PhD Micro Unit 2: Markets Steffen Huck University College London 1 Chamberlin (1948) First market experiment in the history of economics Chamberlin wanted to illustrate how deviations from perfectly competitive equilibrium can arise Subjects could each trade one unit of a good Demand and supply prices were induced (number on a card) Bilateral negotiations 2
Chamberlin cont d 3 Chamberlin cont d 4
Chamberlin cont d 5 Chamberlin cont d Altogether, he conducted 46 markets Sales volume was higher than equilibrium volume in 42 cases, identical in 4. Average price was higher than equilibrium 7 times, lower 39 times. These patterns cannot have been created by chance. Binomial tests could be applied. It is not safe to assume Walrasianequilibria even if there are many traders. 6
Smith (1962) Same basic setup as in Chamberlin But negotiations are not bilateral. Instead offers are made publicly with both, buyers and sellers, making offers. Whoever shouts accepted or yes clinches the deal. Double oral auction Repeated in several periods with same roles and values 7 Smith cont d 8
Smith cont d 9 Smith cont d 10
Smith cont d More seller power 11 Smith cont d Changes in demand, doctoral students 12
Smith cont d Posted-offer market (sellers post price) 13 Smith cont d Market institutions matter Exact shape of demand-and-supply schedule matters But, in general, Walrasian equilibrium appears to be a good predictor for double oral auctions, in particular, if subjects are experienced 14
Where do market institutions come from? In Kirchsteiger, Niederle, Potters (EER 2005) traders can decide whom they want to inform about offers. 15 The endogenous market structure in KNP Traders inform everyone on other side of the market and none of their competitors. This endogenous structure has the same efficiency properties as the double oral auction. 16
Oligopoly markets Small number of firms (typically between 2 and 5) Consumers are simulated by demand function Bertrand, Cournot, Stackelberg, Price leadership, Betrand-Edgeworth, endogenous timing, 17 Bertrand with homogenous products Dufwenberg & Gneezy (IJIO 2000) Markets with 2, 3, and 4 firms Fully inelastic demand Abstract frame Random matching Public feedback across matching groups 18
Dufwenberg & Gneezy cont d Instructions 1 19 D&G cont d Instructions part 2 20
D&G cont d Instructions part 3 21 D&G cont d Instructions, final part 22
D&G cont d Design Two matching groups of size 12 for each n = 2,3,4 Two matching groups of size 24 for n = 2 (treatment 2*) Theoretical prediction: Bertrand paradox applies for all treatments, bid 2. 23 n=3 24
n=3 25 n=4 26
n=4 27 n=2 28
n=2 29 n=2 (bigger group) 30
n=2 (bigger group) 31 D&G cont d Main result: Equilibrium prediction works well for n = 3 and n = 4 but NOT for the duopoly. 32
D&G cont d Explaining the data D&G consider the case where some traders are noise traders With small probability ε opponent chooses to bid 100. With remaining probability they choose equilibrium bid 2. Then the probability that you win with 99 falls dramatically in n. For certain values of ε bid of 99 is optimal for n =2 while bid of 2 is optimal for n>2. 33 D&G cont d But high bids are, perhaps, deliberate attempts to collude And there is remarkable similarity to findings in Cournot games where, indeed, collusion occurs frequently in duopolies but almost never with n>2. 34
Two are few and four are many Huck, Normann, Oechssler (JEBO 2004) review existing literature on Cournot and study pure number effects for n = 2,3,4,5 and compare neutral and economic frame. identify factors that facilitate equilibrium play or collusion 35 Two are few cont d 36
Two are few cont d HNO then focus on previous markets which had features that are conducive to equilibrium play They find number effects that go beyond those predicted by the equilibrium Ratio of actual output over equilibrium output is increasing in number of firms (correlation is significant at 5% level). 37 Two are few cont d 38
Two are few cont d 39 Two are few cont d These earlier results are then confirmed in a new experiment with n=2,3,4,5 and a unified economic frame. For n=2 and n=5 additional treatments with an abstract frame are conducted. 40
Two are few cont d In neutral frame relation between actions (not quantities ) and profits is explained as follows: 41 Two are few cont d HNO find no significant effects of the two frames with n=5. But duopolies are much more competitive with the neutral frame. In fact, collusion disappears and actions are very close to equilibrium. Neutral frame makes it harder to understand the nature of the game 42
Merger in Cournot markets Huck, Konrad, Muller, Normann (2007) study (exogenous) bilateral mergers in linear Cournot markets that have initially three or four firms. Theory predicts that merging firms suffer from merger while outsiders gain. Salant, Switzer, Reynolds merger paradox. 43 Intuition for the merger paradox 44 Merger would be beneficial if outsiders were not to change their production. The optimal response of merged firm to unchanged behaviour of others is to reduce output. This will increase the optimal output of others which further decreases the optimal output of the merged firm. In the new equilibrium industry profits are greater. But the market share of merged firms drops from 2/n to 1/(n-1). Latter effect dominates. Similar to Harsanyi s bargaining paradox.
Experimental design Linear markets with p = max {100 Q, 0} and C(q i ) = q i. Main treatments 4 3 25 periods with 4 firms then merger & 25 periods with 3 3 2 25 periods with 3 firms then merger & 25 periods with 2 2const 25 periods with 2 firms Feedback about aggregate supply and own profits (conducive to Cournot-Nash) 6 markets for each treatment 45 How the merger was implemented Two subjects are randomly drawn, one of whom becomes the manager and takes all further decisions Second subject can send messages every five rounds ( up, down, stay ) Profits are equally shared Initially, subjects were told that experiment would consist of 2 x 25 periods; how the second part would differ was not announced. 46
Results: Total outputs Total outputs in merger treatments match theory well (after an adjustment phase). But exogenous duopolies are more collusive than endogenous (post merger) duopolies. 47 Individual outputs post merger 48
Individual outputs post merger 49 Individual outputs post merger 50
Individual outputs cont d Merged firms produce more than unmerged firms. Unmerged firms react by playing Cournot-Nash with respect to the residual demand. Renders mergers in larger market weakly profitable! 51 Three possible explanation (E1) Label. Firm with merger history is perceived stronger. (E2) Fairness. As two owners of merged firm have to share profits, there is an implicit agreement that they can produce more. (E3) Aspiration levels. Players have become used to a certain payoff level and don t want to lose. Hence they become more aggressive. Other players accept this as they earn more than before. 52
The first extra treatment When merger is implemented, one subject is sent home. Second becomes sole owner. (E1) predicts that effect remains. (E2) and (E3) predict that effect disappears. Effect disappears! 53 The second extra treatment Implements second phase of 4 3 without the first phase; i.e. there are three firms, one of which is owned by two subjects who have to share profits. No history. (E2) Fairness predicts effect remains. (E3) Aspiration levels predict effect disappears. Effect disappears! 54
The third extra treatment A market with entry If the effect can be replicated there it would be particularly strong as industry profits fall This is actually observed. Incumbents produce systematically more than new entrant. 55 Conclusion Mergers are more successful than predicted because merged firms behaviour is driven by aspiration levels. This makes them more aggressive what is tolerated by other firms as they earn more than previously. Implications for the field: A caveat: Cost estimations, based on equilibrium play, might indicate cost advantages for merged firms where there aren t any. Test whether firms that have recently suffered losses behave more aggressively than predicted. (Cyert & March 1956) 56