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 collud