Game Theory: Can oligopolies maximize profits?

Lakshya Narula
Follow @

Lakshya Narula

Lakshya Narula is just another 22 years old engineer turned economics student trying to make a dent in the economics community. He is currently pursuing Ceramic Engineering from IIT(BHU), Varanasi, a self-taught student of economics and a regular writer on Quora who wants to pursue a career in economics.
Lakshya Narula
Follow @

Introduction

Oligopoly is a market structure with only a few sellers occupying the majority of the market share and offering a similar/identical product. The market of soft drinks is a good example in which major players and PepsiCo and Coca-Cola.

I personally like to study about oligopolies because we don’t need core mathematics and formulas to study about it. We just need to apply pure strategic thinking learned from Game Theory.

Game Theory is not about the games that we play on computers or in the playground. It’s about the games we play in real life, strategic games which firms play with one another trying to maximize profits.

What is Game Theory?

Very simple and effective definition of the Game Theory is the study of how people behave in strategic situations. One has to consider how others might respond to the action one takes and the effect of others’actions on the outcome.

Considering the above example, I will try to explain why markets with few companies (in this case two) cannot maximize profits?

Consider this matrix in which we have some numbers/points for each firm taking a particular decision.

Game theory payoff matrix

In Game Theory, it is called a payoff matrix and the individual scores given to each outcome are called the payoffs. The payoffs are (Pepsi, Coke) which means that the payoff for Coke to advertise when Pepsi doesn’t advertise is 13. It might be million dollars or anything, but it is just a payoff.

The Explanation of Payoff Matrix

If Pepsi does not advertise, Coke is better off advertising (13 > 8) and if Pepsi advertises, Coke is again better off advertising (5 > 2). This means that no matter what Pepsi does, Coke is better off advertising, so it will advertise.

The strategy in which no matter what other party does, you do only one thing is called a strictly dominant strategy. It means that particular strategy dominates every other strategy in the game and you will choose that.

The same is the thing with Pepsi also. If Coke does not advertise, Pepsi is better off advertising (13 > 8) and if Coke advertises, Pepsi is again better off advertising (5 > 2). This means that no matter what Coke is doing, Pepsi is better off advertising, so it will advertise.

So, if both will advertise, the equilibrium outcome of this game is (5, 5) called the Nash Equilibrium (after the name of Dr. John Nash whose life is pictured in the movie A Beautiful Mind).

What is Nash Equilibrium?

A Nash Equilibrium is a situation in which players (Coke and Pepsi) will each choose their best strategy given the strategy all other players have chosen. The outcome in that situation is called a Nash Equilibrium.

The profit maximizing condition is when they both don’t advertise (8, 8) and each would gain 8 million dollars in revenue. So, they would meet and form a verbal contract of not advertising. In this way, they can gain 50-50 market share and dominate the market.

But, the key feature of the oligopoly market structure is tension between cooperation and self-interest which we can study by game theory.

Verbal contracts are as easy to break as trust. Here, both the firms have an incentive to cheat as they think that if they advertise, they will gain 13 million dollars and are better off which is clearly not the case. If they both advertise, they will land on the outcome (5, 5), in which case they would be worse off (8 > 5).

This particular game is called The Prisoner’s Dilemma, which says that two rational people won’t cooperate even if it’s good for their self-interest. They won’t cooperate because they have a strong incentive to cheat, so they land on the outcome which is worse off for both of them.

So, why do companies in an oligopoly cannot maximize their individual profits?

Because they won’t cooperate and hence they cannot maximize their profits. Each firm is tempted to raise production and capture a larger share of the market. As each of them tries to do so, total production increases, but price decreases, hence individual profits decrease. In this case, most of the loss in revenue would be from money spent in advertising.

This is the reason why contracts are forced onto the firms and then the market works.

This was originally posted on Quora.

Currency devaluation: Visualized

Lakshya Narula
Follow @

Lakshya Narula

Lakshya Narula is just another 22 years old engineer turned economics student trying to make a dent in the economics community. He is currently pursuing Ceramic Engineering from IIT(BHU), Varanasi, a self-taught student of economics and a regular writer on Quora who wants to pursue a career in economics.
Lakshya Narula
Follow @

 

Introduction

Devaluation is an unconventional monetary policy tool by which the value of a country’s currency is officially lowered within a fixed exchange rate system, where the authority formally sets a new fixed rate with respect to a foreign reference currency. It is often confused with depreciation, which is a decrease in a currency’s value due to market forces of supply and demand under a floating exchange rate system, not by government or central bank policy actions.

For example, a country A has a fixed exchange rate of let’s say 5 units of their currency for US$1. After officially announcing and lowering the exchange rate, it can go for any number greater than 5.

Why do countries devalue their currency?

To Boost Exports

Export is something a country manufactures and sells to another country. Let’s take an example of two countries A and B with the fixed exchange rate equals to 1 unit of A = 1 unit of B. The country A can make enough bricks and has set the value of 1 brick = 1 unit of A while B can make a lot of rice and has set 10 bags of rice = 1 unit of B.

Let’s say that the A’s economy is export-driven economy and exports bricks to country B at a price of 1 unit of B (both currencies are same right now) because the country B is going through a bad season. After few months when the bad season ended, B started making bricks and same price and they don’t require A’s bricks. Now if the country A has to export their bricks to the other country, they have to lower the price, so they devalue their currency by 50% such that 2 units of A = 1 unit of B or the price of bricks fell by 50% than previous and now A can export more to boost their economy.

This is how countries boost exports by devaluing their currencies. In other words, exporters become more competitive in a global market. Exports are encouraged while imports are discouraged.

To correct balance of payments

Also known as trade deficits which occur when net exports are negative, meaning that country imports more than it exports. Many countries can bear trade deficits without devaluing their currency because their productivity is so high that it more than compensates the trade deficits. Persistent deficits are not uncommon today, with the United States and many other nations running persistent imbalances year after year. Economic theory, however, states that ongoing deficits are unsustainable in the long run and can lead to dangerous levels of debt which can cripple an economy. By devaluing the home currency, exports will increase and imports will decrease due to exports becoming cheaper and imports more expensive. This favors an improved balance of payments as exports increase and imports decrease, shrinking trade deficits.

To Reduce Sovereign Debt Burdens

A government may be incentivized to encourage a weak currency policy if it has a lot of government issued sovereign debt to service on a regular basis. If debt payments are fixed, a weaker currency makes these payments effectively less expensive over time.

A central bank can make the conscious effort to make its currency less valuable. If Country XYZ’s currency is set at a fixed exchange rate of 2:1 to the U.S. dollar and, due to a weak economy, XYZ cannot afford to pay the interest rate on its debt outstanding, XYZ may devalue their currency. This means the central bank of XYZ will declare their fixed exchange rate to be 10:1 to the U.S. dollar. This makes their debt outstanding is now worth five times less. It’s a very tricky maneuver with grave economic consequences.

What are the consequences of each objective?

Boosting Exports. First, as the demand for a country’s exported goods increases worldwide, the price will begin to rise, normalizing the initial effect of the devaluation. The second is that as other countries see this effect at work, they will be incentivized to devalue their own currencies in kind in a so-called “race to the bottom.” This can lead to tit for tat currency wars and lead to unchecked inflation. Lastly, if exports are being boosted, the weaker currency also leads to costly imports thereby increasing inflation in the home country.

The balance of payments. There is a potential downside to this rationale, however. Devaluation also increases the debt burden of foreign-denominated loans when priced in the home currency. This is a big problem for a developing country like India or Argentina which hold lots of dollars- and euro-denominated debt. These foreign debts become more difficult to service, reducing confidence among the people in their domestic currency.

Sovereign Debts. This tactic should be used with caution. As most countries around the globe have some debt outstanding in one form or another, a race to the bottom currency war could be initiated. This tactic will also fail if the country in question holds a lot of foreign bonds since it will make those interest payments relatively more costly.

How do countries devalue currency?

Since we are talking about devaluation and not depreciation, we will see how a government changes the fixed exchange rate i.e. how do they devalue their currency?

Print Money. The first thing a government can do is to print more money. See this way, if there are fewer millionaires in a country, a million of that currency would be a very valuable asset but if there are many millionaires, then the value of that million would not be same as the previous one relative to another currency. So, if a country starts printing more money and dumps it into the foreign exchange market, while the other country’s amount of money is fixed, the value of the currency can be decreased or currency becomes weaker.

Sells/releases their own currency. There are two parts in it; unsterilized intervention by the government, and sterilized intervention.

  • Unsterilized Intervention In this case, the central bank buys, or sells, foreign currency securities using the domestic currency that it issues. For example, the Federal reserve can buy euros and sell dollars, which puts a downward pressure on the dollar and depreciates it against the euro. In other words, if the Fed is buying euros, then the demand of euros is increased thereby decreasing the value of the dollar in the market.
  • Sterilized Intervention – It is like an unsterilized intervention but with a twist in order not to change the monetary base (central banks would want to keep the same monetary base in order to not influence the inflation levels). The first stage is conducting an unsterilized intervention. After this, the central bank will turn around to the private sector and “sterilize” the effect of the intervention by either selling domestic currency securities (in the case that it bought foreign currency securities) or buy domestic currency securities (in the case that sold foreign currency securities). If the ECB wants to depreciate the euro but it is scared about inflation it will perform a sterilized intervention. The ECB will buy dollars with euros depreciating the value of the euro, but at the same time will sell euro-denominated securities to private institutions in order to keep the same amount of money available.

In order to be able to perform these activities, central banks need to have sufficient foreign currency reserves in order to stand ready to keep the value. For example, if the dollar was pegged to the euro at 2 dollars per euro, and the euro was seeing appreciation against the dollar, due to one of the reasons above-mentioned, the FED should be ready to sell euros and buy dollars in order to defend the value of its currency. However if it runs out of euro reserves, it will not be able to defend the peg.

We have come a long way and have seen about a very interesting concept of devalution, its objectives, its effects and how can countries devalue the currency. I hope this helps you get an understanding about devaluation.

Monetary Policy Explained

David McDonald

David McDonald

David is a 19-year-old Canadian student currently attending the University of Guelph. He currently studies Public Management and economics with hopes of one day becoming an accomplished journalist. David enjoys reporting on global events and actively try to make a difference in the world.
David McDonald

 

Every country has a central bank, well, about 99% of all nations have one. Central banks control interest rates on money and thus, determine the price (or exchange rate) of money – to a certain extent.

Central banks have the power to regulate the amount of money in the economy. Think of the economy as a stadium full of money. When there is too much money in the stadium, it falls over the edges and people walking by can pick it up and run away with it; this is inflation.

Higher interest rates fill the stadium (bank) up with money, lower interest rates induce spending and help to empty the stadium (the economy).

So, to counteract something we call hyperinflation (so much money spills out over the edges that it basically turns into useless pieces of paper) banks tamper with their base rates (interest rates) in an attempt to control the amount of money being injected into the economy.

It’s imperative when talking about monetary policy that we know the concept of interest rates and GDP inside and out.

Say a bank used to charge a 10% interest rate, but there was too much borrowing going on; nobody was spending any money because they could invest almost everything they earned and make a crap-ton. This high interest rate however was hurting businesses all over the nation because well, nobody was spending money. So, the bank lowers their interest rate to 5%, causing people to withdraw their savings, and start investing – this is monetary policy.

How does this affect GDP? Well, if banks are charging say, a 50% interest rate (this would never happen) then 100% of the economy would be saving money, and very little spending would be occurring, basically only on the necessities. There would be no spending on luxury goods, and little spending on entertainment because everyone would be conscious on saving their money. This would result in a ton of businesses closing down. So, to counteract this, the banks lower their interest rate to 5% to induce more spending in the economy.

We always want our economies to balance as much as possible (or, to reach equilibrium) even though it almost never happens, and when it does balance, it doesn’t stay there for long. To put this in other words, think back to the football stadium. If the central bank’s base rate is 50%, the stadium will be overflowing with money because everyone is saving. Conversely, if the lower the base rate to 5%, suddenly there is no money trickling over the edges and the stadium is now half-full – a sustainable amount.

What is it used for?

There are two main reasons why central banks carry out monetary policy. Detailed below are the two reasons and the methods used to achieve them:

Expansionary monetary policy – This is when the central bank lowers interest rates in the economy in order to encourage borrowing and discourage saving. The purpose of this is to increase the aggregate demand in the economy and boost spending. This will eventually create economic growth. Expansionary monetary policy is mainly used in a recession when demand for goods and services is low and people aren’t spending.

Contractionary monetary policy – This is when the central bank increases interest rates in the economy in order to reduce the amount of spending. The purpose of this method is to decrease the aggregate demand in the economy so that prices don’t rise too fast. Inflation is an issue in most countries and contractionary monetary policy is one way of dealing with it. This policy is often used in times of economic growth where the demand for goods and services is very high.

Want Companies To Change? Make Them

 

Hour after hour, day after day, month after month, it seems that people are continually finding new reasons to chastise corporations with malicious intentions.

It’s a sad indictment of the society we live in that most of these complaints have logical backing behind them; companies continue to act with a complete and utter disregard for their fellow humans every day. However, this begs the question: why exactly do these companies do it?

The reason is one word that has become synonymous with the capitalist society of today: profit.

Essentially, the capitalist system rewards, at the most fundamental level, the accumulation of capital, and for this reason, companies have been incentivised to a greater degree than ever before to pursue profits, no matter the costs.

Why is this a problem?

The answer is obvious. In a civilised society, it’s a basic axiom that there’s more to life than financial gain. We have the environment, for example, which is being degraded at a faster rate than ever before. We have poor people in developing countries who have to settle for subpar wages and atrocious working conditions. Most importantly, we have basic morals; morals that guide us in the right direction, morals that tell us that what these companies are doing is wrong.

What these morals don’t do so well, unfortunately, is to teach us exactly how to bring about the change that we want to see in the world. It’s very well having a vision, but until you actually carry it out, it remains just that; a vision, forever consigned to the confines of your imagination. We’ve all seen many an angry Facebook post or tweet about sweatshops, or environmental damage, or worker exploitation, but what we haven’t seen so much is people’s actions to ameliorate these issues. It may sound like, till now, I’m simply spouting a load of mindless conjecture, but let me ask you this: how many of those companies that you’ve complained about have actually, really, changed their ways? Many of Nike’s workers still live in horrendously unsafe working conditions, more than a decade after a massive public outcry. It took bankruptcy to stop the torrent of harmful

It’s very well having a vision, but until you actually carry it out, it remains just that; a vision, forever consigned to the confines of your imagination. We’ve all seen many an angry Facebook post or tweet about sweatshops, or environmental damage, or worker exploitation, but what we haven’t seen so much is people’s actions to ameliorate these issues. It may sound like, till now, I’m simply spouting a load of mindless conjecture, but let me ask you this: how many of those companies that you’ve complained about have actually, really, changed their ways? Many of Nike’s workers still live in horrendously unsafe working conditions, more than a decade after a massive public outcry. It took bankruptcy to stop the torrent of harmful gasses 

We’ve all seen many an angry Facebook post or tweet about sweatshops, or environmental damage, or worker exploitation, but what we haven’t seen so much is people’s actions to ameliorate these issues. It may sound like, till now, I’m simply spouting a load of mindless conjecture, but let me ask you this: how many of those companies that you’ve complained about have actually, really, changed their ways? Many of Nike’s workers still live in horrendously unsafe working conditions, more than a decade after a massive public outcry. It took bankruptcy to stop the torrent of harmful gasses emitted by Peabody Energy. Most horrendously, more companies than I can feasibly name continue to exploit their workers, safe from the omniscient camera of the news. No matter how strongly worded your Facebook post or tweet is, it’s just not going to get companies to change. In fact, there’s only one thing that can do just that.

At the beginning of this article, I stated that profit is the only thing which companies really care about. As a society, what we can do is to tap into this greed for money; to use their material wants to serve the greater good. How can we do this? Simple. A complete and utter boycott of any companies who break the moral code that binds all entities in a

How can we do this? Simple. A complete and utter boycott of any companies who break the moral code that binds all entities in a civilized society.

In today’s age, the excuse that some products are unique to a specific company has been completely and utterly blown out of the water; never before has there been a greater choice of bread, or jam, or whatever you may want or need.

Whilst I acknowledge that many companies may have acted in an immoral way away from the watchful eye of the newspaper, the least we can do is to stop purchasing products or services from those companies that we know act in a malfeasant way. Not only does this cut a company’s profits, but it also acts as a deterrent to any company who would even entertain the thought of acting in a similar way. This is the perfect carrot and stick application; if these corporations act in a moral way, everyone’s happy, but if they don’t, we’re just as happy to move on to another one.

It’s not as if this sort of idea hasn’t been proven to work in the past, either. It’s been well documented that firms such as General Mills are having to change their ways, not because they were acting immoral previously, but because the ideas of their consumer have drastically changed.

These changing consumer preferences, of course, reduce company profits, and as such, it is imperative for them that they change to suit their consumer. If just consumer preferences can force companies to change in this way, think of what a large scale boycott of all the products that that company was involved in producing would do. It’s both a scary and an inspirational thought; we, the people, could make the old adage of “the consumer is always right” true once more, just through a bit of product stewardship. All it would take is a little willpower and an unbreakable desire to make our world a better place. On first glance, it doesn’t seem at all that hard.

Why don’t we try it?

Liked this article? Be sure to read more from Shrey Srivastava at his blog, Shrey’s Finance Blog.

Which Countries Will Have The Highest Standard Of Living In 30 Years?

David McDonald

David McDonald

David is a 19-year-old Canadian student currently attending the University of Guelph. He currently studies Public Management and economics with hopes of one day becoming an accomplished journalist. David enjoys reporting on global events and actively try to make a difference in the world.
David McDonald

Monaco City View From The Mountains – Monaco has the highest GDP Per Capita of any nation on Earth at $165,000 US dollars – Image acquired from wallpaperscraft.com all rights reserved]

Introduction

We all know the world leaders in standard of living as of today, but how do we even go about measuring such a vast variable? And furthermore, how do we hypothesize what nations will reach affluence in ten years, or even thirty years?

That is what I’m aiming to accomplish with this article.

For starters, I believe GDP at PPPs (purchase power parity – basically the purchasing power of a currency) is a better indicator of average living standards or volumes of outputs or inputs, because it corrects for price differences across countries at different levels of development.

Furthermore, I will assess various GDP per capitas (average wealth of each citizen) and trends among this variable to see which countries will remain, and which will improve in terms of living standards (gdp per capita).

In general, price levels are significantly lower in emerging economies so looking at GDP at PPPs narrows the income gap with the advanced economies compared to using market exchange rates. However, GDP at MERs is a better measure of the relative size of the economies from a business perspective, at least in the short term. For long run business planning or investment appraisal purposes, it is crucial to factor in the likely rise in real market exchange rates in emerging economies towards their PPP rates.

This could occur either through relatively higher domestic price inflation in these emerging economies, or through nominal exchange rate appreciation, or (most likely) some combination of both of these effects. When estimating GDP at market exchange rates in 2050, a similar methodology is therefore adopted as in the original ‘World in 2050’ report where market exchange rates are converging to PPP rates with different converging factors depending on the type of economy.

This leads to projections of significant rises in real market exchange rates for the major emerging market economies due to their higher productivity growth rates, although these projected MERs still fall some way below PPP levels in 2050 for the least developed emerging markets. We have, however, updated our methodology here with new econometric estimates of how this emerging market real exchange rate appreciation is related to relative productivity growth. For the advanced economies, we assume that real exchange rates converge very gradually to their PPP rates at a steady pace over the period from 2015 to 2050. This is consistent with academic research showing that purchasing power parity does hold in the long run, at least approximately, but not in the short run.

Let’s take a look at PwC’s forecasts for the next 30 years with the graph below.

Looking at the top three, we see China overtake the US in terms of Real GDP evaluated at 2014 dollars, and India remaining in a not-so-close third place. India, however, is poised to see tremendous economic growth from years 2030 to 2050. This model alone sees their Real GDP rising by 20,633 evaluated in 2014 billions of dollars, which is the second largest growth in GDP seen on the list next to the 26,866 rise that China is expected to see over the same period.

The rest of the top 12 is poised to remain quite steady for the next 30 years or so, with a few expected outliers (highlighted in blue).

Indonesia and Nigeria are expected to see massive economic growth come mid-century, as these countries continue to become more industrialized.

A report from the World Economic forum notes this about Nigeria’s expected future growth:

“With roughly 170 million inhabitants, Nigeria has Africa’s largest population. But it has only recently been acknowledged as having the continent’s largest economy – 26th in the world – following the release of “rebased” data putting GDP at $510 billion last year.

MGI estimates that, in 2013-2030, Nigeria could expand its economy by more than 6% annually, with its GDP exceeding $1.6 trillion – moving it into the global top 20. Moreover, if Nigeria’s leaders work to ensure that growth is inclusive, an estimated 30 million people could escape poverty.

By 2030, more than 34 million households, with about 160 million people, are likely to be earning more than $7,500 annually, making them aspiring consumers. This implies a potential rise in consumption from $388 billion annually to $1.4 trillion – a prospect that is already attracting investments by multinational consumer-goods producers and retailers.”

Nigeria isn’t the only African nation poised for economic growth; South Africa and Egypt are also among the top 30 nations in the world in terms of GDP and are both expected to gain in value in coming decades.

Africa’s future is indeed looking bright in terms of future investment opportunities, as it receives some of the highest levels in sunlight anywhere in the world, which will create an abundance of solar investment opportunities. Furthermore, Africa is filled with natural resources such as diamonds, gold, agriculture, and fish along its coasts, that increased infrastructure will help business become more sustainable.

Visualizing Global Living Standards

GDP Per Capita

Take a brief look at the diagram above, the countries that have the highest GDP per capita are located in North America, Northern Europe, or Australia. Falling right behind these countries are those in central Europe, Eastern Asia (Japan and South Korea) and Southern Australia (New Zealand).

Below these nations are India, Vietnam, and Malaysia, among some African nations like Nigeria and Sudan.

China lies below India in terms of per capita GDP, but both nations will experience consistent growth in this area for decades to come, which will translate into a more robust middle class and alleviate a great deal of poverty.

Take a good look at this map, because GDP per capita and living standards will rise in almost every single nation on Earth. In other words, this map could become very yellow and orangish.

GDP Per Capita In The Next Thirty Years: Unlikely Contenders

Take a look at the graph below, it details average real growth per capita over the years 2014 until 2050. If you want to see which countries will have the most improved living standards on the planet during this time, look no further. But please note that just because living standards have improved drastically in these areas, does not mean that their living conditions will be comparable with established powers like the US and China.

standard of living

The most important takeaway from this graph is with India I believe. India already has a strong economy, but just measuring their real GDP is not enough to determine potential future living standards in the nation because of how high their population is. This graph gives us a much better look at how GDP per capita will rise, and the PwC annual report shows a 4.1% rise over the next 30 or so years – although it may not seem like a lot, this rise will have a profound impact on the lives of Indians, and will ultimately, raise living standards across the nation.

Other standouts here are of course, Malaysia and Thailand, who are some of the world’s leaders in opioid (heroin) production, and have some of the lowest GDP per capita levels on the planet as of now. [Read more about heroin production in Malaysia and Thailand here.]

China is of course expected to see steady gains in the next few decades, as industrialization continues to flourish in the Asian superpower.

standard of living

Continuing on this graph, we can evaluate some of the richest nations on the planet and see that all of them will experience consistent growth in the coming decades, with Poland, Brazil, and Russia paving the way in terms of GDP per capita.

Now, this doesn’t necessarily correlate to higher living standards, it just means that population density is lower in these countries, and there is simply more working opportunities for citizens there. It is actually commonly understood that the future of Russia’s economy does not look so great, and a 2.7% increase over the next 30 years may seem quite optimistic, but I digress.

To Conclude

I think its safe to say that the countries with the highest living standards today will, for the most part, have the highest living standards thirty years from now, with a few new friends to share a seat at the coveted table.

Several European countries like Switzerland, Germany, the UK, and France, will all continue to have high living standards thirty years from now. Furthermore, the US, Canada, Japan, Australia, China, and India will continue to thrive, among others.

The global economic climate is looking great for the next several decades – even if inevitable recessions loom. For the first time in recent history, an African nation will have one of the largest GDP’s on the planet, and the continent as a whole, will experience increasing living standards.

This is why I believe it is more important to focus on which nation’s will improve the most over the next thirty years rather than who will have the highest living standards because in all honestly, living standards are relative and extremely difficult to measure accurately.

[Disclaimer – All information has been retrieved from PwC UK corporation’s 2014 annual report, which can be found here. ]