SESSION 7

1. SESSION 7 “Oligopoly: Co-operation and Non-co-operation”

2. INTRODUCTION/ PART 1 • 1.1 Causes of Oligopoly • 1.2 Types of Oligopoly • PART 2. NON CO-OPERATIVE BEHAVIOUR • 2.1 Introduction • 2.2 Price and Quantity Behaviour in Oligopoly • Cournot Model (Quantity) • Comparisons/Developments • 2.3 Bertrand Model (Price) • Comparisons/Developments PART 3. CO-OPERATIVE BEHAVIOUR 3.1 The Profit Max Cartel (Co-operation) 3.2 So why doesn’t everyone do it? 3.3 The chances of successful co-operation? CONCLUSIONS

3. INTRODUCTION & PART ONE Competition amongst the few, or ‘small numbers’. Basic distinction between homogeneous and heterogeneous ( i.e. differentiated) goods. Key feature is ‘strategic interdependence’---which refers to fact that the result (pay-off) of my decisions (e.g. price, R&D, advertising) now depend on the choices you make or might make and of course vice versa.

4. How might firms behave now and where will this lead? • (3 basic options ) • ignore the others, which is likely to be dangerous • recognise your mutual interdependence and seek co-operation (collusion), which is likely to be unstable because of the incentives for cheating • act alone (non-co-operation) but take into account the options available to the others when making your decisions, which is likely to be unpredictable • **Non-co-operation means studying behaviour involving ‘seeking to do your best in the light of what others are likely to do’, and this is complex.

5. NOTE: what we are interested in ultimately is where oligopoly type competition leads us in terms of price/output compared with monopoly and perfect comp. examined previously. That is to what extent do prices diverge from costs allowing above normal profits ?? We will see that it is difficult to be clear about this given the complex nature of oligopoly. Fig 8.1 (at lecture) to elaborate.

6. Fig. 8.1: Comparing mon, pc, and oligopoly outcomes a Pm c b Pc Ac/mc MR D Q

7. This is important with respect to Porter’s five forces model, the rivalry part. It tells us the outcome of rivalry is difficult to predict compared with monopoly or perfect competition. General implications for strategy development: how do you take into account the likely actions of others as you develop your strategic options. Too often strategy development ignores this crucial issue. For example, it makes little sense for a company to decide to ‘move upmarket’ without considering whether its rivals might be considering exactly the same move. Or to go for cost leadership. Or whatever. Which is possible if they do the same sort of strategic analysis as you!

8. 1.1 Causes of Oligopoly A brief discussion of the factors which determine industry structure. Structure is evolutionary, and changes over time for a variety of reasons. Technology is fundamental factor, because it influences optimal firm size, but deliberate actions by firms also matter. Most apparent are actions like mergers and acquisitions, and actions to deter entry as examined earlier. Finally government actions are often important. Promoting mergers sometimes and preventing them at other times or limiting the behaviour of dominant firms such as Microsoft.

9. 1.2 Types of Oligopoly The various types of oligopoly discussed. homogeneous product type: oil, aluminium, cement, and other ‘commodity’ products, more or less perfect substitutes heterogeneous types (three), 1. product differentiation and branding of technically similar products such as colas and soap powders to make them imperfect substitutes. Advertising a competitive weapon.

10. 1.2 Types of Oligopoly (cont.) 2. ongoing product development type, where quality and features develop over time, such as autos, civil aircraft and pc’s, and products are imperfect subs. Product development as a competitive weapon. 3. innovation based oligopolies. competition on the basis of introduction of new products, pharmaceuticals and defence equipment. R&D as a competitive weapon. **Key point is that competition is about advertising, product development, and R&D as well as price and output, but we cannot go into all of these dimensions in this introduction.

11. PART TWO/ NON CO-OPERATIVE OLIGOPOLY In this case, each enterprise searches to maximise its own profits,in the light of the options available to its competitors and their possible actions. Several simple models can be developed by varying the assumptions concerning the enterprises and their beliefs or conjectures about one another.

12. PART TWO/ NON CO-OPERATIVE OLIGOPOLY (cont.) Two of the simplest models are worth considering because… 1. They lead to very different outcomes (demonstrating that small changes in our assumptions can lead to big differences in outcomes). 2. They suggest that non-co-operative oligopoly can be bad for profits.

13. COURNOT BASICS EXPLAINED Two firms (1 and 2) choose how much to produce (e.g. what capacity to build?). Ford/GM…Iran/Iraq…Sheraton/Holiday Inn P (industry) = f (q1,q2) P (one) = f (q1,q2) and P (two) = f (q2,q1)

14. COURNOT BASICS EXPLAINED (cont.) Firm one chooses its output to max its profits, and firm two has to do the same, but there can be no co-operation by assumption. NOTE: We are assuming simultaneous decisions. Sequential decisions will be considered later. Firm one makes its choice on the basis of the following logic: What is my profit maximising output IF firm two chooses to produce x units of output? And firm two does the same. Where does this lead? See diagram explanation in lecture.

15. The Cournot case q2 Quantity chosen by f1 given q choices of f2 q1

16. The Cournot case Quantity choices of f2 given q choices of f1 q2 q1

17. The Cournot case, the euilibrium outcome. Only at the intersection are both doing their best GIVEN what the other firm is doing. q2 q1

18. COURNOT BASICS EXPLAINED (cont.) Each firm knows that its own output affects its own profits, that is the more it produces the lower will be the industry price, but each forgets that its output choice also affects the profits of its rival(s). So each enterprise chooses to produce more output than is sensible for the industry as a whole…this adversely affects the profits of both. Remember what is sensible for each is to produce half the monopoly level of output because this would maximise industry profits. And each then gets a half of these profits.

19. COURNOT BASICS EXPLAINED (cont.) But acting independently means that theses firms cannot achieve the sensible level of output. Each has to figure out what is best for them given what the other might do. And when they do this the outcome must be more output than the monopoly level, lower prices, and lower joint profits. So going it alone can’t be as good as co-operating.

20. COURNOT BASICS EXPLAINED (cont.) Also it can be shown that as the number of enterprises increases from 2 to 7/or 8 profits decline to the normal competitive level. So it doesn’t take a lot of firms to produce a competitive outcome in a Cournot world. What is the strategic significance of this? Looking at some key industries, such as autos, supermarkets and computer chips, what do we observe?

21. COURNOT BASICS EXPLAINED (cont.) A strong tendency to over-capacity and squeezed profits. Each firm is planning capacity on the basis of doing its best given what the others are likely to do…but this is leading to excess capacity, weak industry prices and poor to negligible profits. Can this be avoided? Is co-operation and collusion a way out? We will see… Are mergers and acquisitions a way out? By reducing the number of firms involved? Perhaps helps to explain their popularity...

22. COURNOT BASICS EXPLAINED (cont.) Note: We are assuming simultaneous decisions. Sequential decisions, where one firm moves first, produce a different result. Not surprisingly in this case (called the Stackleberg case) the first mover benefits at the expense of the follower. It will produce more of the industries output and grab more of the profits.

23. COURNOT BASICS EXPLAINED (cont.) The strategic importance of this result is as follows: If you want to do better you have to move early to commit resources to production. This reduces the options available to the competition and, assuming they are rational, they will have to accept being second best. But of course there are risks involved in moving first also (remember saying: act in haste, repent in leisure). First moving can mean moving too early, before enough information is available about tastes and technologies for good decisions.

24. COURNOT BASICS EXPLAINED (cont.) Some first movers do ok, but not all first movers stay ahead. Often second movers become industry leaders. Plus there is another problem. What if both firms think they are the natural leader, or first mover, and neither accepts the follower role. Both think the game is sequential but it isn’t. See a problem. Lesson is, make sure you know the game you are in before you make a serious move. Is it chess or poker or bridge?

25. BERTRAND BASICS EXPLAINED Two firms producing a homogeneous product (oil, cement) now choose to set their prices (not their outputs) and to let the market decide what level of production can be sold at that price. Each still wants to max. its own profits. And each needs to take account of the possible actions of the other(s).

26. BERTRAND BASICS EXPLAINED (cont.) Consider the logic of the first firm. It argues that for any given price (p2) set by firm two, its own best (profit max.) price will be just below this level. Because? But the second firm also thinks that its best price is a price just below any price that might be set by firm one.

27. BERTRAND BASICS EXPLAINED (cont.) So the only stable (equilibrium) outcome, where both are doing their best given what the other is doing... is one where price equals the competitive level and above normal profits are squeezed to zero. Because at any other price one firm feels it can do better by reducing its price. It isn’t worried about the industry, only about itself. It is trying to do the best it can do given what the others might be doing. So with just two firms we get a competitive outcome!

28. GETTING ROUND THE BERTRAND TRAP The importance of differentiating the product. If the enterprises concerned can convincingly differentiate the product this may allow them a way out of the destructive logic of price competition. This is no doubt why firms in industries like oil and soap powder and tobacco and airline travel spend heavily on differentiation activity. With differentiation the logic of the firms changes from mutually destructive price cutting to a situation where higher prices are possible and so above normal profits can prevail.

29. GETTING ROUND THE BERTRAND TRAP (cont.) The logic involved this time is like this (intuitive version). With different products, Sales (firm one) = f (p1, p2) So profits (firm one) will be a function of both prices. Sales will fall as you raise your own price but not to the extent that you lose all customers, assuming consumers are convinced by the differences,

30. GETTING ROUND THE BERTRAND TRAP (cont.) But sales will rise as your rival raises its price because you will gain some sales (and vice versa for your rivals). So if you are doing your best given what the other firm might do, then your profit max. price will now be an increasing function of that of your rivals, and vice versa. This leads to a predicted outcome where prices are above the competitive level and profits are above normal. So differentiation works as long as the costs involved do not soak up the healthier industry profits available.

31. PART 3: CO-OPERATIVE BEHAVIOUR 3.1 Co-operation and the Profit Maximising Cartel Intuitively it seems likely that co-op is better than not. Co-op allows firms (or countries as in case of OPEC) to act AS IF there was a monopoly and thus to set a monopoly price and share monopoly profits. But if this is the case everyone would do it. So why don’t they? Because there are costs involved as well as benefits. First, explain the profit maximising cartel. This allows for monopoly prices and for stability, better investment and employment planning. Takes the guesswork out of oligopoly (see fig 8.2 next ).

32. Fig 8.2:The perfect cartel P Pm Ac/mc Pc D MR Qc Qm Q

33. PART 3: CO-OPERATIVE BEHAVIOUR 3.1 Co-operation and Profit Maximising Cartel (cont.) The precise gap between the co-operative and the non-co-operative solution will depend on many factors, such as how good the cartels information is, but in essence successful co-operation is likely to be better than non-co-operation.

34. 3.2 If co-operation is so good why doesn’t everyone do it? Why isn’t every oligopoly effectively cartelised? Discuss.

35. Answers… 1. Owners/ managers feel they can win the comp battle outright and so co-op would protect the weak from their strengths, the hubris effect (which may lead to nemesis of course). 2. It is likely to be against the law in many countries, although not in all, and of course national laws can’t stop international cartels such as OPEC and the De Beers CSO. Why might governments make co-operation against the law? (text chap 13 discusses.) . 3. Cartels have to operate so that benefits exceed costs. Costs include negotiation, contracting, monitoring, enforcing, and these can be high if cartels are against the law because written contracts would then be dangerous and unenforceable in the courts.

36. Answers…(cont.) Two factors in particular that influence the cost-benefit calculation… 4. FIRST the cartel has to be able to keep new entrants out. Otherwise the cartels profits will attract competition and lower profits again. OPEC was successful for a while until oil companies found new sources- in the North Sea, in Alaska, in Asia, places where it became attractive to look for oil basically because of the high prices set by OPEC. Professional organisations such as doctors and lawyers usually operate a licensing system which allows some control over entry, although this might not be its intention, or so they say.

37. Answers…(cont.) The issue of cheating... 5. SECOND the cartel has to be able to control cheating by its members. Which isn’t so easy. Because at the cartel price, cheating is very attractive for each individual member. The cartel quota allocation is not a profit max output for the individual firm. If everyone else is honest and sticks, it pays you to cheat. If the others aren’t honest why should you be! So why should anyone stick to the cartel agreement?

38. Herein lies the problem of cartel instability... Agreements are made in good faith, but everyone knows that each member has an incentive to cheat and is likely to do so if they think they can get away with it. And this raises the costs of monitoring and enforcement. The problem of cheating may be considered using the famous ‘prisoner’s dilemma’ game. NOTE: box 8.5 in the text book gives the formal analysis. This shows how self interest can dominate the benefits of co-operation. And it is a fairly universal result.

39. So now consider... What determines the chances of successful co-op? Please discuss…(answers to follow)

40. 3.3 The chances of successful co-operation Depends on 3 factors: a. The temptation to cheat... Which is related to the rewards available and these vary with the nature and circumstances of the industry. Eg in high fixed cost industries the temptation to cheat during a period of slack can be very strong particularly if assets are hard to resell for a decent price (ie costs are sunk).

41. We can consider cheating a bit more fully. What if the PD game is repeated rather than just one off? Does that alter the calculations of those involved? It might do. Because then cheaters have to take retaliation into account. That is if I cheat today, you cheat tomorrow, tit for tat, and my short period gain costs me in the long term. This can be analysed in the co-operation game (see textbook). So does repetition and the use of tit for tat strategies breed good behaviour? Or does familiarity breed contempt?

42. Co-operation, cheating and retaliation. Game theorists argue thus. If the number of periods over which the game is played is know, then repetition makes no difference. People will cheat. Only if the number of periods is infinite or unknown will co-operation be more likely. The logic is outlined in the PS text. Along with the example of Saudi Arabia threatening tit for tat pricing against the cheaters in OPEC.

43. b. The chances of detection… Depends essentially on the costs of detection . If it is difficult to detect cheating it is more likely to happen, just like shoplifting. Difficult to catalogue all the factors involved, here are some possibilities: - the number of customers - the propensity of customers to switch suppliers - the visibility and transparency of contracts

44. c. The chances of effective punishment… If punishment is possible cheating is less likely...what determines the possibilities? 1. The legality of co-operation. If legal, contracts are possible and thus legal enforcement is possible. One of the case studies you may come across in business policy is about champagne where a powerful cartel existed without any legal problems. Enforcement is difficult without legal backing although this doesn’t worry the so called Colombian drugs cartel. Why might this be ? 2. The nature of the colluders. Drug dealers possibly make better colluders than do car manufacturers. Collusion amongst different nations such as coffee producers is hard compared to other cases because no effective punishment is available except exclusion from the cartel. 3. The sociology of the industry. A strong social environment with close ties amongst producers as in champagne or whisky. More difficult for the OPEC members although the Arab countries tend to be more disciplined than the non Arab countries in OPEC.

45. CONCLUSION Oligopoly involves strategic interdependence and this makes it more difficult to understand and analyse. We have examined two approaches, non-co-operative and co-operative.

46. CONCLUSION (cont.) The result of the non-co-operative approach is that the outcome is sensitive to changes in the underlying characteristic being assumed. Arguably, however, because we have only looked at a few possible cases, oligopoly does allow for positive profits to exist. The co-op approach examines the attractions of co-op and the difficulties involved in achieving successful co-op. This suggests that oligopoly industries might move between periods of stability and instability. The key factors making co-operation a problem are legal restraints and cheating. We considered the chances of successful co-op and the factors which influence the temptations to cheat and the chances of detection.

47. CONCLUSION (cont.) There are no simple answers for oligopoly. Profits can be anywhere from the competitive level to the monopolistic level depending on the case involved. Describing the attractiveness of industries in structural terms is thus more difficult than it seems. For example you can’t say categorically that an industry with two firms is always more attractive than one with four. Or that a homogeneous product industry is categorically less attractive than one where differentiation is possible. You can say co-operation will generally be better than going it alone, but as we have seen co-operation isn’t always feasible.

48. Team tasks 7 • What are the fundamental characteristics of oligopoly? • Describe the main enterprises involved in your case study industry and the nature of rivalry in that industry? (price, advertising and branding, R&D?) • Explain the attractions of co-operation for oligopolistic enterprises. • Why is it usually difficult to achieve co-operation? • Is there any evidence of co-operation in your case industry? What form does it take? • If there is none, why might this be? • Assuming co-operation was not possible where would this lead in terms of industry attractiveness? (Think of Cournot et al here) • How might the enterprises attempt to make the industry more attractive other than by co-operation?