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Tacit Collusion
Collusion among firms occurs when firms act in unison to set prices or divide up market to exploit
consumers.
In practice formal agreements between firms are difficult to enforce (and often illegal).
How can informal agreements, i.e. unaccompanied by any binding contract, be self-enforcing?
Repeated interaction introduces scope for self-enforcing tacit collusion. Not necessarily a formal
agreement, just a common understanding about collusive behaviour and how deviations from it will
be punished.
Tacit Collusion
Theoretical analysis of tacit collusion often draws on theory of repeated games.
We look at case in which firms interact repeatedly and can condition their
behaviour on the history of their interaction.
Well require that strategies form a subgame perfect equilibrium.
Well look at conditions under which equilibrium behaviour allows firms to collude.
Repeated Games
In a repeated game a stage game is played repeatedly, with players observing the outcome of the stage game after each stage.
A players payoff from the repeated game is the discounted sum of payoffs from the individual stage games: i.e. player is repeated
game payoff is i = t t1it, where [0, 1] is a discount factor and it is is stage game payoff in period t.
What can be achieved in an equilibrium of the repeated game depends on the structure of the stage game.
Repeated Games
Examples of stage games:
i) Prisoners Dilemma.
Player d
1
c
Player 2
d
c
1, 1 3, 0
0, 3 2, 2
Key features:
cooperative outcome (c, c) yields payoffs 1 = 2 = 2
2s best-response to cooperation by 1 is defect
yielding payoff 2 = 3
unique equilibrium (d, d) yielding payoffs 1 = 2 = 1
Dynamic Oligopoly: Supergames
Repeated Games
ii) Cournot duopoly with zero costs and p = 1 Q.
Players: {1, 2}
Strategies: q1 0, q2 0
Payoffs: 1 = (1 q1 q2)q1, 2 = (1 q1 q2)q2
Key features:
joint-payoff maximising quantities q1 = q2 = yielding payoffs 1 = 2 = 1/8
best-response to q1 = is q2 = 3/8 yielding payoff 2 = 9/64
unique equilibrium q1 = q2 = 1/3 yielding payoffs 1 = 2 = 1/9
Repeated Games
Players: {1, 2}
Strategies: p1 0, p2 0
Payoffs: 1 = (1 p1)p1, 2 = 0 if p1 < p2
1 = (1 p1)p1, 2 = (1 p2)p2 if p1 = p2
1 = 0, 2 = (1 p2)p2 if p1 > p2
Key features:
joint-payoff maximising prices p1 = p2 = yielding payoffs 1 = 2 = 1/8
best-response to p1 = is p2 = yielding payoff 2
unique equilibrium p1 = p2 = 0 yielding payoffs 1 = 2 = 0
General Results
Finitely repeated game: the stage game is played in periods t = 1, 2, , T.
A general result: If the stage game has a unique Nash equilibrium, then the finitely repeated game has a unique subgame perfect
equilibrium (SPE) where the Nash equilibrium of the stage game is played in every period.
General Results
Reason: SPE strategies must specify that players play Nash equilibrium strategies of the stage game in period T. Given this (and because there is a unique Nash equilibrium in
the stage game), nothing a player does in T 1 can influence SPE outcome of period T. Therefore in T 1 in order to maximise the sum of discounted payoffs from T 1 and T
a player should maximise profits in stage T 1, i.e. play T 1 as if it were last period. This means they must play Nash equilibrium strategies of stage game in T 1. Etc., etc.
General Results
Infinitely repeated game: stage game is played in t = 1, 2,
3, i.e. no final period.
Two general results:
1. The infinitely repeated game has a SPE where the Nash
equilibrium of the stage game is played in every stage.
2. There are many other SPE (so-called "Folk theorems").
In particular, if sufficiently close to 1 the joint-payoff
maximising outcome can be attained in a SPE.
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A formal statement of 2:
General Results
Let siN denote a Nash equilibrium strategy of the stage game for player i, and let itN = it(s1N, ,snN) denote the corresponding Nash equilibrium payoff of the stage game for player i.
Consider a profile of stage game strategies (s1C, , snC) yielding each player i a payoff of itC = it(s1C, , snC) > itN.
If is sufficiently close to one, then there exists a SPE of the infinitely repeated game where player i receives a repeated game payoff i = itC/(1 ).
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General Results
The SPE is supported by strategies which promise to play sC, but threaten to revert to sN:
Play siC in period 1. In period t, if the outcome of all preceding periods has been (s 1C, , snC) then play siC; otherwise play siN.
If all players adopt this strategy this results in (s1C, , snC) being played in every period and each player receiving a repeated game payoff of itC/(1 ).
Such strategies variously called trigger, grim, or Nash reversion strategies.
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General Results
These strategies will form a Nash equilibrium if no player can do better than follow this strategy, given that all the other players are following this strategy.
Suppose player i assumes all the other players follow trigger strategy, and is considering whether to use it as well:
If player i uses trigger strategy she gets i = itC/(1 ).
How could she improve on this?
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General Results
If player i deviates from siC, all other players will revert to their stage game equilibrium strategies in subsequent periods, and so in subsequent periods the best player i can do is choose s iN, getting itN in each period. In the period when she deviates she should choose the best
response to the cooperative strategy, i.e.
maximise it (s1C, si1C, si, si+1C, , snC).
Denote the resulting stage payoff by itD .
Optimal deviation yields i = itD + itN/(1 ).
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General Results
Player i has no incentive to deviate if
itC/(1 ) itD + itN/(1 )
or (itD itC)/(itD itN)
If (itD itC)/(itD itN) for all i, then the trigger strategies form a Nash equilibrium.
Note itD itC > itN and so (itD itC)/(itD itN) < 1. Thus there exists a < 1 such that the condition holds for all i.
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General Results
Trigger strategies form an equilibrium if sufficiently high, specifically (itD itC)/(itD itN)
Note that this condition can be written
(itD itC)/(itD itC + itC itN)
or
1/(1 + (itC itN)/(itD itC))
So in order to sustain collusion in equilibrium using trigger strategies we need benefit of collusion (itC itN) to be large enough relative to temptation to deviate (itD itC)
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General Results
To see that the Nash equilibrium will be subgame perfect consider a subgame beginning in period t.
This subgame is itself an infinitely repeated game where in each period the players play the stage game, receive a stage game payoff, and the payoff from this subgame is the discounted sum of the stage
payoffs.
That is, the subgame is just like the original repeated game.
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General Results
There are two possibilities:
i)
If a previous period resulted in an outcome other than (s1C, ..., snC) the players plan to play the Nash equilibrium of the stage game in every stage. This constitutes a Nash equilibrium for the subgame.
ii)
If the outcome of all previous periods is (s1C, ..., snC) the players plan to play the trigger strategy. This also constitutes a Nash equilibrium for the subgame.
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Player d
1
c
Player 2
d
c
1, 1 3, 0
0, 3 2, 2
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20
21
22
23
24
25
26
27
not at all
9/17
only under price under either price or
competition
quantity competition
If n = 3:
not at all
4/7
2/3
only under qty
under either price or
competition
quantity competition
Dynamic Oligopoly: Supergames
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29
30
31
i) If game was in cooperative phase in previous period and outcome was (, ) then game stays in cooperative phase
ii) If game was in cooperative phase in previous period and outcome was not (, ) then game switches to punishment phase
iii) If game was in punishment phase last period and outcome was (, ) then game switches to cooperative phase
iv) If game was in punishment phase in previous period and outcome was not (, ) then game stays in punishment phase
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33
punishment is credible: having entered punishment phase players do not have incentive to deviate from producing
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35
(Note: if its optimal to comply now rather than later, its also optimal to comply now rather than never. i.e. V P 1/16 + VP VP (1/16)/(1 ).)
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37
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(C)
(S)
40
ii) Full collusion is sustainable if condition (S) can then be met when q C = . If S cannot be met when qC = , the best that can be achieved is the lowest output satisfying
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qP
qC
9/32
1
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