HKKK TMP 38E050

Markku Stenborg 2005

1
3. Cartels and Collusion
Competition less than jointly max profit firms have
incentives to avoid competition
These incentives are basis for competition policy
Explicit cartels, implicit tacit collusion
How would these show up in reaction fn picture?
Detect Cartels and Collusion?
Hard to do w/ econ alone
Lerner Index L = (p - c
i
)/p = s
i
/e?
If p, s
i
and e known, make inference on p - c
i
Often not practical: p, c
i
and e not known accurately enough
But with good enough data this can be done
Identical prices?
Not evidence for cartel
Perfect competition identical prices
HKKK TMP 38E050
Markku Stenborg 2005
2
3.1 Explicit Cartel
Intuition:
Few competitors easy to form cartel/collude
Many competitors hard to form cartel/collude
Selten (1973): 4 is few, 6 is many
Intuition: w/ 6 competitors staying outside cartel gives
more than joining cartel w/ 5 other firms
Result from 2-stage model:
1. Decide to join/stay out
2. Choose output
If n > 5, best strategy in stage 1 is to stay out
If n < 5, best strategy in stage 1 is join cartel
HKKK TMP 38E050
Markku Stenborg 2005
3
3.2 Tacit Collusion
Implicit agreement or understanding not to compete
Eg. firms "agree" on monopoly price and output
Unstable: cheating and undercutting gives even higher
profits than collusion, if rivals adher to agreement
Need mechanism to remove incentives for cheating

"Stick-and-Carrot" Theory:
Cheating draws punishment and low profits in future
Collusion draws rewards (high profits)
Deters from cheating on promise to fix prices
Future reward Collude now
Requires that future matter
HKKK TMP 38E050
Markku Stenborg 2005
4
3. Cartels and Collusion
How to punish?
Price war
Punishment will also hurt the punisher
Need incentives to punish

Collusion in Bertrand Competition
Read Motta Ch 4
Model: firms interact repeatedly
Assume c = 0, mkt demand q = a - bp
Per period profits now H
it
= p
it
q
it
(p
it
, p
jt
)
Bertrand equil price for one-shot game = 0
Each period t each firm chooses price p
it
knowing all previous
prices p
it-s
, s = 1,2,3,
No end-game problem: repeat per-period game infinitely
many times
Or: Prob(next period is last) < 1
HKKK TMP 38E050
Markku Stenborg 2005
5
3. Cartels and Collusion
Future matters but less than today: firms discount future
profits with discount factor 0 < o < 1
Owners of firms value m
t+1
= om
t


where r is discount (or interest) rate, P probability that game
ends after this period and k firm's marginal cost of capital
Firm goal: max present value of per-period profit stream
V
i
= E
t
o
t
t
i
t
Strategy?
Plan ahead how to play entire game
What per-period moves to choose after any history
Think: players desing strategy before game starts and
then leave computers to execute strategy
k
P
r

=
+
=
1
1
1
1
o
HKKK TMP 38E050
Markku Stenborg 2005
6
3. Cartels and Collusion
Examples of simple strategies:
One-shot Bertand price always
Tit-for-Tat: do today what rival did yesterday
p
i1
= p
M
; p
it
= p
M
if p
jt-1
= p
M
, else p
it
= 0
Equilibrium: No incentive to change strategy
Is "always one-shot Bertrand equil behavior" still an equil
strategy?
Yes: if i always chooses p
it
= 0, best j can do is to choose
p
jt
= 0 H
it
= 0
Both always charge monopoly price and earn H
it
= H
i
M
/2 > 0
equilibrium?
If j always charges p
jt
= p
M
, what should i do?
Look at rf: i should choose p
it
= p
M
- c
If i deviates from p
M
, it earns higher profits every period
H
i
D
= p
M
- c > p
M
/2 (D: deviate or defect), hence
V
i
D
= E
t
o
t
H
it
(p
i
D
,p
j
M
) > V
i
M
= E
t
o
t
H
it
(p
i
M
,p
j
M
)
HKKK TMP 38E050
Markku Stenborg 2005
7
3. Cartels and Collusion
Strategy always monopoly price is not in equilibrium
Grim Strategy (GS):
Choose p
i1
= p
M
Choose p
it
= p
M
if p
jt-1
= p
M
Else always choose p
it
= 0
Suppose j knows i plays GS; what is best for j?
GS is best reply (among others)
GS is a best reply against itself
Both firms using GS is an equilibrium
Punishment needs to be credible, otherwise it is only empty
threat
There must be incentives to start punishment
Punishment must be part of equilibrium path from that
moment onward, so that no firm will want to deviate
from punishment
One-shot Nash equil behavior always credible punishment
HKKK TMP 38E050
Markku Stenborg 2005
8
3. Cartels and Collusion
GS punishes defection forever
Punishment "too hard", lesser punishment suffices
Optimal punishment: shortest number of periods T such that
extra profits gained by defection are vanished
Stay on intended equil path: earn H
M
/2 each period
Temptation: gain H
M
- H
M
/2 - c = H
M
/2 - c during
defection
Punishment: earn zero profits long enough so that profits
(defect + punishment) < profits (collusion)
Minimum length of sufficient punishment depends on
discount factor o
Often optimal punishment is minimax strategy of per period
game, ie tougher than one-shot equil behavior
GS easy to use
Point here collusive outcome, not details how one supports
outcome
HKKK TMP 38E050
Markku Stenborg 2005
9
3. Cartels and Collusion
"Folk Therorem": Any outcome that leaves each player more
than one-shot minmax is sustainable as an equil outcome in
infinitely repeated game
There are many equilibrium strategies
"Anything" is in equil
No predictive power w/o more assumptions
Generally collusion is sustainable if temptation to defect is
low enough and punisment following the deviation strong
enough
Firm wants to keep colluding if present value of devi-ating is
smaller than present value of adhering to collusive
agreement
PV of collusion here
V
i
C
= E
t
o
t
H
it
(p
i
C
,p
j
C
) = p
i
C
/(1-o)
as E
t
d
t
= 1/(1-d) if |d| < 1
HKKK TMP 38E050
Markku Stenborg 2005
10
3. Cartels and Collusion
PV of deviation = profits reaped during deviation + present
value of profits earned during punishment:
V
i
D
= H
D
+ E
t
o
t
H
it
(p
i
P
,p
j
P
) = H
D
+ o p
i
P
/(1-o)
Note: here punishment assumed to be infinitely long
Collusion is sustainable if



Incentive to deviate depends on discount factor
If discount factor is too low to support collusion, either
toughen up punishment or try to lower degree of collusion
Longer or harder price war
Reduce collusive prices from monopoly price
Note: punisments are never observed
None used since threat is enough
1 1
C P D C
D i i i i
i
D P
i i

> + >

HKKK TMP 38E050

Markku Stenborg 2005
11
3. Cartels and Collusion
Homework
Assume duopoly, c=0, mkt demand q = 100 - p, and price
must be integer (100, 99, 98, ...)
Assume punishment: p
t
= 0 (= c)
What is optimal punishment strategy for
o = 0.5
o = 1
Need to find i) monopoly price and profits and ii)
optimal one-period defection for i if j charges
monopoly price
Then calculate how long price war needed to make
defection unprofitable
HKKK TMP 38E050
Markku Stenborg 2005
12
3. Cartels and Collusion
Collusion with Imperfect Information
What if firms cannot observe rivals' exact prices nor
quantities sold?
Don't know if rival defected don't know when to start
price war
No threat of price war collusion not sustainable?
Use other info: Sales were less than expected
Think Bertrand oligopoly with identical goods and with
stochastic demand
Firm has 0 demand today: somebody deviated and stole
customers or shift in demand?
Start price war when price or demand drops "enough"
Start price war even if you know nobody deviated, as
nobody has incentives to deviate
Intuition: no punishment no firm has incentives to
collude per period equil only possibility
HKKK TMP 38E050
Markku Stenborg 2005
13
3. Cartels and Collusion
Factors that Help Collusion
General idea: stronger, earlier and more certain punishment
increases possibilities to collusion
Topsy-Turvy principle: the more firms have
opportunities for aggressive competition, the less
competition there is
Public prices and other market transparency
Easy to observe deviation
Size of cartel
N equally sized firms
Each firm receives 1/N
th
share of total monopoly profits
Collusion sustainable if one shot defection followed by
punishment leaves less profits that staying on collusive
path:

o
<
1
) ( 1
) (
M M
M M
p Q p
N
p Q p
o
<
1
1
N
HKKK TMP 38E050
Markku Stenborg 2005
14
3. Cartels and Collusion
Product differentation works two ways
More products are differentiated, the larger price
decrease needed to
steal mkt share
punish deviator
More products are differentiated, less incentive to cheat
and try to steal mkt share
More products are differentiated, less price war by rivals
affects profits
Introduces non-price competition: more variables to
monitor and more ways to cheat
Cost conditions and capacity utilization
Capacity constraint or steeply rising MC reduce profit
margin for extra output
Reduce incentive to cheat
Reduces possibilities and incentives to punish
HKKK TMP 38E050
Markku Stenborg 2005
15
3. Cartels and Collusion
Free capacity
Increases temptation to cheat
Allows harsher punishment increases possibilities and
incentives to punish
Elasticity of firm demand
Inelastic firm demand more mkt share means
significant reduction in price less incentive to cheat
More elastic demand is, the harder it is to sustain
collusion
Multimarket contact
Firms produce several competing goods or operate on
several geographic mkts
More opportunities to cheat
Price war on all mkts allows more severe punishments

HKKK TMP 38E050
Markku Stenborg 2005
16
3. Cartels and Collusion
Firm symmetry
Firms have different shares of a specific asset (capital)
which affects marginal costs
Joint profit maximization: output is shifted away from
small (inefficient) firms towards large (efficient) firms
Smallest firm has highest potential to steal business of its
rivals and, has highest incentives to disrupt collusive
agreement
Incentives to deviate are reversed when equilibrium calls
for punishments
Largest firm loses most at punishment phase, it will have
highest incentives to deviate from punishment
Capacity constraints
Incentives to stay in collusive equilibrium are very
different for large and small firms
Small firm will have some incentive to cheat in short run,
as it can only increase its sales marginally up to capacity
level
HKKK TMP 38E050
Markku Stenborg 2005
17
3. Cartels and Collusion
Large firm has a lot more capacity available and can gain
more customers with same price deviation from collusive
norm
Large firms tend to have a greater incentive to
deviate from collusive price
Asymmetry in capacities will also have an important
effect on effective punishments
Worst punishment firm can impose on its competitors
is to produce up to full capacity
Small firm that is already producing at almost full
capacity has low possibilities to punish rivals that do
not follow collusive norm
Large firm competing with small firm will have large
incentives to deviate from any collusive norm without
this being disciplined threat of low prices in future
Increases in asymmetries in capacities make collusion
more difficult
HKKK TMP 38E050
Markku Stenborg 2005
18
3. Cartels and Collusion
Collusion and Antitrust
See Motta Ch 4, Europe Economics report, UPM/Haindl and
Gencor/Lonrho decisions, and browse my forest paper
Joint dominance and coordinated effects in legal jargon ~
collusion in econ jargon
Core of policy problem: Collusion arises as equilibrium
behavior
Hard to prohibit or deal with ex post
Solution: try to prevent collusion, ban business practices and
mergers that help to facilitate collusion see above
Analyses of asymmetry in assets and capacity constraints
suggest merger guidelines that differ from traditional
wisdom
For a given number of firms, Herfindahl and other
concentration tests predict that more symmetric industry
is more competitive
HKKK TMP 38E050
Markku Stenborg 2005
19
3. Cartels and Collusion
Asymmetry may be pro-competitive
Asymmetric industry may even more than compensate
for reduction in number of firms in merger involving large
firm
Increased asymmetry hurts collusion and may benefit
competition
How to identify collusion?
Possible to detect collusion from behavior alone?
Firms have more mkt power than one shot equil?
Estimate cost, demands and reaction fns and compare
actual behavior to non-cooperative and collusive equil
Doable, but gets technical with differentiated products
(see Nevo, Slade)
HKKK TMP 38E050
Markku Stenborg 2005
20
3. Cartels and Collusion
Detecting Collusion
Inferences about competition from price and quantity data
rest on assumptions on 1) demand, 2) costs, and 3) nature
of firms unobservable strategic interactions see Market
Power above
Demand specification plays critical role in competition
models
Demand position, shape and sensitivity to competitors
actions affects firms ability to price above cost
In oligopoly, supply behavior equation is aggregate first-
order condition for profit-maximization, not aggregate MC
curve
Mark-up = supply MC depends on firms competitive
interactions
Data can be consistent both with collusion and competition,
depending on demand and cost specification
Wrong model for demand and/or cost?
HKKK TMP 38E050
Markku Stenborg 2005
21
3. Cartels and Collusion
Example
Constant elasticity industry demand curve at each period t
[1] ln Q
t
= a e ln P
t
+ b Z
t
+ u
t
,
where e is demand elasticity, Z
t
vector of demand shifters
and u
t
error term
Constant elasticity variable cost function
C
i
(q
it
) = c
i
q
d
it
FOC for maximizing per period profits by choosing q
it
:
[2] p
t
(1 + e/u
it
) = c
i
q
d
it

where u
it
is CV parameter (Q
t
/q
it
) (q
it
/Q
t
)
Recall, for cartel u
it
= 1, u
it
= 1/N for symmetric Cournot
Observing u
it
close to one or much above 1/N indication for
collusion
We only observe (Q
t
,P
t
) pairs that solve true [1] and
[2], not functions themselves, so assumptions on
functions and stochastics (u
t
) matter