Strategic Choice in Oligopoly Monopolistic Competition and Everyday

Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life MB MC Chapter 10: Thinking Strategically

MB MC Thinking Strategically n Interdependencies In making choices, people must consider the effect of their behavior on others. l Imperfectly competitive firms may consider how rivals will respond to price changes or new advertising. l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 2

MB MC n Using Game Theory to Analyze Strategic Decisions Basic Elements of a Game The players l Their strategies l The payoffs l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 3

MB MC n Using Game Theory to Analyze Strategic Decisions Example Should United Airlines spend more on advertising? l Note l u The airline industry is an oligopoly with an undifferentiated product. Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 4

MB MC The Payoff Matrix for an Advertising Game American’s Choices Leave ad spending the same Raise ad spending $5, 500 for United $8, 000 for United $5, 500 for American $2, 000 for American United’s Choices Leave ad spending the same Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. $2, 000 for United $6, 000 for United $8, 000 for American $6, 000 for American Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 5

MB MC n Using Game Theory to Analyze Strategic Decisions Dominant Strategy l One that yields a higher payoff no matter what the other players in a game choose Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 6

MB MC n Using Game Theory to Analyze Strategic Decisions Dominated Strategy l Any other strategy available to a player who has a dominant strategy Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 7

MB MC n Using Game Theory to Analyze Strategic Decisions Nash Equilibrium l Any combination of strategies in which each player’s strategy is her or his best choice, given the other player’s strategies Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 8

MB MC n Using Game Theory to Analyze Strategic Decisions Nash Equilibrium l When each player has a dominant strategy, equilibrium occurs when each player follows that strategy Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 9

MB MC n Using Game Theory to Analyze Strategic Decisions Nash Equilibrium l There can be an equilibrium when players do not have a dominant strategy Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 10

MB MC Theory of Games n Example Should American spend more on advertising? l Assume l u United and American are the only carriers serving the Chicago – St. Louis market Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 11

MB MC 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 Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 12

MB MC 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 Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 13

MB MC The Prisoner’s Dilemma n Prisoners Dilemma l 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 Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 14

MB MC The Prisoner’s Dilemma n Example l Should the prisoners confess? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 15

MB MC 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 Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 20 years for Horace 0 years for Jasper Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 1 year for each 16

MB MC The Prisoner’s Dilemma n Exercise l Which of these games is a prisoner’s dilemma? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 17

MB MC Which of These Games Is a Prisoner’s Dilemma? GAME 1 Chrysler Don’t Invest 10 for each Invest 4 for GM 12 for Chrysler GM Invest Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 12 for GM 4 for Chrysler Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 5 for each 18

MB MC Which of These Games Is a Prisoner’s Dilemma? GAME 2 Don’t Invest Chrysler Don’t Invest 4 for GM 12 for Chrysler 5 for each GM Invest Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 10 for each 12 for GM 4 for Chrysler Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 19

MB MC The Economics of Cartels n Prisoner’s Dilemmas Confronting Imperfectly Competitive Firms l Cartel u. A coalition of firms that agrees to restrict output for the purpose of earning an economic profit Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 20

MB MC The Economics of Cartels n Economic Naturalist l Why are cartel agreements notoriously unstable? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 21

MB MC 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 Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 22

MB MC 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 Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 23

MB MC The Payoff Matrix for a Cartel Agreement Mountain Spring Charge $1/bottle Charge $0. 90/bottle $500/day for each $0 for Aquapure $990/day for Mt. Spring Aquapure Charge $0. 90/bottle Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. $990 for Aquapure $0 for Mt. Spring Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life $495/day for each 24

MB MC The Prisoner’s Dilemma n Economic Naturalist l When will the rival firms stop cutting prices? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 25

MB MC The Prisoner’s Dilemma n Tit-for-tat and the Repeated Prisoner’s Dilemma Cooperation between players will increase the payoff in a prisoner’s dilemma. l There is a motive to enforce cooperation. l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 26

MB MC The Prisoner’s Dilemma n Tit-for-tat strategy for repeated games l Tit-for-tat strategy u Players cooperate on the first move, then mimic their partner’s last move on each successive move Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 27

MB MC The Prisoner’s Dilemma n Tit-for-tat strategy for repeated games l Tit-for-tat strategy requirements u Two players u A stable set of players u Players recall other player’s moves u Players have a stake in future outcomes Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 28

MB MC The Prisoner’s Dilemma n Question l Why is the tit-for-tat strategy unsuccessful in competitive, monopolistically competitive, and oligopolistic markets? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 29

MB MC The Prisoner’s Dilemma n Economic Naturalist l How did Congress unwittingly solve the television advertising dilemma confronting cigarette producers? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 30

Cigarette Advertising as a Prisoner’s Dilemma MB MC Philip Morris Advertise on TV $10 million/yr for each RJR Don’t Advertise on TV Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. $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 Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 31

MB MC The Prisoner’s Dilemma n Economic Naturalist l Why do people shout at parties? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 32

MB MC Games in Which Timing Matters n Should Dodge build a hybrid viper? Dodge Viper and Chevrolet Corvette compete for the domestic sports car market l Both know the other is considering a hybrid l If both build the hybrid they each make $60 million l If neither build they make $50 million l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 33

MB MC Games in Which Timing Matters n Should Dodge build a hybrid viper? If Chevrolet builds and Dodge does not, Chevrolet will earn $80 million and Dodge $70 million. l If Dodge builds and Chevrolet does not, Dodge earns $80 million and Chevrolet $70 million. l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 34

MB MC Games in Which Timing Matters n Should Dodge build a hybrid viper? Does either have a dominant strategy? l What will happen if Dodge gets to choose first? l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 35

MB MC The Advantage of Being Different Is there a Nash Equilibrium? Dodge Viper Offer hybrid Chevrolet Corvette Don’t offer hybrid Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 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 Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 36

MB MC Decision Tree for Hybrid Offer hybrid B Offer hybrid Don’t offer hybrid A Don’t offer hybrid C Dodge decides Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 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 Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 37

MB MC Games in Which Timing Matters n Credible Threats and Promises l Credible Threat u. A threat to take an action that is in the threatener’s interest to carry out Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 38

MB MC Games in Which Timing Matters n What Do You Think? l Why couldn’t Chevrolet deter Dodge from offering a hybrid by threatening to offer a hybrid of its own, no matter what Dodge did? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 39

MB MC Games in Which Timing Matters n Credible Promise l A promise to take action that is in the promiser’s interest to keep Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 40

MB MC Games in Which Timing Matters n Should a business owner open a remote office? Pay the manager $1, 000 l Make an additional $1, 000 l If the manager is dishonest, she can make $500 more and cost the owner $500 l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 41

Decision Tree for the Remote Office Game MB MC 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 Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 42

MB MC n Monopolist Competition When Location Matters Why do we often see convenience stores located on adjacent street corners? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 43

MB MC n Monopolist Competition When Location Matters Assume 1 mile street with 1, 200 shoppers evenly distributed l Store A is located at the West end of the mile l n Question l Where would you open a new store on the mile? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 44

MB MC n Monopolist Competition When Location Matters Differentiation by: l Physical location u The l choice to locate at B. Location in time u Timing of flight departures u Timing of film showings l Produce space u Soft Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. drinks Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 45

MB MC Commitment Problems n Commitment Problem l A situation in which people cannot achieve their goals because of an inability to make credible threats or promises Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 46

MB MC Commitment Problems n Commitment Device l A way of changing incentives so as to make otherwise empty threats or promises credible Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 47

MB MC Commitment Problems n Commitment Problems Prisoner’s dilemma l Cartels l Remote office l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 48

MB MC Commitment Problems n Commitment Devices Underworld code, omerta l Military arms control agreements l Tips for waiters l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 49

MB MC Games in Which Timing Matters n What do you think? l Will Sylvester leave a tip when dining on the road? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 50

MB MC The Strategic Role of Preferences n Game theory assumes that the goal of the players is to maximize their outcome. n In most games, players do not attain the best outcomes. n Altering psychological incentives may also improve the outcome of a game. Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 51

MB MC n The Strategic Role of Preferences Question l In a moral society, will the business owner open a remote office? Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 52

The Remote Office Game with an Honest Manager MB MC 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 Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 53

MB MC n The Strategic Role of Preferences Are People Fundamentally Selfish? Do you tip at out-of town restaurants? l What would be your first offer in the ultimatum bargaining game? l Would you refuse a lopsided offer? l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 54

MB MC n The Strategic Role of Preferences Are People Fundamentally Selfish? l 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. Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 55

MB MC n The Strategic Role of Preferences as Solutions to Commitment Problems Concerns about fairness, guilt, humor, sympathy, etc. do influence the choices people make in strategic interactions. l Commitment to these preferences must be communicated for them to influence choices. l Copyright c 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 56

End of Chapter MB MC Chapter 10: Thinking Strategically