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Dynamic Oligopoly

Week 4: Tacit collusion. Martin ch 3. Belleflamme and Pietz 14.2


Week 5: Dynamic competition with price rigidities. Maskin and Tirole
(1988): A Theory of Dynamic Oligopoly: II: Price Competition,
Kinked Demand Curves and Edgeworth Cycles, Econometrica

Dynamic Oligopoly: Supergames

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.

Dynamic Oligopoly: Supergames

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.

Dynamic Oligopoly: Supergames

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.

Dynamic Oligopoly: Supergames

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

Dynamic Oligopoly: Supergames

iii) Bertrand duopoly with zero costs and p = 1 Q

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

Dynamic Oligopoly: Supergames

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.

Dynamic Oligopoly: Supergames

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.

Dynamic Oligopoly: Supergames

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.

Dynamic Oligopoly: Supergames

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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)

Dynamic Oligopoly: Supergames

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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.

Dynamic Oligopoly: Supergames

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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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Example: The Infinitely Repeated


Prisoners Dilemma
Lets return to our symmetric Prisoners Dilemma.

Player d
1
c

Player 2
d
c
1, 1 3, 0
0, 3 2, 2

The trigger strategy is:


In period 1 play c. In period t > 1, if the outcome of all preceding periods has been (c, c) then play c; otherwise
play d.

Dynamic Oligopoly: Supergames

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Example: The Infinitely Repeated


Prisoners Dilemma
Suppose Player 1 adopts this strategy.
If Player 2 also uses this strategy the outcome will be (c, c) in every period: 2 = 2 + 2 + 2 2 + = 2/(1 ).
If Player 2 plays d in period 1, then Player 1 will choose d in periods 2, 3, . Player 2s optimal deviation results in (c, d) in period 1 and (d, d) in all subsequent periods.
Payoff from deviation: 2 = 3 + 1 + 2 1 + = 3 + /(1 ).
No incentive to deviate if 2/(1 ) 3 + /(1 )
or

Dynamic Oligopoly: Supergames

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Example: The Infinitely Repeated


Prisoners Dilemma
If then it is a Nash equilibrium for both players to use the trigger strategy.
In fact, this Nash equilibrium is subgame perfect.
Thus, if is sufficiently high (i.e., if players are sufficiently patient) cooperation can be sustained as a subgame perfect equilibrium in the infinitely repeated Prisoners Dilemma.

Dynamic Oligopoly: Supergames

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Example: Basic Cournot Game


ii) Cournot duopoly with zero costs and pt = 1 Qt.
Can joint-profit maximising outcome be sustained as an equilibrium?
From earlier slide: q1tC = q2tC = , q 1tN = q2tN = 1/3, 1tC = 2tC = 1/8, 1tD = 2tD = 9/64, 1tN = 2tN = 1/9.
The trigger strategy is
In period 1 produce 1/4. In period t > 1, if the outcome of all preceding periods has been (1/4, 1/4) then produce 1/4; otherwise produce 1/3.
This is a subgame perfect Nash equilibrium as long as
(itD itC)/( itD itN) = 9/17

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Example: Basic Cournot Game


Note that this result can be generalised to the case with n firms: itC = 1/(4n), 1tD = (n+1)2/(4n)2, itN = 1/(n + 1)2
Joint-profit maximising outcome can be sustained in equilibrium as long as
(itD itC)/(itD itN) = (n+1)2/(n2 + 6n +1)
The expression (n+1)2/(n2 + 6n +1) increases with n. In this sense, collusion is harder to sustain the larger the number of firms in the market.
E.g. if = 0.6 can sustain collusion between 2 firms but not between 5 firms.

Dynamic Oligopoly: Supergames

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Example: Basic Bertrand Game


iii) Bertrand duopoly with zero costs and Q t = 1 pt
Can joint profit maximising outcome be sustained as an equilibrium?
From earlier slide: p1tC = p2tC = , p 1tN = p2tN = 0, 1tC = 2tC = 1/8, 1tD = 2tD = 1/4, 1tN = 2tN = 0.
The trigger strategy is
In period 1 charge . In period t > 1, if the outcome of all preceding periods has been (, ) then charge ; otherwise charge 0.
This is a subgame perfect Nash equilibrium as long as
(itD itC)/( itD itN) = 1/2

Dynamic Oligopoly: Supergames

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Example: Basic Bertrand Game


With n firms: itC = 1/(4n), 1tD = 1/4, itN = 0
Joint-profit maximising outcome can be sustained in equilibrium as long as
(itD itC)/(itD itN) = 1 1/n
The expression 1 1/n increases with n. Again, collusion is harder to sustain the larger the number of firms in the market.

Dynamic Oligopoly: Supergames

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Example: Price versus Quantity Competition


In previous lectures we found that in markets for homogeneous goods and constant average and marginal costs, price competition is fiercer than quantity competition. Equilibrium prices lower when firms compete
in prices.
These lectures looked at static models. What can we say about price versus quantity competition from perpective of repeated game theory?
Is it easier to sustain collusion under price or quantity competition?

Dynamic Oligopoly: Supergames

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Example: Price versus Quantity Competition


Compared to quantity competition, under price competition benefit of collusion is larger, but so is temptation to deviate.
With n = 2 the first effect dominates and it is easier to sustain collusion using grim trigger strategies under price competition.
With n > 2 the second effect dominates and it is easier to sustain collusion using grim trigger strategies under quantity competition.

Dynamic Oligopoly: Supergames

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Example: Price versus Quantity Competition


Can joint profit maximisation be sustained (by trigger strategies)?
If n = 2:

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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Stick and Carrot Strategies


We found that trigger strategies sustain collusion in a linear Cournot duopoly if > 9/17 0.53.
What if firms less patient? E.g. if = ?
Trigger strategies cannot sustain full collusion in this case.
But while trigger strategies are simple, perhaps they are too grim?
Perhaps there are some other repeated game strategies that might sustain collusion?

Dynamic Oligopoly: Supergames

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Stick and Carrot Strategies


Stick and carrot strategies allow players to go back to cooperative play (carrot) after a deviation from cooperation, but only after some punishment has been meted out (stick).
The presence of the carrots give players an incentive to use the stick.
Even if the punishment involves choices that are not part of a Nash equilibrium of the stage game, the carrot might make such punishment credible.
This gives possibility of more severe punishments that deter deviation from cooperation.

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Stick and Carrot Strategies


We will present stick and carrot strategies for Cournot duopoly with zero costs and p t = 1 Qt
Recall joint profit maximisation: q1tC = q2tC = , 1tC = 2tC = 1/8
Game can be in either cooperative or punishment phase depending on history of play
S&C strategy specifies
in cooperative phase produce ,
in punishment phase produce
Players keep track of which phase the game is in as follows

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Begin in period one in cooperative phase

Stick and Carrot Strategies

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

Dynamic Oligopoly: Supergames

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Stick and Carrot Strategies


If both players follow this strategy it will result in (, ) in every period, and so joint profits maximised.
But is this a subgame perfect Nash equilibrium?
We will assume player 1 follows stick and carrot strategy and check whether player 2 has an incentive to deviate.
Note 2t(, ) = 1/8, 2t(, ) = 0. Player 2s best-response function is q2 = (1 q1)/2 so best response to is 3/8: 2t(, 3/8) = 9/64. Best response to is : 2t(, ) = 1/16.

Dynamic Oligopoly: Supergames

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Stick and Carrot Strategies


To check whether these strategies form an equilibrium we need to check that
i)

punishment is credible: having entered punishment phase players do not have incentive to deviate from producing

ii) collusion is optimal: no incentive to deviate from

Dynamic Oligopoly: Supergames

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Stick and Carrot Strategies


First consider a subgame in which a player has deviated in previous period (i.e. we are in punishment phase)
By complying with stick and carrot strategy player 2 gets
0 + (1/8)/(1 ) = VP
Suppose player 2 decides to deviate this period, then comply with stick and carrot strategy next period. Her best deviation gives
1/16 + VP

Dynamic Oligopoly: Supergames

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Stick and Carrot Strategies


Optimal to comply now rather than later if
VP 1/16 + VP
(1 )VP 1/16
/8 1/16

(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 ).)

Dynamic Oligopoly: Supergames

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Stick and Carrot Strategies


Next consider a subgame where stick and carrot strategy requires producing q 2 = (i.e. cooperative phase)
By complying with stick and carrot strategy player 2 gets
VC = (1/8)/(1 )
By deviating for one period then complying she gets
9/64 + VP
Optimal to comply if
VC 9/64 + VP
(1/8)/(1 ) 9/64 + 2 (1/8)/(1 )
1/8

Dynamic Oligopoly: Supergames

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Stick and Carrot Strategies


The stick and carrot strategies form a subgame perfect Nash equilibrium as long as .
Thus in the infinitely repeated Cournot quantity setting game, full collusion may be sustainable with stick and carrot strategies even when it is not
sustainable by grim trigger strategies.

Dynamic Oligopoly: Supergames

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Stick and Carrot Strategies


In general, a stick and carrot strategy specifies qC and qP. Let
itC = it(qC, qC) denote stage game payoff in cooperative phase (when both players comply)
itP = it(qP, qP) denote stage game payoff in punishment phase (when both players comply)
itD denote stage game payoff when j complies and i deviates optimally in cooperative phase
itE denote stage game payoff when j complies and i deviates optimally in punishment phase

Dynamic Oligopoly: Supergames

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Stick and Carrot Strategies


For these to form a subgame perfect Nash equilibrium q C and
qP must satisfy
i) Punishment is credible:
itE itP (itC itP)

(C)

ii) Collusive output is sustainable:


itD itC (itC itP)

(S)

Note that if these two conditions are met punishment does


not occur in equilibrium. The threat of punishment
disciplines players and allows them to achieve qC in
every period.

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Stick and Carrot Strategies


The best collusive outcome that can be sustained occurs when
i)

qP threatens the harshest credible punishment. i.e. condition C binds:


itE itP = (itC itP)

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

Dynamic Oligopoly: Supergames

itD itC = (itC itP)

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Stick and Carrot Strategies


Optimal stick-and-carrot strategy in the linear Cournot duopoly (based on Belleflamme
and Peitz Figure 14.1, with p = 1 Q, c = 0)

qP

qC

9/32

Dynamic Oligopoly: Supergames

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