1. Chapters 13 & 14: Imperfect Competition & Game Theory

2. Reality: Imperfect Competition
Perfect competition and monopoly represent idealized market structures that rarely exist
These are useful in showing tendency and direction, but in the real world the payoff to an action often depends not only on the action itself, but also on how it relates to actions taken by others
Read the 3 economist, 3 lawyer parable on page 455, it’s funny (particularly if you are an economist)
Game theory is a useful tool to use to analyze likely outcomes when individual payoffs depend on the actions of others
Three elements of game theory: 1) the players, 2) the list of possible strategies, and 3) the payoffs associated with each combination of strategies

3. Algebraic Example of Game Theory in the Marketplace
MEXICO OIL
VENEZUELA PETROLEUM
Cooperate
(P=5)
Cheat
(P=4)

4. Oligopoly Assumptions: Restricted entry Few firms producing
Implications:
The actions of one oligopoly firm will affect the prices and profits of the other firm(s) in the market
There are several possible hypotheses about how oligopoly firms behave
May collude and act as a monopoly
May compete against each other and drive prices to the perfectly competitive level
May compete, but arrive at equilibrium somewhere between the monopoly and perfectly competitive prices
The exact structure of the oligopoly likely depends on the products they are producing and the degree of product differentiation

5. Cournot Duopoly Model
Two firms in the market that sell identical products
Each firm assumes that the other will keep production levels fixed regardless of their own production
Each firm has a “reaction function” that determines of the optimal level of output given the other firm’s output Q1
Firm 2’s
reaction function
Q1*=(a-bQ2)/2b
Q2*=(a-bQ1)/2b
a/3b
Firm 1’s
reaction function Q2
a/3b

6. Bertrand Model Two firms in the market that sell identical products
Each firm assumes that the other will keep prices fixed at the current level regardless of the price they set
Each firm’s best strategy is to sell just below the price of the other firm so that they can capture the entire market demand
The firms will continue to reduce the price until it reaches the competitive market price

7. Stackelberg Model Two firms in the market that sell identical products
The market consists of a “leader” and a “follower”
The follower is a naïve Cournot duopolist
The leader will choose its quantity level by taking into account how that will affect the follower’s response Q1
Firm 2’s
reaction function
Firm 1’s [leader’s] demand curve: P = a - b[Q1 + (a-bQ1)/2] = (a-bQ1)/2
Firm 2’s [follower’s] reaction function : (a-bQ1)/2b
a/2b
Firm 1’s
reaction function Q2
a/4b

8. Comparison of Oligopoly Models
Monopoly
a/2
Cournot
Assume MC=0
Stackelberg
Bertrand/
Perfect Competition
a/2b
a/b

9. Monopolistic Competition
Differentiated products
Many sellers
Free entry
Each seller faces a downward-sloping demand curve
UnderCuts
Cheap Snips
Dean Suarez Salon

10. Classic Prisoner’s Dilemma
CLYDE
Squeal
Remain Silent
BONNIE
12 years for B
12 years for C
0 years for B
20 years for C
20 years for B
0 years for C
1 year for B
1 year for C
They both will end up squealing which is the socially WORST (for those two) possible outcome because the total years in prison is the greatest with this strategy.
Payoff to an action often depends not only on the action itself, but also on how it relates
to actions taken by others

11. Game Theory
Nash equilibrium - the combination of strategies in are such that neither player has any incentive to change given the strategy of others
Players in games may have dominant or non-dominant strategies
Dominant strategy - when a player has a strategy in a game that produces better results regardless of the strategy chosen by other players (opponents)
Each player may have a dominant strategy, but the result of each player exercising their dominant strategy may be less beneficial for the players (e.g. price wars) and/or society as a whole
Non-dominant strategy - when at least one player does not have a dominant strategy, rather the best strategy for that player is dependent on what others choose
Nash equilibrium may occur even if a player does not have a dominant strategy b/c one (or more players) bases decision on what others will do

12. Nash Equilibrium: Dominant Strategy
PEPSI
Advertise
Don’t Advertise
COKE
C: $100 m
P: $100 m
C: $250 m
P: $25 m
C: $25 m
P: $250 m
C: $200 m
P: $200 m

13. Nash Equilibrium: Non-Dominant Strategy
ADIDAS
Advertise
Don’t Advertise
NIKE
N: $100
A: $100
N: $135
A: $200
N: $50
A: $125
N: $140
A: $115