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Cameron Skinner and Matt Deady

Econ 368
Competitive Strategy Game Paper
12/15/09
Investigation of Tacit Collusion and Predatory Capacity Building

in the CSG

This combined paper seeks to address two key issues that arose in the

Competitive Strategy Game. The first part will deal the potential for tacit

collusion in Market C, whereas the second part will focus on the predictions

of the predatory capacity building model for Market D. Both parts also

provide information on the strategy we undertook at the start of the game

and how it could have been improved.

PART 1

Introduction

Though discussing collusion and the market characteristics that

facilitate it in class is one thing, determining whether these models actually

give us reasonable predictions in a real world simulated game is another. A

number of problems can arise in the real world, leading to cases in which

important variables must be estimated and wrong assumptions can spawn

drastically different results. However, the Competitive Strategy Game

provides a wonderful opportunity to examine the interactions of firms with

much more transparency than might be available in real life. Though all of

the firms may have had roughly the same amount of information about their

competitors that would be available in a real world situation, the end of the

game provides an opportunity to regard interactions in retrospect with


almost complete information. Therefore, this paper seeks to explore whether

firm actions in Market C exhibit the characteristics of tacit collusion.

Market Characteristics

Before examining the behaviors of each firm, it is important to

determine whether the characteristics of Market C are more or less likely to

breed collusive behavior. There are many factors that can push firms in one

way or the other and many of them will be touched on in this section.

1.) In order to determine whether collusion is more or less attractive, an

estimate of the discount factor (δ ) must be obtained using this equation:

1
δ= (h)(1 + g)
r
(1 + )
f

δ is a measure of patience that each firm has. If  is high, then it means

that firms are more patient and long-run potential gains will appear more

attractive than short-term gains. The reverse is true as well. As δ falls,

short-term gains become more attractive for the firm. Therefore, a higher 

helps to facilitate collusion. Plugging in given variables while applying what

we know about Market C a fairly decisive answer can be attained. We know

that the interest rate r = .02, a relatively low number, f = 1 because the

interest rate was “per period” and firms interacted every period (about 3

times per week), and the market growth (g) averages .381 for all 21 periods

of the game.1 Furthermore, the probability of market continuation h = 1 until

1 Refer to “Profile of Market C” and “CSG Final Data.”


the last round when h = .2 This is because the firms know that the game
1
3

will definitely last at least 20 rounds and only then did uncertainty of market

continuation arise. With this knowledge, for periods 1 through 20, we can

then estimate that

1
δ= (1)(1 + .381) = 1.354
.02
(1 + )
1

and for period 21, we can estimate that

1 1
δ= ( )(1 + .381) = .451
.02 3
(1 + )
1

From these estimates, we can conclude that because  is so high for the

first 20 rounds, patience would not be a limiting factor when it came to firms

colluding in Market C. On the other hand, because δ is much lower for the

21st round, it would appear that collusion would be difficult in the final period

because firms would not have enough patience required. It is important to

note that this is just an estimate and the value we used for g would most

likely be slightly off depending on each firm’s opinion of expected growth for

the future.

2.) Barriers to entry can have a large effect on the attractiveness of collusion

in markets because colluders will have a greater chance of keeping prices

high without having to worry about the risk of a competitor entering the
2 Market continuation was determined using a random number generator and the game
would end with any value below .333.
market and undercutting them. In the case of the CSG, all costs can be

considered barriers to entry because firms have a general idea of where they

stand compared to other firms. Thus, if they find that they have costs above

the mean values, this will serve as a disincentive to entry.

Market C had a mean entry cost $70,000 and a standard deviation of

$10,000 dollars. This standard deviation amounted to 14.3% of the mean

entry cost. It also had a mean cost for one unity of capacity that was $500

with a standard deviation of $100, or 20% of the mean capacity cost. Finally,

its mean marginal cost was $20 with a standard deviation of $2 or 10% of

the mean marginal cost. Knowing that the entry cost was a one-time cost,

reason would imply that these firms would consider the potential differences

in capacity costs as the largest barrier to entry, while only being mildly

concerned about marginal costs. This is because the potential differences in

capacity cost would be multiplied many times over with the production of

feasible levels of capacity (averaging 261 for the first period in Market C) and

with the constant capacity rebuilding because its maximal useful life was

only 3 periods, giving firms with lower costs a much greater advantage.

Therefore, firms with higher capacity costs would be expected to stay out of

the market, while firms with lower costs would be expected to enter the

market. Supporting this theory is the immediate entry of the two lowest cost

producers, CCP and TSM, into Market C.3

Another potential barrier to entry is brand loyalty. In the given “Profile

of Market C,” information suggests that brand loyalty was certainly strong in
3 Refer to Table 1
this market. According to the table, a firm would actually lose revenue if they

undercut the price of a competitor in most cases.4 An example of this can be

seen by looking at the column indicating the approximate market share of

Firm 1 after a 20% price cut by Firm 2. Assuming that there are 2 firms in the

market and they are both pricing at $200 to begin with, we calculate that

they are each making a total revenue = (.5)(357)(200) = $35,700, assuming

that the demand is the same as given.5 However, even if Firm 2 were to

lower their prices 20% to 160, they would not capture enough of the market

for it to be a profitable decision. In fact their total revenue = (.59)(357)(160)

= $33,700.8, a full $2,000 lower than when they were pricing the same as

the other firm and splitting the market. Because consumers appear

somewhat ambivalent to a large change in price, it appears that brand

loyalty plays a large role in Market C, creating a barrier to entry for firms

looking to enter the market in later periods.

3.) The number of firms in the market can effect whether collusion is more

likely to show up or not. If we assume Bertrand Competition with Grim

Trigger for this example we see that as the number of firms increases,

collusion becomes less likely:

D: (1-)π m+δ 0 C: (1-δ )π (


m ) +δ π (
m )

D-C: (1-) ( )m δ π (


m )  δ

4 Refer to Table 2
5 Refer to Table 2
This equation implies that as the number of firms increases, the patience

each firm must have increases as well. Therefore, firms must be much more

patient in markets with large numbers of firms. If we apply this equation to

Market C assuming that there are 4 firms in the market (the average for all

21 periods is 3.76 firms so we will round to 4) we find that .75 .

According to this answer, collusion will be more profitable than defection

assuming that our answer for δ in Part 1 is correct. Therefore, evidence

suggests that Market C should be a friendly environment to collusion.

4.) The fourth characteristic to consider when evaluating Market C is the

effect of cost asymmetries have on collusive behavior. It is known that the

larger the cost asymmetries, the harder it is for collusive behavior to take

hold because collusion is relatively less profitable for the low-cost firm and

punishment will not be as severe. Therefore, when colluding, the low cost

firm must have a high  because short-term gains will be more lucrative for

them than for the other firms. Though the cost asymmetries appear to be

fairly large when we look at Table 1 (e.g. 381 to 462 for the two leading

firms), δ would appear to be high enough from our initial calculation to

make this a non-issue.

However, if we chose to ignore δ , differences in prices do appear.

When looking at Graph 1 it becomes apparent that large price differences

only appear through period 15 and after that they tend to converge.6 This

could mean one of two things: either increases in demand allowed firms to

competitively raise their prices, or CCP was essentially defecting between


6 Refer to Graph 1
periods 5 and 14 with limited success and found it more profitable to keep

prices high for the final 6 periods with the other firms. Therefore, we can

conclude that though cost asymmetries were rather large in Market C, they

may not have had a strong effect on whether firms acted collusively or

competitively.

5.) A few final characteristics can also affect the attractiveness of collusion in

Market C. First, an ease of strategy changes makes collusion more likely.

This is because it facilitates fast retaliations for defectors and does not allow

defectors to enjoy their potential benefit for too long. Because capacity could

be built and implemented within 2 periods or excess capacity could be put to

use in just 1, it would appear strategy change were quite easy in Market C.

Second, transparency in Market C was very high, also helping to facilitate

collusion. Firms knew the price charged by competitors every period, their

competitor’s capacity at the end of each period, and the overall and the

approximate market sales every period. Furthermore, firms had a rough

estimate of where they stood in comparison to the costs of other firms

because of the initial data given to each team at the start of the game. With

all of this information, coordination between firms would have been much

more straightforward than otherwise. Third, market growth was expected to

increase rapidly, but with great uncertainty. This characteristic would

normally have had the effect of making collusion more difficult for firms in

the market. However, because market sales each period were known,

companies should have been able to estimate the growth rate of the
previous period and how much demand the other firms were able to capture.

Therefore, we can assume that because of the amount of information

available to each team, fluctuations in demand should have only been a

minor hindrance to collusion.

In summary, Market C’s characteristics make it ripe for collusion. The

discount factor is sufficiently high so that firms do not have an incentive to

defect, barriers to entry are substantial, strategy change is simple, and

market transparency was high.

Analysis

When looking at the data from Market C, it becomes apparent that

tacit collusion may not have been at play despite the strong market

characteristics in favor of it. Though prices certainly were far above costs,

problems arise when investigating incentives and punishment, two key

features of collusion.

Brand loyalty appears to have acted more as a barrier to collusion than

to entry. The main issue stems from the fact that brand loyalty was so strong

that the pricing behavior of firms did not really matter. This can be seen in

the data in Table 2 and Graph 1.7 As we can see from Graph 1, increases in

price are mirrored by increases in the quantities sold and Table 2 implies

that even with vast price differences, consumers were not willing to change

brands. Applying the same logic shown in Part 2 of the previous section for a

firm trying to enter the market and uncut price, this strong brand loyalty

would have made defecting a poor decision. Total revenues would have been
7 Refer to Table 2 and Graph 1
lower overall because the defecting firm would not have been able to make

up the difference in gaining a larger share of consumers in the market. Thus

there was no incentive to ever defect. Furthermore, prices of one firm did not

greatly affect the performances of the other firms in the market. This implies

that firms did not have control over collusive so the group of firms that would

have been colluding were left without a carrot that they could control. Thus,

we see that there was no carrot or stick possessed by the majority of firms

we would expect to be tacitly colluding implying that colluding could not in

fact be taking place.

If not collusion, then can firm behavior in Market C be identified as

competitive? If we assume that there would be Bertrand Competition as we

did is Part 3 of the previous section, then prices would at least have begun to

converge towards the second highest marginal cost. However, just by

looking at Graph 2 we can see that prices are constantly rising, pointing to

firm behavior that is not indicative of Bertrand Competition.

Instead, it would appear that each firm acted as a monopolist.8 This

behavior can be explained with brief consideration of the data and market

characteristics. Brand loyalty was so strong that firms in Market C were

producing goods that did not serve as very good substitutes to each other.

This made it seem as if each firm was in its own independent market where

they were able to raise prices very high because of the inelastic demand and

growth rate of the market. However, as we can see from the pricing data, the

8 Leland and I discussed the fact that it was neither collusive nor competitive and came to
this decision on 12/14.
market prices were nowhere near as high as they could have been.

Furthermore because every firm was pricing far below where they could

have been, the firm with the lowest comparable price still was not able to

gain much of the incoming consumer base each period.

How Should We Have Behaved?

With this knowledge of Market C, it is obvious that our firm, CCP,

should have adopted a different strategy. Though Matt and I believed that

we would have been able to gain more of the market by keeping our prices

lower than the other firms, we should have considered that doing this had

the effect of bringing in less revenue than pricing higher as figures from Part

2 above show. Perhaps if other firms had been pricing much higher (in the

thousands) this would have been a productive strategy, but this was not the

case. Furthermore, we should have analyzed the extent of market growth

more closely, leading to a decision to increase our capacity much earlier. If

we were to replay the game with the current information we have now, our

strategy would have led us to keep prices much higher than they were and

increase capacity much more quickly than we did.

Table 1
Marke Marke Market
tA tC D
Costs Costs Costs
Tea Capacit M Capacit M Capacit
m Entry y C Entry y C Entry y MC
25000 20
OXC 45668 757 58 77949 531 20 7 2093 3
25000 24
MDD 50007 799 57 80017 615 19 5 3185 2
25000 16
CCP 53848 914 54 74190 381 21 7 4379 7
25000 18
JWC 51342 892 56 68375 532 21 3 2993 7
25000 18
BXH 51335 1020 56 76050 548 15 2 4155 1
24999 19
TSM 57896 550 59 67794 462 16 5 2819 6

25000 20
Mean 50000 800 50 70000 500 20 0 4000 0
Std.
Dev. 3000 150 10 10000 100 2 5 1000 20

Table 2
Approximate Market Share of Firm 1
Price Differential of Firm 2 -20% -15% -10% -5%
Price of Firm 1
100 45% 46% 47% 49%
200 41% 46% 49% 49%
300 40% 44% 44% 47%

Graph 1

PART 2

The second part of the paper will examine our situation in Market D

and the extent to which the predatory capacity building model can make

predictions of what happened in the CSG. We entered Market D thinking that

we could take advantage of our low marginal cost to produce over capacity

make a profit. Furthermore, there were only 2 firms in the market so we

figured there would not be that much competition, causing prices to stay

high. We did not anticipate that all other players’ capacity costs in market D

would be much lower than ours. The other firms we were competing against

had capacity that was a standard deviation less then the mean (and more

than $1000 less than ours). We thought we could produce at over capacity

and take advantage of our low marginal cost. We had the lowest marginal

cost in market D which was more than one and a half standard deviations

below the mean.


What we perhaps failed to take into account was what the capacity

already created by the other firms told us about their commitment to

produce. According to the Predatory Capacity Building model, firms

considering entry should use information about other firms capacity to

influence their decision to enter the marketplace. The model also asserts

that incumbent firms should consider the effects of their capacity building on

entry deterrence when they are deciding how much capacity to build. I will

look at how effectively firm JWC used predatory capacity expansion to deter

firms that didn't enter market D and also the rationality in our decision to

enter market D. Lastly, I will look if this predatory conduct should be

considered anticompetitive action*

Before going into the specific application of the Predatory Capacity

Expansion Model in the CSG, I will explain the general idea behind the model.

Predatory conduct is defined as any action taken by a firm to deter entry by

rivals This is accomplished by using a mixture of methods to reduce future

profit. The Predatory Capacity Expansion Model shows how a firm could

potentially increase their capacity in order to deter entry from another firm

in order to maintain their market power. Because additional capacity lowers

post investment costs, an incumbent firm with a lot of capacity has an

advantage over an entrant that has to build capacity and pay costs to

produce. Furthermore, building excess capacity signals the incumbent firm

has made a commitment to fighting entry since it will be easier for a firm to
rationalize overproducing if it has already paid the capacity costs. The two

key assumptions in this model are ex post credibility and ex ante rationality.

To start the model, we will define a few variables:

Let k1 = capacity purchased


Let r = cost of capacity
Let c = marginal cost
Let q1 = incumbent's production

The cost of producing will be will be:

C(q1) = cq1 if q1 < k1

cq1 + (q1 – k1)r otherwise

Firm one's best response obviously depends on their costs. This means

player one's best response will change when player one produces beyond k1.

Firm two's best response function is also shown in the above graph. Both

firms will produce the quantity at which the intersection of the best response

functions. The key to effective predatory conduct is that firm two has to pay

a sunk cost to enter. The amount of capacity held by the incumbent firm

obviously doesn't matter if player two's sunk costs are either so great that
entry is never rational or so low that even maximum capacity will not deter

entry. If sunk costs are within a certain range though, entry can be deterred

by increasing capacity.

I will make several assumptions that will make this model a little

different from the CSG. First of all, I will treat it as a two period game in

which the sunk cost is the sunk cost divided by expected total periods. The

sunk cost for our firm is:

250007/21 = 11905

We will be firm 2, the entrant, and for the sake of simplicity we will assume

that MDD did not enter and firm one will be JWC, the incumbent. I will use

the two firm demand to create a linear demand equation:

P(Q) = A – BQ = 1833 -.343Q

The marginal cost for our firm will be the same as the game: 167. Since we

didn't know firm one's marginal cost we will use the expected marginal cost:

200. Capacity cost will be per period like sunk cost with the resale value of

used capacity factored in. Also we will use our capacity cost and the

expected capacity cost of firm 1. This means that our capacity cost per unit

is:

(1-.3)(4379)/6 = 511

Firm one's capacity per unit:

(1-.3)(4000)/6 = 467
Our first task is to find the maximum capacity firm one will charge and

see if maximum rational capacity building can deter entry. First, we must

find the equilibrium where the incumbent firm has no capacity constraints.

Setting best response functions equal we get:

q2 = 1833 – 167 – 511 – [(1833 – 200)/2(.343) - q2/2]


2(.343) 2

q2 = 395
q1 = 2183
P(Q) = 1833 - .343(2183+395) = 949

From this result, we can find the expected profit for each firm:

π1 = (949 – 200) 2183 = 1635067

π2 = (949 – 167 – 511) 395 = 107045

Would JWC consider purchasing that much capacity? JWC monopoly profits

from deterring entry must be larger than their Stackleberg leader profits if

they allow entry. The Stackleberg leader produces the monopoly quantity

and then the other firm best responds model making monopoly profit:

If Entry is Deterred

monopoly π1 = (1833 – 200)2 = 1943651 – rk1 = 1943651 - 467(2183) =


1797390
4(.343)

If Entry is Allowed
monopoly q1 = (1833 – 200 – 467) = 1700
2(.343)

BR2(q1) = (1833 – 167 – 511) – 1700 = 834


2(.343) 2

P(q1,q2) = 1833 – .343(834 + 1700) = 1398


2
Stackleberg π1 = (1398 – 667)1700 = 1242700
Since firm one's profits are greater if entry is deterred, firm one would

indeed try and to build capacity to keep us out of the market as long as entry

for our firm isn't inevitable.

“As long as entry for our firm isn't inevitable” is the key phrase there.

We should also make sure that capacity building can actually effect our entry

strategy. If our sunk costs are higher than our Stackleberg follower profits,

then we should theoretically never enter. If our sunk cost is so low that even

firm one's maximum capacity will not deter us from entry, then we will

always enter and it would be irrational for firm 1 to try and stop us. To find

out if entry will never happen:

Stackleberg π2 = (1398 – 678)834 = 600480 > 11905

To find out if entry is inevitable:

Maximum capacity built

π2 = (949 – 167 – 511) 395 = 107045 >11905

Since we will make positive profits even when firm one is producing

maximum capacity and since positive profits are greater than a payoff of

zero for not entering the market even when firm one builds the maximum

capacity, our firm should enter market D every time shown by the chart on

the right.
So we weren't complete idiots for entering market D. There was a potential

for profits.

If our sunk costs had been in between S1 and S2, then it might have been in

firm one's best interest to build capacity to deter entry by firm 2. See charts

below:

There are a few things that happened in the CSG that our model

doesn't account for and some of these omissions could help explain why

what seemed like a good idea turned out to be a colossal failure. First of all,

our entry made the market an oligopoly of three firms not a duopoly. This
will decrease all firms’ profits in the marketplace. The predatory capacity

building may not be worth the profit from being in a duopoly. Furthermore,

firms can produce goods without purchasing capacity. A firm like ours with

low marginal cost and high capacity costs could produce over capacity at

less cost than it would be to produce at capacity (up to a point). This means

that our firm would not be as deterred by predatory capacity building as the

model indicates because our capacity cost differ so drastically.

Our most costly misestimation was that we didn't consider the

possibility of a price war. If we had been properly educated, we might have

been wary about entering market D because it had the potential to reach a

Bertrand equilibrium (where each firm's price is equal to the highest firm's

marginal cost). The market is set up with a huge incentive to undercut your

competitors by a small amount. When we decided to enter the market the

price for JWC was $1200 and the price for MDD was $1150. On paper this

looked great, we thought we would make huge profits. MDD's pricing

strategy should have already been apparent to us. In period 2, MDD

undercut JWC by around 5%, they took 98% of the market. We should have

predicted both firms alternatively dropping their prices by a very small

amount until all of us reached marginal cost.

This effect can be seen in periods 6 through 13 when prices dropped

from $1200 to $625. Often undercutting by the smallest amount possible

(such as the one dollar deductions in periods 9-11). At the minimum price,
our cost was probably at or below marginal cost – certainly not enough to

recoup our sunk cost. Our estimated losses in that period:

π2 = (P – c)q – S/P = (625 – 678)1000 – 11905 = -54105

It also didn't help that we accidentally exited Market D in period 12 and

reentered the next period so we had to pay the sunk cost twice. The

Bertrand model predicts that it only takes two firms to reach perfect

competition. The CSG seemed to follow that prediction pretty well because

all firms were pretty near our marginal cost. If we had taken this into account

when making our decision to enter market D, we would have realized that

the price would drop to around $600 and it was not profit maximizing to

enter unless we had the lowest cost and could take all of the market. Since

our capacity cost were so high, this was an impossibility.

Prices converge on firm's respective marginal costs as the Bertrand Model

Predicts

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