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Increased Competition Transforms a Coordination Game into a Prisoners' Dilemma
When more firms enter a market, the nature of their strategic interaction can shift from a coordination game, which can support a high-price cartel, to a prisoners' dilemma. This transformation occurs because the entry of new competitors reduces the share of profits available to each member of a potential cartel. As the reward for cooperation diminishes, the incentive for any single firm to defect by cutting its price becomes stronger. This makes a low-price strategy the dominant choice for everyone and renders the cartel unsustainable.
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Social Science
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CORE Econ
Economics
Introduction to Microeconomics Course
The Economy 2.0 Microeconomics @ CORE Econ
Ch.8 Supply and demand: Markets with many buyers and sellers - The Economy 2.0 Microeconomics @ CORE Econ
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Strategic Pricing in a Changing Market
Consider a market where a small number of firms have been able to maintain high prices by implicitly agreeing not to undercut each other. If several new firms enter this market, why does this situation often destabilize, leading to widespread price cuts?
The Impact of Market Entry on Collusive Pricing
Consider a market where a few firms have successfully maintained high prices through a cooperative agreement. If several new firms enter this market, the cooperative agreement is likely to fail. This failure occurs primarily because the new entrants are typically more aggressive and willing to set lower prices to gain market share.
The Stability of Cooperative Pricing
Initially, two firms are the only competitors in a market. They can each choose to set a high price or a low price. If both set a high price, they each earn a substantial profit. If one sets a low price while the other sets a high price, the low-pricing firm captures most of the market and earns a very large profit, while the high-pricing firm earns very little. If both set a low price, they both earn a small profit. Now, imagine several new firms enter this market. How does the entry of these new competitors most likely alter the strategic decision-making for the original firms?
Initially, two firms in a market can each choose to set a 'High Price' or a 'Low Price'. If both set a High Price, they successfully coordinate and each earns $50 million. If both set a Low Price, they compete and each earns $10 million. If one sets a Low Price while the other sets a High Price, the low-pricer earns $60 million and the high-pricer earns only $5 million. Now, several new competitors enter the market. This new entry changes the potential profits for the original two firms. Which of the following new payoff structures best illustrates why the original firms would now abandon their high-price strategy and cut prices?
Two large firms, Firm A and Firm B, have been the only sellers in a market, successfully maintaining high prices through an unspoken agreement. A third firm, Firm C, is now entering the market. Which of the following statements provides the most accurate economic explanation for why the entry of Firm C makes it much more likely that the high-price agreement between Firm A and Firm B will collapse?
Incentive Shift in a Cartel
A market initially has only two firms that successfully cooperate to keep prices high. After several new firms enter, the market dynamics change. Match each term to the description that best fits its role in this transformation.
The Three-Firm Price-Setting Game as a Prisoners' Dilemma