strategic choice in oligopoly, monopolistic competition, and everyday life 1

Strategic Choice in Oligopoly, Monopolistic Competition,

and Everyday Life

Strategic Choice in Oligopoly, Monopolistic Competition,

and Everyday Life

1

Thinking Strategically

Interdependencies In making choices, people must

consider the effect of their behavior on others.

Imperfectly competitive firms may consider how rivals will respond to price changes or new advertising.

Using Game Theory toAnalyze Strategic Decisions

Basic Elements of a Game The players Their strategies The payoffs

Example Should United Airlines spend more on

advertising? Note

The airline industry is an oligopoly with an undifferentiated product.

Using Game Theory toAnalyze Strategic Decisions

The Payoff Matrix for an Advertising Game

Raise adspending

Leave adspendingthe same

Raise adspending


$5,500 for American$5,500 for American

$5,500 for United$5,500 for United

American’s Choices

United’s Choices







Dominant Strategy One that yields a higher payoff no

matter what the other players in a game choose

Dominated Strategy Any other strategy available to a

player who has a dominant strategy

Dominant and Dominated Strategies

Any combination of strategies in which each player’s strategy is her or his best choice, given the other player’s strategies

When each player has a dominant strategy, equilibrium occurs when each player follows that strategy

Nash Equilibrium

Nash Equilibrium

There can be an equilibrium when players do not have a dominant strategy

Example Should American spend more on

advertising? Assume United and American are the

only carriers serving the Chicago – St. Louis market

Equilibrium When One Player Lacks a Dominant Strategy

Raise adspending


Raise adspending











United’s Choices

What Should United and American do if Their Payoff Matrix is Modified?

Raise adspending


Raise adspending











United’s Choices

The Prisoner’s Dilemma

A game in which each player has a dominant strategy, and when each plays it, the resulting payoffs are smaller than if each had played a dominated strategy

Example Should the prisoners confess?

The Payoff Matrix for a Prisoner’s Dilemma

Confess Remain Silent

Confess

RemainSilent

Jasper

Horace

5 years5 yearsfor eachfor each 20 years for Jasper20 years for Jasper

0 years for Horace0 years for Horace

1 year1 yearfor eachfor each0 years for Jasper0 years for Jasper

20 years for Horace20 years for Horace

The Economics of Cartels

Cartel A coalition of firms that agrees to

restrict output for the purpose of earning an economic profit like a monopoly

Yet, cartel agreements are notoriously unstable. Why?

Prisoner’s Dilemmas Confronting Imperfectly Competitive Firms

The Market Demandfor Mineral Water

Pri

ce $

/bo

ttle

)

Bottles/day

Assume• 2 firms (Aquapure &

Mountain Spring• MC = 0• Cartel is formed & agree

to split output and profits

2,000

D

1.00

1,000

MR

2.00

Impact of Cartel• Q = 1,000 bottles/day• P = $1/bottle• Each firm makes $500/day

The Temptation to Violate a Cartel Agreement

Pri

ce $

/bo

ttle

)

Bottles/day

D

1.00

1,000 2,000

MR

2.00

1,100

0.90

Aquapure lowers P• P = $.90/bottle• Q = 1,100 bottles/day

Mountains Spring retaliates• P = $.90/bottle• Both firms split 1,100

bottles/day @ $.90• Profit = $495/day

The Payoff Matrix for a Cartel Agreement

Charge $1/bottle Charge $0.90/bottle

Charge$1/bottle

Charge$0.90/bottle

Mountain Spring

Aquapure

$990/day for $990/day for Mt. SpringMt. Spring

$0 for$0 forAquapureAquapure$500/day $500/day

for eachfor each

$0 for $0 for Mt. SpringMt. Spring

$990 for$990 forAquapureAquapure $495/day $495/day

for eachfor each

Food For Thought

When will the rival firms stop cutting prices?

Cooperation between players will increase the payoff in a prisoner’s dilemma. There is a motive to enforce

cooperation. Tit-for-tat strategy

Players cooperate on the first move, then mimic their partner’s last move on each successive move

Tit-for-tat and the Repeated Prisoner’s Dilemma

Tit-for-tat strategy requirements Two players A stable set of players Players recall other player’s moves Players have a stake in future

outcomes

Tit-for-tat and the Repeated Prisoner’s Dilemma

Why is the tit-for-tat strategy unsuccessful in competitive, monopolistically competitive, and oligopolistic markets?

Food For Thought

Why did the ban on television advertising beneficial to cigarette producers?

Cigarette Advertising as a Prisoner’s Dilemma

Cigarette Advertising as a Prisoner’s Dilemma

Advertise on TV Don’t advertise on TV

Advertise on TV

Don’tAdvertiseon TV

$5 million/yr$5 million/yrfor Philip Morrisfor Philip Morris

$10 million/yr$10 million/yr for eachfor each

$35 million/yr$35 million/yr for RJRfor RJR

Philip Morris

RJR

$20 million/yr$20 million/yr for eachfor each$35 million/yr$35 million/yr

for Philip Morrisfor Philip Morris

$5 million/yr$5 million/yr for RJRfor RJR

Determinants of a Successful Cartel

A successful cartel requires a good enforcement mechanism: detect cheating and punish cheating sellers.

Determinants of cost of detecting price chiseling Number of buyers Customer turnover Availability of price information

Food for Thought

Which of the following type of auction encourages collusion: sealed-bid or open-bid auction?

Many manufacturers offer minimum price guarantee such as Best Buy or Circuit City, does this pricing practice facilitate collusion?

Games in Which Timing Matters

Should Dodge build a hybrid viper? Dodge Viper and Chevrolet Corvette

compete for the domestic sports car market

Both know the other is considering a hybrid

If both build the hybrid they each make $60 million

If neither build they make $50 million

Should Dodge build a hybrid viper? If Chevrolet builds and Dodge does

not, Chevrolet will earn $80 million and Dodge $70 million.

If Dodge builds and Chevrolet does not, Dodge earns $80 million and Chevrolet $70 million.


Should Dodge build a hybrid viper? Does either have a dominant

strategy? What will happen if Dodge gets to

choose first?


The Advantage of Being Different

Offer hybrid Don’t offer hybrid

Dodge Viper

Chevrolet Corvette

Offer hybrid

Don’t offer hybrid

$60 million/yr$60 million/yrfor Dodgefor Dodge

$60 million/yr$60 million/yr for Chevroletfor Chevrolet







Is there aNash Equilibrium?

If Dodge and Chevrolet make their decisions independently and simultaneously, two equilibria arise. Dodge offers viper while Chevrolet does not Chervorlet offers viper while Dodge does not

What will happen if Dodge gets to choose first?

Multiple Equilibria

Decision Tree for Hybrid

A

Dodgedecides

Offer hybrid

Don’t offerhybrid

B

C

$50 million for Chevrolet$50 million for Dodge

Offerhybrid

Don’toffer

hybrid

Offerhybrid

Don’toffer

hybrid

Chevroletdecides



$60 million for Chevrolet$60 million for DodgeD

E

F

G

FinalOutcome

Credible Threats

Credible Threats A threat to take an action that is in

the threatener’s interest to carry out

Why couldn’t Chevrolet deter Dodge from offering a hybrid by threatening to offer a hybrid of its own, no matter what Dodge did?

A promise to take action that is in the promiser’s interest to keep

Credible Promise

Should a business owner open a remote office? Pay the manager $1,000 Make an additional $1,000 If the manager is dishonest, she can

make $500 more and cost the owner $500

Credible Promise

Decision Tree for the Remote Office Game

A

Owner does not open remote office

Manager manages honestly;owner gets $1,000,manager gets $1,000

Managerial candidatepromises to managehonestly

B

Owner opensremote office

C

Manager manages dishonestly;owner gets -$500,manager gets $1,500

Owner gets $0,manager gets $500 byworking elsewhere

Should a business owner open a remote office?Is the outcome an equilibrium?

Monopolistic CompetitionWhen Location Matters

Why do we often see convenience stores located on adjacent street corners?

Assume 1 mile street with 1,200 shoppers evenly

distributed Store A is located at the West end of the

mile Question

Where would you open a new store (say Store B) on the mile?

If you were Store A, why did you locate at the West end in the very beginning?


Differentiation by: Physical location

The choice to locate at B. Location in time

Timing of flight departures Timing of film showings

Product space (product differentiation) Soft drinks


Commitment Problems

A situation in which people cannot achieve their goals because of an inability to make credible threats or promises

Example Prisoner’s dilemma Cartels Remote office

A way of changing incentives so as to make otherwise empty threats or promises credible

Example Underworld code, omerta Military arms control agreements Tips for waiters

Commitment Device

The Strategic Role of Preferences

Game theory assumes that the goal of the players is to maximize their outcomes.

In most games, players do not attain the best outcomes.

Altering psychological incentives may also improve the outcome of a game.

Question In a moral society, will the business

owner open a remote office?

The Strategic Role of Preferences

The Remote Office Game with an Honest Manager

A

Owner does not open remote office

Manager manages honestly;owner gets $1,000,manager gets $1,000

Managerial candidatepromises to managehonestly

B

Owner opensremote office

C

Manager manages dishonestly;owner gets -$500,manager gets -$8,500

Owner gets $0,manager gets $500 byworking elsewhere

The value of dishonesty to the manager is $10,000

Preferences as Solutions to Commitment Problems Concerns about fairness, guilt, humor,

sympathy, etc. do influence the choices people make in strategic interactions.

Commitment to these preferences must be communicated for them to influence choices.

The Strategic Roleof Preferences

EndEnd

44

strategic choice in oligopoly, monopolistic competition, and everyday life 1

Documents

united slide

day slide

horace slide

thought slide

dominated strategies

prisoner s dilemma slide

strategic decisions

louis market slide