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12.4 Competition Versus Collusion: The Prisoners’ Dilemma

Collusion is an illegal method, but this process if followed by the firms, results in high profits. But to avoid the illegal means the companies prefer to follow a non-cooperative equilibrium, Nash equilibrium.

In this equilibrium, each company has to decide to set a price to draw more profits. Even the firms do mind to cooperate among themselves to set a price which will be profitable for both. Instead, if one company raises the price the other tends to lower it to grab higher shares of the market.

Deciding the price of the product or service in a competitive market is always uncertain. The first step is an assumption, hoping that the other firm will take some other measures. For instance, a firm may charge way lower expecting its competitor to raise the price to create collusion to gain profit. The other firm may choose to set the price of its product lesser than the former. Hence the later firm will gain profit.

These decisions are generally made from the demands curve. So the firms should be aware of on each move to gain profit. Hence there are different possibilities to consider.

The different ways, which help the firms to make decisions about setting the prices, are:

Payoff matrix: It is a table which is maintained and followed by the firms. This table contains all the different possibilities that can happen while setting the price. If the two firms are engaged in playing a non-cooperative game; each firm tries to take the best decisions while keeping the competitive company in account.

This table is called payoff matrix because it keeps a track of all the profits the company can earn while considering all the possible decisions made by its competitor. So, the firms maintain a table to keep track of the prices they need to set for the product.

The Prisoner’s dilemma: This situation particularly arrives when the firm owners are being arrested for may be collusion. But mostly this happens for oligopolistic firms. Now, if the people of the firm are arrested for collaborating in a crime, three conditions arise; assuming that the prisoners cannot maintain any communication.

The three conditions are:

  • Confession of both prisoners: If both the prisoners decide to confess about the crime and their partaking in it, both the prisoners will receive an equal prison time of five years.
  • Refuse to confess: If both the firms refuse to confess about the crime, it becomes a harder case for the prosecutors. The prisoners have the right to plea bargain, and then they will receive an equal prison time of two years.
  • One confesses: Among the two if one prisoner agrees to confess and the other refuses to confess; the one who confessed will receive a prison time for one year only. While, the one who refused to confess will serve ten years of prison time.

These three conditions make the situation dilemmatic for the prisoners. A table is maintained to track these possibilities. A payoff matrix table can also be used for this cause. The prisoners cannot talk to each other which make the situation more tough.

  • The prisoners may not trust each other.
  • The prisoners may refuse to cooperate among each other.
  • They are unable to discuss the situations between them.

All these dilemmas result in one year, two years or five years of prison time.

Oligopolistic firms tend to face such dilemmas. So these firms specially decide to compete passively and aggressively to avoid the collusion situation. They try to cooperate among themselves and maintain the current market shares, because if the competition leads any to collude then they may have to face prisoner’s dilemma.

12.5 Implications of the Prisoners’ Dilemma for Oligopolistic Pricing

The aggressive and passive competition among the oligopolistic firms can ruin the reputation and may even run out of business. But this outcome is not necessary. The prisoner’s dilemma can be avoided if the managers of the firm do not end up in prison.

To avoid it, the firm should revise the price set of its competitors and its own. With the help of payoff matrix table, the prices can be tracked and adjusted accordingly. The behaviours of the competitors can be observed and the respective measures can be taken.  This helps in maintaining the reputation of the company which helps the oligopolistic firms to prevail.

There are two options left for the managers of the firm. They may decide to cooperate among themselves and try to maintain a moderate high price which will fetch them respectable profit and the firms will also be able to hold the market shares. The managers may even want to compete aggressively and not cooperate, which leads to a collusive situation.

Sometimes the collusion war between the firms is short lived. The firms may compete by changing the prices, increasing the advertisements, etc.

Price rigidity:

This is a characteristic of oligopolistic firms. As collusion is a fragile situation and may result in prison time, so the firms try to maintain a stable price. The companies try not to change the prices even when there are changes in demand in the target market.

The firms do not intend to reduce the price regardless the market situations. They fear about their competitors that they may start reducing their price which may again lead to another price war. Likewise, they think that if the rise the price along with the rise of demands in the market, their opponent may stick to lower prices which may lead them to lose market shares.

Kinked demand curve of an oligopoly firm shows the demand curve for the current price. Beyond a particular price the curve of the graph shows elastic properties. The concept of price rigidity is based on the demand curve of this graph. Because the curve is kinked, the marginal revenue curve will show a discontinuous graph.

The graph is simple and is widely considered among firms, but it is not able to clearly explain theoretically how the oligopoly firm managed to reached the kinked price. It is helpful in describing the price rigidity of the firms.

So, a prisoner’s dilemma leads to avoidance of destructive competition among prices which brings the market situation to price rigidity. All this followed with uncertainty; that the firms cost can change but there may be no change in price which may make the firm run out of business.

Price signalling and price leadership

The main issue among the competing oligopoly firms is no communication. The aggressive price wars can be avoided if the firms agree to coordinate. But coordination seems to be a difficult term to follow when the market and demands are fluctuating.

But to avoid a collusive situation communication among the firms are demanding.  But when they cannot decide on a price, they announce their raised price. Announcement of raising the price of a product is a form of signalling, known as Price signalling. The firm communicates with its competitor through this way, and they hope that the other firm will understand this announcement as a signalling and will also raise its price. This is fruitful if the competitor raises its price all the firms earn higher profits from the market without competing.

Now, if a firm regularly keeps on announcing prices and the changes in the prices, its competitive firm may take it as price signalling every time and may change its prices accordingly. And it is called Price leadership. This is a simple method to avoid coordination problems.

A firm may be considered as a leader firm and on the announcements of its price changes the other firms follow the suit of the leader. Every firm charges the same as the leader, so there is no competition, there is no price wars. All the firms earn the same profits.

This process of price signalling and price leadership might lead to a lawsuit. But this can be avoided if the large firm naturally emerge and become a leader. It is the decision of the competitive firms, whether to follow the price leadership from the leader company or stick to its own price. The firm may also not decide to undercut the leader to avoid any aggressive price war.

Often it is seen that large companies may deny changing their prices. They may fear that the competitive firms may not follow their suit.  So despite of changing market status and demand curves they try to stick to their former prices to avoid such uncertainties. That time sometimes it is seen that other small firm may take up the lead. So price leadership can depend from time to time and from condition to condition.

The dominant firm model:

What is a dominant firm?

It is usually seen that in oligopolistic markets, may be one firm is holding some major shares of the total sales. While the other small firms hold the remaining shares. The major firm which is holding most part of the shares is known as dominant firm. When some firm act as such, the company holds the power so that it can set higher price to maximize the level of its profit.

There are two possible results of setting higher price by a dominant firm:

  • The smaller firms may accept the major firm as price leader, and follow the price suit.
  • They may stick to their own price and act as competitor firms.

So, the dominant firm often faces hurdles while setting high price. The firm should revise its demand curve.

12.6 Cartels

Cartel is an agreement and cooperation of producers, to set prices along with its output levels. It is not necessary for all producers who are present in the firm to join the cartel. Almost all cartels involve only the subset of producers of the firms. It is seen cartels are often international.

Considering that the market and demands are inelastic, the agreements reached in the cartels if maintained by the participating firms can fetch prices which are quite above competitive level.

Formation of collusion is prohibited by U.S antitrust laws but accepted by many other foreign countries. Therefore, prohibition from some countries does not hinder the formation of cartels in or by other countries. So, it is often seen that oil companies participate in cartels despite the illegal issues from its own country.

Cartels are generally formed by producers are to raise prices to a profitable level. But it is also seen that cartels also sometimes fail to raise price for some products; such as:

  • Copper
  • Tin
  • Coffee
  • Tea
  • Cocoa

The conditions for cartel success:

It is seen that some cartels proved to be fruitful while other proved as failure. But there are two clauses which may drive a cartel to success. They are:

  • The members participating in the cartels should agree and accept to the decisions and agreements. The producers are free to communicate among each other unlike the prisoners. So the members are free to formalize and assess the views and decisions of other firms. The firms may present different prices, different market readings, different demands, etc. So, all the readings are considered by each firms participating and they settle on an agreement.
  • The potential of attaining monopoly power of the firms in necessary to be considered. A cartel can easily solve organizational problems. If the graph of its demand curve is highly elastic then it is not possible to raise the price. But mostly it is seen that monopoly powers proves to bring success to the cartels.

Analysis of cartel pricing:

It is rarely seen that, few producers participate. A cartel is responsible for certain portion of its total production. Different response is considered while analysing the price of the product. It is decided by considering dominant firm model to set a price. Graphs are used to analyse the cartel pricing of OPEC and CIPEC.

Summary:

  • When monopolistic firms compete for different products, it becomes easier for other firms to enter and exit the market easily.
  • Firms having a small level of monopoly power, they eventually exit after they run out of profit.
  • Only oligopolistic firms are accountable for production in oligopolistic markets.
  • Cournot model of oligopoly suggests that all the oligopolistic firms make the decisions for outputs at the same time.
  • Firms following equilibrium are earning high profit.
  • The firm which follows Stackelberg model, it sets it output first.
  • The firm has strategic advantage and earns higher profit.
  • Firms should have the potential to earn higher profits if the firms collusively agree in raising prices.
  • Collusion is prohibited in many countries.
  • Prisoner’s dilemma results in price rigidity.
  • Price leadership signals other firms to follow their pricing suit.
  • Cartels are needed to be attended and there are conditions to gain success in cartels.

Questions for review

  • State the characteristics of monopoly companies.
  • What is the equilibrium price when a market introduces new product?
  • Why is the demand curve flat than total market demand curve in monopolistic firm?
  • Why is Cournot equilibrium stable?
  • Explain why it is advantageous to set output first in Stackelberg model.
  • State the common points between Cournot and Bertrand models.
  • Explain Nash equilibrium.
  • How price rigidity is explained by kinked demand curve?
  • State the reason for oligopolistic farms to be price leaders.
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