Fridman put this idea in what is known in game theory as Folk theorem :. The sustainability of the equation will depend mainly in two factors: the credibility of the threat of punishment, and the discount factor. The former is easily understood as a credible threat will ensure no deviations are made, and the latter is related with how much does each party value the profits obtained from the results of following a collusive strategy, compared to the possible profits of changing their strategy.
Firms in highly concentrated markets will tend to collude since all the profits will be distributed amongst fewer firms. Firms that compete with other firms over many markets can establish trigger strategies that can be applied in all these markets, which will create a more devastating punishment strategy.
If firms have different cost structures, the one with the lowest costs will be incentivised to lower its prices, and thus cause the other firm to have to exit the market.
In game theory , collusion agreements can be described using the extensive form , as depicted in the adjacent game tree.
In this case, two firms share the market, already colluding and maintaining high prices. Each firm can decide to stop colluding and start a price war, in order to increase their market share, even force the other to quit the market. Firm 1 can either keep colluding with firm 2, or start a price war. If firm 1 decides to keep colluding, firm 2 will need to make a decision. If they both agree to collude, they will get 5,5.
However, if one of them decides to start a price war, the set of payoffs will be either 4,3 or 3,4, depending on which one starts the war and therefore acquires a greater market share.
This result may change when considering repeated games , as seen before. Jun 4. Lope Gallego. Summary In this LP, we learn about how oligopolists can collude in order to maximise their profits, even though this agreement will not likely last. Also, we see what entry and exit barriers are, and how they affect the number of oligopolists in the market. Finally, we also learn about contestable markets, which mean competitive results can also be reached in oligopolistic markets.
The police offer each prisoner a bargain:. However, the resulting outcome is not Pareto-optimal. Both players would clearly have been better off if they had cooperated. For both players, the choice to betray the partner by confessing has strategic dominance in this situation; it is the better strategy for each player regardless of what the other player does.
This set of strategies is thus a Nash equilibrium in the game—no player would be better off by changing his or her strategy. As a result, all purely self-interested prisoners would betray each other, resulting in a two year prison sentence for both. This outcome is not Pareto optimal; it is clearly possible to improve the outcomes for both players through cooperation. If both players had denied the crime, they would each be serving only one year in prison.
However, the collective outcome would be improved if firms cooperated, and were thus able to maintain low production, high prices, and monopoly profits. Coca-Cola and Pepsi compete in an oligopoly, and thus are highly competitive against one another as they have limited other competitive threats. Considering the similarity of their products in the soft drink industry i. In such a scenario, there are a number of plausible reactions and outcomes.
If Coca-Cola reduces their prices, Pepsi may follow to ensure they do not lose market share. In this situation, defection results in a lose-lose. Which is to say that, due to the initial price reduction by Coca-Cola betrayal of status quo , both companies likely see reduced profit margins. The Cournot model, in which firms compete on output, and the Bertrand model, in which firms compete on price, describe duopoly dynamics.
A true duopoly is a specific type of oligopoly where only two producers exist in a market. There are two principle duopoly models: Cournot duopoly and Bertrand duopoly. Cournot duopoly is an economic model that describes an industry structure in which firms compete on output levels.
The model makes the following assumptions:. The Cournot model focuses on the production output decision of a single firm. For example, suppose that there are two firms in the market for toasters with a given demand function.
Firm A will determine the output of Firm B, hold it constant, and then determine the remainder of the market demand for toasters. Firm A will then determine its profit-maximizing output for that residual demand as if it were the entire market, and produce accordingly.
Firm B will be conducting similar calculations with respect to Firm A at the same time. The Bertrand model describes interactions among firms that compete on price. Firms set profit-maximizing prices in response to what they expect a competitor to charge. The model rests on the following assumptions:.
Pricing just below the other firm will obtain full market demand, though this choice is not optimal if the other firm is pricing below marginal cost, as this would result in negative profits.
If Firm B is setting the price below marginal cost, Firm A will set the price at marginal cost. If Firm B is setting the price above marginal cost but below monopoly price, then Firm A will set the price just below that of Firm B. If Firm B sets the price above monopoly price, Firm A will set the price at monopoly level. Bertrand Duopoly : The diagram shows the reaction function of a firm competing on price. Imagine if both firms set equal prices above marginal cost.
Each firm would get half the market at a higher than marginal cost price. However, by lowering prices just slightly, a firm could gain the whole market. As a result, both firms are tempted to lower prices as much as they can. However, it would be irrational to price below marginal cost, because the firm would make a loss.
Therefore, both firms will lower prices until they reach the marginal cost limit. According to this model, a duopoly will result in an outcome exactly equivalent to what prevails under perfect competition. Colluding to charge the monopoly price and supplying one half of the market each is the best that the firms could do in this scenario.
However, not colluding and charging the marginal cost, which is the non-cooperative outcome, is the only Nash equilibrium of this model. The accuracy of the Cournot or Bertrand model will vary from industry to industry. If capacity and output can be easily changed, Bertrand is generally a better model of duopoly competition. If output and capacity are difficult to adjust, then Cournot is generally a better model.
A cartel is an agreement among competing firms to collude in order to attain higher profits. Cartels usually occur in an oligopolistic industry, where the number of sellers is small and the products being traded are homogeneous.
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