Lecture 4 Strategic Interaction Game Theory Pricing in Imperfectly Competitive markets

Game Theory Tool used for analyzing multiagent economic situations involving strategic interdependence

How Do We Describe a Game? A game is described by: –number of players/agents –the “strategies” available to each player –each player’s preferences over outcomes of the game For any game, a strategy choice by each one of the players results in a unique outcome of the game

What is a Strategy? A strategy is an action plan for a player. It specifies: –what action the player takes –when the player takes the action –the way that the action choice depends on the information the player has when taking the action Two action plans that specify different actions represent two different strategies

Predicting Behavior in Games If games are to help us understand observables, we need a way of predicting how agents behave in game settings; i.e., we need a notion of equilibrium for games The standard notion of equilibrium is the Nash equilibrium Roughly speaking a Nash equilibrium has the feature that each player’s strategy choice is best for that player given other players’ strategies

Pricing in Imperfectly Competitive Markets

Determinants of Pricing Decision Economic analysis of pricing in imperfectly competitive markets identifies the following elements of the market environment as important to pricing decision: –number of competitors/ease of entry –similarity of competitors’ products –capacity limitations –on-going interactions –Information on past pricing decisions

Bertrand Simultaneous price setting Identical products No capacity constraints One time interaction Price competition results in price equal marginal cost for all firms and zero profits

Bertrand Bertrand paradox (p=mc even though few firms in market) can be resolved by relaxing certain assumptions: No Capacity Constraints Undifferentiated Products One-shot competition

Capacity Constraints Suppose each firm has max capacity of Ki If firm j sets a higher price than firm i, j may get the left-over demand that firm i can’t satisfy if demand exceeds i’s capacity So setting price above MC may be worthwhile

Cournot Same analysis can be applied to situations where firms decide first on how much to produce and then on what price to set If total quantity produced is low relative to market demand, then it is as if constrained Firms will set prices such that total demand just clears total output

Cournot Capacity (or output) constraint limits the usefulness of price competition Can get p>mc and firms can earn economic profits

Cournot vs. Bertrand Cournot: -when demand is large relative to capacity -when capacity is more difficult to adjust than price Bertrand: -when demand is small relative to capacity -when capacity is easier to adjust than price