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Collusion Essay Plan
- Module
- Principles Of Microeconomics
- Institution
- Loughborough University (LU)
Essay Plan on the topic of collusion in an oligopoly
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Introduction:- When a firm interacts repeatedly over time this can change incentives of the firms; firms
recognise interdependence and collude to act as a monopolist thus dampening competition
and raising prices
- What is a prisoner’s dilemma briefly: 2 criminals A and B have various payoffs depending on
whether they stay silent or confess; using normal form gives solution of Dominant Strategy
Nash equilibrium of (confess confess) even though payoffs higher for both A and B if both
stay silent
Main Body
- COMPETING DUOPOLISTS ARE EFFECTIVELY IN A PRISONERS DILEMMA;
- In Cournot model both firms have
incentive to each produce half of
monopoly output and hence share half
of monopoly profits each. However, if
this was agreed each would have
incentive to cheat on this agreement
to get to each firms best response
function to expand output and thus get
more profit.
- In Bertrand model both firms have
incentive to each charge the monopoly price and thus both get greater levels of profit as
they divide monopoly output between them equally. However again both also have an
incentive to undercut the price slightly onto their best response functions in order to sell to
the whole market.
- NECESSARY CONDITIONS FOR OLIGOPOLISTS TO COLLUDE:
1. Sellers must be aware of each other’s strategies; if firms are not aware then deviations
cannot be punished; firms may form cartels in order to check if each other are
conforming to the agreement
2. Sellers must interact repeatedly: incentive to deviate must have credible LR punishment;
usually in form of a price war where firms keep undercutting each other on price; if
game is played only once as seen by the original prisoners dilemma both firms will have
the incentive to deviate; however if game is played repeatedly firms can come up with
better strategy and collaborate as although there is incentive in SR to deviate in LR it is in
best interests to collaborate and avoid price war
- For an infinitely or indefinitely repeated game backwards induction cannot be used to solve:
- In an infinitely repeated game strategy (cooperate, cooperate) can be a Nash equilibrium if
there is no incentive to deviate from this grim trigger strategy
- Grim trigger strategy is where each firm plays cooperate as long as the other has always
done so; but if one person chooses to deviate then the firms go back to playing (deviate,
deviate) forever. Deviation triggers punishment and the punishment lasts forever.
- There is short term incentive to deviate while the other plays cooperate as a higher payoff
results (benefit in short term of 200-150 = 50) however there is long term punishment
where both play deviate instead of cooperating.
- Long term punishment for one period is 75 (150 – 75) however firms are punished forever
and so we need to get value of future payoffs in present value;
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