McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 13: Strategic Decision Making in Oligopoly Markets

Managerial Economics 13-2 Oligopoly Markets Interdependence of firms’ profits Distinguishing feature of oligopoly Arises when number of firms in market is small enough that every firms’ price & output decisions affect demand & marginal revenue conditions of every other firm in market Dr. Chen’s notes: In general, the number of firms is considered as “small” between 2 to 15. However, economists prefer to use concentration ratio to define oligopoly. For example, the four-firm concentration ratio (CR-4) calculates the total market share contributed by the top four firms in a market. According to the rule of thumb, if the CR-4 is greater than 40%, then the market structure is defined as oligopoly.

Managerial Economics 13-3 Strategic Decisions Strategic behavior Actions taken by firms to plan for & react to competition from rival firms Game theory Useful guidelines on behavior for strategic situations involving interdependence Dr. Chen’s notes: Every oligopoly firm can have a perceptible impact on the sales of the other firms by pricing strategies, quantity of output, or quality control. In other words, firms’ decision- making depends on each other. Just like playing chess game: you don’t know the next move until your rival acts. That’s why oligopoly is considered as the most complicated market structure. No single model can summarize an oligopolistic firm’s behavior.

Managerial Economics 13-4 Prisoners’ Dilemma The most famous 2X2 (two by two) game. The first 2 means two strategies; the last 2 means two players. Both players choose their own strategy at the same time (simultaneously); once they made the decision, no chance for replay. We study the Prisoner’s Dilemma to see how the game theory works to explore the strategic decision making involving interdependence for oligopoly.

Managerial Economics 13-5 Prisoners’ Dilemma (Text p. 516) Bill Don’t confessConfess Jane Don’t confess A 2 years, 2 years B 12 years, 1 year Confess C 1 year, 12 years D 6 years, 6 years J J B B

Managerial Economics 13-6 Solving a Game In the Prisoner’s dilemma, can we predict what will be the final outcome (equilibrium)? That is, what are the strategic decisions of Jane and Bill? The answer is “Jane will confess and Bill will also confess.” Why? Dr. Chen’s notes: You have to study my additional lecture note of CH 13, “How to solve a “2X2” game”, to learn the game solving process for different applications. Before you do so, please read the next slide to have some fundamental concepts.

Managerial Economics 13-7 Some Concepts for Game Solving Simultaneous decision A player must make individual decision (i.e. choose a strategy) without knowing or observing the decisions of the rival(s); players make decision at the same time Dominant strategy A dominant strategy is the choice better (i.e. greater payoff) than the other strategies, given all possible choices of the rival. Equilibrium in a game A situation in which all decision makers have no incentive to switch their chosen strategy Dr. Chen’s notes: OK, please study “How to solve a “2X2” game” in detail now.

Managerial Economics 13-8 Making Mutually Best Decisions For all firms in an oligopoly to be predicting correctly each others’ decisions: All firms must be choosing individually best actions given the predicted actions of their rivals, which they can then believe are correctly predicted Strategically astute managers look for mutually best decisions

Managerial Economics 13-9 Nash Equilibrium Set of actions or decisions for which all players are choosing their best actions given the actions they expect their rivals to choose All dominant strategy equilibria are also Nash equilibria; however, Nash equilibria can occur without dominant strategies Dr. Chen’s notes: Nash equilibrium is named after John Nash whose story has been filmed in the Oscar winning movie, “The Beautiful Mind.” Unlike the market equilibrium condition in PC, monopoly, or MC market (e.g. P=MC=ATC for PC in LR), a Nash equilibrium is a “status” in which each player is doing the best he or she can given what the other players are doing. All the final stable outcome(s) in the games of “How to solve a 2X2 game” are Nash equilibria. Dominant strategies are a sufficient condition, not a necessary condition for Nash equilibrium.

Managerial Economics Sequential Decisions One firm makes its decision first, then a rival firm, knowing the action of the first firm, makes its decision The best decision a manager makes today depends on how rivals respond tomorrow

Managerial Economics First-Mover & Second-Mover Advantages First-mover advantage If letting rivals know what you are doing by going first in a sequential decision increases your payoff Second-mover advantage If reacting to a decision already made by a rival increases your payoff Determine whether the order of decision making can be confer an advantage

Managerial Economics Cartel An organization of firms who make formal and collusive agreement to operate the industry as a monopoly Determine the profit-maximizing output and price then each firm (member) shares the monopoly profit by its percentage of total production Illegal in the U.S. (1890 Sherman Act, Anti- trust law) Dr. Chen’s notes: From this slide to the topic of “price leadership”, we will talk about the “cooperative” behavior among oligopolies. When oligopolies seek to reduce the business risk from interdependency, they collude in decision-making, particularly in quantity of output and pricing. OPEC in the crude oil market serves as the typical example of cartel collusion.

Managerial Economics Cheating in Cartel Pricing schemes usually strategically unstable & difficult to maintain Each member has a strong incentive to cheat by producing more than the agreed amount of production Cheating occurs at elastic demand in which the additional production will Cause the market price to fall Raise the total revenue for the cheater Hurt the rest of members by lower total revenue

Managerial Economics Punishment for Cheating With repeated decisions, cheaters can be punished When credible threats of punishment in later rounds of decision making exist Dr. Chen’s notes: How the OPEC punished the cheaters? Kick them out of the organization or cut the cheater’s share in production. Because the cartel profit is always greater than the competitive profit, each member still wants to stay in cartel.

Managerial Economics Price Matching Firm publicly announces that it will match any lower prices by rivals Usually in advertisements Discourages noncooperative price- cutting Dr. Chen’s notes: Price matching is like a game in which no player is willing to be the first mover. Everyone just keeps the current price to wait for any price cut from rivals. Even a rival does cut the price, only few customers will carry the “proof” of lower price to ask for price matching. As a result, the market price will not be lowered by this game.

Managerial Economics Price Leadership Price leader sets its price at a level it believes will maximize total industry profit Price leader is the firm with the greatest market share or the best technology (lowest average costs) Rest of firms cooperate by setting same price Does not require explicit agreement Dr. Chen’s notes: If the price leader has the lowest average costs (e.g. best technology), why not kick out all the other firms by setting a very low price? In reality, most leading (dominant) firms cannot tip the whole market demand due to capacity limitation. If the firm tries to supply the whole demand, it will lose the cost advantage (i.e. diseconomies of scale will occur). Therefore, the price leader prefers to enjoy monopoly profit in its own market segment rather than to compete with the other in the whole market.

Managerial Economics Strategic Entry Deterrence Established firm(s) makes strategic moves designed to discourage or prevent entry of new firm(s) into a market Two types of strategic moves Limit pricing: A lower price to eliminate the incentive for new entry Capacity expansion: A lower unit cost to threat new entry by future price cut

Managerial Economics Limit Pricing Established firm(s) commits to setting price below profit- maximizing level to prevent entry Under certain circumstances, an oligopolist (or monopolist), may make a credible commitment to charge a lower price forever Dr. Chen’s notes: In general, the established firm has a greater market share with lower average costs. Limit price can be set below the potential entrant’s ATC but still above the firm’s ATC. However, if the potential entrant has a better technology (i.e. lower average cost), then the limit price will not work.

Managerial Economics Capacity Expansion Established firm(s) can make the threat of a price cut credible by irreversibly increasing plant capacity When increasing capacity results in lower marginal costs of production, the established firm’s best response to entry of a new firm may be to increase its own level of production Requires established firm to cut its price to sell extra output