TEACHING TOOLS

THE OLIGOPOLY GAME

DAVID HEMENWAY’, ROBERT MOORE”, and JAMES WHITNEY“

1. INTRODUCTION

The following in-class exercise has been used successfully by all of us in a variety of classes, including Principles of Microeconomics, Intermediate Mi- croeconomic Theory, and Industrial Organization. The purpose of the game is to illustrate some of the difficulties involved in price coordination (collusion) under circumstances of imperfect competition. It also serves to give students insights into the importance of information and communication in these cir- cumstances. The exercise takes anywhere from 15 minutes to 45 minutes, depending on how many of the variants below you actually use. No prior knowledge of oligopoly theory is required. We have used the exercise in classes as small as 15 students and as large as 70.

II. DESCRIPTION OF THE ACTUAL EXERCISE

The exercise begins with the distribution of the handout that we include in the Appendix. After the students have read the handout, we usually spend a few more minutes explaining how the game works and ask if there are any questions about how the game will be played. Make sure you do not discuss advantages/disadvantages of alternative strategies at this point. Confine the questions to the mechanics of what will happen during the exercise.

We then start the first round. At the count of 3, each student raises her hand. Her hand must be either closed or open, as the i.nstructions on the handout mandate. (See Appendix if you have not done so already.) Students then record their score, and the procedure is repeated after letting the students briefly ponder what has happened. It is essential that students not communicate with each other during this pause. This same procedure is repeated until all six rounds have been completed. The first game is now complete, and students compute their grade according to the scale on the handout.

What Will Happen-Game One In the 40 or so times we have conducted this exercise, the overwhelming

majority of the class votes to “compete” each round. Thus, the maximum score any student can receive is 60 points (a D grade). Those few who tried to “collude” receive zero points in each round, and quickly get discouraged. After the six initial rounds have been played, we allow the students to discuss strategy and then permit them to replay the game. At this point the brighter students point out (correctly) that as long as a majority votes to collude, everyone can get an A+!! When the other students realize this, they are

* Harvard University, School of Public IIealth; **Occidental College, Department of Economics.

527 Economic Inquiry Vol. XXV. Ortober 1987, pp 727-7’30

728 ECONOMIC INQUIRY

encouraged and want to play the game again. If the rules of the game do not change, they usually advise each other to vote to “collude,” and the second game starts.

The Second Game

At the start of the second six rounds, usually a majority do indeed vote to collude, and so those who do receive 20 points per round. Those who continue to “compete” (and “cheat” on the cartel) do even better, and receive 40 points per round. This causes some grumbling out loud about those “cheaters,” and toward the fourth or fifth round, the cartel breaks down and a majority of students “cheat” and vote to “compete.” Sometimes, the cartel breaks down as early as the second or third round of the second game.

Alternatioe Versions of the Second Game Variation 1: Changing the Points Required for a Given Grade. As the “price” for being allowed to communicate and then replay the game, the points required to achieve particular grades might be changed. For example, the points needed to receive an A+ might be increased from “Over 100” to “Over 120,” with the other assigned points remaining unchanged. Some students will soon see that it is still possible for all to receive an A+. However, to do so it becomes necessary to designate specific “cheaters” for each round. The re- sulting strategy is analogous to bid-rigging. While the likelihood of a break- down of the cartel increases with this variation, the strategies, anxiety and anger generated enrich the subsequent discussion of the outcome. Variution 2: Going from Open Communication to “Sealed’ Vote. After two or three rounds of the second game, the interjection of a “surprise” devel- opment can lead to interesting results. One such “surprise” is to inform the class &hat antitrust authorities have become suspicious about the conduct of their industry. As a result, the students are obliged to cut down on their level of communication by closing their eyes for the voting and vote-counting during the remaining rounds. Even though the predetermined strategy of the students remains optimal, it is striking how quickly the collusion breaks down when the lines of communication are broken. Students can become quite hostile toward those who break ranks first, so it may be advisable to make sure that students lower their hands before opening their eyes.

111. DISCUSSION

At the conclusion of the second game, we discuss what has happened and some of the implications. There are many points that one can bring out about what has gone on. Here are several that we mention:

1) The importance of the number of sellers: students can understand that if they were to play this game with only a few students it would be easier to recognize their mutual interdependence. In addition, it would be easier to communicate. Finally, the chances of cheating would diminish. The parallel to seller concentration is easily drawn.

HEMENWAY ET AL.: OLIGOPOLY GAME 729

2) The importance of communication in overcoming the incentive to “cheat”: without any communication, students realize that it is quite difficult to collude, even with as few as 15 students. This becomes particularly evident if Variation 2 is employed during the game.

3) The importance of having a disciplining device: even with communication and no antitrust worries, it would be much easier to “collude” if the “cheaters” could be punished.

4) Analogies to “real world” collusion incidents: for example, with Variation 1 of the second game, it is useful to draw parallels with the bid-rigging practices of the construction industry, the dancing partners arrangement of the petro- leum industry during the Depression, and the bid rotation scheme of the heavy electrical equipment conspiracy.

5) Other obstacles any successful cartel must overcome: as difficult as col- luding turns out to be in this exercise, the cartel here did not have to worry about several important problems real-life cartels face. These include: i) stu- dents never have to agree on an “exact” price-if they decide to “collude,” the “colluding price” is already established; ii) students never have to worry about possible entry of new firms-we point out that with the colluding price, there are strong incentives for new firms to enter the industry and disrupt the cartel; iii) students never have to worry about competition other than price- there are no differences in the quality of the product here. (For many cartels the agreement on price is not sufficient since non-price competition can be an important source of difficulty.)

If you plan to discuss game theory and oligopoly behavior, you can use this game as an illustration of the “Prisoner’s Dilemma.” However, we have found that there is no need to introduce game theory in order to use this exercise. (You can display the payoffs in non-payoff-matrix form if you feel this will alleviate problems for your students.)

One Last Word We place little or no weight on the “grade” received by the students on

this exercise. However, it is important that they take the game seriously. A little initial deception concerning the significance of the game can be helpful in this respect. Afterwards, we point out that our motivation for trying to make them play seriously is that real-life firms are playing for profits, not grades.

APPENDIX-OLIGOPOLY GAME CLASS HANDOUT

Purpose: To illustrate the problem of price coordination under oligopoly. Instructions:

1. Take out a piece of paper, write your name at the top, and write the

2. The following “pay-off matrix” describes the game we will be playing: numbers 1 through 6 vertically down the left hand side of page.

your 4 possible pay-offs will be explained in class.

730 ECONOMIC INQUIRY

“Rivals” Compete Collude

Compete 10 40

Collude 0 20

3. We will play this game for six rounds. The object of the game is to maximize your “profits” (total pay-offs). After each round, you will record your own pay-off on your piece of paper.

4. For each round, you will decide whether to “compete” or “collude.” You will indicate “compete” BY AN OPEN HAND. You will indicate “collude” by a FIST (for solidarity?). All hands must go up at the count of “THREE.”

5. The response of your “RIVALS” will be determined by the majority of all votes in the class.

6. There is to be no talking (except for questions you may have about the rules of the game).

7. You will receive a grade on this exercise that will be determined as follows: Over 100 = A + ; 90-100 = A; 80-90 = B; 70-80 = C; 60-70 = D; below 60 = F.

ExurnplelErplanation: Suppose in the first round, more than half of you decide to “compete.” Then those of you who raised an open hand (“compete”) would receive 10 points. Those of you who raised a fist (“collude”) would receive 0 points. We will then pause, and everyone will record their points (pay-off) on their own sheet of paper. Then we will play round 2 and everyone will vote all over again . . . suppose in round 2 a majority of you raise a fist. Then those who raised an open hand receive 40 points and those who raised a fist receive 20 points.

(After six rounds, we will vote to determine if you want to play the game for another grade. However, before we vote, a 10 minute communication session will be allowed, where you will be able to discuss strategy with your classmates.)

You