1 Frank & Bernanke 3 rd edition, 2007 Ch. 11: Ch. 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life

2 Thinking Strategically Interdependencies Interdependencies In making choices, people must consider the effect of their behavior on others. 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. Imperfectly competitive firms may consider how rivals will respond to price changes or new advertising.

3 The Payoff Matrix for a Game Raise ad spending Leave ad spending the same Raise ad spending Leave ad spending the same $5,500 for American $5,500 for United American’s Choices United’s Choices $2,000 for American $8,000 for United $6,000 for American $6,000 for United $8,000 for American $2,000 for United The airline industry is an oligopoly with an undifferentiated product

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

5 Nash Equilibrium Any combination of strategies in which each player’s strategy is her or his best choice, given the other player’s strategies 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 When each player has a dominant strategy, equilibrium occurs when each player follows that strategy There can be an equilibrium when players do not have a dominant strategy There can be an equilibrium when players do not have a dominant strategy

6 One Player Lacks a Dominant Strategy Raise ad spending Leave ad spending the same Raise ad spending Leave ad spending the same $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 American’s Choices United’s Choices Does A have a dominant strategy? Does U have a dominant strategy? What is the Nash eq m ?

7 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 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

8 Prisoner’s Dilemma Example ConfessRemain Silent Confess Remain Silent Jasper Horace 5 years for each 20 years for Jasper 0 years for Horace 1 year for each 0 years for Jasper 20 years for Horace

9 Is This a Prisoner’s Dilemma? Don’t Invest Don’t Invest 12 for Chrysler 10 for each 4 for GM GAME 1 Invest 5 for each 4 for Chrysler 12 for GM Chrysler GM Invest

10 Is This a Prisoner’s Dilemma? GAME 2 Don’t Invest Don’t Invest 12 for Chrysler 10 for each 4 for GM Chrysler GM Invest 5 for each 4 for Chrysler 12 for GM

11 Prisoner’s Dilemma and Cartels Cartel: A coalition of firms that agrees to restrict output for the purpose of earning an economic profit Cartel: A coalition of firms that agrees to restrict output for the purpose of earning an economic profit Why are cartel agreements notoriously unstable? Why are cartel agreements notoriously unstable?

12 The Market Demand for Mineral Water Price $/bottle) Bottles/day Assume 2 firms (Aquapure & Mountain Spring MC = 0 Cartel is formed & agree to split output and profits 2,000 D ,000 MR 2.00 Impact of Cartel Q = 1,000 bottles/day P = $1/bottle Each firm makes $500/day

13 The Temptation to Violate a Cartel Agreement Price $/bottle) Bottles/day D ,0002,000 MR , Aquapure lowers P P = $.90/bottle Q = 1,100 bottles/day Mountains Spring retaliates P = $.90/bottle Both firms split 1,100 $.90 Profit = $495/day

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

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

16 Tit-for-tat strategy requirements Two players Two players A stable set of players A stable set of players Players recall other player’s moves Players recall other player’s moves Players have a stake in future outcomes Players have a stake in future outcomes Why is the tit-for-tat strategy unsuccessful in competitive, monopolistically competitive, and oligopolistic markets? Why is the tit-for-tat strategy unsuccessful in competitive, monopolistically competitive, and oligopolistic markets?

17 Cigarette Advertising as a Prisoner’s Dilemma Advertise on TVDon’t advertise on TV Advertise on TV Don’t Advertise on TV $5 million/yr for Philip Morris $10 million/yr for each $35 million/yr for RJR Philip Morris RJR $20 million/yr for each $35 million/yr for Philip Morris $5 million/yr for RJR How did Congress unwittingly solve the television advertising dilemma

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

19 Decision Tree for Hybrid A Dodge decides Offer hybrid Don’t offer hybrid B C $50 million for Chevrolet $50 million for Dodge Offer hybrid Don’t offer hybrid Offer hybrid Don’t offer hybrid Chevrolet decides $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

20 Credible Threat and Promise Credible Threat Credible Threat A threat to take an action that is in the threatener’s interest to carry out 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? 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 Credible Promise A promise to take action that is in the promiser’s interest to keep A promise to take action that is in the promiser’s interest to keep

21 Decision Tree for the Remote Office Game A 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?

22 The Remote Office Game with an Honest Manager A 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

23 Monopolist Competition When Location Matters Assume Assume 1 mile street with 1,200 shoppers evenly distributed 1 mile street with 1,200 shoppers evenly distributed Store A is located at the West end of the mile Store A is located at the West end of the mile Question Question Where would you open a new store on the mile? Where would you open a new store on the mile?

24 The Curious Tendency of Monopolistic Competitors to Cluster

25 Commitment Problem A situation in which people cannot achieve their goals because of an inability to make credible threats or promises A situation in which people cannot achieve their goals because of an inability to make credible threats or promises Commitment Device Commitment Device A way of changing incentives so as to make otherwise empty threats or promises credible A way of changing incentives so as to make otherwise empty threats or promises credible Underworld code, omerta Underworld code, omerta Military arms control agreements Military arms control agreements Tips for waiters Tips for waiters

26 The Strategic Role of Preferences Game theory assumes that the goal of the players is to maximize their outcome. Game theory assumes that the goal of the players is to maximize their outcome. In most games, players do not attain the best outcomes. In most games, players do not attain the best outcomes. Altering psychological incentives may also improve the outcome of a game. Altering psychological incentives may also improve the outcome of a game.

27 Are People Fundamentally Selfish? Do you tip at out-of town restaurants? Do you tip at out-of town restaurants? What would be your first offer in the ultimatum bargaining game? What would be your first offer in the ultimatum bargaining game? Would you refuse a lopsided offer? Would you refuse a lopsided offer? 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. 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.

28 Preferences as Solutions to Commitment Problems Concerns about fairness, guilt, humor, sympathy, etc. do influence the choices people make in strategic interactions. 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. Commitment to these preferences must be communicated for them to influence choices.