In trying to figure out how to model an oligopoly, we're going to go down two paths. One path is to model oligopolies that try to find their equilibrium by acting in concert. That is, they collude and figure out what they're going to do jointly. Another way to observe oligopoly is to in fact go down with a more formal theory of how individual players, not colluding with each other, but making decisions that make themselves best off, we'll end up finding an equilibrium play, that's called game theory. But here, in this video, we want to introduce this idea of collusion. We're thinking about how do firms behave when we have a small number of players? So let's start with this idea. I know it's a little bit dissatisfied to not tell you exactly how many players there are, but it just has to be enough players that can actually get together in a room or something and have enough where with all, but they can come to an agreement that they're all going to follow this particular chosen path. So the way we're going to do this, our goal will be to understand the tasks the group needs to solve, if they're going to get priced above the competitive level. They can just go ahead and beat each other up and act like competitors or they can maybe put together a set of rules that will allow them to behave with each other in a way where they make more money than acting like competitive. So we're going to start this thing. To model this, we'll assume we have a competitive industry. These tasks are something that is not going to be easy, and we're going to talk about how the relative difficulty of the two of them. But in order to make this work, what I want you to think about is the following. Let's suppose that we take an industry that's currently competitive. This industry is currently competitive and the industry has to figure out how do I get from this point? We're not making very much money in this competitive industry, because we're fighting out tooth and nail to a situation where we have perhaps a better outcome. So we'll start from the industry that's relatively competitive, and I think what we'll do, because everybody is quite familiar with this, is we'll think about the oil industry. Let's use the example of the oil industry, and so we'll draw some axes here. Vertical axis is price and the horizontal axis is quantity. We're going to think about the industry in, let's say, oil in 1965. In 1965, there will be a demand curve for oil and it looks like something like this. I'll just put demand 1965. There's a supply curve that looks like this. Historically, the price of oil was about three dollars a barrel for many years. After the post World War II, starting in 1945 all the way up to 1973, oil was about three bucks a barrel forever. That's just a nominal price, that's not inflation adjusted or anything, and it had a relatively low price here, which we'll just put down is for purposes as example, three dollars. In order to act like a cartel, we have to think about the individual firm too. So this looks like the equilibrium for the market. Let me draw a picture that also has the individual player on there. You know these things, we call them the side-by-side picture back in the day when we were doing this in competitive cases. So we have the price on the vertical axis is the same, that they're both measured in dollars and cents, and that's because we're talking here about the market, cap Q, and here is an individual firm, lowercase q, and in this market, we've got this demand curve that looks like this, pretty steep, and we've got this supply curve that looks like this, and this is sending out a signal to the market, and which at three dollars, and that signal to the market looks like this. This should be the marginal revenue, and then there's some marginal cost for the individual firm. This firm i, so this would be the marginal cost for firm i. That looks like an original equilibrium. There's three task, okay? So I'm going to copy this because I'd like to use it again. We're going to go back to the previous picture, which are going to move down here. It will go back to equilibrium. So as you can see, this is the side-by-side equilibrium. Price in the market, three dollars. Historically, three dollars for many years in a row, individual players go out and produce at, label this, this would be the original output for an individual firm and this would be the original output for the market. let's think about cartel tasks. The first task we'll call originally. Task number 1 is the cartel has to determine the optimal price and quantity for the cartel. So think about this, this is OPEC, that's obviously what we're talking about, and OPEC had been in organizations since the '60s, but the organization that they had four of those, mostly an organization that was get together and concerned itself about, how to deal with the problem of Israel and the political tensions between the world and Israel. But in early 1970s, OPEC understood that they had a remarkable amount of economic power if they could somehow control the amount of oil that they actually produced, because they were the major player in the market. So what we want to do is think about what would be the output toys they would choose? So on this next picture, you can see that currently, OPEC and the market is producing there, individual proletarians producing here. OPEC says, "You know what, what we want to do is think about some higher price. We don't like three dollars, how about ten dollars? How about getting in up there? How could we do that?" Well, the only way they could do that, is to do what? Well, they'd have to somehow reduce output. If they could reduce output back to here, they might be able to get that 10 dollars, okay? So the first problem that OPEC had was to figure out how much do we really want to make, how much price do we want, and how much are we going to have to reduce our output? So they have a bunch of economists working for them and they have a pretty good estimate of what the shape of the demand curve looks like. They've been following it through different markets. They can see out depending on how transportation costs may raise the cost for some people in some sectors, and we see how people respond when you have different prices, try to measure elasticity and all these different things. But still they have to come up with some output. So what we're going to call that output is Q star sub fix and P star sub fix, we don't want to use Q sub C For cartel or Q sub C for collusion because basically, we've been using C for competition to belong and I don't want to loose any embedded muscle memory there. We're talking about competition, we usually put Q sub C. Collusive arrangements usually, economist colleagues price-fixing. You get together, you figure out what price you want to have, and you forgot how much output has to fall. So the first task is you need to determine this. Now it's not easy, okay? Some people want to go for the throat and go for higher. Some people don't want to rock the boat. By the way, if it was an occlusive arrangement in the United States, of course, we would never get to see this happen because it's against the law. So they wouldn't be out in the open, they'd be doing it in some back room of some far away place, with no cameras on them and no recording devices. In OPEC case, they actually had videotape meetings. They had video of them getting together in a room and yell at each other, pounding on table and stuff, because some of the members of OPEC wanted to really go for the throat and really reduce output. Get to a situation where we just push output all the way back here, and we'll make a fortune, okay? Others said, "No, no, no, that will cause the whole world." Since oil and energy is one of the greatest and it was in fact the most important element in manufacturing across the world. That would really basically send the world into a tailspin, a recession or maybe even a depression. So we should be a little bit softer, we can survive with, just say, six bucks. So we don't have to reduce output that much and we'll get six dollars. So they had lots of debate about. So the first task might seem simple, but it's hard. Some people say, "Well, maybe, they just go ahead and act like a monopoly." It could act like a monopolist. They could look at this picture and they could say, "Given this, this is really just the some of our marginal cost curve. Then maybe, I could set the marginal revenue curve. I could find the marginal revenue curve, and I could say, 'Well, this should be the right price.'" But it's true that if they did that, that would be the maximum profit for them as a group but individually, they still might have different individual priorities or what they want to have happen. The point that you need to keep in mind is the first task which looks like it might be pretty simple. Let's just reduce our output and make some price, higher prices was not that simple. But suppose they figured that out, next step we'll have to think about task number 2. That's for another video.
