Strategic Choice in Oligopoly Monopolistic Competition and Everyday

Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 1

Thinking Strategically n Interdependencies n n 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. Slide 2

Using Game Theory to Analyze Strategic Decisions n Basic Elements of a Game n n n The players Their strategies The payoffs Slide 3

Using Game Theory to Analyze Strategic Decisions n Example n n Should United Airlines spend more on advertising? Note n The airline industry is an oligopoly with an undifferentiated product. Slide 4

The Payoff Matrix for an Advertising Game American’s Choices Raise ad spending Leave ad spending the same $5, 500 for United $8, 000 for United $5, 500 for American $2, 000 for American United’s Choices Leave ad spending the same $2, 000 for United $6, 000 for United $8, 000 for American $6, 000 for American Slide 5

Dominant and Dominated Strategies n Dominant Strategy n n One that yields a higher payoff no matter what the other players in a game choose Dominated Strategy n Any other strategy available to a player who has a dominant strategy Slide 6

Nash Equilibrium n n 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 Slide 7

Nash Equilibrium n n There can be an equilibrium when players do not have a dominant strategy Example n n Should American spend more on advertising? Assume United and American are the only carriers serving the Chicago – St. Louis market Slide 8

Equilibrium When One Player Lacks a Dominant Strategy American’s Choices Raise ad spending Leave ad spending the same $3, 000 for United $8, 000 for United $4, 000 for American $3, 000 for American $4, 000 for United $5, 000 for American $2, 000 for American United’s Choices Leave ad spending the same Slide 9

What Should United and American do if Their Payoff Matrix is Modified? American’s Choices Raise ad spending Leave ad spending the same $3, 000 for United $4, 000 for United $8, 000 for American $5, 000 for American $8, 000 for United $5, 000 for United $4, 000 for American $2, 000 for American United’s Choices Leave ad spending the same Slide 10

The Prisoner’s Dilemma n n 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 n Should the prisoners confess? Slide 11

The Payoff Matrix for a Prisoner’s Dilemma Jasper Confess Remain Silent 5 years for each 0 years for Horace 20 years for Jasper Horace Remain Silent 20 years for Horace 0 years for Jasper 1 year for each Slide 12

The Economics of Cartels n Cartel n n n 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 Slide 13

The Market Demand for Mineral Water Assume • 2 firms (Aquapure & Mountain Spring • MC = 0 • Cartel is formed & agree to split output and profits Price $/bottle) 2. 00 Impact of Cartel • Q = 1, 000 bottles/day • P = $1/bottle • Each firm makes $500/day 1. 00 MR D 1, 000 2, 000 Bottles/day Slide 14

The Temptation to Violate a Cartel Agreement Aquapure lowers P • P = $. 90/bottle • Q = 1, 100 bottles/day Price $/bottle) 2. 00 Mountains Spring retaliates • P = $. 90/bottle • Both firms split 1, 100 bottles/day @ $. 90 • Profit = $495/day 1. 00 0. 90 MR D 1, 000 1, 100 2, 000 Bottles/day Slide 15

The Payoff Matrix for a Cartel Agreement Mountain Spring Charge $1/bottle $500/day for each Charge $0. 90/bottle $0 for Aquapure $990/day for Mt. Spring Aquapure Charge $0. 90/bottle $990 for Aquapure $0 for Mt. Spring $495/day for each Slide 16

Food For Thought n When will the rival firms stop cutting prices? Slide 17

Tit-for-tat and the Repeated Prisoner’s Dilemma n Cooperation between players will increase the payoff in a prisoner’s dilemma. n n There is a motive to enforce cooperation. Tit-for-tat strategy n Players cooperate on the first move, then mimic their partner’s last move on each successive move Slide 18

Tit-for-tat and the Repeated Prisoner’s Dilemma n Tit-for-tat strategy requirements n n Two players A stable set of players Players recall other player’s moves Players have a stake in future outcomes Slide 19

Food For Thought n Why is the tit-for-tat strategy unsuccessful in competitive, monopolistically competitive, and oligopolistic markets? Slide 20

Cigarette Advertising as a Prisoner’s Dilemma n Why did the ban on television advertising beneficial to cigarette producers? Slide 21

Cigarette Advertising as a Prisoner’s Dilemma Philip Morris Advertise on TV $10 million/yr for each RJR Don’t Advertise on TV $5 million/yr for RJR $35 million/yr for Philip Morris Don’t advertise on TV $35 million/yr for RJR $5 million/yr for Philip Morris $20 million/yr for each Slide 22

Determinants of a Successful Cartel n n A successful cartel requires a good enforcement mechanism: detect cheating and punish cheating sellers. Determinants of cost of detecting price chiseling n Number of buyers n Customer turnover n Availability of price information

Food for Thought n n 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 n Should Dodge build a hybrid viper? n n 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 Slide 25

Games in Which Timing Matters n Should Dodge build a hybrid viper? n n 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. Slide 26

Games in Which Timing Matters n Should Dodge build a hybrid viper? n n Does either have a dominant strategy? What will happen if Dodge gets to choose first? Slide 27

The Advantage of Being Different Is there a Nash Equilibrium? Offer hybrid Chevrolet Corvette Don’t offer hybrid Dodge Viper Offer hybrid Don’t offer hybrid $60 million/yr for Chevrolet $80 million/yr for Chevrolet $60 million/yr for Dodge $70 million/yr for Chevrolet $50 million/yr for Chevrolet $80 million/yr for Dodge $50 million/yr for Dodge Slide 28

Multiple Equilibria n If Dodge and Chevrolet make their decisions independently and simultaneously, two equilibria arise. n n n Dodge offers viper while Chevrolet does not Chervorlet offers viper while Dodge does not What will happen if Dodge gets to choose first? Slide 29

Decision Tree for Hybrid Offer hybrid B Offer hybrid Don’t offer hybrid A Don’t offer hybrid C Dodge decides Chevrolet decides D $60 million for Chevrolet $60 million for Dodge E $70 million for Chevrolet $80 million for Dodge F $80 million for Chevrolet $70 million for Dodge G $50 million for Chevrolet $50 million for Dodge Offer hybrid Don’t offer hybrid Final Outcome Slide 30

Credible Threats n n 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? Slide 31

Credible Promise n A promise to take action that is in the promiser’s interest to keep Slide 32

Credible Promise n Should a business owner open a remote office? n n n 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 Slide 33

Decision Tree for the Remote Office Game Should a business owner open a remote office? Is the outcome an equilibrium? Manager manages honestly; owner gets $1, 000, manager gets $1, 000 C Owner opens remote office A Managerial candidate promises to manage honestly B Manager manages dishonestly; owner gets -$500, manager gets $1, 500 Owner does not open remote office Owner gets $0, manager gets $500 by working elsewhere Slide 34

Monopolistic Competition When Location Matters n Why do we often see convenience stores located on adjacent street corners? Slide 35

Monopolistic Competition When Location Matters n Assume n n n 1 mile street with 1, 200 shoppers evenly distributed Store A is located at the West end of the mile Question n n 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? Slide 36

Monopolistic Competition When Location Matters n Differentiation by: n Physical location n n Location in time n n n The choice to locate at B. Timing of flight departures Timing of film showings Product space (product differentiation) n Soft drinks Slide 37

Commitment Problems n n A situation in which people cannot achieve their goals because of an inability to make credible threats or promises Example n n n Prisoner’s dilemma Cartels Remote office Slide 38

Commitment Device n n A way of changing incentives so as to make otherwise empty threats or promises credible Example n n n Underworld code, omerta Military arms control agreements Tips for waiters Slide 39

The Strategic Role of Preferences n n n 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. Slide 40

The Strategic Role of Preferences n Question n In a moral society, will the business owner open a remote office? Slide 41

The Remote Office Game with an Honest Manager manages honestly; owner gets $1, 000, manager gets $1, 000 The value of dishonesty to the manager is $10, 000 C Owner opens remote office A Managerial candidate promises to manage honestly B Manager manages dishonestly; owner gets -$500, manager gets -$8, 500 Owner does not open remote office Owner gets $0, manager gets $500 by working elsewhere Slide 42

The Strategic Role of Preferences n Preferences as Solutions to Commitment Problems n n 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. Slide 43

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