Oligopoly and Game Theory Topic Students should be able to: Use simple game theory to illustrate the interdependence that exists in oligopolistic markets Understanding the prisoners’ dilemma and a simple two firm/two outcome model. Students should analyse the advantages/disadvantages of being a first mover Students will not be expected to have an understanding of the Nash Equilibrium Students should be able to: Use simple game theory to illustrate the interdependence that exists in oligopolistic markets Understanding the prisoners’ dilemma and a simple two firm/two outcome model. Students should analyse the advantages/disadvantages of being a first mover Students will not be expected to have an understanding of the Nash Equilibrium

Oligopoly and Game Theory Topic 3.3.9

Game Theory and Oligopoly Game theory is the study of how people and businesses behave in strategic situations (i.e. when they must consider the effect of other people’s responses to their own actions). In an oligopoly, each company knows that its revenues and profits depend on the actions of other firms. This gives rise to the classic example of the “Prisoners’ Dilemma”. Game theory is the study of how people and businesses behave in strategic situations (i.e. when they must consider the effect of other people’s responses to their own actions). In an oligopoly, each company knows that its revenues and profits depend on the actions of other firms. This gives rise to the classic example of the “Prisoners’ Dilemma”. Oligopoly theory makes heavy use of game theory to model the actual behaviour of businesses in concentrated markets

Key Concepts – Game Theory Cooperative outcome An equilibrium in a game where the players agree to cooperate Dominant strategy A dominant strategy is one where a single strategy is best for a player regardless of what strategy other players in the game decide to use Nash equilibrium Any situation where all participants in a game are pursuing their best possible strategy given the strategies of all of the other participants Tacit collusion Where firms undertake actions that are likely to minimize a competitive response, e.g. avoiding price-cutting or not attacking each other’s market Whistle blowing When one or more agents in a collusive agreement report it to the authorities Zero sum game An economic transaction in which whatever is gained by one party must be lost by the other.

Game Theory – Prisoners’ Dilemma Prisoner B SilentBetray Prisoner A Silent(6M,6M)(10Y,0) Betray(0,10Y)(5Y,5Y) Comment on the best strategies for each player and the likely outcome in this game The prisoners' dilemma is a particular game that illustrated why it is difficult to cooperate, even when it is in the best interest of both parties. Both players select their own dominant strategies for short-sighted personal gain / self-interest. Eventually, they reach an equilibrium in which they are both worse off than they would have been, if they could both agree to select an alternative (non- dominant) strategy.

Prisoners’ Dilemma – Decision Trees Prisoner B SilentBetray Prisoner A Silent(6M,6M)(10Y,0) Betray(0,10Y)(5Y,5Y)

Nash Equilibrium Nash Equilibrium is an important idea in game theory – it describes any situation where all of the participants in a game are pursuing their best possible strategy given the strategies of all of the other participants. In a Nash Equilibrium, the outcome of a game that occurs is when player A takes the best possible action given the action of player B, and player B takes the best possible action given the action of player A

A Simple Pricing Game Firm B (right hand figures below) Expected Profit ($bn) High PricesLow Prices Firm A High Prices$3bn; $3bn$0bn, $5bn Low Prices$5bn; $0bn$1bn, $1bn In this two firm game, they have to decide whether to set high or low prices The table shows the profits (pay-offs) that results from each set of choices In this two firm game, they have to decide whether to set high or low prices The table shows the profits (pay-offs) that results from each set of choices This grid shows a pay-off matrix – it shows a simple game between A and

A Simple Pricing Game Firm B (right hand figures below) Expected Profit ($bn) High PricesLow Prices Firm A High Prices$3bn; $3bn$0bn, $5bn Low Prices$5bn; $0bn$1bn, $1bn To understand the game we isolate one firm and assume that Firm B makes the first decision. Assume that each firm is a profit maximiser. This grid shows a pay-off matrix – it shows a simple game between A and

A Simple Pricing Game B Profit $bnHigh PricesLow Prices A High Prices$3bn; $3bn$0 bn, $5bn Low Prices$5bn; $0bn$1bn, $1bn In this game, regardless of what the other firm decides to do, the best response of the other firm is to charge a lower price – they may settle at this low price

Pricing Game – Incentives to Collude B Profit $bnHigh PricesLow Prices A High Prices$3bn; $3bn$0 bn, $5bn Low Prices$5bn; $0bn$1bn, $1bn If these firms got together and decided to collude by both setting a high price, then both of them would earn higher total profits – this would be pareto optimal

Rock Paper Scissors – Nash Equilibrium? In the famous Rock, Paper, Scissors game: Rock > Scissors, Paper > Rock and Scissors > Paper. Is there an optimum strategy when playing this game? RockPaperScissors Rock( 0, 0)(-1, 1)(1, -1) Paper(1, -1)(0, 0)(-1, 1) Scissors(-1, 1)(1, -1)(0, 0) There is no Nash Equilibrium in this game!

Rock Paper Scissors – Random Strategy RockPaperScissors Rock( 0, 0)(-1, 1)(1, -1) Paper(1, -1)(0, 0)(-1, 1) Scissors(-1, 1)(1, -1)(0, 0) In this game matter what both players choose, at least one of them can always improve their payoff by switching to a different choice. If one of them wins the game, the loser can improve their payoff by switching. If it's a tie, either player can improve their payoff by switching to a different choice.

Pricing Game for Two Confectioners Nestle and Cadbury are the two dominant firms in the UK chocolate market. They face the decision whether to raise prices using their market power, or to leave prices unchanged. Their payoff matrix is below showing the change in profits Identify if a Nash Equilibrium exists in the game above Nestle Pay-off is profits in £s Raise Price Remain Unchanged CadburyRaise Price(2, -2)(12, -12) Remain Unchanged (10, -10)(0, 0)

Pricing Game for Two Confectioners Nestle and Cadbury are the two dominant firms in the UK chocolate market. They face the decision whether to raise prices using their market power, or to leave prices unchanged. Their payoff matrix is below showing the change in profits Nestle Pay-off is profits in £s Raise Price Remain Unchanged CadburyRaise Price(2, -2)(12, -12) Remain Unchanged (10, -10)(0, 0) A player has a dominant strategy when it has one strategy that offers a higher pay- off than any other irrespective of the choice made by the other player.

First Mover Advantage Two players A and B take turns choosing a number between 1 and 10 (inclusive) A goes first The cumulative number of ALL of the numbers chosen is calculated as the game progresses The winner is the player whose choice of number TAKES THE TOTAL to 100 or more Does this game have first mover advantage? Two players A and B take turns choosing a number between 1 and 10 (inclusive) A goes first The cumulative number of ALL of the numbers chosen is calculated as the game progresses The winner is the player whose choice of number TAKES THE TOTAL to 100 or more Does this game have first mover advantage?

First Mover Advantage – 0 to 100 Game For Player A to win, he/she must a number that takes the total to 100 or more The only way this can happen is Player B to leave me a number of 90 or more Player A needs to ensure Player B is left with 89 Player B knows this too Player A needs to leave Player B with 78 Use backward-induction to work towards the solution 100 – 89 – 78 – 67 – 56 – 45 – 34 – 23 – 12 Player A can ensure he/she wins by going first and choosing 1 For Player A to win, he/she must a number that takes the total to 100 or more The only way this can happen is Player B to leave me a number of 90 or more Player A needs to ensure Player B is left with 89 Player B knows this too Player A needs to leave Player B with 78 Use backward-induction to work towards the solution 100 – 89 – 78 – 67 – 56 – 45 – 34 – 23 – 12 Player A can ensure he/she wins by going first and choosing 1

Examples of First Mover Advantage? Just EatGolden Leaf Holdings Oculus RiftSpotify

Evaluating First Mover Advantage Advantages of being the fist mover A business first into the market can develop a significant competitive advantage through learning by doing - making it difficult and costly for new firms/rivals to enter They can exploit internal economies of scale (leading to lower LRAC) and also build brand loyalty/ repeat demand Consumer behaviour can become habitual – hard to eat into! Critical evaluation points Employees from first mover may leave to set up challenge brands – taking some of the intellectual capital with them First movers are often unprofitable, failure rate can be high Second-movers can learn much from first mover mistakes

Applications of Game Theory Interdependent pricing in an oligopoly – Price wars in concentrated markets Decisions on how much to spend on – Research and development – Marketing – New product launches – Output decisions Co-operative and collaboration between businesses (trust)

Oligopoly and Game Theory Topic Students should be able to: Use simple game theory to illustrate the interdependence that exists in oligopolistic markets Understanding the prisoners’ dilemma and a simple two firm/two outcome model. Students should analyse the advantages/disadvantages of being a first mover Students will not be expected to have an understanding of the Nash Equilibrium Students should be able to: Use simple game theory to illustrate the interdependence that exists in oligopolistic markets Understanding the prisoners’ dilemma and a simple two firm/two outcome model. Students should analyse the advantages/disadvantages of being a first mover Students will not be expected to have an understanding of the Nash Equilibrium