Current issues

CURRENT ISSUES IN AGRIBUSINESS

LECTURE MATERIALS FOR BSc. AGRIBUSINESS MGT IV

Compiled by:

Dr. Robert Aidoo
Dept. of Agric. Economics, Agribusiness & Extension, KNUST, Kumasi-Ghana

Course outline
Course Objective:
• The objective of this course is to expose students to current trends in the field of
agribusiness in international circles.
• Content:
The origin and principal features of the World Trade Organization (WTO), its role and mandated
ISO. The need for an ISO content variation and applicability to developed and developing
countries, international trade and international commodity organizations. Alternatives and
consequences of public policy in the agri-food system.
What we will cover:

•

The global agri-food system and structural Changes/evolution

•

Linkages/Integration in Businesses (Vertical and Horizontal Integration)

•

Vertical Coordination in the agribusiness industry

•
•
•
•

Game Theory and Economics of Cooperation
WTO issues
ISO issues
Agricultural Insurance Issues

2

Lecture 1

THE AGRI-FOOD SYSTEM AND
STRUCTURAL CHANGES

Food chain- A reflection from SCM

Input
suppliers
Farmers

Processors

Retailers

Consumers
4

The Evolving Food and Agriculture System
• In the past, food was viewed strictly in terms of
commodities produced in bulk and meant to be plentiful and
affordable.
• But, in the decades of prosperity in the last half century, the
concept of food and our expectations have changed and
taken on a new significance.
• Consumers today have come to expect a great deal more of
the food system.
• The food system now delivers more nutritious food with
wider variety; improved safety, with less environmental
impacts; and greater convenience than at any time in the
history of the world.
5

• Over the last century, the global food system requires that in
addition to providing the physical food commodity; we:
–
–
–
–
–

Ensure food safety
Promote nutritious and convenient foods and products,
Protect environmental quality,
Protect workforce, and
Keep markets functioning efficiently.

• The key challenge is the ongoing transformation of
agriculture into the a global, consumer-driven food system.
• How do countries (especially less developed economies)
make a paradigm shift from the largely commodity-oriented
agriculture to a more function focus and consumer oriented
agriculture?
6

Agricultural Diversity
• Farming today consists of enormously different farms, growing numerous
crop and livestock products for sale in markets that range from their
immediate neighbours to consumers worldwide.
• Farms differ in size, type and value of commodities produced, technology
used, resource endowment, and many other attributes.
• Farmers differ in commitment of time, management abilities, business
goals, and financial resources.
• The result is a sector that cannot be accurately characterized by any
single measure or indicator.
• It is, therefore, important to recognize and understand this diversity that
makes up today’s agriculture if we are to adequately prepare for its future.
• The developed world (especially US) saw a concentration of resources
into fewer and larger farms throughout the 20th century.
• While production doubled over the last 50 years, farm numbers dropped by more than two7
thirds.

Consumer-Driven Agriculture
• Historically, farmers’ main objective was to keep up with the food
demand generated by a growing population.
• Over time, people wanted not only to ensure that their basic energy
requirements were met, but also to eat better through access to a wider
variety of nutritious foods.
• The number of foods labeled “low-fat” or “healthy food” shows how the
food system has evolved to address consumer demand.
• Food marketing is also changing in other ways. Mass merchandisers,
warehouse club stores, specialty stores, and restaurants are becoming
increasingly favored over traditional supermarkets.
• Meanwhile, consumers are increasingly eating away from home,
reflecting the premium on convenience.
• The competitive job market and urbanization have changed the
traditional role of women in the home, thereby creating demand 8
for
convenient foods.

• Consequently, the structural change well underway in
commercial agriculture is characterized by:
–
–
–
–

Larger farm sizes;
Specialization;
More efficient production methods; and
Greater coordination.

• For these farms, a decided change in their role in the overall
food system is occurring.
• Farmers once purchased inputs and sold products in armslength transactions and largely were price takers in both
markets.
• But, those lines are fast blurring, with differentiated products,
bundled systems, and greater system coordination.
9

• Buyers and sellers of agricultural commodities and
producers rely less on cash markets and more on dozens of
kinds of contractual arrangements.
• New
production
methods,
a
variety
of
joint
venture/marketing
arrangements,
and
information
technology are lowering the total costs of doing business by
introducing size economies and reducing transaction costs.
• While this structural change clearly is advantageous for
some, it also prompts concerns about competition,
market access, and the use of market power by some
participants to the disadvantage of others.

10

The main drivers of change
• Today, a small number of very powerful forces are
propelling the fast-paced change occurring in every single
component of the food system.
• They include:

a) Globalization of markets and culture,
b) Technology,
c) Fundamental changes in our family structure,
life style and workforce, and
d) Environmental and safety concerns

11

a. Globalization
• Today, much more agricultural trade is market driven because of the
collapse of the Soviet Union, the end of the U.S.- European Union (EU)
subsidy wars, and China’s shift to more market-oriented agricultural
policies.
• International trade agreements, reforms in domestic agricultural policies,
financial market liberalization, and a constellation of other policy changes
that boost competition have further hastened globalization.
• Growth in international trade and investment illustrates the impact of
globalization on the food system.
• Foreign-owned firms had foodservice sales in the United States of $6.4
billion in 1998.
• McDonald’s has become the largest overseas foodservice operator, with more than
28,000 restaurants in 121 countries.

12

•

Globalization of markets pressurizes firms to be more competitive, to “shorten the
supply chain,” streamlining the system (eliminating transactions and their
associated costs) to efficiently meet rapidly changing consumer demand.

•

Businesses in the food system around the world compete against each other to
provide high-quality products at the best price.

•

Globalization makes it imperative for companies to diversify their sources of raw
materials and buy from the farmer, wholesaler, or food processing company that
provides the best product for the lowest price at any given time.

•

Available evidence points to increasingly fierce competition in the agricultural
system, suggesting that the innovative, cost-effective producers will prosper.

•

Mergers, acquisitions, and further globalization of the food system can be
expected to continue.

•

Helping consumers to eventually get what they want can be good business, and
–

businesses that can do this quickly and efficiently tend to succeed while those who are slow to
understand key trends face rapid erosion of competitive position.

13

b. Technology
•

Technological change in agriculture focused traditionally on tools and
techniques to lower farmer production costs and increase yields.

•

Such technologies, which have added greatly to production efficiency, increased
profit margins of early adopters, and ultimately lower consumer prices, still have
a role in today’s agricultural economy.

•

Increasingly, though, the market today is pushing technological progress in new
directions, for new purposes, using new tools - all with different implications for
business and policy decision making.

•

Bio-based technologies promise opportunities never before imagined.
–

•

Production and processing technologies are opening entirely new energy, industrial, and
pharmacological markets for today’s farmers.

Technology is shifting at every level in the production and marketing chain
towards satisfying consumer demand for quality, safety, nutrition, and choice.
14

•

Production Technology: Recent advances in agricultural production technology
have both reduced producer costs and conserved natural resources.

•

Consumer-Oriented Technology:
Consumers’ demands for food safety, freshness, quality, convenience, and even
attractiveness have led to brand new industries, each relying on new and unique
avenues of technological advance.

•

Information Technology:
– Information technology (IT) contributes to the faster flow of information among
potential buyers and sellers of food and agricultural products.
– It thus affects the speed at which markets operate, and it shortens the
timeframe in which purchase, inventory, and pricing decisions must be made.
– Adoption of information technology by farmers in the USA, particularly the
Internet, has occurred at the same or greater rate than in the general
population or among small businesses.

15

•

Agricultural Biotechnology:
– Biotechnology is a collection of powerful tools that can be used to
increase production or cut costs, develop product attributes desired by
consumers, or enhance environmental quality.
– It is a technology that has application in not just one, but every segment
of the food supply chain (i.e. input supply, production, processing,
consumption).

16

c. Fundamental changes in family structure, life
style and workforce
• Drive for more convenience and added value foods:
– Demographic and lifestyle changes
– Eating away from home (due to work pressures and
urbanization)
– Women working outside the home (limited time to
prepare time-consuming traditional diets (e.g. Fufu)

• Nutrition and health issues:
– Food labels and packaging
– Sugar, Fat and cholesterol in foods
– Chemical residues in foods (organic foods)
17

d. Environmental and safety concerns
• Environmental
protection
biodiversity –flora and fauna)

(river

bodies,

– There is a call for Sustainable agriculture/Green
agriculture/Organic farming
– Socio-environmental Certification of agric products

• Safety of workforce has become very important
and the type of labour used in agriculture
– Child labour issues
18

Motivation for these structural changes
• The desire to capture economies of scale and
economies of scope (horizontal)
• Reducing uncertainty and controlling quality in
the supply chain (vertical)
• Competition in the food industry in future will
be more between alternative supply chains
than individual firms
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Summary
•

Consumers’ demands for food safety, freshness, quality, convenience,
and even attractiveness have brought about a revolution in the agri-food
system.

•

The food system has entered a consumer-driven era and diversity within
the farm sector is enormous.

•

New waves of new technology are sweeping through the entire food
system.

•

Agribusinesses must now operate in a globally competitive economic
environment.

•

A diversifying agricultural system, based more on end products and less
on raw commodities, brings new challenges along with broad benefits.
20

Lecture 2

LINKAGES/INTEGRATION IN BUSINESSES

21

Business integration?
• Business integration is the process of attaining
close linkage or coordination among several
departments, groups, organizations, systems,
etc. to ensure efficient business operations.

22

What is Vertical Integration?
• Vertical integration is the process in which several steps in
the production and/or distribution of a product or service are
controlled by a single company or entity, in order to increase
that company’s power in the marketplace.
• Vertical integration occurs when one company owns outright two or
more stages of production as a way to seek greater economic
value.
• Vertically integrated companies in a supply chain are united
through a common owner.
• Usually each member of the supply chain produces a different
product or (market-specific) service, and the products combine to
satisfy a common need.
23

Example of vertical integration
•

While you are relaxing on the beach sipping chilled cold drink, the brand
that you see on the bottle is the producer of the drink but not necessarily
the maker of the bottles that carry these drinks.

•

This task of creating bottles is outsourced to someone who can do it
better and at a cheaper cost.

•

But once the company achieves significant scale it might plan to produce
the bottles itself as it might have its own advantages.

•

This is what is called vertical integration:
– The company tries to get more things under its reign to gain more control over the
profits the product / service delivers.

•

A monopoly produced through vertical integration is called a
vertical monopoly.
24

Types of Vertical Integration

There are three basic classifications of Vertical Integration:

• Backward integration – This is where the firm/company tries to own an
input product company as a subsidiary.
Examples include:
–
–
–
–
–

Soft drink company owning a bottle manufacturing firm
A car company owning a company which makes tires.
Poultry farm owning a feed mill, maize farm, hatchery, etc.
Cocobod owning a jute sac manufacturing company
Cassava processing firm owning a cassava farm

• Forward integration – Where the business tries to control the post
production areas, namely the distribution network.
Examples include:
– Poultry farm owning a distribution firm to sell its eggs or owning a meat processing plant (e.g. Santinos)
– A fertilizer producing company owning a distribution firm to sell the product
– A licensed cocoa buying company owning a haulage company to cart its cocoa to the port (e.g.
Adwumapa buyers Ltd)
– Like a mobile company opening its own Mobile retail chain.

•

Balanced integration – It is a mix of the above two. A balanced strategy to take
25
advantage of both worlds.

What is Horizontal Integration?
• Horizontal integration (or lateral integration) simply means a strategy to
increase a firm’s market share by taking over a similar company.
• Horizontal integration occurs when a firm is being taken over by, or
merged with, another firm which is in the same industry and in the same
stage of production as the merged firm.
• This take-over / merger / buyout can be done in the same geographic
area or probably in other countries to increase your reach.
• Horizontal integration is a strategy used by a company/firm that seeks to
sell a type of product in numerous markets.
• Horizontal integration in marketing is much more common than
vertical integration is in production.

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•

Examples include:
– A car manufacturer merging with another car manufacturer.
•
•

In this case both the companies are in the same stage of production and also in the same industry.
This process is also known as a "buy out" or "take-over".

– A feed company in Kumasi buying out a similar feed company in Techiman
– If Benso Oil Mills (BOP) or Twifo Oils Mills buys or merges with Juaben Oil Mills
– The merger between Intercontinental Bank and Access Bank

•

The goal of horizontal integration is to consolidate ‘like’ companies
and monopolize an industry.

•

A monopoly created through horizontal integration is called a
horizontal monopoly.

27

Advantages associated with business integration
•

Have economies of scale and scope

•

Expand your knowledge and capabilities

•

Increase market (and profits)

•

Own the whole life cycle so that you can change it the way you want ( it avoids the
hold-up problem)

•

Reduce competition (by merging with them rather than competing)

• Increased control over product quality and consistency (helping meet
consumer demand)
• Flexibility in operations--Greater control over the timing of production (You
are able to adjust to the ebb and flow of market demand).

28

Hold-up problem ?
•

In economics, the hold-up problem is a situation where two parties
(such as a supplier and a manufacturer or the owner of capital and
workers) may be able to work most efficiently by cooperating, but refrain
from doing so due to concerns that they may give the other party
increased bargaining power, and thereby reduce their own profits.

•

For example, imagine a scenario where profit can be made if agents X
and Y work together, so they form an agreement to do so, after X buys
the necessary equipment.

•

The hold-up problem occurs when X might not be willing to accept that
agreement, even though the outcome would be Pareto efficient, because
after X buys the necessary equipment, Y would have bargaining power
and might decide to demand a larger proportion of the profits than before
(free rider problem!).

•

One way to avoid the hold-up problem is for the firms to merge, a tactic
known as vertical integration.
29

Economies of scale?
• Economies of scale are the cost advantages that an
enterprise obtains due to expansion.
• There are factors that cause a producer’s average cost
per unit to fall as the scale of output is increased.
•

"Economies of scale" is a long run concept and refers to
reductions in unit cost as the size of a facility and the
usage levels of other inputs increase.

• Diseconomies of scale is the opposite.

30

Economies of scope?

•

Economies of scope are conceptually similar to economies of scale. Whereas 'economies
of scale' for a firm primarily refers to reductions in average cost (cost per unit) associated
with increasing the scale of production for a single product type, 'economies of scope' refers
to lowering average cost for a firm in producing two or more products.

•

Economies of scope makes product diversification efficient if they are based on the common
and recurrent use of proprietary know-how or on an indivisible physical asset.
–
–

If a sales force is selling several products they can often do so more efficiently than if they are
selling only one product.

–

•

For example as the number of products promoted is increased, more people can be reached per
dollar spent.

The cost of their travel time is distributed over a greater revenue base, so cost efficiency improves.

Economies of scope can also operate through distribution efficiencies:
–

It will be more efficient to ship a range of products to any given location than to ship a single type of
product to that location.

–

Selling in different geographic market will be more efficient than selling in a single market location.
• So a company which sells many product lines, sells the same product in many countries, or
sells many product lines in many countries will benefit from reduced risk levels as a result of its
economies of scope.
• If one of its product lines falls out of fashion or one country has an economic slowdown, the
31
company will, most likely, be able to continue trading.

Limitations of business integration
1. One challenge to vertical integration is statutory.
– In the US, several states have laws in place designed to protect the role of the
independent producer, preventing corporations from engaging in certain
agricultural activities.
– Nine states currently have some form of anti-corporate farming law in effect,
including South Dakota, Minnesota, Nebraska and Kansas. Typically, they
restrict a company’s ability to engage in farming or to acquire, purchase, or
otherwise obtain land for agricultural production. Many have an exception for
certain types of family-owned corporations.
– Mergers have seen increased scrutiny from federal regulators and approvals are
becoming more difficult to obtain.

2. Production and market risk. Farming is a risky business. Yet for
vertically integrated companies involved in production agriculture,
programs such as federal crop insurance and federal farm programs
are less likely to be available to help manage the associated risks.

32

3. Public and community perception (negative).
– In developed economies, proposed mergers involving vertical integration are seeing
increased resistance within the public sector as well.
– Independent producers often encounter much less resistance when developing a new
venture than a proposed vertically integrated project.
– When it comes to marketing, the public’s perception and support, for independent
producers can also be a benefit, as opposed to the public’s possible antipathy toward
vertically integrated companies in one sector.

4. One challenge that those looking at vertical integration may find is the
perception that the independent producer, with his connection to the land,
is a better steward of the land and the environment.
5. Differences in organizational cultures (in the case of mergers)
6. Liabilities of the organizations are all taken on board (in mergers and
acquisition)
33

•

Vertical coordination includes “any type of formal or informal
arrangement that has the effect of more closely relating successive
steps in the production and/or processing of food and fiber” (Davis
1957).

•

Vertical coordination includes a continuum of possibilities—from spot
market transactions to full vertical integration.

•

The middle ground encompasses various hybrid forms including
contracts, strategic alliances and quasi-integration (joint ventures).

•

In spot markets, goods are exchanged between multiple buyers and
sellers in the current time period, and price is often the sole determinant
of the sale, e.g., auction markets, food commodity sales in an open
market.

•

Spot markets
commodities.

are

efficient

for

the

distribution

of

homogenous
35

•

However, as agricultural products become more differentiated and buyers
prefer more heterogeneous products, there is a need for improved
information flow along the supply chain.
– Thus, methods of vertical coordination which allows closer buyerseller relationships are emerging, such as contracts, strategic
alliances and quasi-vertical integration.

36

Contracts

•

contracts can be classified into three broad groups.

•

Market specification contracts represent an agreement by a buyer to
provide a market for a seller's output. The buyer may assume some risk and
the right to make decisions over the timing of marketing. The farmer retains
control over production.

•

Production-management contracts entail more buyer control, allowing the
buyer to specify and/or to monitor production practices, input usage, etc.

•

Resource-providing contracts represent the greatest level of control for
buyers who provide a market outlet, supervise production practices and
supply key inputs.

•

In doing so, the buyer usually assumes a greater proportion of the risk and
may retain ownership of the product, with the farmer, in effect, being paid a
management fee.

•

In all these, there is increased coordination level in the supply chain ( why do
you think this is necessary??...... To ensure that you get what you have asked for so you
can satisfy your customers…)
37

quasi-vertical integration
•

Typically, quasi-vertical integration (a joint venture) is a long-term
contractual obligation in which both the buyer and seller have invested
resources in the relationship.

•

It differs from full vertical integration because the relationship ceases at
the end of an agreed period of time and the firms remain independent
entities afterwards.

•

An example would be a joint venture in which participants share the costs,
risks, profits and losses of a venture.
– An agreement for a cassava farmers’ group to supply cassava roots to a gari processing
firm for five years
– Blue skies and mango farmers

•

Franchises and licenses are other examples but are not common in the
agricultural sector.
38

strategic alliance
•

A strategic alliance is characterized by parties sharing an objective, resulting risks
and mutual control over decision making (Amanor-Boadu and Martin, 1992).

•

Typically, it is more flexible than a contract and requires that the parties
recognize their mutual goals and work together to achieve them.

•

Trust is implicit in a successful strategic alliance.

•

An example might be a strategic alliance between a group of producers who follow
specified production practices and a pork processor who receives hogs of a specified
quality.

•

The processor may also have a strategic alliance with a food retailer to introduce a
high-quality packaged pork product developed jointly and another strategic alliance
with a hog breeding firm to introduce specific genetics/breeds into the supply chain.

•

In this case, the strategic alliance involves all four parties, spanning the supply chain
from producer to retailer.

•

We can also look at Ghana COCOBOD, LBCs and cocoa farmer associations or
chocolate manufacturer, certification firms, cocoa supplier, LBCs and Farmers. 39

Full vertical integration
•

Full vertical integration occurs when one firm owns two or more
stages of the production-processing-distribution process.

•

Everything occurs under one management.

•

At this point, there is very little or no need for coordination.

•

However, because of some problems associated with full integration
(e.g. huge capital outlay and limited specialization, etc.),
organizations tend to focus on specific aspects of production and
rather coordinate with other firms at other stages in the supply
chain.
40

Some things to note about VC
•The search for quality is a key engine of VC
•Traders, agribusinesses, and food companies contract or
coordinate with farms and provide inputs and assistance in
return for guaranteed and quality supplies.

•Enforcement is an important problem: Enforcement is
problematic when public enforcement institutions are absent
– Trust is often lacking as a base for business exchanges in many
developing and transition countries.
– Companies try to create self-enforcing contracts by designing the
terms of the contracts such that nobody has an incentive to breach
the contract.
– They also try to enforce contracts by interlinking markets e.g. The
enforcement of credit transaction

• Not all examples of VC are successful:
–

In particular, where governments are heavily and actively involved in the

management of the integration, the effects are dubious at best.
– In cotton supply chains in Central Asia where the government has allowed
private gins to develop and to compete, such as in Kyrgyzstan and
Kazakhstan, farms have benefited from VC, with relatively high prices and
strong cotton growth.
– In Tajikistan and Uzbekistan, where governments actively control input
supplies, production, processing, and marketing of cotton, VC resulted in
major fee extraction from cotton farmers, with depressed prices and
stagnating cotton production.
– Cocobod and mass spraying exercise in Ghana

TRADE ASSOCIATIONS
• An organization that represents the interests of the member firms of an
industry
• A trade association, also known as an industry trade group, business
association or sector association, is an organization founded and
funded by businesses that operate in a specific industry.
•

An industry trade association participates in public relations activities
such as advertising, education, political donations, lobbying and
publishing, but its main focus is collaboration between companies,
or standardization.

43

• One
of
the
primary
purposes
of
trade
groups/associations is to attempt to influence
public policy in a direction favorable to the group's
members.
• In the USA, this can take the form of contributions to the
campaigns of political candidates and parties through
Political Action Committees (PACs); contributions to "issue"
campaigns not tied to a candidate or party; and lobbying
legislators to support or oppose particular legislation.
•

In addition, trade groups attempt to influence the activities of
regulatory bodies

44

A critique
• A common criticism of trade associations is that, while they
are ‘non-profit making’ organisations that claim to do
valuable work which is ultimately for the public benefit, they
are in reality fronts for price fixing cartels and other, more
subtle, anti-competitive activities that are not in the public
interest.
– The potentially anti-competitive nature of some trade association
activities has been a matter of public concern. For instance, under the
guise of ‘standard setting’ trade associations representing the
established players in an industry can set rules that make it harder for
new companies to enter a market.

45

Examples of Trade Associations in Ghana
•
•
•
•
•
•
•
•
•
•
•

Association of Ghana Industries (AGI)
Peasant Farmers Association of Ghana
General Agricultural Workers Union (GAWU)
Ghana National Association of Poultry Farmers
Brong Ahafo Regional Association of Poultry Farmers
Feed Millers Association of Ghana
Co-operation Alata Samina Manufacturing & Marketing Association
Federation of Association of Ghanaian Exporters (FAGE)
Ghana Cocoa, Coffee and Sheanut Farmers Association
Yam exporters Association of Ghana
etc.

Question:
In your opinion, what can be done to strengthen agricultural trade
associations in Ghana to be effective at lobbying Government to formulate
favourable agricultural policies?
46

Summary on Market structures

47

Features of the four market structures

Summary of the Features of the four market structures

GAME THEORY AND THE ECONOMICS OF COOPERATION
• Game theory – the study of multi-person decision problems
(the reactions of a few interdependent decision makers).
• It is the study of how people behave in strategic situations.
• Strategic decisions are those in which each person, in
deciding what actions to take, must consider how others
might respond to that action.
• Game - any situation that involves well-defined rules and
outcomes, where outcomes are dependent on players’
strategic decisions.

Game theory and Oligopoly
• Because the number of firms in an
oligopolistic market is small, each firm must
act strategically.
• Each firm knows that its profit depends not
only on how much it produces but also on
how much the other firms produce.

The Prisoners’ Dilemma
• The prisoners’ dilemma is a game that provides insight into
the difficulty in maintaining cooperation.
• Often people (firms) fail to cooperate with one another
even when cooperation would make them better off.
• The prisoners’ dilemma is a particular “game” between two
captured prisoners that illustrates why cooperation is
difficult to maintain even when it is mutually beneficial.

The dilemma
Two suspects, Kofi and Kwame, are arrested by the police.
The police have insufficient evidence for a conviction, and, having
separated both prisoners, visit each of them to offer the same deal:
–

if one testifies for the prosecution against the other and the other
remains silent, the betrayer gets 3 months and the silent accomplice
receives the full 10-year sentence.

–

If both stay silent, both prisoners are sentenced to only 1 year in jail
for a minor charge.

–

If each betrays the other, each receives a three-year sentence.

–

Each prisoner must make the choice of whether to betray the
other or to remain silent.

–

However, neither prisoner knows for sure what choice the other
prisoner will make.

–

So this dilemma poses the question: How should the prisoners
act?

The Prisoners’ dilemma
Kofi’s alternatives
Does not confess
Does not confess

Kwame’s
alternatives
Confesses

Everyone gets
1 year
Kwame 3 months
Kofi- 10 years

Confesses
Kwame 10 years
Kofi 3 months
Everyone gets
3 years

The Prisoners’ dilemma is the duopoly’s dilemma.
• Prisoners cannot coordinate their confessions.
• Even though they both would get less if they do not
confess, they betray one another, because of the
greater payoff.
• No matter what the other player does, one player will
always gain a greater payoff by playing defect.
•

Since in any situation playing defect is more beneficial
than cooperating, all rational players will play defect.

The Prisoners’ Dilemma -Another combination

Bonnie’ s Decision

Confess

Remain Silent

Bonnie gets 8 years

Bonnie gets 20 years

Confess
Clyde gets 8 years

Clyde’s
Decision

Clyde goes free

Bonnie goes free

Bonnie gets 1 year

Remain
Silent
Clyde gets 20 years

Clyde gets 1 year

Can you predict what these two perps will do?

Dominant strategy
• The dominant strategy is the best strategy for a player
to follow regardless of the strategies chosen by the
other players.
• In the Prisoners’ Dilemma game, each player’s dominant
strategy is to confess.
• And yet, they would both be better off if they remained
silent
• The pursuit of self interest leads to misery for all.

• Cooperation is difficult to maintain, because
cooperation is not in the best interest of the
individual player.
• The Prisoners’ Dilemma is an apt metaphor
for many social situations in which we’d all
be better off if we cooperated, but we don’t

Payoffs for firms A и B under different pricing policies

A’s Price
2.00

2.00

1.80

10mil. for each

5m for В
12m for А

12m for В
5m for А

8m for each

B’s Price
1.80

Collusive behavior
• How could the firms overcome the
prisoners’ dilemma?
– Collusion!!!

• Collusive behavior
prices for the buyers!

will set higher

An Oligopoly Game – Another example

Iraq’s Decision
High Production
Iraq gets $40 billion

Low Production

High
Production
Iran’s
Decision

Iran gets $40 billion


Low
Production


• From the above game:
• Self-interest makes it difficult for the
oligopoly to maintain a cooperative
outcome with low production, high prices,
and monopoly profits.

Another example: An Arms-Race Game

Decision of the United States (U.S.)

Arm

Disarm
U.S. at risk

U.S. at risk and weak

Arm
Decision
of the
Soviet Union
(USSR)

USSR at risk

USSR safe and powerful

U.S. safe and powerful

U.S. safe

Disarm
USSR at risk and weak

USSR safe

An Advertising Game

Marlboro’ s Decision

Advertise
Marlboro gets $3
billion profit

Don’t Advertise
Marlboro gets $2
billion profit

Advertise
Camel gets $3
billion profit

Camel’s
Decision
Don’t
Advertise

Marlboro gets $5
billion profit
Camel gets $2
billion profit

Camel gets $5
billion profit
Marlboro gets $4
billion profit
Camel gets $4
billion profit

Why do People Sometimes Cooperate?
• Firms that care about future profits will
cooperate in repeated games rather than
cheating in a single game to achieve a
one-time gain.

PUBLIC POLICY TOWARD OLIGOPOLIES
• Cooperation
among
oligopolists
is
undesirable from the standpoint of society as
a whole because it leads to:
– production that is too low, and
– prices that are too high.

• Antitrust laws make it illegal to restrain trade
or attempt to monopolize a market.

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