The Economic Framework

• For our purposes two basic sets of agents:– Consumers– Firms

• Interact through markets

• Faced with some economic environment or market structure, each agent makes decisions

Market Structure

• What is a market?

-Set of firms and consumers whose interactions establish the price of products that are viewed as close substitutes by consumers (firms produce different brands)

• When are brands ‘close substitutes’?

• Cross Price Elasticity

-Measures how responsive quantity demanded is to changes in price of other goods.

-% change in quantity demanded of X / % change in price of Y.

Market Power

• Ability to raise price above marginal cost• Interested in strategies that can be used to

obtain and/or preserve market power-pricing strategies-product positioning strategies-choice of quality-advertising strategies-R&D strategies

• Market power depends on:

i) Demand Elasticity

ii) Market concentration

iii) Collusive behaviour

Market Structure

Perfect Competition vs Monopoly

Perfect Competition

• Perfectly competitive environment

-large number of small producers

-identical product

-perfect information

-free entry into and exit from market

- price takers

• Firms choose output level to maximize profits:

Max Profits=Revenue-Costs

Max PxQ-C(Q)

What Q should the firm choose?

The one that makes MR=MC

Q

P,C

Q

MC

ACPh

Pl At P : eco losses

At P : eco profits h

l

• In the long run 2 things can happen:

-firms in industry can adjust their fixed factors to maximize profits

-new firms can enter, old firms can leave

As a result, all firms break even in the long run

Monopoly

• A single firm serves an entire market for a good that has no close substitutes

• Why are some markets monopolized?

- Cost advantages over other firms

- Government created

Monopolists are price makers

• Amount of output they sell responds continuously as a function of the price they charge

• In fact, they can charge a price above MC—they have market power

• Operate where MR=MC

• What is MR?

-MR= ∆R /∆Q= ∆(PxQ)/∆Q

=P[1+1/E]

-So, P[1+1/E]=MC

Price is marked-up over marginal cost

What is a Game?

• A game describes any situation:– involving the interaction of two or more

individuals – in which the individuals can make choices that

affect the “outcome” of the interaction

How Do We Describe a Game?

• A game is described by:– number of players/agents– the “strategies” available to each player– each player’s preferences over outcomes of

the game

• For any game, a strategy choice by each one of the players results in a unique outcome of the game

What is a Strategy?

• A strategy is an action plan for a player. It specifies:– what action the player takes – when the player takes the action – the way that the action choice depends on the

information the player has when taking the action

• Two action plans that specify different actions represent two different strategies

• Dominant Strategy

-yields at least as high a payoff as any other strategy available to agent regardless of strategy choices of other agents

Predicting Behavior in Games

• If games are to help us understand observables, we need a way of predicting how agents behave in game settings; i.e., we need a notion of equilibrium for games

• Some equlibrium notions:

• Dominant strategy equilibrium

• Nash equilibrium

Dominant Strategy Equilibrium

Roughly speaking a Dominant strategy equilibrium has the feature that each player’s strategy choice is best for that player regardless of other players’ strategy choices

Nash Equilibrium

Roughly speaking a Nash equilibrium has the feature that each player’s strategy choice is best for that player given other players’ strategies– each player acts in a purely self-interested

way and seeks to be as “well off” as possible– in making a strategy choice, each player

forms beliefs about what strategies the other players are choosing

– These beliefs are correct in equilibrium