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  • Jacob: Welcome to Crash Course Economics, I’m Jacob Clifford

  • Adriene: and I’m Adriene Hill, and today were talking about competition and game theory.

  • Jacob: Games? Like board games or video games? I can beat my seven year old at Call of Duty.

  • Adriene: No, not quite like that. In this kind of game, if you lose, youre bankrupt.

  • [Theme Music]

  • Jacob: So when we talk about markets, there are basically four different types, or market structures.

  • They vary based on things like number of producers, control over prices,

  • and barriers to entry -- how hard it is for new businesses to jump in the market.

  • Most agricultural products, like strawberries, are in a type of market called perfect competition.

  • There are thousands of farmers all growing identical strawberries and it's pretty easy

  • to get in the market. You just plant strawberries. Individual businesses don't have control over prices.

  • One farmer can’t convince you to pay $10, if you can it buy from other farmers for $4.

  • A monopoly is on the other end of the spectrum. There is one large company that produces a

  • product with few substitutes. And because high barriers prevent competition,

  • a monopoly has a lot of control over price.

  • There are two types of markets in between these extremes. Monopolistic competition is

  • a market with many producers and relatively low barriers; their products are very similar

  • but not identical. This could be something like furniture stores or fast food. McDonald's

  • and Burger King do have noticeably different products.

  • One might be able to charge a slightly higher price if, for whatever reason, consumers prefer

  • that type of burger. But, if either tried to increase their prices a lot, everyone would

  • just go to their competitor. And, if McDonalds and Burger King both tried to raise prices

  • at the same time, some other company would enter the market since the barriers are relatively

  • low. Taco Bell would start selling hamburguesas.

  • The last type are Oligopolies and that's what we're gonna focus on today. Oligopolies are

  • markets that have high barriers to entry and are controlled by a few large companies.

  • Oligopolies are all over the place. In fact their products are likely in front of you

  • right now. The laptop computer market is dominated by companies like HP, Dell, and Apple. And

  • the majority of mobile phones are produced by Apple, Samsung, and LG.

  • You also see this type of thing in markets for cars, air travel, movies, candy, and game consoles.

  • Adriene: Like monopolistic competition, oligopolies often sell products that are similar but not

  • identical and this gives them some control over their prices. But how much? You might

  • love your iPhone, but if Apple raised the price of a phone to $3,000 you might switch to Android.

  • But the price of an iPhone is pretty close to the price of a high-end Android. So how do they compete?

  • The answer is non-price competition and, as you might guess, it's competing without changing the price.

  • This happens in a lot of industries. Companies focus on things like style, quality, location, or service.

  • The goal is to distinguish their product from their competitors.

  • Like, the jeans that one company sells might be virtually identical to everyone else’s

  • in terms of quality, but if they can convince consumers that having a designer label on

  • their butt is cool, buyers might pay much much more. The same logic holds true if a

  • company has better customer service or has more convenient locations.

  • The most recognizable form of non-price competition is advertising. Companies spend billions of

  • dollars each year introducing new products or services and differentiating themselves

  • from their competitors. And despite all that spending, most of the time, advertising just

  • kind of fades into the background. Can you remember the ad that ran before this video? No? Me neither.

  • Don Draper might tell you, “half the money spent on advertising is wasted; the trouble

  • is, you don't know which half.” It’s clear that not every advertisement sticks, but advertising

  • can work to help a brand stand out.

  • Jacob: So, those ads that run before YouTube videos? Some are for products sold in monopolistically

  • competitive markets, but the majority are probably from oligopolies. I mean, think of

  • car companies -- they advertise A LOT.

  • Generally, monopolies don’t bother advertising because they have no competition, and firms

  • in perfectly competitive markets don’t run ads because their products are identical.

  • Advertising just increases their costs and drives up the prices, which means customers go to their competitors.

  • So oligopolies sound like they operate pretty much like monopolistic competition but the

  • big difference between the two is that oligopolies are made up of a few large companies. This

  • means that each company makes decisions with the actions of their competitors in mind.

  • They use game theory -- the study of strategic decision making. Let’s go to the Thought Bubble.

  • Adriene: Let’s start with a classic of game theory, something called theprisoner’s dilemma.”

  • Suppose Stan and I are arrested for scrawling in wet cement outside the YouTube studios.

  • Were being interviewed separately. If we both confess, well both have to pay

  • a $10,000 fine. If neither of us confesses, well get off scot free. And If I take a

  • deal and confess, but Stan doesn’t -- I’ll walk away and Stan will owe $20,000. And vice versa.

  • So what do we do? Because we can’t discuss it, we both confess, and both end up owing

  • $10,000. This is Game Theory: even if people or companies rationally follow their own self-interest,

  • the best outcome is hard to reach when they can’t or don’t cooperate.

  • Game theory helps explain why you get drug stores and coffee shops next to each other.

  • Let’s say that Craig and Phil both start selling tchotchkes on the Coney Island Boardwalk.

  • At first they start on opposite sides of the strip -- sharing customers equally. Phil realizes

  • that if he gets closer to Craig, hell retain all of his old customers...and snag some of

  • Craig’s. But Craig’s no dummy; he moves his cart closer to Phil’s.

  • This continues until they both wind up right in the middle of the boardwalk, sharing customers

  • equally--and unable to improve their position.

  • This also plays out with pricing. If Craig lowers his price on Crash Course nesting dolls,

  • Phil will likely compete by dropping his prices as well. In the end theyre gonna continue

  • to share customers equally, and earn less money.

  • If Craig understands game theory, he knows there’s no reason to change his price. Instead

  • he focuses on providing knick-knacks that differentiate his kiosk from Phil’s. This

  • can help explain why prices in oligopolies tend to get stuck and why companies focus

  • so much on non-price competition.

  • Thanks Thought Bubble. So, What if Craig and Phil don’t compete at all? What if instead,

  • they agree to charge the same high price, conspiring to form what economists call a cartel?

  • Again they split the customers 50/50, but now they make even more profit --

  • benefiting at the expense of consumers.

  • This is called COLLUSION, and it’s illegal in the US. There are strict antitrust laws

  • designed to prevent it. But that doesn’t mean companies don’t figure out other ways to raise prices.

  • Price leadership is when one company changes its prices, and its competitors have to decide

  • if theyre going to follow suit. Since they're not actively colluding, it’s technically legal.

  • But it can be hard to tell the difference. Look at airline baggage fees.

  • When some airlines started charging fees for checked bags, other airlines quickly joined them.

  • And when one big airline changes their baggage fee, the others tend move to the same price point.

  • Are they colluding, or is this a case of price leadership?

  • Well, the Justice Department’s looking into it.

  • Other countrieslaws differ, and cartels do exist. The best example is OPEC -- The

  • Organization of Petroleum Exporting Countries. It’s an international cartel made up of

  • 12 oil-producing countries that manipulate oil supplies to control prices. They control

  • 80% of the world’s known oil reserves and nearly half of the world’s crude oil production.

  • Jacob: Economists like to explain oligopolies and game theory by creating something called a payoff matrix.

  • Let’s say Stan and Brandon have competing companies. Each can set prices high or low.

  • The numbers in the boxes represent the amount of profit each company will earn in different situations.

  • The profit on the left in each cell is for Stan and the numbers on the right are for Brandon.

  • So if Stan has a low price and Brandon has a high price, Stan earns $300 and Brandon earns $50.

  • Now, payoff scenarios for companies are never this transparent, but the matrix says a lot

  • about oligopolies. The optimal outcome is for each business to charge high prices so they both get $200.

  • Stan knows this, but he also recognizes that there could be even more profit by charging

  • a lower price. Brandon comes to the same conclusion, so they both price low and they end up in

  • the worst combined outcome with each only making $80 profit.

  • Even if they collude and agree to price high, they both have an incentive to cheat on that agreement.

  • So collusion and cartels are often unstable. They can only last if the agreement is monitored and strictly enforced.

  • A lot of times, it's possible to predict the final outcome based on the information in

  • the payoff matrix. The best outcome for Stan, when Brandon makes a move, is called Stan’s best response.

  • So, if Brandon prices high, Stan’s best response is to price low and if Brandon prices

  • low than Stan’s best response is, again, to price low. That’s called having a dominant

  • strategy: it always gives the best available outcome, no matter what the other guy does.

  • For Brandon, pricing low is his dominant strategy too: regardless of what Stan does, pricing

  • low always results in a better outcome.

  • Adriene: Game theory helps companies make decisions, but, potential payoffs are never

  • easy to predict and there are many situations where there's no clear dominant strategy.

  • Sometimes, the best response changes depending on what competitors do.

  • Those that don’t keep up or are slow to adapt are pushed aside. It’s called Game

  • Theory, but to former industry leaders like Pan American Airways, Atari, and Research

  • In Motion -- that made Blackberry phones, the end of the game was not that fun.

  • In any game, there are winners and losers, unless it’s some lame co-op thing. But at

  • its best, healthy competition promotes innovation which, in the end, makes us all better off.

  • Jacob: And ideally we get cheaper air fares, constantly improving cell phones, and amazing

  • video game consoles. Thanks for watching, well see you next week.

  • Thanks for watching Crash Course Economics, which is made with the help of all these awesome people.

  • You can help keep Crash Course free, for everyone, forever, by supporting the show at Patreon.

  • Patreon is a voluntary subscription service where you can help support the show by giving a monthly contribution.

Jacob: Welcome to Crash Course Economics, I’m Jacob Clifford

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