Econ, Prof. Foldvary
February 21, 2005
A Professors Dilemma
As Marisa entered her Monday morning economics class, at Santa Clara University, she noticed that the room was in a state of commotion. As she sat down she heard people saying, “…Our books will not be here for a few weeks because there is a predicament surrounding the book producers.”
She didn’t quite understand what this meant. She sat there trying to make sense of it, just then her teacher, Professor Foldvary being his lecture. He began to explain what the turmoil was all about. He went to the chalk board and the first thing that he wrote was “Oligopoly” in big letters. He then began to explain to the class what this word meant.
Professor Foldvary explained that an oligopoly was “a market structure in which only a few sellers offer similar or identical products.” In relations to the disorder of the class room, this term was quite important. He continued to explain that the United States consisted of two main book printing companies, Thomson South-Western Inc., and McGraw-Hill Inc. These two companies created an oligopoly, or more specifically a Duopoly (an oligopoly consisting of two firms).
At that moment, student, Ryan Romanchuck, raised his hand and asked “How can we distinguish an oligopoly form other market forms?”
Professor Foldvary explained that it is evident that firms form an oligopoly when one firms actions effect the actions of the other firm. In this sense, firms often use “strategic behavior” in which one firm’s actions depend on how the other firm chooses to act. However, it is possible to reach a median in which both firms can maximize their profits. This is done through a “collusion.” Professor Foldvary described this as an agreement among firms in a market, in regard to the quantities to produce or the prices to charge.
In an effort to maximize their profits, Thomson South-Western Inc., and McGraw-Hill Inc, formed a cartel, which is most easily defined as a group of firms acting in unison. Here they set there quantity produced to be at 20 million copies each at a price of $50 a book. Each company would produce 10 million copies and sell them at a price of $50 a book. Through this effort, the companies together would accumulate a total revenue of 1 billion dollars, each company receiving 500,000,000. In this situation, each company would be maximizing profits.
“So what is the problem if each company is maximizing its profits?” asked Taylor Adams.
Professor Foldvary responded by saying that sometimes companies are inclined to break the cartel, in an effort of self-interest, to increase their companies revenue.
“But isn’t that risky behavior on the part of the business that breaks the cartel, seeing that it does not know how the other company will react?” asked Marisa Carter.
“True, and in this case, the two companies involved have taken a risk,” said Professor Foldvary.
At that moment a voice from the back shouted “Wait I still don’t understand...”
Professor Foldvary continued, “Ok everyone get out a piece of paper and a pen and I will walk you through the concept of ‘Prisoners Dilemma’.” He then began to explain to the class that ‘game theory’ is a concept which explains how people behave in strategic situations. He illustrated this though the case of Thomson South-Western Inc., and McGraw-Hill Inc. Thomson South-Western Inc. had entered a cartel with, McGraw-Hill Inc. Soon after the cartel was made, Thomson South-Western Inc. began to ponder what would happen if it were to break the cartel, and increase production, thereby increasing its own revenue. At that same time, McGraw-Hill Inc. had the same thoughts about whether or not to increase their production. The decisions made by each company would affect the decisions made by the other company; however neither company knew what the other’s next move would be. Therefore they were forced to take a risk.
Thomson South-Western Inc. was forced to weigh their options. If they were to uphold the collusion, and produce 10 million books, and McGraw-Hill Inc. was to do the same, each company would generate revenue of 500,000,000 dollars. However if Thomson South-Western Inc. were to keep production the same, and McGraw-Hill Inc. decided to break the cartel and produce 15 million books, Thomson South-Western Inc. would generate less then 500 million dollars, and McGraw-Hill Inc would generate more than 500 million dollars as a result of higher production. On the other hand, if Thomson South-Western Inc. were to break the cartel and increase production to 15 million books and McGraw-Hill Inc. had decided to do the same, each company would receive less then 500 million. However if Thomson South-Western Inc. broke the cartel and increased production to 15 million books, but McGraw-Hill Inc. decided to uphold the collision, Thomson South-Western Inc. would increase their revenue above 500 million and McGraw-Hill Inc would receive a revenue of less then 500 million.
McGraw-Hill Inc. was also aware of the possible results, depending on whether or not it decided to increase production or to honor the collision. After weighting their options the two companies made their decisions. Thomson South-Western Inc. resolved to maintain their production at 10 million in the hope that McGraw-Hill Inc. would do the same. However that was not the case and McGraw-Hill Inc made the decision to increase their production to 15 million books which intern increased their revenue to above 500 million and decreased the revenue that Thomson South-Western Inc. received. Cooperation among these two companies was not apparent as one of the companies decided to break the cartel.
Professor Foldvary continued to explain that this game “provides insight into the difficulty of maintaining cooperation.” Even though cooperation would have served a more positive result for both companies, people are inclined to be driven by self-interest. In this case higher production would have been a ‘dominant strategy’ for Thomson South-Western Inc., because regardless of the decisions made by McGraw-Hill Inc, the result would not have been a sole loss for the company (It would have been a mutual loss for both companies or a loss for McGraw-Hill Inc).
“This is an example of why oligopolies have such a hard time maintaining monopoly profits,” stated Professor Foldvary, “because each oligopoly has an incentive to cheat.”
Then Marisa raised her hand and said, “So basically Thomson South-Western Inc. chose to uphold the cartel, and keep production low, and therefore lost revenue. While McGraw-Hill Inc. chose to cheat and break the cartel, and therefore generated higher revenue from increased production.”
“Exactly,” exclaimed Professor Foldvary. “Thomson South-Western Inc. should now engage in a ‘tit-for-tat’ strategy in which it starts by cooperating, and then does whatever the other company did the time before.”
“And because of this setback and confusion between the companies, our text books are on back order,” stated Professor Foldvary.