Game Theory!. Cartels A group of suppliers who try to act together in order to reduce supply, raise...

Game Theory!Game Theory!

CartelsCartels• A group of suppliers who try to act together A group of suppliers who try to act together

in order to reduce supply, raise prices, and in order to reduce supply, raise prices, and increase profits.increase profits.

• A group of supplied who try to act as AS IF A group of supplied who try to act as AS IF they were a monopolistthey were a monopolist

• Example: OPECExample: OPEC• Question to answer: When will cartels be Question to answer: When will cartels be

able to achieve their goal of being a able to achieve their goal of being a monopolist?monopolist?

Game TheoryGame Theory• A study of strategic decision-makingA study of strategic decision-making– A decision in making situations that are A decision in making situations that are

interactiveinteractive• Example: Craps players make decisions, Example: Craps players make decisions,

pokers players make strategic decisionspokers players make strategic decisions• Game theory is used to analyze cartels Game theory is used to analyze cartels

because the best decision of one cartel because the best decision of one cartel member depends on the decisions of every member depends on the decisions of every other cartel member which in turn depends other cartel member which in turn depends on the decisions of every other cartel on the decisions of every other cartel membermember

Game TheoryGame Theory

• Also used to study war, romance, business Also used to study war, romance, business decisions, evolution, voting and other decisions, evolution, voting and other situations involving interactionssituations involving interactions

• Game theory is applied to the economics of Game theory is applied to the economics of network of goodsnetwork of goods

• A network of goods is a good who value to A network of goods is a good who value to one consumer increases the more that other one consumer increases the more that other consumers use the goodconsumers use the good

• Ex. Cell phonesEx. Cell phones

Cartels and Game TheoryCartels and Game Theory

• Why did the price of oil more than triple Why did the price of oil more than triple in 1973-1974?in 1973-1974?

• Saudi Arabia, a cartel of oil exporting Saudi Arabia, a cartel of oil exporting countries cut back on their production countries cut back on their production of oilof oil


• Very few cartels can move in an industry Very few cartels can move in an industry from competition to pure monopolyfrom competition to pure monopoly

• OPEC seems to be all powerful but in OPEC seems to be all powerful but in reality, very few cartels arereality, very few cartels are–UNLESS…..they have strong government UNLESS…..they have strong government

supportsupport–Would have much control over market Would have much control over market

price for a very long timeprice for a very long time


• Cartels tend to collapse due to three Cartels tend to collapse due to three reasons:reasons:

1.1.Cheating by cartel membersCheating by cartel members2.2.New entrants and demand New entrants and demand

responseresponse3.3.Government prosecutionGovernment prosecution

1. Cheating by cartel members1. Cheating by cartel members• For oil-exporting nations, if they worked For oil-exporting nations, if they worked

together to reduce production and raise prices, together to reduce production and raise prices, it would succeedit would succeed

• Cartel members earn high profits on each barrel Cartel members earn high profits on each barrel of oil that comes out of the groundof oil that comes out of the ground

• BUT……members will cheat on the cartel BUT……members will cheat on the cartel agreementagreement

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

Logic of Cheating…..Logic of Cheating…..No CartelNo Cartel

CountriesCountries Output per Output per CountryCountry

OutputOutput Profit per Country Profit per Country (per day)(per day)

1010 10 MBD10 MBD 100 MBD100 MBD $360 $360 millionmillion

World World OutputOutput

100 MBD100 MBD

World World PricePrice

$36$36

Logic of Cheating…..Logic of Cheating…..CartelCartel





80 MBD80 MBD


$50$50

Logic of Cheating…..Logic of Cheating…..Cartel with One CheaterCartel with One Cheater






82 MBD82 MBD


$47.50$47.50

1. Cheating by cartel members1. Cheating by cartel members

• The logic is simple, a single cartel The logic is simple, a single cartel member does not have extensive member does not have extensive monopoly power, so cutting back monopoly power, so cutting back production doesn’t raise the world price production doesn’t raise the world price enough to make up for its loss of salesenough to make up for its loss of sales

• What happens when nine countries What happens when nine countries cheat and only one country keeps its cheat and only one country keeps its promise?promise?

Logic of Cheating…..Logic of Cheating…..Cartel with Nine Cheaters and One Non-Cartel with Nine Cheaters and One Non-

CheaterCheater






98 MBD98 MBD


$37.50$37.50


• Cheating pays when other firms keep their Cheating pays when other firms keep their promise and cheating pays when other firms promise and cheating pays when other firms cheatcheat

• When a monopolist increases quantity When a monopolist increases quantity beyond the profit-maximizing quantity, the beyond the profit-maximizing quantity, the monopolist hurts itselfmonopolist hurts itself

• When a cartel cheater increases quantity When a cartel cheater increases quantity beyond the profit-maximizing quantity, the beyond the profit-maximizing quantity, the cheater benefits itself and hurts other cartel cheater benefits itself and hurts other cartel membersmembers

1. Cheating by cartel members1. Cheating by cartel members• When the decisions of two or more firms When the decisions of two or more firms

significantly affect each others’ profits, they are significantly affect each others’ profits, they are in a situation of interdependence.in a situation of interdependence.• The study of behavior in situations of The study of behavior in situations of

interdependence is known as game theory.interdependence is known as game theory.• The reward received by a player in a gameThe reward received by a player in a game——such such

as the profit earned by an oligopolist—is that as the profit earned by an oligopolist—is that player’s payoff.player’s payoff.• A payoff matrix shows how the payoff to each of A payoff matrix shows how the payoff to each of

the participants in a two player game depends the participants in a two player game depends on the actions of both. Such a matrix helps us on the actions of both. Such a matrix helps us analyze interdependence.analyze interdependence.

The Payoff TableThe Payoff TableRussia’s StrategiesRussia’s Strategies

CooperateCooperate CheatCheat

Saudi Saudi Arabia’s Arabia’s

StrategiesStrategies

CooperateCooperate ($400, $400)($400, $400) ($200, $500)($200, $500)

CheatCheat ($500, $200)($500, $200) ($300, $300)($300, $300)

Saudi Arabia’s Payoff

Russia’s Payoff

Russia’s Strategies

Cooperate Cheat

Saudi Arabia’s

Strategies

Cooperate ($400, $400) ($200, $500)

Cheat ($500, $200) ($300, $300)

The Payoff TableThe Payoff Table• Two numbers in each both of the table Two numbers in each both of the table are the payoffs to the playersare the payoffs to the players• Dominant Strategy – is a Dominant Strategy – is a Strategy that has a higher payoff than any other Strategy that has a higher payoff than any other Strategy no matter what the other player doesStrategy no matter what the other player does• When Russia acts in their own interest and SaudiWhen Russia acts in their own interest and SaudiArabia acts in their own interest, the result is anArabia acts in their own interest, the result is anoutcome that is in the interest of neitheroutcome that is in the interest of neither

The Prisoner’s DilemmaThe Prisoner’s Dilemma

• This describes situations where the pursuit of This describes situations where the pursuit of individual interest leads to a group outcome individual interest leads to a group outcome that is in the interest of no onethat is in the interest of no one

• Ex:Ex: Japan’s StrategiesJapan’s Strategies


United United States’ States’



CheatCheat ($500, $200)($500, $200) ($300, $300)($300, $300)

If both players cooperate, fishing revenues can be If both players cooperate, fishing revenues can be maximized and the stock of fish will be maintained for maximized and the stock of fish will be maintained for

future generationsfuture generationsBUT….if one player cheats, the other has an incentive BUT….if one player cheats, the other has an incentive to cheat and this will reduce the stock of fish below to cheat and this will reduce the stock of fish below

the best possible outcome and will eventually deplete the best possible outcome and will eventually deplete the productthe product

Prisoner’s Dilemma & Prisoner’s Dilemma & Nash EquilibriumNash Equilibrium

• An action is a dominant strategy when it is a An action is a dominant strategy when it is a player’s best action regardless of the action taken player’s best action regardless of the action taken by the other player. Depending on the payoffs, a by the other player. Depending on the payoffs, a player may or may not have a dominant strategplayer may or may not have a dominant strategyy..

• A Nash equilibrium, also known as a non-A Nash equilibrium, also known as a non-cooperative equilibrium, is the result when each cooperative equilibrium, is the result when each player in a game chooses the action that maximizes player in a game chooses the action that maximizes his or her payoff given the actions of other players, his or her payoff given the actions of other players, ignoring the effects of his or her action on the ignoring the effects of his or her action on the payoffs received by those other playerspayoffs received by those other players

Repeated Interaction and Tacit CollusionRepeated Interaction and Tacit Collusion Players who don’t take their interdependence into account Players who don’t take their interdependence into account

arrive at a Nash, or non-cooperative, equilibrium. But if a arrive at a Nash, or non-cooperative, equilibrium. But if a game is played repeatedly, players may engage in strategic game is played repeatedly, players may engage in strategic behavior, sacrificing short-run profit to influence future behavior, sacrificing short-run profit to influence future behavior. In repeated prisoners’ dilemma games, tit for tat is behavior. In repeated prisoners’ dilemma games, tit for tat is often a good strategy, leading to successful tacit collusion. often a good strategy, leading to successful tacit collusion.

Tit for tat involves playing cooperatively at first, then doing Tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period.whatever the other player did in the previous period.

When firms limit production and raise prices in a way that When firms limit production and raise prices in a way that raises each others’ profits, even though they have not made raises each others’ profits, even though they have not made any formal agreement, they are engaged in tacit collusionany formal agreement, they are engaged in tacit collusion

2. New entrants and demand response2. New entrants and demand response

• High prices of a cartel will attract new High prices of a cartel will attract new entrantsentrants

• These entrants do not feel bound by previous These entrants do not feel bound by previous agreementsagreements

• Cartels are more successful when there are Cartels are more successful when there are fewer substitutes for the cartelized good – fewer substitutes for the cartelized good – implies less elastic demandimplies less elastic demand– More subs are typically available in the long run More subs are typically available in the long run

than in the short run, do demand curves tend to than in the short run, do demand curves tend to become more elastic over time, thus limited a become more elastic over time, thus limited a cartel’s powercartel’s power


• With the ease of new entrants, it is With the ease of new entrants, it is easier to maintain a cartel in a natural easier to maintain a cartel in a natural resource than in a manufactured goodresource than in a manufactured good

• Two successful cartels – oil and Two successful cartels – oil and diamondsdiamonds


• Natural resources are not the only Natural resources are not the only “thing” in limited supply“thing” in limited supply

• A cartel may control access to some key A cartel may control access to some key inputs that cannot be easily duplicatedinputs that cannot be easily duplicated

• Ex. Major League Sports – NBA, NFL, Ex. Major League Sports – NBA, NFL, MLB, MLSMLB, MLS


• NBA consists of 30 teamsNBA consists of 30 teams• Teams compete on the court but “collude” Teams compete on the court but “collude”

off the courtoff the court• They use the NBA league structure to keep They use the NBA league structure to keep

down player salaries – “salary cap”down player salaries – “salary cap”– If they do, face “the luxury tax”If they do, face “the luxury tax”

• Each team, when joining the NBA, agrees to Each team, when joining the NBA, agrees to limit how much spent on playerslimit how much spent on players

• Example of a buyer’s cartel – result is that Example of a buyer’s cartel – result is that professional basketball salaries are lower professional basketball salaries are lower than they should bethan they should be

3. Government prosecution3. Government prosecution

• Cartels have been illegal since the Sherman Cartels have been illegal since the Sherman Antitrust Act of 1890Antitrust Act of 1890

• Governments don’t always prosecute cartels Governments don’t always prosecute cartels and sometimes even support themand sometimes even support them

• Most cartels operate with clear legal and Most cartels operate with clear legal and governmental backinggovernmental backing

• Examples: OPEC, milk cartels, coal mining, Examples: OPEC, milk cartels, coal mining, agriculture, medicineagriculture, medicine


• Government-enforced monopolies and Government-enforced monopolies and cartels are one of the most serious problems cartels are one of the most serious problems faxing poor nations such as Mexico, Russia, faxing poor nations such as Mexico, Russia, Indonesia and AfricaIndonesia and Africa

• Entrepreneurs who start new businesses Entrepreneurs who start new businesses sometimes find that the law force them out sometimes find that the law force them out of competition with the small number of so-of competition with the small number of so-called untouchable big men who have called untouchable big men who have cartelized the major sectors of the cartelized the major sectors of the governmentgovernment


• A government-supported cartel also A government-supported cartel also means higher prices, lower quality means higher prices, lower quality of service and less innovationof service and less innovation

Game Theory!Game Theory!

CartelsCartels

• A group of supplied who try to act as AS IF A group of supplied who try to act as AS IF they were a monopolistthey were a monopolist

• Example:Example:


• Example: Craps players make decisions, pokers Example: Craps players make decisions, pokers players make strategic decisionsplayers make strategic decisions

• Game theory is used to analyze cartels because Game theory is used to analyze cartels because the best decision of one cartel member depends the best decision of one cartel member depends on the decisions of every other cartel member on the decisions of every other cartel member which in turn depends on the decisions of every which in turn depends on the decisions of every other cartel memberother cartel member


• Also used to study war, romance, business Also used to study war, romance, business decisions, evolution, voting and other decisions, evolution, voting and other situations involving interactionssituations involving interactions

• Game theory is applied to the economics of Game theory is applied to the economics of network of goodsnetwork of goods


• Why did the price of oil more than triple Why did the price of oil more than triple in 1973-1974?in 1973-1974?


• Very few cartels can move in an Very few cartels can move in an industry from competition to pure industry from competition to pure monopolymonopoly

• OPEC seems to be all powerful but in OPEC seems to be all powerful but in reality, very few cartels arereality, very few cartels are


• Cartels tend to collapse due to three Cartels tend to collapse due to three reasons:reasons:


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

Logic of Cheating…..Logic of Cheating…..No CartelNo Cartel





100 MBD100 MBD


$36$36

Logic of Cheating…..Logic of Cheating…..CartelCartel





80 MBD80 MBD


$50$50

Logic of Cheating…..Logic of Cheating…..Cartel with One CheaterCartel with One Cheater






82 MBD82 MBD


$47.50$47.50


• The logic is simple, The logic is simple,

• What happens when nine countries cheat What happens when nine countries cheat and only one country keeps its promise?and only one country keeps its promise?

Logic of Cheating…..Logic of Cheating…..Cartel with Nine Cheaters and One Non-Cartel with Nine Cheaters and One Non-

CheaterCheater






98 MBD98 MBD


$37.50$37.50


• Cheating pays when other firms keep their Cheating pays when other firms keep their promise and cheating pays when other firms promise and cheating pays when other firms cheatcheat

• When a monopolist increases quantity When a monopolist increases quantity beyond the profit-maximizing quantity, the beyond the profit-maximizing quantity, the monopolist hurts itselfmonopolist hurts itself

The Payoff TableThe Payoff TableRussia’s StrategiesRussia’s Strategies


Saudi Saudi Arabia’s Arabia’s



CheatCheat ($500, $200)($500, $200) ($300, $300)($300, $300)

Russia’s Strategies

Cooperate Cheat

Saudi Arabia’s

Strategies

Cooperate ($400, $400) ($200, $500)

Cheat ($500, $200) ($300, $300)

The Payoff TableThe Payoff Table

• Dominant Strategy – Dominant Strategy –

The Prisoner’s DilemmaThe Prisoner’s Dilemma

• Ex:Ex:Japan’s StrategiesJapan’s Strategies


United United States’ States’



CheatCheat ($500, $200)($500, $200) ($300, $300)($300, $300)


• High prices of a cartel will attract new High prices of a cartel will attract new entrantsentrants

• These entrants do not feel bound by previous These entrants do not feel bound by previous agreementsagreements

• Cartels are more successful when there are Cartels are more successful when there are fewer substitutes for the cartelized good – fewer substitutes for the cartelized good – implies less elastic demandimplies less elastic demand


• With the ease of new entrants, it is With the ease of new entrants, it is easier to maintain a cartel in a natural easier to maintain a cartel in a natural resource than in a manufactured goodresource than in a manufactured good


• Natural resources are not the only Natural resources are not the only “thing” in limited supply“thing” in limited supply

• A cartel may control access to some key A cartel may control access to some key inputs that cannot be easily duplicatedinputs that cannot be easily duplicated

• Ex. Ex.


• NBA consists of 30 teamsNBA consists of 30 teams• Teams compete on the court but “collude” Teams compete on the court but “collude”

off the courtoff the court• They use the NBA league structure to keep They use the NBA league structure to keep

down player salaries – “salary cap”down player salaries – “salary cap”– If they do, face “the luxury tax”If they do, face “the luxury tax”

• Each team, when joining the NBA, agrees to Each team, when joining the NBA, agrees to limit how much spent on playerslimit how much spent on players

• Example of a buyer’s cartel – Example of a buyer’s cartel –


• Cartels have been illegal since ____________Cartels have been illegal since ____________________________________________________________• Governments don’t always prosecute cartels Governments don’t always prosecute cartels

and sometimes even support themand sometimes even support them• Most cartels operate with clear legal and Most cartels operate with clear legal and

governmental backinggovernmental backing• Examples:Examples:


• Government-enforced monopolies and Government-enforced monopolies and cartels are one of the most serious problems cartels are one of the most serious problems faxing poor nations such as Mexico, Russia, faxing poor nations such as Mexico, Russia, Indonesia and AfricaIndonesia and Africa

• Entrepreneurs who start new businesses Entrepreneurs who start new businesses sometimes find that the law force them out sometimes find that the law force them out of competition with the small number of so-of competition with the small number of so-called untouchable big men who have called untouchable big men who have cartelized the major sectors of the cartelized the major sectors of the governmentgovernment

Game Theory!. Cartels A group of suppliers who try to act together in order to reduce supply, raise...

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