1. Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life

2. 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.

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

4. 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.

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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?

12. 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

13. 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

14. 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

15. 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 $.90
Profit = $495/day
Price $/bottle)
1.00 MR D
1,000
2,000
Bottles/day

16. 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

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

18. 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

19. 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

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

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

22. 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

23. 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

24. 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?

25. 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

26. 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.

27. 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?

28. 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

29. 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

30. Decision Tree for HybridA
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

31. 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?

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

33. 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

34. 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?

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

36. 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?

37. 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

38. 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

39. 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

40. 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.

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

42. 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

43. 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.

44. End