Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life

Thinking Strategically Interdependencies 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.

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

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

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 Raise ad spending $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

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

Nash Equilibrium 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

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

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

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

The Prisoner’s Dilemma 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 Should the prisoners confess?

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

The Economics of Cartels 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

The Market Demand for Mineral Water 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 Price $/bottle) Bottles/day

The Temptation to Violate a Cartel Agreement 1,100 0.90 Aquapure lowers P P = $.90/bottle Q = 1,100 bottles/day 2.00 Mountains Spring retaliates P = $.90/bottle Both firms split 1,100 bottles/day @ $.90 Profit = $495/day Price $/bottle) 1.00 MR D 1,000 2,000 Bottles/day

The Payoff Matrix for a Cartel Agreement Mountain Spring Charge $1/bottle Charge $0.90/bottle $0 for Aquapure $500/day for each Charge $1/bottle $990/day for Mt. Spring Aquapure $990 for Aquapure Charge $0.90/bottle $495/day for each $0 for Mt. Spring

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

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

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

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

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

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

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

Food for Thought 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 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 hybrid If both build the hybrid they each make $60 million If neither build they make $50 million

Games in Which Timing Matters 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.

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

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

Multiple Equilibria If Dodge and Chevrolet make their decisions independently and simultaneously, two equilibria arise. 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 A Dodge decides Offer hybrid Don’t offer hybrid B C $50 million for Chevrolet $50 million for Dodge Offer Don’t offer Chevrolet $80 million for Chevrolet $70 million for Dodge $70 million for Chevrolet $80 million for Dodge $60 million for Chevrolet $60 million for Dodge D E F G Final Outcome

Credible Threats Credible Threats 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?

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

Should a business owner open a remote office? Credible Promise Should a business owner open a remote office? 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

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

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

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

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

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

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

The Strategic Role of Preferences 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.

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

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

The Strategic Role of Preferences Preferences as Solutions to Commitment Problems 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.

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