Game Theory and Oligopoly: Episode #26

This week’s episode is a little better than last week’s.  Crash Course does a good job of defining different kind of product markets out there, but could improve when talking about collusion and market substitutes.  Let’s get started:

The Prisoner’s Dilemma

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Suppose Stan and I are arrested for scrawling in wet cement outside the YouTube studios.  We’re being interviewed separately. If we both confess, we’ll both have to pay a $10,000 fine. If neither of us confesses, we’ll get off scot free. And If I take a deal and confess, but Stan doesn’t — I’ll walk away and Stan will owe $20,000. And vice versa.

This is not an appropriate example to show game theory.  In game theory, the result of confessing when your accomplice doesn’t confess should be greater than if neither of you confess.  If we were to tweak Crash Course’s example to make it work, if Adriene confessed and Stan didn’t, she would go free AND get $5000, making it a true dilemma between risking your freedom to get money.  In Crash Course’s scenario as is, neither prisoner would confess, since there is no extra incentive.

This is particularly strange because Crash Course actually gives a perfect example of the prisoner’s dilemma later in the episode when talking about bread pricing, which we’ll get to later.

Pricing and Product Differentiation

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If Craig lowers his price on Crash Course nesting dolls, Phil will likely compete by dropping his prices as well. In the end they’re gonna continue to share customers equally, and earn less money.

If Craig understands game theory, he knows there’s no reason to change his price. Instead he focuses on providing knick-knacks that differentiate his kiosk from Phil’s. This can help explain why prices in oligopolies tend to get stuck and why companies focus so much on non-price competition.

Crash Course often talks about price as if its determined arbitrarily by whims of the entrepreneur.  Businesses determine their price based on supply and demand, and are limited by a major factor: cost.  If Craig and Phil are selling the exact same good, and Craig can afford to sell his good at a lower price while Phil cannot, Phil needs to sell a different good, which in the hypothetical, is exactly what Phil does.

This is what Crash Course means when talking about non-price competition.  Companies often distinguish themselves by portraying their product to be original and having no substitute.  Think about how Apple markets the iPhone.  For a lot of Apple users, Android would not give them the same comfort and familiarity, and they are willing to pay more because they feel that they are getting more.  Android products give them a different (and to them, worse) experience that they won’t substitute for the iPhone.

Collusion

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What if Craig and Phil don’t compete at all? What if instead, they agree to charge the same high price, conspiring to form what economists call a cartel?  Again they split the customers 50/50, but now they make even more profit — benefiting at the expense of consumers.  This is called collusion, and it’s illegal in the US. There are strict antitrust laws designed to prevent it. But that doesn’t mean companies don’t figure out other ways to raise prices.

Some economists argue that collusion would not occur in the free market, since it would not benefit the companies as Crash Course implies.  Absent any government restrictions on entering the market, if all the companies agree to raise their prices together, it creates a greater incentive for a new competitor to enter the marketplace and charge a lower price. Those former market leaders might benefit in the short term (before the new competitor emerges), but they might not.  People might buy substitutes if the price is too high.

Crash Course makes this exact point, although much later in the episode:

Even if they collude and agree to price high, they both have an incentive to cheat on that agreement.  So collusion and cartels are often unstable. They can only last if the agreement is monitored and strictly enforced.

Price Leadership

Price leadership is when one company changes its prices, and its competitors have to decide if they’re going to follow suit. Since they’re not actively colluding, it’s technically legal.  But it can be hard to tell the difference.

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Look at airline baggage fees.  When some airlines started charging fees for checked bags, other airlines quickly joined them. And when one big airline changes their baggage fee, the others tend move to the same price point.  Are they colluding, or is this a case of price leadership?  Well, the Justice Department’s looking into it.

Why would all of the airlines agree to raise their prices at once?  Any potential gains in profit would likely be offset by the decline in the number of people priced out of the market.  Does Crash Course think airlines arbitrarily chose luggage as their outlet for charging more for no reason?  Could Crash Course give any other alternative explanation?

As we mentioned before, cost is a significant limitation in pricing.  If one passenger is creating less cost for the airline, the airline would be able to give them a cheaper price.  This is the case for luggage; it’s not that everyone with luggage has to pay more, but instead, airlines are separating the luggage cost from the ticket price, allowing some people to opt-out of paying for their luggage cost.  Previously, luggage costs were priced into the ticket, making the overall ticket price higher.  Do you recall which were the first airlines to charge for luggage?  They were budget airlines like Spirit and Frontier, those who market the most towards having a low price.

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Other countries’ laws differ, and cartels do exist. The best example is OPEC — The Organization of Petroleum Exporting Countries. It’s an international cartel made up of 12 oil-producing countries that manipulate oil supplies to control prices. They control 80% of the world’s known oil reserves and nearly half of the world’s crude oil production.

OPEC collusively raises prices (and sometimes, lowers their prices) to their own peril.  It takes longer for competitors and substitutes to enter the marketplace in energy markets, and OPEC may have benefitted at the outset, but the result was new competitors entering the markets (namely the fracking boom in the United States) as well as substitutes (more energy-efficient and electric cars were sold).  OPEC’s artificially high prices hurt both the consumers and OPEC itself, but the market adjusted to better meet the needs of consumers.

How Businesses Compete

The highlight of the episode is when Crash Course gives a perfect example of why businesses are incentivized to charge the lowest price for their goods.  As Crash Course explains, prices are determined by the predicted profit:

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If Brandon prices high, Stan’s best response is to price low and if Brandon prices low than Stan’s best response is, again, to price low. That’s called having a dominant strategy: it always gives the best available outcome, no matter what the other guy does.  For Brandon, pricing low is his dominant strategy too: regardless of what Stan does, pricing low always results in a better outcome.

Thanks for reading, and you can look forward to a new episode reviewed every Thursday! And don’t forget to join our newsletter and our facebook group, and comment below!

Tom Woods and Bob Murphy on Monopolies

Could this be timed any better?

Tom Woods and Bob Murphy talk about Monopolies and Competition in their podcast this week.  There is a lot of overlap with our post this past Thursday, and they explain antitrust law much differently (and perhaps, more persuasively) than I did, so do check it out here:

http://contrakrugman.com/ep-32-why-antitrust-is-the-problem-not-the-solution/

-Gary

Monopolies and Anti-Competitive Markets, Episode #25

Screen Shot 2016-04-21 at 1.01.28 PM   This week, Crash Course talks about monopolies and competition.  This episode was a mixed bag with plenty to comment on.  Let’s get to it:

Crash Course’s Episode Introduction

Before beginning each episode, the hosts of Crash Course give a quick introduction to the subject of this week’s video, followed by the opening credits.  This week’s introduction was a little confusing:

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Today we’re going to talk about monopolies! Which are terrible, illegal, and only serve to exploit helpless consumers, except when they’re delivering essential services that competitive free markets kind of fail to deliver.

So from this definition we can figure out that 1) monopolies would not occur in a free market and 2) monopolies are good for delivering essential services because free markets fail to provide them.  We’ve already talked about the concept of Market Failures in Episode 21.  In short, sometimes markets, despite being more efficient than the public sector, do not provide certain goods because governments already provide them for “free” (see: tax revenue).  For example, why would you pay for a more efficient private fire department when you’re already forced to pay for one?  The “free” public option distorts eliminates the incentive for entrepreneurs to enter the market.

The Good: Barriers to Entry

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The true power of a monopoly comes from its ability to keep competitors out of the market. Monopolies are able to erect obstacles that economists call barriers to entry.

Most economists would agree that the monopolies themselves cannot erect the barriers to entry;  existing barriers to entry are just a fact of the market.  However, governments can and do create barriers to entry, sometimes with influence from the monopolies.  Crash Course gives a great example of how this is done:

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Imagine a city where there are a limited number of licenses for food trucks, and I own all of them for my fleet of artisanal macaroni and cheese trucks. I also know the mayor, since he’s a big fan of artisanal macaroni and cheese. If I can convince the mayor to ban traditional push cart food vendors, with their shwarma and their bacon-wrapped hot dogs, I’ll have a monopoly on street food.  

I’m not increasing profit by producing more stuff. I’ve influenced government regulations in such a way that anyone who’s hungry, but doesn’t want to enter a building, has to buy food from me. This is sometimes called crony capitalism.

Crash Course’s example does not show the monopolies themselves creating barriers to entry for competitors, but rather using the power of the government regulation to crush competition.

The Bad: Freewheelin’ Monopolies

Monopolies can restrict output and charge higher prices without worrying about competitors. This is why most economists support anti-trust laws that promote competition and outlaw anticompetitive tactics.

This is the quick-and-easy justification for antitrust laws.  However, some schools of economic thought take issue with this.

These schools argue that as a company with monopoly power increases its prices (or restricts supply arbitrarily), the greater the incentive for a competitor to enter the market to provide the good for a lower price.  For example, if Google Search (which has a dominant market share) started charging $1 per search, it would encourage Bing, Yahoo, or a new competitor to move into that market.  This would apply to monopolies as well as oligopolies, so it does not matter how much market share a company has in the market, since there is always the threat of a new competitor entering, even if there are high barriers to entry.

In the above scenario, we are assuming that the companies are functioning in a free market, and that there are not any legal barriers to entry for the other companies.  If there is a law that there can only be so many search engine licenses, this would prevent new competitors from entering the market.

Examples of Bad Monopolistic Behavior

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In the late 1990s, Microsoft was accused of pressuring PC manufacturers to pre-install Microsoft’s web browser, Internet Explorer, and exclude their main browser competitor, Netscape. Regulators busted them, and almost busted up the company.

Companies in different markets often make deals with each other.  For example, Pepsi and Taco Bell agreed that only Pepsi products would be sold at Taco Bell.  Is this also monopolistic behavior?  And if Microsoft had a main browser competitor, then they wouldn’t be a monopoly, would they?

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Even Toys R Us! It’s gotten in trouble for conspiring with toy suppliers, like Hasbro and Mattel, to stop the manufacturers from selling certain toys to other stores.

Examples of exclusive deals between companies are numerous and simply a part of business relationships.  From Crash Course’s explanation, I do not see the difference between corporate contracts and bad monopolistic behavior.

“Natural” Monopolies

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Natural monopolies are special situations where it is more cost effective to have one large producer rather than several smaller competing firms. The best examples are public utilities in markets such as electricity, water, natural gas, and sewage. They may be privately owned or publicly owned but either way, they remain a monopoly because the government limits competition.

The better definition of a natural monopoly is one that exists because of high fixed or start up costs.  They are highly regulated and often completely managed by government.  Competition in these markets are usually not allowed.

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I mean, if there were three competing electric power companies in one city, that would mean building three different power plants, and running three sets of power lines through the streets.  The result would be higher costs. So, in this case, it would be cheaper to have one electric company because they have economies of scale.

I’ve mentioned this before, but since we don’t know what a free market in power would look like, everything is speculation.  Especially today with more people going off the power grid, we are seeing how the power market free from government monopolization would be, and it’s not as horrific as many speculate.

Competition encourages cost-lowering efficiency.  With an active market in power, companies would be competing with providing the best service for the cheapest price.  In the current market, the main incentive is to not attract any negative attention from the regulators.

that would mean building three different power plants, and running three sets of power lines through the streets

Are people really concerned with how many power plants exist or how many power lines there are?  If the argument is that fewer competitors creates a better market, these arguments are really grasping at straws here.  Why not make the same argument for automobiles?

Right now there are multiple factories producing cars and motorcycles, with multiple dealerships taking up space in every town.  Why not pass a law that only allows for one automotive producer?  It would save so much in cost!

While Crash Course did have some good nuggets in this episode, it failed to explain a coherent standard for when a central power should allow monopolies, create them, or destroy them.  As with most subjects, Crash Course sums things up with “monopolies are sometimes good, sometimes bad, but it’s complicated.”

The use of government force to regulate or manipulate businesses activity is significant, and there should be a division between “natural monopolies that occur in a free market” and “government-created monopolies” because the way an economist looks at them will be different depending on the monopoly.

Thanks for reading, and you can look forward to a new episode reviewed every Thursday! And don’t forget to join our newsletter and our facebook group, and comment below!

Revenue, Profits, and Price: Crash Course Economics #24

After last week’s more theoretical discussion on the what-ifs of the US education system, Crash Course comes back to hard textbook economics in week 24.  What’s even better is that this week’s topic falls within microeconomics, which is the most agreeable and least controversial area of economics.

Crash Course doesn’t make any objectionable comments in this video, but there are some points I’d like to flesh out, especially because I know it’ll be helpful when reviewing future episodes.  Let’s get to it:

Opportunity Costs

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Let’s say a lawyer stops practicing law and decides to open up a pizza parlor. Let’s say his total revenue from selling pizza is $50,000 and he has to pay $20,000 to cover stuff like the ingredients, the oven, rent, and wages. Now, an accountant would calculate his profit, the revenue minus the costs, as $30,000. Not bad. But an economist recognizes that there‘s a cost missing: the opportunity cost. Our pizza entrepreneur loses the income he would have earned by being a lawyer, let’s say $100,000. If you factor that in, he is actually losing $70,000.

The concept of opportunity costs is so fundamental to economics, it cannot be overstated.  Crash Course’s example is spot on here with the example of a private business owner.

However, this principle of opportunity cost might be even more important in public policy work.  When a government spends tax revenue on a particular project, it’s easy to look at the project and say “Wow, how great is this!  We didn’t have this thing before, and now we do!  Thanks government!”

The problem occurs when you think about all the other places the money could have gone.  For example, instead of building an expensive statue in town square, the city government could have built shelters for the homeless, fix the potholes in the street, or subsidize a local medical clinic.  Or even better (to many economists), the money could be left in the hands of taxpayers, and then they can decide where to spend their money (spoiler: it probably wouldn’t be on a statue).

This problem of opportunity costs for public projects only gets bigger if you look at larger governments.  For example, the US federal government spent $3 million to research obesity rates for lesbians.  Do you think that, maybe, the money could be better spent on just about anything else?

No economist does a better job at explaining opportunity cost than Frederic Bastiat in his Parable of the Broken Window.  If you aren’t familiar with it, do yourself a favor and check it out.  It’s still changing the way many people think about spending and opportunity cost, and it’s 150 years old.

Businesses and Marginal Cost

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Businesses use this same logic. They calculate their potential revenue and their costs of production, including implicit costs, to make informed decisions […] eventually, they’ll get to a point where hiring another worker only adds one more pizza to their hourly total. Now, the marginal cost of that last pizza is huge. And, it’s likely to be higher than the additional revenue the company is gonna get from selling that pizza.

Crash Course then moves on to talk about a different subject without reaching the obvious conclusion: the business would not hire that additional worker.

This principle of marginal cost will be very important when talking about the minimum wage, which will have its own episode.  Crash Course has already stated in a previous episode that some universal economic principles do not apply when talking about the minimum wage, so we’ll see how they reconcile their lessons on marginal cost and price floors with the minimum wage when we get to it.

Economic Profit, Normal Profit, and Competition

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So there’s actually two types of profit. Accounting profit, which is revenue minus just explicit costs, those traditional out-of-pocket costs you think of when you run a business. And there’s Economic profit which is revenue minus explicit and implicit costs — which is those indirect opportunity costs.

The idea of the two-profit system was a little confusing to me at first, and I still think it causes more confusion than helpful understanding of economics.  Basically, economic profit occurs when a business creates or dominates a market before other competitors enter the market to take away profit share.  Economic profit is zero when you have a competitive market, since it is theorized that normal profit will equal the opportunity cost of doing something else.  This is all pretty theoretical and not very helpful since it’s tough to think about a business’s opportunity cost (although it may be easy to determine a person’s opportunity cost), and the term “economic profit” is not used too frequently from what I’ve read.

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Competition will lower the price and reduce your sales.  New vendors will continue to enter until all that extra profit disappears […]

But remember, this is only in very competitive markets that have low barriers for entry. If it’s hard for other companies to enter a market than a business can earn economic profit.

Another great economic principle that Crash Course is citing here is that businesses will enter markets with good profitability.  Markets with good profitability are those will a sustainable demand for the goods, so if enough people buy a particular good, potential businesses will see the increased demand in the market and try to move in to compete for those profits.

But unlike Crash Course might be suggesting, this can also happen in markets with high capital barriers to entry.  For example, creating and manufacturing smart phones is very capital intensive, but yet there are currently numerous competitors in the market, each fighting for a share of the profit.  On the other hand, high regulatory barriers to entry are much harder to overcome and will reduce the number of competitors in the market.

This was a pretty great episode for Crash Course.  The rest of the episode on economies of scale, sunk costs, and marginal return are spot on and don’t require further comment.  This week was pretty unobjectionable, which is a relief for us at Crash Course Criticism.

Thanks for reading, and you can look forward to a new episode reviewed every Thursday! And don’t forget to join our newsletter and our facebook group, and comment below!