strategic choice in oligopoly, monopolistic competition, and everyday life

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Strategic Choice in Oligopoly, Monopolistic Competition,

and Everyday Life

Strategic Choice in Oligopoly, Monopolistic Competition,

and Everyday Life

Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life

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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.

Thinking Strategically

InterdependenciesIn 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.


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Using Game Theory toAnalyze Strategic Decisions

Basic Elements of a GameThe playersTheir strategiesThe payoffs


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ExampleShould United Airlines spend more on

advertising?Note

The airline industry is an oligopoly with an undifferentiated product.



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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








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Dominant StrategyOne that yields a higher payoff no matter

what the other players in a game choose



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Dominated StrategyAny other strategy available to a player

who has a dominant strategy



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Nash EquilibriumAny combination of strategies in which

each player’s strategy is her or his best choice, given the other player’s strategies



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Nash EquilibriumWhen each player has a dominant

strategy, equilibrium occurs when each player follows that strategy



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Nash EquilibriumThere can be an equilibrium when players

do not have a dominant strategy



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The Theory of Games

ExampleShould American spend more on

advertising?Assume

United and American are the only carriers serving the Chicago – St. Louis market


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Equilibrium When One Player Lacks a Dominant Strategy

Raise adspending


Raise adspending











United’s Choices


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

Raise adspending


Raise adspending











United’s Choices


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The Prisoner’s Dilemma

Prisoners DilemmaA 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


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ExampleShould the prisoners confess?


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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


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ExerciseWhich of these games is a prisoner’s

dilemma?


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Which of These GamesIs a Prisoner’s Dilemma?

Don’t Invest

Don’tInvest

12 for Chrysler12 for Chrysler10 for each10 for each 4 for GM4 for GM

GAME 1

Invest

5 for each5 for each4 for Chrysler4 for Chrysler

12 for GM12 for GM

Chrysler

GM

Invest


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Which of These GamesIs a Prisoner’s Dilemma?

GAME 2

Don’t Invest

Don’tInvest

Invest

12 for Chrysler12 for Chrysler

10 for each10 for each

4 for GM4 for GM

Chrysler

GM

Invest

5 for each5 for each

4 for Chrysler4 for Chrysler12 for GM12 for GM


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The Economics of Cartels

Prisoner’s Dilemmas Confronting Imperfectly Competitive FirmsCartel

A coalition of firms that agrees to restrict output for the purpose of earning an economic profit


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Economic NaturalistWhy are cartel agreements notoriously

unstable?

The Economics of Cartels


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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


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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


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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


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Economic NaturalistWhen will the rival firms stop cutting

prices?


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Tit-for-tat and the Repeated Prisoner’s DilemmaCooperation between players will increase

the payoff in a prisoner’s dilemma.There is a motive to enforce cooperation.


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Tit-for-tat strategy for repeated gamesTit-for-tat strategy

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


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Tit-for-tat strategy for repeated gamesTit-for-tat strategy requirements

Two playersA stable set of playersPlayers recall other player’s movesPlayers have a stake in future outcomes


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QuestionWhy is the tit-for-tat strategy unsuccessful

in competitive, monopolistically competitive, and oligopolistic markets?


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Economic NaturalistHow did Congress unwittingly solve the

television advertising dilemma confronting cigarette producers?


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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


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Economic NaturalistWhy do people shout at parties?


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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 hybridIf both build the hybrid they each make $60

millionIf neither build they make $50 million


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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.


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Should Dodge build a hybrid viper?Does either have a dominant strategy?What will happen if Dodge gets to choose

first?


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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?


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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


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Credible Threats and PromisesCredible Threat

A threat to take an action that is in the threatener’s interest to carry out


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What Do You Think?Why couldn’t Chevrolet deter Dodge from

offering a hybrid by threatening to offer a hybrid of its own, no matter what Dodge did?


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Credible PromiseA promise to take action that is in the

promiser’s interest to keep


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

$500 more and cost the owner $500


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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?


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Monopolist CompetitionWhen Location Matters

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


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Assume1 mile street with 1,200 shoppers evenly

distributedStore A is located at the West end of the

mile

QuestionWhere would you open a new store on the

mile?


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The Curious Tendency of Monopolistic Competitors to Cluster


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Differentiation by:Physical location

The choice to locate at B.

Location in time Timing of flight departuresTiming of film showings

Produce spaceSoft drinks


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Commitment Problems

Commitment ProblemA situation in which people cannot achieve

their goals because of an inability to make credible threats or promises


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Commitment DeviceA way of changing incentives so as to

make otherwise empty threats or promises credible

Commitment Problems


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Commitment ProblemsPrisoner’s dilemmaCartelsRemote office

Commitment Problems


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Commitment DevicesUnderworld code, omertaMilitary arms control agreementsTips for waiters

Commitment Problems


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What do you think?Will Sylvester leave a tip when dining on

the road?


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The Strategic Role of Preferences

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

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

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


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QuestionIn a moral society, will the business owner

open a remote office?

The Strategic Role of Preferences


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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


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The Strategic Roleof Preferences

Are People Fundamentally Selfish?Do you tip at out-of town restaurants?What would be your first offer in the

ultimatum bargaining game?Would you refuse a lopsided offer?


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Are People Fundamentally Selfish?If narrow self-interest is not the only motive

for making choices, then the other motives must be understood to predict and explain human behavior.


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Preferences as Solutions to Commitment ProblemsConcerns 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.

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End ofChapterEnd of

Chapter

strategic choice in oligopoly, monopolistic competition, and everyday life

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