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PROFESSOR: OK, so what we're going to do today is continue
our discussion of oligopoly which we started last time.
I want to return to the example we were using last
time to discuss the example of Cournot competition.
We started last time by talking about general game
theory and the prisoner's dilemma and the concept of
Nash equilibrium.
Then we turned to a specific example of a Cournot
competition, the way we can specifically model two firms
competing in a market.
And so if you recall the example from last time, we had
demand curve of the form p equals 339 minus q where this
is thousands of passengers per month.
And we had a marginal cost of $147.
And we have flat marginal cost, so average cost equals
marginal cost equals 147, equals average cost. So flat
marginal cost.
And what we said, so therefore if the firm was a monopolist,
if American Airlines say was a monopolist, they would set
marginal revenue equal to marginal cost which would be
339 minus 2q equals 147.
And so the monopolist was going to set a quantity of 96.
That was the monopolist quantity with the price.
So the quantity of monopolist is 96 and the price of
monopolist is $243.
So that was the monopoly case.
Something you should be very facile with for tomorrow night
is solving those kinds of monopoly problems. And then we
said, OK, but what if, in fact, it recognizes that it's
not a monopoly.
There's another firm in the market.
United is in the market as well.
Well in that case it has to consider its residual demand.
So in that case we said the qa, its residual demand, for
American was equal to the total market q minus the
quantity absorbed by United, qu.
And we showed last time what this leads to graphically.
And so we re-handed out figure 16-3 just to review.
The notion was that each firm develops a
best response curve.
Each firm says, based on what the other firm's going to do,
here is my best level of production.
Here's my profit maximizing level of production.
And each firm having developed a curve, there's an
equilibrium where those curves intersect because at that
point both firms are happy.
You've achieved your Nash equilibrium because at that
point both firms are satisfied with the strategy they're
playing given what the other firm's playing.
So that point of intersection, both firms' best response are
consistent with each other.
And that's we developed last time graphically.
Intuitively, I think it follows from the same logic,
the idea is we're playing this game and the game will only
have a stable outcome if we're both
satisfied with the outcome.
If we're not both satisfied we'll continue to change our
behavior and it won't be stable.
And so what I want to do now is talk about how we solve for
this mathematically.
So let's just think about the mathematics of solving for
Cournot equilibrium.
So what's the mathematics now?
What's American Airlines's residual demand function?
Well their price, p sub a, is equal to the total demand,
339, minus what they supply minus what United supplies.
So the price in the market, they don't have separate
prices, the price in the market is going to be 339
minus what each of them supplies.
So now American can't control q sub u, American has to take
that as an outside given factor.
That's what they're responding to.
So American says, I need to optimize this with respect to
what I can control which is q sub a.
So how does it do it?
Well, it computes marginal revenue.
Well marginal revenue is p times q sub a.
So that's 339qa minus qa squared minus quqa.
Just multiplying through.
That's their revenue function.
So marginal revenue, differentiating with respect
to qa which is all they can control, is going to be 339
minus 2qa minus qu.
That's going to be their residual
marginal revenue function.
And they're going to set this equal to marginal cost. So I'm
going to set marginal revenue equal to marginal cost. So
they're going to set this equal to 147 which is marginal
cost. And solving.
you get that qa equals 96 minus 1/2qu.
qa equals 96 minus 1/2qu.
Once again reviewing, what we're doing is we're saying we
set up their residual demand function.
We compute what that implies in terms of revenues.
We differentiate with respect to their control variable, q
sub a, to get a marginal revenue function.
You set that equal to marginal cost. And you solve for their
best response curve.
Essentially you just solve mathematically for the curve
you see here graphically.
You go to the graph and you look at American's best
response curve.
That is exactly this line.
When qu is 0, it intersects at 196.
When qu is 192, qa is 0.
So you can see we've just mathematically developed where
this best response curve comes from.
We've just solved for that mathematically through the
similar mathematics of monopoly profit maximization.
In this case we're essentially saying, imagine you're a
monopoly except for the stuff produced by the other guy.
That's the way to think about it.
Imagine you're a monopoly except for what the other guy
does and you get this best response function.
Now, since we set this problem up to be symmetric--
that is we said the marginal cost identical for both firms,
and the market demand applies to both firms--
since we set this up to be symmetrical, then we know that
we can also write a symmetrical best response
function for United, which is q sub u equals 96
minus 1/2 q sub a.
We can solve for this but there is a shortcut.
If it's symmetrical problem they'll have symmetrical best
response functions.
So we can just write the symmetrical
best response function.
And then we can find the equilibrium.
Remember the steps I went through last time.
Now we have n equations and n unknowns.
We have two equations and two unknowns.
We can just solve by plugging one into the other.
And we get that qa star equals qu star equals 64.
Which is in fact where these curves intersect.
So that's how I found the intersection of these curves
was solving mathematically for the optimal level of
production given what the other guy's doing.
And the price, what's the price?
Well the price is 339 minus q sub a minus q sub u.
So it's 339 minus 128 or 211.
So you end up with each firm producing 64,000
units a price of $211.
And this is the Cournot equilibrium.
Because it's on both firms' best response function.
Both firms are maximizing profits.
And in maximizing profits they both have chosen the same
point to produce and so you're done.
They're happy.
That's the Nash equilibrium.
Yeah.
AUDIENCE: So in the last lecture was
that game theory box.
And this would be the lower right hand box, correct?
PROFESSOR: That's a very good point, yes.
This is sort of like game theory but with a whole
distribution.
But in some sense it's like at each point you've
reached that point.
But I really wouldn't draw that parallel actually.
The parallel that's important from that is
the equilibrium concept.
The reason we choose the prisoner's dilemma instead of
choosing the equilibrium concept--
and the equilibrium concept is, you're in equilibrium when
each firm's dominant strategy yields an equilibrium outcome.
Here we've just taken that intuition and solved
mathematically for each firm's dominant strategy.
And that yields an equilibrium outcome.
AUDIENCE: That top left box, there's no way--
we shouldn't think about that at all?
PROFESSOR: No, actually it's a great segue to what I'll talk
about next which is a cooperative equilibrium.
So what we've solved for is we solved for a non-cooperative
equilibrium.
Where they're not cooperating.
So it's like the prisoner's dilemma in the sense they end
up in that lower corner.
But in some sense I think that parallel, I'm not sure how
much that helps other than thinking about the strategies
and about thinking that that's non-cooperative.
We want to turn to next what happens if they can cooperate.
But before I do so, two things.
First of all, these problems do not have to be symmetric.
I've just solved symmetric problem often, and you'll see
symmetric problems, that makes the math easier.
But they don't have to be.
American and United can be different and you could solve
the same math.
And in fact Perloff goes through an example like that.
Symmetry is not guaranteed in these problems, it's just a
feature of the way I set this up.
So this question is a great segue to the next topic, which
is what about cooperative equililbria.
Can't American and United get together and form a cartel?
Remember we talked in the prisoner's dilemma about how
that would be the best outcome if the two persons could just
trust each other.
Well here can't American and United just trust each other
and form a cartel?
And what they do here mathematically is pretty easy.
They would just say, look, let's get together and pretend
we're one firm.
Then let's act as that one firm monopoly would and split
the profits.
It's the way a cartel could work.
They could say let's get together, we'll produce as if
we're a monopoly and let's split the profits.
Well what would happen if they did that?
Well we know that the total monopoly production if they
had been a monopoly is 96.
So that's a big Q. The quantity for the market is 96
and the price if they're a monopoly is $243.
So what they did is they said, look, we'll each do 48
flights, for a total of 96 and we'll charge $243 and we'll
agree to do that.
But what would happen?
Well their profits to each firm would be their 48 flights
they do times the price they get minus the marginal cost.
Marginal cost is average cost here.
The price they get minus the marginal cost. That would mean
per firm the profits would be $4,608.
So each firm would make $4,608 in profits.
Actually that's four million.
This is in thousands, right.
So $4,608,000.
Let's compare that to the profits they made as Cournot
competitors.
Once again comparing the upper box to the lower box, going
back to the prisoner's dilemma.
I think that is actually useful to think about.
Let's compare that to what happened when they were
Cournot competitors.
When they were Cournot they each took 64 flights.
They each did more flights when they were competing, but
they only got to charge $211 with that same marginal cost.
So their profits as Cournot competitors
were $4,096,000 each.
So by monopolizing and splitting the market they
raised their profits by 12.5%, by an eighth.
Their profits went up by an eighth, by 12.5%, which is a
major jump in profits by getting together and forming
this cartel.
Just as the two prisoners were better off not ratting each
other out, they were both better off not
ratting each other out.
These guys are both better off getting together and forming a
cartel and splitting the profits, same logic.
So why don't we see these cartels everywhere?
Why do we have American and United, why don't
they just do this?
Well that's for two reasons.
Two reasons why we don't see these cartels everywhere.
The first reason, so why not cartels?
The first reason why we don't see cartels is there's a
fundamental instability.
Cooperative equilibria are fundamentally unstable because
any one party has an incentive to cheat.
Any one party in a cartel can make money by cheating because
they stick the other firms in the cartel.
So let's just talk about this for a second.
Imagine what would happen if American decided to cheat.
Imagine they had this cartel, it's running along, they're
each making their $4,608,000 per month profit.
They're all very happy.
Now imagine American says, wait a second, what if on the
sly I increase my number flights from 48 to 50?
What if I just did that and did it in a way which wasn't
immediately transparent to United?
So American takes its q sub a which was cranking along as 48
and it raised it to 50.
Well what happens?
Well if they do that the total quantity in the market instead
of being 96 rises to 98.
And if it rises to 98 that means the price is going to
fall, right?
This is not a price discriminating monopolist,
this is a one price monopolist. So if they want to
sell 98 flights, the price is going to have to fall.
So the price is going to fall to $241 from the
current level of $243.
Well you might say, gee American just shot
itself in the foot.
Its just lowered the price by selling more flights.
But look what happens to American's profits.
American's profits are now 50 times 241 minus 147 which
equals $4,700,000 which is higher than it
was making ib a cartel.
American just increased its profits to more than they were
making when they cartelized splitting the profits.
And what's happened to United?
So this is profits for American.
United's still doing 48 flights but the price has now
fallen to $241.
So United's profits fall to $4512.
United's profits fall.
American's profits go up.
So basically American has stuck it
to United by cheating.
It's raised its profits at the expense of United.
And why is that?
What's the intuition?
Well it goes back to our monopoly intuition.
Because when one firm cheats in a cartel it gets all the
benefit of the extra quantity, but only feels part of the
poisoning effect.
Remember when a monopolist increases its quantity.
It's got these two effects.
It sells more but poisons its previous sales.
Well here when American sells two more flights, it sells
more, it's got all that effect like a monopolist would, but
the poisoning effect is shared with United.
They don't feel as much pain from that price going down
because they're sharing that pain with United.
They get all of the benefit from quantity going up and
only part of the pain for price coming down.
And that's why it makes sense to cheat.
A monopolist would never cheat itself.
It'd make no sense for the monopolist suddenly to go from
96 to 98 and say, ha I've cheated myself because it
would feel the entire pain of the poisoning effect.
But American doesn't.
That's shared with United.
So it actually makes sense to cheat because they get all the
benefit of the more quantity and only part of the cost of
the lower price.
And that's intuitively what's going on.
Questions about that?
Well knowing this, clearly United says, wait a second, if
we form a cartel American will cheat.
So I'm going to cheat first and the
whole thing falls apart.
And we get back to the repeated game intuition we
talked about in our game theory lecture.
Where if they can commit to never cheat, if they can
commit to punish each other if they cheat, you might be able
to make this work in a repeated game, but only if the
repeated game never ends.
So if there's either not a repeated game, or it's a
repeated game with an end, then there's going to be
incentive for someone to cheat.
Once there's an incentive for someone to cheat, the whole
thing falls apart.
And that's why cartels are fundamentally unstable.
Now there's a second reason why we don't see cartels which
economists would always put second.
We always put the economic stuff first and the legal
stuff second.
The second is they're illegal, but we think that's less
important as economists because we think folks are
often smart enough to figure their way around laws.
Technically these are illegal.
In fact, in the late 1800s cartels were very
common in the US.
They were called the trusts.
There were trusts in sugar, railroads, other areas.
This is how these robber barons made all their money--
the Rockefellers and the Vanderbilts and stuff-- was by
building monopolies.
That's what made their money.
And then in the early 20th century Congress passed what
was called anti-trust laws which explicitly forbid the
creation of cartels or these kind of trusts.
So technically they're illegal.
In fact, there are lots of ways, and Perloff talks about
this in his book, there are lots of ways that firms can
implicitly cartelize.
There are ways that firms can say, look we'll get together
not under the government's auspices and we'll agree that
you raise your price and I'll do it two weeks later and look
like we're not a cartel.
I'm just following you, but in fact we've agreed to do it.
So there is some implicit cartelization and basically
that's why there's an anti-trust division exists
that's quite large.
The Department of Justice is basically to prosecute exactly
those cases when firms try to do that.
Now in fact, however, the government has a bit of blood
on its hands in this respect, because sometimes the
government actually promotes cartels even though it might
not mean to do so.
And the best example was the 1981 voluntary export
restraint policy, the Reagan administration.
1981 was the worst recession before this one.
Actually unemployment was higher than this one.
This is a very bad recession, but actually unemployment was
higher in 1981.
It was well over 10%.
And a big place where unemployment was high was in
the manufacturing sector, particularly auto
manufacturing.
We were getting killed by Japan.
Basically this was the first wave of Japan really producing
much better cars than the US.
And US car manufacturers were suffering
enormously as a result.
So basically the Reagan administration was trying to
figure out what to do about this.
One thing you could do, and we'll talk about in
international trade in a few lectures, you could impose a
quota and you could actually say to Japanese producers, you
can't sell in America.
But Reagan was a Republican.
And Republicans are for free trade.
And he really couldn't do that politically.
Plus economists have often said that's a bad idea.
And we'll talk about why that's a bad idea.
What Reagan did instead was said to the Japanese auto
manufacturers, look, I'm a charismatic guy.
I'm Ronald Reagan.
Why don't we get together in a room and I'll convince you to
just export less to America.
Let's have a voluntary export restraint agreement.
Where I'm not going to put on a quota, because that would be
bad, I'm going to actually suggest to you, I'm going to
make you an offer you can't refuse that you just export
less to the US.
It was basically a back door way of imposing a quota
without looking as politically bad as actually imposing one.
And in fact, Japanese automakers agreed to this and
reduced their sales of cars in the US.
Now why would they agree to this?
Now there's two explanations.
One is they could have thought if they didn't then a quota
was coming.
They could have said, look, this is kind of an olive
branch before they lower the hammer.
That's a really bad set of metaphors,
but you get the idea.
That basically look, if we don't do this, then he's going
to impose a quota.
The other is they could have said, thank you Ronald Reagan,
you've just formed a cartel for us.
We can't stop from competing against each other.
We can't stop cheating.
We'd like to form a cartel but we can't.
But you've told us we have to cartelize because you've
limited how much we can sell.
You've essentially said, look you can't sell more than this.
You have to agree to sell more than that.
You've essentially allowed us a framework where we can get
together and implicitly cartelize in a way where it's
hard to cheat because then we'd be violating the
agreement with America.
So basically what Reagan gave the Japanese was a cartel
enforcing device.
What American and United need is some way where American and
United can monitor each other to make sure they don't cheat.
That's what Reagan gave the Japanese.
Said, I'm going to report on how many cars are selling in
the US and you're going to agree to limit it to this.
And they're like, great, that gives us the tool we need to
enforce the cartel we wanted in the first place.
Thank you very much.
They made a ton of money.
American consumers lost out.
And I'll talk more about international trade on why
that happens.
But the bottom line is, this end up
being just like a quota.
The bad thing about quotas and things like this is that
essentially they raise prices and hurt American consumers.
And in this case they were bad for American consumers and
very good for Japanese producers.
We essentially increased profits for Japanese producers
which they used to develop better cars and then came in
later and killed us in the car market anyway.
So it was dynamically a pretty terrible policy.
So that's the legal issues around cartels.
Now what I want to do now is step back for a second and
say, we've now talked about three different kinds of
market forms. We've talked about perfect competition.
We've talked about monopoly.
And we've talked about oligopoly.
In particular, non-cooperative oligopoly which is a more
interesting case since within cartels it's going to be hard
to sustain.
Non cooperative oligopoly.
We've talked about three.
How do these compare?
So let's just do ourselves a little chart.
Let's consider the three cases.
We've got monopoly, oligopoly, and perfect
competition, three cases.
Let's ask how they compare on quantity and
on profits per firm.
Quantity produced in the market and profits per firm.
And let's do it for this American, United example.
Well we know the monopoly case, we told you that in the
monopoly case 96 units get produced in the market.
And the profits per firm are $4,608,000.
In the oligopoly case that's the Cournot case, in the
Cournot oligopoly case we said the total amount in the market
was 64 per firm or 128,000.
And the profits per firm were lower.
They were $4,096,000 per firm.
Now what about in perfect competition?
What's the quantity that's going to be sold, what's the
price going to be in perfect competition?
We haven't done perfect competition.
You can tell me.
You can just do that intuitively.
What's going to happen in this market if there's perfect
competition what's this price going to be?
Somebody raise their hand and tell me.
Yeah in the back.
AUDIENCE: [INAUDIBLE]
PROFESSOR: 147, because price equals marginal cost in
perfect competition.
So quantity would be 339 minus 147 or 192.
There will be 192 units sold.
And what will profits be?
Zero.
Zero profits in perfect competition.
With a flat marginal cost there will be zero profits
with perfect competition.
So we can now compare this and we could say, an oligopoly
case leads to less output and more profits than does perfect
competition.
And a monopoly case leads to even less output and even more
profits than does oligopoly.
And basically how do we think about welfare in this case.
Well to think about welfare you'd have to actually draw
the diagrams to compute producer and consumer surplus.
What I could draw and show you is basically social welfare is
highest in the perfect competition case, lowest in
the monopoly case, and we talked a couple times about
the deadweight loss of monopoly.
This is not a price
discriminating monopolist remember.
This is a one price monopolist so there's deadweight loss.
And it turns out if you write down the graph that it's in
between the oligopoly case.
Oligopolies cause some deadweight loss, it's worse
than perfect competition but better then monopoly in terms
of total welfare.
And in fact, the bottom line is, we can actually pretty
much tell what happens to welfare.
A shortcut for thinking about welfare
is to look at quantity.
Because remember what social welfare is about, what causes
deadweight loss, is trades that aren't made.
Under perfect competition every trade that has a
positive social surpluses is made.
So the closer the quantity produced comes to the perfect
competition level, the smaller will be the deadweight loss,
roughly speaking.
So it isn't always true, and you can find bizarre
deviations, but a good rule of thumb is that welfare, the
distortion of perfect competition will be
proportional to how much quantity falls relative to
perfect competition.
If quantity falls a lot relative to perfect
competition, that's going to be a big loss in welfare.
If quantity is falling just a little, it's going to be a
small loss in welfare.
And that goes back to that deadweight loss triangle.
About the fact that it's smallest right around the
perfect combination equilibrium and gets bigger as
you move further away.
So basically perfect combination is the best,
monopoly is the worst, oligopoly would be somewhere
in between.
This leads to the question.
I think you might look at this chart and ask yourself is
well, gee, does this sort of say that the number of firms
determines welfare?
You've got one firm, two firms, infinite firms so can
we make a more general statement about the role the
number of firms.
And it turns out the Cournot model we can.
Basically in the Cournot model, the more firms there
are, the closer you get to perfect competition.
In the Cournot model as n increases you approach perfect
competition.
And in particular, and the book does the math in this,
you don't need to know the math, it's more the intuition.
But the book shows that the markup in a market, price
minus marginal cost over price, in a Cournot market is
equal to 1 over n times the elasticity of demand.
That is that we've said before that markup was inversely
proportional to elasticity of demand.
I might have used a different letter, I might have used nu
for that elasticity.
But this is elasticity of demand.
I forget what letter I used last time.
Same elasticity I've been using.
So basically, we said before we had this equation, right?
We said markup was inversely proportional
to elasticity demand.
The more inelastic was the good, the higher market power
the monopolist had.
Well here we now divide by n.
So the point is, that for a given elasticity of demand the
more firms that are competing in the oligopolistic setting,
the closer and closer you're going to get to a zero mark-up
with a Cournot equilibrium.
So it's just this intuition you see from this table.
This is one firm.
Then oligopoly can imagine a number of branches.
This is oligopoly with two firms. You should be able to
show yourself.
If there were three firms, which you can solve, that's
three equations and three unknowns.
It's the same math we just did.
It's high school math.
You can do this if you just put in three firms, do three
equations and three unknowns, you get an even higher
quantity and so on.
So as the number of firms goes up you're going to move that
quantity up towards the perfect competition level and
profits will fall towards the zero that we get from perfect
competition.
And this is consistent with our rough notion.
We talked about extremes, about perfect competition
being lots of firms, the monopoly being one firm.
But this confirms the rough intuition of the more firms,
the more competition.
That's a good solid intuition.
Now this raises the interesting question about
should we ever allow the number of firms
in a market to shrink.
Should we ever allow the number of firms in
the market to shrink?
What we call that is we call that a merger.
You've all heard of mergers.
When two companies merge to form one company.
Well by the logic I just told you that's going to be bad.
I just said that the more firms you
have, the higher welfare.
The more you get towards perfect competition.
And yet mergers happen all the time.
The government does not stop them.
The government typically investigates them if they're
big mergers, the government would
typically investigate them.
But by and large they often let them go through.
Why is that?
Why should the government not stop all mergers?
And in particular, if anyone for extra credit, can anyone
tell me what concept we covered which would explain
why it might make sense to allow firms to merge.
Yeah.
AUDIENCE: The economy of scale.
PROFESSOR: Economies of scale, exactly.
That's the term I was looking for.
It could be that you have two firms that are producing
inefficiently relative to having combined production.
So you've got one plant that produces the left shoes and
one plant that produces the right shoes.
And that's not a good example because they wouldn't really
compete with each other.
But you know the point.
The point let's say you've got two firms competing with each
other and they're both running a plant at half capacity.
There's two separate plants running half capacity, much
more efficient to have them merge and have one plant run
at full capacity.
And yes, if they merged they would then be a monopolist,
but it's possible the cost efficiencies could be so high
a monopolist with lower marginal cost might be better
than oligopolist with higher marginal cost. This is kind of
like the patent example I did last lecture
or the lecture before.
Where I talked about how a patent could be a good thing
or a bad thing.
It depends on how much demand increases due to the patent.
It's the same notion here.
The tradeoff is on the one hand you get marginal cost
down by allowing a merger, on the other hand you reduce the
number of firms in the market by allowing a merger.
And there's that tradeoff.
You're going to raise each firm's mark-up ability but by
lowering marginal cost you might actually in essence,
might in the end lower the price.
And that's exactly what the Department of
Justice does every day.
And this is what is the hundreds of economists that
work for the Department of Justice do, they have quite an
interesting job.
They have to go ahead and evaluate these mergers.
People want to merge and they have to say, well which effect
is going to be larger.
How do we decide whether the savings from economies of
scale exceed the cost and increase market power?
And that's just an incredibly hard thing to do.
That turns out to be an incredibly hard thing to do.
And part of the reason it's hard is exactly comes back to
what I talked about when I talked about regulating
monopolies.
Because the data is controlled by the market participants.
And so you can have necessarily good data on what
it's going to do.
So a great example is hospitals.
Over the last 20 years there's been enormous mergers in the
hospital sector.
Even here in Boston we've seen huge mergers of things like
the Beth Israel and Deaconess hospitals merge.
Other hospitals merged.
These mergers were big and had to go before regulators.
And the hospitals rightly argue, look, there's huge
economies of scale in hospital production.
Partly because hospitals are rarely full.
They have to have excess capacity in case somebody
comes in injured.
They have to have an extra bed around.
They don't want people sleeping in the halls.
As a result, in a situation where you're rarely full,
where you're constantly under capacity, there could be huge
economies of scale from combining and using your
combined space more effectively.
So pretty compelling argument.
And for that reason, pretty plausible.
Most hospital mergers were allowed through.
Very few hospital mergers were rejected.
Well what happened?
It turns out the hospitals just lied.
They kept exactly the same production process they had
before the merger and just raised prices.
So in fact, Beth Israel and Deaconess each kept their
building just like they had before the merger.
They just charged more.
Essentially they just cartelized.
But the government let it go through.
And what we've done, essentially, is we're fooled
by the theory of these economies of scale, when in
fact there was nothing to force the companies to
necessarily do much to realize them.
We just allowed them to have market power.
So basically this is an incredibly tricky and
difficult issue in deciding whether to allow mergers or
not is basically evaluating whether in practice you'll see
the economies of scale that justify the
increased market power.
And that's why the Department of Justice has a hard job.
Questions about that?
One other point I want to make here is about the size the
market is, I've talked about how mathematically the size of
the market will lead to more competition.
There's also another reason, which is the bigger the
market, the harder to enforce a cartel.
If there's two players in the market and one cheats, the
other one has the first one whacked or something.
You know what's going on, you can keep an eye on each other,
you know who's to blame.
When there's lots of players in the market it becomes--
so let's say there was 10 airlines flying, it becomes
hard to figure out who's cheating.
Or more still, imagine the most important cartel in the
world which is OPEC.
The Organization of Petroleum Exporting Countries.
This is an organization of 20 plus countries who control the
world's oil supply.
But there's no good way of tracking who's
selling what oil.
We just know the total amount of oil sold out there.
So if a country like Venezuela run by some nutty guy decides
to cheat and throw a bunch of oil on the market, it's hard
for the other members of OPEC to actually view that.
OPEC's efficiency has varied over time.
At times OPEC has not done such a good job of controlling
the supply of oil in the world, at other times it has.
But basically the more players,
the harder it becomes.
And as a good example, which is the cartel to produce
mercury was an existing cartel.
Italy and Spain essentially had controlled the market to
sell mercury.
They had a very well functioning cartel.
Other countries entered and the cartel broke down.
So we can see this.
And this becomes a big issue in thinking about the benefits
of enforcing competition.
And becomes a big issue in government policy.
Here's another government policy issue which you may
followed lately which is the rare earths issue.
You guys all know as scientists better than I, the
importance of rare earths, but these are materials which are
very important for putting in cell phone
batteries and other things.
These are important new materials
for the modern economy.
The US used to be the dominant producer of rare earths and
then China turned out were able to produce it much more
efficiently, so we just let China take it.
So now 97% of the world's rare earths are produced in China.
China's now started saying things like, Japan we're mad
at you, we're not selling you rare earths, which is a huge,
huge problem.
And basically we've allowed China to essentially
monopolize this market.
Now we tend to think in economics it's a bad idea for
the government to subsidize businesses.
The government should just let the economy work and decide
what works.
But this may be a case where the government wants to say,
no, we are going to actually subsidize rare earths
production in America, to make sure on national security
grounds we have enough in case China decides to shut us off.
And that's exactly the kind of issue the government has to
face in terms of trying to decide whether or not to try
to actively get in there and promote competition versus
just letting the market work.
Questions about that?
Now I want to talk about one last thing before we stop,
which is the fact that Cournot competition is not the only
model of competition out there.
In fact it might not even be the first one
that comes to mind.
In fact, if I said to you, imagine two firms competing to
sell something, the first thing to come to your mind
would probably not be best response functions.
If you say, well they just compete over the price.
And if there was really tough competition the price would
just come down.
And the limit, if they're incredibly good competitors,
the price would have to come down close to marginal cost.
Well that is a different model of competition that we call
Bertrand or price competition.
Cournot competition is competition over quantities.
You get together and decide how much quantity to produce
given what the other guy is producing and then the market
gives you the price.
Bertrand competition is the flip of that, which is firms
set their price and they produce whatever the market
demands at that price.
Once again, Cournot competition is firms set their
quantity and then they set the price reading it
off a demand curve.
Bertrand competition is totally different.
They say, we're just going to compete over price and we'll
just produce whatever quantity you want at that price.
We don't really even care what demand is.
We're just going to compete over price.
And the idea is that you have some marginal cost that firms
will never go below in the long run.
And the question is how much will they compete down to that
marginal cost. In practice, what's crazy about Bertrand
competition is it's possible with two firms you can get to
the perfectly competitive outcome, with only two firms.
Because those two firms are competitive enough in setting
the price, they can fight it all the way down to the
marginal cost.
That is if I ever try set it to marginal cost plus $1,
you'll come in and set it to marginal cost plus $0.99,
because you can still make money.
Now I'll come and set it to marginal cost plus $0.98,
because I can still make money.
And we'll compete it all the way down until we both are
charging marginal cost plus a penny.
And if anyone tries to sell a higher price they can't sell
the product because people will only buy the
lower priced good.
So you could have a world with Bertrand competition where
essentially firms compete over price.
And where unlike this case, oh I just covered it up, unlike
our comparison where with two firms there's still lots of
profits to be made.
In Bertrand competition it's possible that two firms are
enough, just two firms are enough to get us to perfect
competition.
You don't need n firms. Two firms are enough.
And in some sense, if we thought about it, that's
probably the first model we have in mind if we thought
about firms competing is they compete over
where to set the price.
And that's essentially what the Bertrand model is.
So two questions about that.
The first is, well jeez, which model do we use?
How do we know whether it's Bertrand competition or
Cournot competition?
How do we know which model to use?
We've got a market with two firms in it, you tell us the
models are going to give very different answers, how do we
know which one to use?
And the answer is, basically we don't know which
one to use for sure.
We can talk about the conditions under which
quantity competition is more likely and under which price
competition is more likely.
Basically quantity competition is going to be more likely
when there's lags in the production process.
So that you can't flexibly say, here's my price, I'll
produce as much as I want.
If an airline said, I'm charging this, I'll fly as
many guys as I want, you can't do that.
You only have so many planes.
Airlines can't just set a price and then meet whatever
demand comes out.
Airlines have to actually sent a quantity.
They have to say there's this many flights we can do.
So when there's lags in the production process it's going
to be hard to do pure price competition.
It's going to be more like quantity competition.
That's going to be like airlines or cars.
On the other hand, take selling cereal at a
supermarket.
The supermarket if it runs out of cereal the next day it can
get a whole bunch more.
The supermarket can almost instantaneously replenish any
supply it's out of.
So there, you're more likely to see same price competition
between say cereals in the supermarket.
People can just compare very easily.
And if one's cheaper they'll just buy it up and if it runs
out the supermarket will just reload the next
day with that cereal.
Essentially it's pretty easy to meet quantity.
So this is not a very clean distinction.
But the bottom line is quantity competition is going
to be more likely when it's a hard good
to produce on demand.
And price competition more likely when it's an easy good
to do that.
That's how you're going to think about which kind of
competition makes the most sense in which context.
That's point one.
Point two, and the last point I want to make.
What can firms do to avoid Bertrand competition.
Let's say, for example, you're a cereal producer.
You're in a Bertrand market.
Well this is a shitty market to be in.
I just said two firms can drive your profits to zero.
What do you do?
What do cereal producers do?
Yeah.
AUDIENCE: Differentiate.
PROFESSOR: They product differentiate.
So the way to beat Bertrand competition is through product
differentiation.
Once your products are different, then you can price
above marginal cost. Then they're not perfect
substitutes anymore and you can price above marginal cost.
Have you ever asked yourself why the hell there's so many
kinds of cereal.
I mean have you been to the supermarket?
It's crazy.
Why are there so many kinds of toothpaste and shampoo.
It's all the same crap.
Why?
Because it's product differentiation.
It's to avoid Bertrand competition.
Because once you can differentiate,
you get market power.
Differentiation provides market power.
In the book, this is too detailed for the course, but
in the book Perloff talks about this as monopolistic
competition.
Which is sort of an odd oxymoron, right?
Monopolistic competition.
But these are models of differentiated products where
essentially you can say, look I'm different enough that
essentially I can charge a higher price than my
competitor.
This comes back the concept of contestable
markets we talked about.
The idea is that, look, if you're different you can
charge a little bit higher price.
Once it's too high people are going to switch back to the
other food.
But if you make it different enough,
people will pay something.
The most famous example is Apple Cinnamon Cheerios.
Cheerios have been around forever.
And what happened was people bought
Cheerios, it was very popular.
But then supermarkets started producing generic Cheerios.
And Cheerios are like pretty freaking easy to produce.
And it turned out they were identical.
And supermarkets charged like half as much
for the generic Cheerios.
And Kellogg's, no Kellogg's?
Not Kellogg's, the other one.
General Mills.
General Mills was all like, any of
you guys from Minnesota?
Mall of America has this cool General Mills thing in
Minnesota, I remember it.
So General Mills said, well gee, we're
getting killed here.
These generic Cheerios are going to wipe out our profits.
So they invented the Apple Cinnamon Cheerios.
And this was a product differentiation where
basically they could still charge a high price for Apple
Cinnamon Cheerios because it was different enough from the
generic cheerios the supermarket was making.
And they could patent them.
They could say, hey, we've got a different thing we can
patent our secret Apple Cinnamon formula.
So supermarkets now just can't copy us.
So for a while we get price greater than the marginal
cost. Or even if supermarkets can copy them, they at least
get for a while price above marginal cost until
supermarkets catch on and make the product.
So product differentiation is the way that firms fight
Bertrand price competition.
So is this bad?
Once again we don't know.
It depends how much you like Apple Cinnamon Cheerios.
Just like patents, it depends on whether the new good they
invented delivers sufficient extra consumer surplus that
it's worth the fact that they can market prices on it.
In fact, one of the most famous studies in this field
was done by my colleague Jerry Hausman, who actually measured
the demand curve for Apple Cinnamon Cheerios and the cost
of producing Apple Cinnamon Cheerios and found that the
introduction of Apple Cinnamon Cheerios raised consumer
welfare by $67 million a year.
That even though the prices were high because of product
differentiation, people were so happy with this wonderful
new taste, it shifted demand out so much that actually
consumer welfare went up.
Even though this was a tool introduced by the companies to
avoid price competition, which should make
consumers better off.
So it's all about these trade-offs between how much
does it make consumers better off versus how much more
market power does it give the producers.
And product differentiation is another example of that.
Why don't we stop there and we'll come back.
Good luck tomorrow night and we'll come back on Wednesday
and move on to factor markets.