Table of contents
2. The Price Leader in the Oligopoly
3. How Prices are determined
3.1. Influences on the Surpluses and Welfare
4. Absence of the Bertrand-Nash Equilibrium
5. Punishment in the Cartel
6. Product Introduction
6.1. Applied Game Theory
The US automobile industry is a good example of an oligopoly. It consists mainly of three major firms, General Motors (GM), Ford, and Chrysler. The influence of this oligopoly can be seen in the prices and the development and introduction of new car models into the American car market. Extensive work has been done on the field of collusive behaviour in the US automobile market and moreover the introduction of the small car in the 1950s shows how the firms collude when it comes to the introduction of a new car.
This paper will show which firm is the price leader in the GM, Ford, and Chrysler oligopoly and explain how prices are determined, in this step there will be drawn a comparison between the surpluses and welfares in this oligopoly and a perfect competition. Then it will be analysed why there cannot be found a Bertrand-Nash Equilibrium. The oligopoly in the American automobile industry is collusive, because of that, it will after that be pointed out how price cheaters are punished in that cartel. Finally the underlying decisions of an introduction of a new car model will be examined and the game theory will be applied to that.
2. The Price Leader in the Oligopoly
In the oligopoly of the American automobile industry a vivid dynamic between price leaders and price followers can be found. Here the example of the pricing decisions between 1965 and 1971 shows strong evidence that General Motors is the price leader in this oligopoly (Boyle & Hogarty, 1975). In this time span Chrysler always announced its price increases first, after that General Motors announced a price increase which was smaller than Chrysler’s. General Motors’ move then led to Chrysler reducing its own price to be roughly the same as General Motors’ (Boyle & Hogarty, 1975). Boyle and Hogarty (1975) do not mention explicitly how Ford behaved in that pricing arrangement but it can be assumed that Ford is a price follower who in the end copies General Motors’ chosen price.
3. How Prices are determined
Now after having explained the relationships and the pricing behaviour in this cartel, the next step is to show how the amounts of the prices are chosen. It is clear that there is a difference between how prices are chosen in perfect competition markets and the oligopolistic market. In perfect competitions the market participants can maximise their profit by producing the quantity where the marginal costs of producing a unit is equal to the market price which itself is equal to the marginal revenue. This yields to the fact that the market is efficient and competitive because the market participant just charges the price where economic profit is zero. In contrast to that, the collusive companies of General Motors, Ford, and Chrysler are trying to avoid this competitiveness in the market by pricing jointly (Bresnahan, 1987). The oligopolists act like a single monopolist when it comes to pricing decisions and want to maximise the joint profit instead of the firm’s single profit (Bresnahan, 1987). This pricing decision leads to the result that the collusive price is way above the marginal costs at this quantity, so maximising the profit of the single companies to be as the maximised profit in the perfect competitive market (Bresnahan, 1987).
3.1. Influences on the Surpluses and Welfare
This collusive price setting behaviour leads, as usual in oligopolies or in this specific case of oligopolists acting like one single monopolist, to a loss in total welfare and in the consumer surplus. At the same time there is an increase in producer surplus because the price in the collusive oligopoly acts like a mark-up on the price-quantity equation of equalising marginal costs with marginal revenues. In figures, the collusive price generates a produce surplus of $4billion in each year, while the loss of the consumers is $7billion in each year (Bresnahan, 1981). The total loss in welfare is over $3billion in each year (Bresnahan, 1981). This figures show that there is a big loss in market efficiency after the introduction of the collusive price by the oligopolists.
Price Leadership under Oligopoly: Types, Price-Output Determination and Feedback!
In certain situations, organizations under oligopoly are not involved in collusion.
There are a number of oligopolistic organizations in the market, but one of them is dominant organization, which is called price leader.
Price leadership takes place when there is only one dominant organization in the industry, which sets the price and others follow it.
Sometimes, an agreement may be developed among organizations to assign a leadership role to one of them. The dominant organization is treated as price leader because of various reasons, such as large size of the organization, large economies of scale, and advanced technology. According to the agreement, there is no formal restriction that other organizations should follow the price set by the leading organization. However, sometimes agreement is formal in nature.
Price leadership is assumed to stabilize the price and maintain price discipline.
This also helps in attaining effective price leadership, which works under the following conditions:
i. When the number of organizations is small
ii. Entry to the industry is restricted
iii. Products are homogeneous
iv. Demand is inelastic or less elastic
v. Organizations have similar cost curves
Types of Price Leadership:
Price leadership helps in stabilizing prices and maintaining price discipline. There are three major types of price leadership, which are present in industries over a passage of time.
These three types of price leadership are explained as follows:
i. Dominant Price Leadership:
Refers to a type of leadership in which only one organization dominates the entire industry. Under dominant price leadership, other organizations in the industry cannot influence prices. The dominant organization uses its power of monopoly to maximize its profits and other organizations have to adjust their output with the set price.
The interests of other organizations are ignored by the dominant organization. Therefore, dominant price leadership is sometimes termed-as partial monopoly. Price leadership by the leading organization is most commonly seen in the industry.
ii. Barometric Price Leadership:
Refers to a leadership in which one organization declares the change in prices at first and assumes that other organizations would accept it. The organization does not dominate others and need not to be the leader in the industry. Such type of organization is known as barometer.
This barometric organization only initiates a reaction to changing market situation, which other organizations may follow it if they find the decision in their interest. On the contrary, the leading organization has to be accurate while forecasting demand and cost conditions, so that the suggested price is accepted by other organizations.
Barometric price leadership takes place due to the following reasons:
a. Lack of capacity and desire of organizations to estimate appropriate supply and demand conditions. This influences organizations to follow price changes made by the barometric organization, which has a proven ability to make correct forecasts.
b. Rivalry among the organizations may make a leader, which can be unacceptable by other organizations. Thus, most of the organizations prefer barometric price leadership.
iii. Aggressive Price Leadership:
Implies a leadership in which one organization establishes its supremacy by threatening the organizations to follow its leadership. In other words, a dominant organization establishes leadership by following aggressive price policies and forces other/organizations to follow the prices set by it.
Price-Output Determination under Price Leadership:
Price leadership takes place when there is only one dominant organization in the industry, which sets the price and others follow it. Different economists have developed different models for determining price and output in price leadership.
Here, we would discuss a simple model for determining price and output in price leadership, which is shown in Figure-4:
Suppose there are two organizations, A and B producing identical products where organization A has a lower cost of the production than organization B. Therefore, consumers are indifferent between these two organizations due to identical products. This implies that both the organizations would face same demand curve, which further represents equal market share.
In Figure-4, DD is the demand curve of both the organizations and MR is their marginal revenue. MCa and MCb are the marginal cost curves of organization A and B respectively. As stated earlier, the cost of production of organization A is less than B, thus, MCa is drawn below MCb.
Let us first start the discussion of price leadership with the case of organization A. The profits of organization A would be maximized at a point where MR intersects MCa. At this point, the output of organization A would be OQ with the price level OP. On the other hand, the profits of organization B would be maximized at a point where MR intersects MCb with output OQ1 and price OP1.
In such a case, the price of organization B is more as compared to organization A. However, both the organizations have to charge the same price as products are homogeneous. In this case, organization A is the price leader and organization B is the follower.
Thus, organization A will dictate the price to organization B. Both the organizations will follow the same output, OQ and price OP. However, the profits earned by organization B are less than A, as it has to produce at price OP which is less than its profit maximizing price, OP1. In addition, the organization B also has high costs of production that leads to lower profits at price OP1.
Drawbacks of Price Leadership:
The price leadership suffers from various drawbacks.
These are discussed as follows:
i. Makes it difficult for the price leader to assess the reactions of followers.
ii. Leads to malpractices, such as charging lower prices by rival organizations in the form of rebates, money back guarantees, after delivery free services, and easy installment facility. The prices charged by rival organizations are comparatively less than the prices set by the price leader.
iii. Leads to non-price competition by rival organizations in the form of aggressive promotion strategies.
iv. Influences new organizations to enter into the industry because of price rise. These new organizations may not follow the leader of the industry.
v. Poses problems if there are differences in cost of price leaders and price followers. In case, if cost of production of price leader is less, then he/she would fix lower prices. This will lead to a loss for a price follower if his/her cost of production is more than the price leader.