Micro Chapter 23

Presentation 2- Game Theory

Homogeneous Oligopoly

• An oligopoly in which the firm produces a standardized product

• Ex- steel, cement, copper, aluminum

Differentiated Oligopoly

• An oligopoly in which the firms produce a differentiated product

• Considerable non-price competition through heavy advertising

• Ex- automobiles, sporting goods, tires

Control Over Price

• Oligopolies are “price makers” and can set price and output levels to maximize profit

• Oligopolies have few rivals but must consider how they will react to any change in price, output, product characteristics or advertising

Mutual Interdependence

• A situation in which each firm’s profit depends not entirely on its own price and sales strategies but also on those of the other firms

• Ex- McDonald’s considers Burger King, Rawlings considers the reactions of Wilson

Barriers to Entry

• 1. Economies of Scale

• 2. Large expenditure of capital (human-made resources)- industries such as jet engine, auto, petroleum refineries

• 3. Ownership and control of raw materials- mining and electronics

Mergers

• Combining of two or more competing firms may substantially increase their market share leading to economies of scale and lower costs on production inputs

Concentration Ratio

• The percentage of total output produced and sold by an industry’s largest firms

• **When the 4 largest firms in an industry control 40% of the market, that industry is considered oligopolistic

• Ex- the 4 largest cereal producers make 78% of American breakfast cereals

Shortcomings of Concentration Ratios

• 1. Localized markets- ratios are measured nationally

• 2. Interindustry Competition- between two products associated with different industries (ex- copper and aluminum)

• 3. World Trade- doesn’t take into account imports

Herfindahl Index

• A measure of the concentration and competitiveness of an industry

• Sum of the squared percentage market shares of all of the firms in an industry

• Index=(%S1^2)+(%S2^2)+….(%Sn^2)

• Where %S1 is the percentage of the market share of firm 1

Herfindahl Index Cont’d

• Ex- Single firm industry= 100^2= 10,000

• Ex- 4 firms with equal 25% market share

• (25^2)+(25^2)+(25^2)+(25^2)= 2500

• ***the larger the Herfindahl Index, the greater the market power within an industry

• ***the closer to zero, the more competitive

Game Theory

• Oligopoly pricing behavior has the characteristics of certain games of strategy such as chess

• The best way to play the game depends on the way one’s opponent plays

• Shown in a payoff matrix (2 firms)

Collusion

• A situation in which firms act together in agreement to fix prices, divide a market, or otherwise restrict competition

• Both firms could agree to a high pricing strategy

Dominant Strategy

• One strategy is better for a given player, regardless of what his/her opponent chooses to do

Game Theory Video

• http://www.youtube.com/watch?v=AOEbJF0k8vM

•

Uptown: DominantStrategy = LowRareair: Dominant Strategy = Low

Game TheoryGame Theory Model to Analyze Behavior

RareAir’s Price Strategy

Upt

own’

s Pr

ice

Stra

tegy

A B

C D

$12

$12

$15

$6

$8

$8

$6

$15

High

High

Low

Low•2 Competitors•2 Price Strategies•Each Strategy Has

a Payoff Matrix

O 23.2

Incentive to Cheat

• In the previous example, both firms could increase profit by utilizing a low price strategy

• Each firm could increase profit from $12 million to $15 million by breaking the agreement with low prices

Nash EquilibriumNash Equilibrium

NASH EQUILIBRIUM : when each player is pursuing their best possible strategy in the full knowledge of the other players’ strategies. A Nash equilibrium is reached when nobody has any incentive to change their strategy. It is named after John Nash, a mathematician and Nobel prize-winning economist.https://www.youtube.com/watch?v=CemLiSI5ox8

John F. Nash, 1928 -

Russell Crow portrays John Nash in A Beautiful Mind

An Example of a Nash Equilibrium

a b

b 2,1

0,1

1,0

1,2

Row

Column

a

(b,a) is a Nash equilibrium.To prove this: Given that column is playing a, row’s best response is b. Given that row is playing b, column’s best response is a.

Prisoners’ Dilemma Video

• https://www.youtube.com/watch?v=t9Lo2fgxWHw

Prisoner’s DilemmaPrisoner’s DilemmaAn illustration of Nash EquilibriumAn illustration of Nash Equilibrium

Art’s StrategiesArt’s Strategies

Bob’s Bob’s StrategiesStrategies

ConfessConfess Deny

Con

fess

Den

y

10 yrs.10 yrs.

1 yr. 1 yr.

3 yrs.3 yrs.

3 yrs. 3 yrs.

1 yr.1 yr.

10 yrs. 10 yrs.

2 yrs.2 yrs.

2 yrs. 2 yrs.

Consider Art’s options…

1. If Bob denies and Art denies, then Art will get two years. Art is better off confessing and getting one year.

2. If Bob confesses and Art denies, then Art will get ten years, so Art is much better off confessing and taking three years.

Consider Bob’s options…

1. If Art denies and Bob denies, then Bob will get two years. Bob is better off confessing and getting one year.

2. If Art confesses and Bob denies, then Bob will get ten years, so Bob is much better to confess and take three years.

Thus, both parties will rationally choose to confess, and take three years – even though they could have been better off denying. Each party does this because, considering the possible options of the other party, they always found the better option was to confess. When neither party has an incentive to change their strategy, they are in “Nash Equilibrium.”

Art and Bob are both suspects in a crime, and they are both offered the following deal if they confess…

Cartels• A cartel is an organization of

independent firms whose purpose is to control and limit production and maintain or increase prices and profits.

• EX- OPEC controlling oil production

• Like collusion, cartels are illegal in the United States.

Coffee Problem

Don’t Advertise

Advertise

Don’t Advertise 15/15 10/20

Advertise 20/10 12/12

STARBUCKS

SF

CO

FF

EE

1. What is Starbuck’s dominant strategy2. What is SF Coffee’s dominant

strategy3. Is there a Nash Equilibrium?4. If they collude what is their profit?5. If no collusion, what is their profit?