Lecture 5 Oligopoly and Strategic Behavior Managerial Economics ECON 511 Professor Changqi Wu

OligopolySlide 2 Topics for Today Oligopolistic competition Prisoners’ dilemma and Nash equilibrium Games with sequential moves

OligopolySlide 3 1. Oligopolistic Competition What’s common in these industries? Newspaper publishing, internet browsers, credit cards, property development A few sellers in the market, each commands a substantial market share High barriers to entry Interdependence among the few A firm must conjecture about its rival's action and reaction to its own action

OligopolySlide 4 Game Theory and Strategy Game theory is a branch of mathematics that studies strategic interactions among rational players Strategy is an action plan that leads to successful achievement of the goal Game theory has been used in economics to analyze interactions between rivals. An illustration: Prisoners’ dilemma

OligopolySlide 5 2. Prisoners’ Dilemma There are two players Each player wants to maximize her own payoff Communication between two players is not allowed and both players move simultaneously There are two possible strategies: cooperation (deny any wrongdoing) and noncooperation (confess to the police)

OligopolySlide 6 -5 Noncooperative Cooperative Player 1 Player 2 Prisoners’ Dilemma noncoopetative

OligopolySlide 7 Observations Payoffs to each and every player depend on other player’s action A dominant strategy produces a better payoff than alternative course of action Both players end up worse-off at the equilibrium

OligopolySlide 8 Nash Equilibrium A combination of strategies such that each and every player's strategy is an optimal response to the other player’s strategy No one is willing to deviate unilaterally from a Nash equilibrium. Some game may not have a pure strategy Nash equilibrium, but will have a randomized Nash equilibrium

OligopolySlide 9 1 Head Tail Player 1 Player 2 Matching Pennies Head 1 1 1

OligopolySlide 10 1 Opera Football Wife Husband Battle of Sexes Opera

OligopolySlide Price war No price war Firm 1 Firm 2 Business Application Price war

OligopolySlide 12 How to Resolve the Prisoners’ Dilemma Changing payoffs Introducing a third player Game with repeat play Detecting the cheater Punishment of cheaters

OligopolySlide 13 Detecting Cheater Difficulties in cheating detection price may fall because of changes in demand multi-dimensional interactions it is harder to identify the cheater than to detect cheating Detection device: “lowest price guarantee”

OligopolySlide 14 Strategies to Punish the Cheater Trigger strategy Tit-for-tat strategy Step 1: Begin with cooperation Step 2: Mimic rival's action Business applications “meet-competition clauses"

OligopolySlide 15 The Tit-For-Tat Strategy Player 1Player 2 RoundActionAction Payoff CC C-5 NC NC5 NCNC NC5C-5 C3C3 C3C Payoff

OligopolySlide 16 Advantages of the TFT Strategy Simplicity and clarity Niceness Provocability Forgiveness

OligopolySlide 17 When to Play the TFT Strategy? The objective is to achieve a high payoff, NOT to win the contest The game must repeat many times Cheating detection is not a problem Discount factor cannot be too small There is a good chance that other players play TFT strategy.

OligopolySlide Game with Sequential Moves Players move in sequence in choosing their strategies The second mover can observe the action of the first mover The first mover must look forward and think backward: backward induction.

OligopolySlide 19 Battle for the Evening News TVB ATV 1, 1 3, 4 4, 3 2.5, 2.5 6:00 6:30 6:00 6:30 6:00 6:30 Payoffs TVB, ATV

OligopolySlide 20 First Mover Advantage First-mover advantage: the gains from the right to move first To take the best position in the market A firm can enjoy the first mover advantage when it moves is credible.

OligopolySlide 21 Credible Commitment Can ATV do better by threatening TVB that it will broadcast news at 6:30 anyway? An empty threat works against a player’s own interest A player can make her threat credible by taking a costly and irreversible move Burning the bridge

OligopolySlide 22 Empty Threat Enter No entry Price cut Output cut 2, 0 5, 5 15, 0 Entrant Payoffs Incumbent Entrant Incumbent

OligopolySlide 23 Credible Commitment Expand capacity Do nothing Enter No entry Enter No entry Price cut Output cut Price cut Output cut -5, , 2 10, 0 2, 0 5, 5 15, 0 Incumbent Entrant Payoffs Incumt Entrant. Incumbent

OligopolySlide 24 Key Learning Points Nash equilibrium describes the combinations of strategies that nobody wants to deviate from. Prisoners’ dilemma hurts the interests of both players. Some devices can be used to resolve such a dilemma. Firms can gain advantages by acting as the first mover.

OligopolySlide 25 References Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life, by Avinash Dixit and Barry Nalebuff Co-Opetition: By Barry Nalebuff and Adam Brandenburger.

OligopolySlide 26 Key Learning Points Strategic interaction is an important element in business. The Cambridge Zoo provides a taxonomy of business strategies. One should take into account the nature of the investment in the first stage (tough or soft) and the nature of the strategic relationship between the rivals in the second stage (strategic substitute and strategic complement) when making investment decisions.