of the other. We will consider two cases: Scenario 1: When one sibling cheats the other does not retaliate. Scenario 2: When one sibling cheats the other does retaliate.

5 5 Scenario 1: When one sibling cheats the other does not retaliate. We begin with the joint profit maximizing agreement in place. Today Adam s firm produces 50 units and Beth s firm 100 units; total production equals 150 units. Question: Does Adam have an incentive to cheat if Beth does not retaliate? To answer this question we should calculate Adam s marginal revenue and compare it to his marginal cost. Question: What experiment could we conduct tomorrow to calculate Adam s marginal revenue based on the premise that Beth will not retaliate? Answer: Adam could increase his production from 50 to 51 while Beth continues to produce 100 units: Quantity Firm A Firm B Joint Price Tomorrow Today Question: What will the price equal tomorrow? Consider the market demand curve as illustrated in figure 17.2: Demand Curve Today the price equals $90.00 and consumers demand 150 units. 100 Hence, to clear the market tomorrow, the quantity demanded must increase by 1 unit. 80 To increase the quantity demanded by 1 unit, by how much must the price fall? To answer this question we calculate the slope of the demand curve: o What does the slope of the market demand curve equal?.20. Slope = Rise Run = =.20 o Hence, to increase the quantity demanded by 1 unit, the price must fall by $.20, from $90.00 to $ Figure 17.2: Demand curve Now we can calculate Adam s marginal revenue: Adam s Quantity Price Adam s Total Revenue = PriceQuantity Tomorrow: (1+50) = Today: Adam s Marginal Revenue = = ( ) 50 = (.20) 50 ã é TR tends to rise by 89.80, the price, as a consequence of the additional unit sold. TR tends to fall by as a consequence of the lower price. Output Effect Price Effect é ã MR A = Adam s Marginal Revenue = = D Q (units per day)

6 6 Now, compare Adam s marginal revenue with his marginal cost: Adam s Firm Marginal Revenue 80 Marginal Cost 60 When Adam produces one more unit and Beth does not retaliate, his profit rises by about $20: Adam produces 1 more unit Beth does not retaliate Adam s Profit = Adam s TR Adam s TC Up by 20 Up by 80 Up by 60 NB: Adam has an incentive to cheat if Beth does not retaliate. Micro Lab 17.2 allows us to check out logic: Micro Lab 17.2: Cheating without Retaliation Joint Profit Maximization Firm A Cheats Firm B Does Not Retaliate Firm A Firm B Firm A Firm B Quantity Total Revenue 4,500 9,000 4,580 8,980 Total Cost 3,000 5,000 3,060 5,000 Profit 1,500 4,000 1,520 3,980 Cons Surplus 2,250 2,280 Firm A Cheats Firm B Does Not Retaliate Change from Joint Profit Maximization Firm A Firm B Consumer Society Profit Profit Surplus The lab reveals some important points. When Adam cheats and Beth does not retaliate: Firms: o Adam s profit rises; hence, Adam has an incentive to cheat in this case. o Beth s profit falls; hence, Beth has good reason to be upset. Consumer: Consumer surplus increases. The gain in consumer surplus is greater than the loss in joint profits. Society as a whole (firms and consumers together) is better off.

7 7 Question: Does Beth have an incentive to cheat if Adam does not retaliate? Question: What experiment could we conduct tomorrow to calculate Beth s marginal revenue based on the premise that Adam will not retaliate? Answer: Beth could increase her production from 100 to 101 while Adam continues to produce 50 units: Quantity Firm A Firm B Joint Price Tomorrow Today Once again, to clear the market the quantity demanded must increase by 1 unit; since the slope of the demand curve is.20, the price must fall by $.20, from $90.00 to $ Beth s Quantity Price Beth s Total Revenue = PriceQuantity Tomorrow: (1+50) = Today: Beth s Marginal Revenue = = ( ) 100 = (.20) 100 ã é TR tends to rise by 89.80, the price, as a consequence of the additional unit sold. TR tends to fall by as a consequence of the lower price. Output Effect Price Effect é ã MR B = Beth s Marginal Revenue = = Comparing Beth s marginal revenue with her marginal cost: Beth s Firm, Firm B Marginal Revenue 70 Marginal Cost 60 When Beth produces one more unit and Adam does not retaliate, her profit rises by about $10: Beth produces 1 more unit Adam does not retaliate Beth s Profit = Beth s TR Beth s TC Up by 10 Up by 70 Up by 60 NB: Beth has an incentive to cheat if Adam does not retaliate.

8 8 Micro Lab 17.3 allows us to check out logic: Micro Lab 17.3: Cheating without Retaliation Joint Profit Maximization Firm A Cheats Firm B Does Not Retaliate Firm A Firm B Firm A Firm B Quantity Total Revenue 4,500 9,000 4,490 9,070 Total Cost 3,000 5,000 3,000 5,060 Profit 1,500 4,000 1,490 4,010 Cons Surplus 2,250 2,280 Firm B Cheats Firm A Does Not Retaliate Change from Joint Profit Maximization Firm A Firm B Consumer Society Profit Profit Surplus The lab reveals some important points. When Beth cheats and Adam does not retaliate: Firms: o Beth s profit rises; hence, Beth has an incentive to cheat in this case. o Adam s profit falls; hence, Adam has good reason to be upset. Consumer: Consumer surplus increases. Society as a whole: Welfare of society as a whole (firms and consumers together) increases. Summary of Scenario 1: The No Retaliation Scenario Adam s Firm, Firm A Beth s Firm, Firm B Marginal Revenue Marginal Cost We now calculate the effect of each sibling s profit when one sibling produces 1 more unit and the other does not retaliate: Adam produces 1 more unit Beth does not retaliate Beth produces 1 more unit Adam does not retaliate Adam s Profit = Adam s TR Adam s TC Beth s Profit = Beth s TR Beth s TC Up by 20 Up by 80 Up by 60 Up by 10 Up by 70 Up by 60 NB: Each sibling has an incentive to cheat if the other does not retaliate.

9 9 When one sibling cheats and the other does not retaliate: Firms: Joint profit decreases. o Cheating sibling s profit rises; hence, a sibling has an incentive to cheat. o Non-cheating sibling s profit falls; hence, the non-cheating sibling has good reason to be upset. Consumer: Consumer surplus increases. The gain in consumer surplus is greater than the loss in joint profits. Society as a whole (firms and consumers together) is better off. Adam has a greater incentive to cheat because his profit rises by more than Beth s. Why? While marginal cost is identical for the two siblings, marginal revenue is not. Marginal revenue is greater for Adam than it is for Beth. This occurs because marginal revenue depends on both the output effect and the price effect. Marginal Revenue = Output Effect Price Effect Depends on Quantity The price effect tends to reduce marginal revenue and it depends on the quantity produced. Since Adam produces less, his price effect is less and consequently, his marginal revenue is greater.

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