Between the Extremes: Interaction and Strategy

1. Between the Extremes:Interaction and Strategy Chapter 7 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2. INTRODUCTION (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3. NASCAR In a NASCAR race, the drivers are mutually interdependent. The impact of a strategy depends on the simultaneous Strategies chosen by other drivers. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. What’s Next? In this chapter we will examine the strategy choices and their impact in markets where the firms are mutually interdependent. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. OLIGOPOLY: MANY OUTCOMES, FEW EXPLANATIONS (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. Automobiles In the 1950s and 1960s, the “Big Three” automobile manufacturers (General Motors [GM], Ford, and Chrysler) had U.S. sales almost entirely to themselves, and their market shares changed little over those years. Two possible reasons suggest themselves. Might they have had an unwritten understanding not to compete aggressively, or might they have been so evenly matched as competitors that their rivalrous efforts largely cancelled each other out? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. Personal Computers A small number of large producers dominate U.S. personal computer (PC) sales. Aggressive competition in price and technology has left profit margins persistently low for all except Apple. Why have some makers that dominate other markets, like Japan’s Sony, achieved only tiny shares of PC sales? Why has the continuing shakeout not weakened competition among the survivors, whose quality-adjusted prices continue to fall rapidly? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. Cigarettes Since the early twentieth century between four and six manufacturers have dominated the U.S. cigarette industry. All of them have enjoyed steady and generally high profits through good times and bad. As the domestic cigarette market shrinks, price competition remains unaggressive in all segments of the industry except generics. Why has this industry never seen aggressive competition since its inception? Why has price competition been restricted to generics? Might restrictions on advertising actually be helping producers to maintain their profitability? (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. Airlines From the 1940s to 1978, the federal Civil Aeronautics Board (CAB) restricted the U.S. skies to a handful of airlines. The CAB fixed fares at high levels and regulated service quality down to such details as the sizes of sandwiches that could be served in flight. Legislation brought an end to all of these controls in 1978. New airlines opened for business, price competition strengthened, and incumbent airlines transformed their route structures to hub-and-spoke systems. After deregulation they the airlines became a low-price, low-profit industry, with little certainty that today’s competitors will stay in business. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Why the Differences? In all of these examples each seller’s pricing and production decisions depend in important ways on decisions other sellers are making. This sort of interdependence, along with other industry characteristics, may help explain why outcomes in oligopoly markets are so diverse. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. DOMINANT FIRMS (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. The Dominant Firm with a Competitive Fringe The dominant firm has a residual demand (DRes) that comes from subtracting the fringe supply (SF) from the market demand (D). Acting as a monopolist, the dominant firm produces where MR = MC and sets price according to their residual demand curve. The fringe firms take that price as given and produce an amount according to the fringe supply curve. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. The Dominant Firm with a Competitive Fringe – Predicted Outcomes The more elastic market demand is, the lower market price will be and the smaller the dominant firm’s profits. The smaller the percentage of the market served by the fringe, the higher will be the price the dominant firm chooses and the higher its percentage of market output. The more elastic the supply curve of the fringe, the more elastic residual demand will be and the lower the dominant firm’s profits. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. The Histories of Dominant Firms Here is a list of dominant firms in a 1979 textbook. By 2005, most of the listed firms had declined substantially, some had vanished by merger or bankruptcy, and some faced new competitors from other industries. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. GAMES (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16. A Price-Fixing Example Suppose that you and me have decided to fix prices and the above matrix shows the payoffs we would receive based on our choices to keep the agreement or break the agreement. The first number in each cell is your payoff, the second, mine. You and I both have a dominant strategy which is to break the agreement. When we both choose our dominant strategy, we end up with a payoff of $7, clearly not the optimal outcome! (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. Nash Equilibrium When all players are choosing their best strategies on the assumption that their opponents are doing likewise, the outcome is called a Nash equilibrium. In this game, when you choose bottom and I choose left, it is a Nash equilibrium. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. Commitments - Conflicts and Chickens The person who decides to produce Red items earns $7 and the one who produces Blue gets only $4. If you want to produce red you must either be the first to actually begin doing so, or you must make some sort of commitment that will discourage me from trying to beat you to the punch. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Commitments – How Smart are People? Economists have, however, run controlled experiments (with cash rewards for the best performers) to examine the depth of peoples’ reasoning. Most experimental subjects are one-step or two-step reasoners. Very few of the experimental subjects appear to foresee the outcome if everyone is perfectly rational, but it does not take perfect rationality to win—all you need is to be a step more foresighted than your opponents. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. Mixed Strategies - Heads or Tails Paradoxically, choosing at random can sometimes be best for a player. In a mixed strategy situation one does best by unpredictably mixing one’s strategies in accordance with probabilities that depend on the strategies of the others. In this simple game of heads or tails, it should be fairly clear that each of us maximizes our income by randomly choosing heads and tails on every play, each with probability of 0.5. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. Mixed Strategies - Auto Racing Cars A (ahead) and B (behind) are both behind the leader of an existing draft line, and each must decide whether to leave that line and attempt to pass. This game has a solution in mixed strategies. Car A should leave the line with probability 0.833, and Car B should leave with probability 0.625. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

22. MODELS OF OLIGOPOLY (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

23. Quantity-Setting Duopoly – Cournot Model AugustinCournot was the first to tackle the complexities of interaction among oligopolists. Cournot chose a simplification that remains a mainstay of economics to this day: he assumed that when each seller chooses its own output it believes the others in the market will not respond and will keep their outputs as they were before. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

24. Quantity-Setting Duopoly – Cournot Model For the market demand curve shown on the left we can derive firm A’s and B’s reaction functions shown on the right. In the Cournot model, the equilibrium is where the two reaction functions intersect. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

25. Quantity-Setting Duopoly – Cournot Model An increase in cost will shift the reaction functions and produce a new equilibrium. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

26. Price-Setting Duopoly – Bertrand Model Instead of choosing quantities to produce, A and B will now choose prices. Each will further assume that the other will not change price in response to his or her decision. We now have the model first devised by Joseph Bertrand, a British critic of Cournot. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

27. Price-Setting Duopoly – Bertrand Model D is the same market demand curve as in the Cournot model. If A is the first to choose a price, she picks the monopoly price of $6 and produces 6 units. B enters the market and charges a price slightly below A’s, say $5.50 (the middle line on the graph), with the expectation that A will keep her price at $6. A would need to respond with a lower price or else lose all her customers. And so this goes until the price war stops at the same place a perfectly competitive market would end up. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

28. A Leader and a Follower – Stackelberg Model In the Stackelberg model one seller acts as a leader and the other as a follower. After the leader L chooses her output, follower F makes his most profitable choice in light of L’s decision. The Stackelberg model allows the leader to think a step ahead. L’s foreknowledge that F will act this way allows her to make larger profits than F, who in turn is worse off than he would have been if both of them had held identical Cournot assumptions about each other’s output. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

29. Conclusions: Is Oligopoly Theory Relevant? Oligopoly markets exhibit every imaginable outcome on the line between cutthroat competition and collusion to share the profits of a monopoly. In the current state of their knowledge, economists are simply unable to examine the characteristics of an industry and conclude that its participants will act according to the assumptions of a Bertrand, Cournot, or some other model. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

30. Conclusions: Is Oligopoly Theory Relevant? In the international rice trade, countries behave more like price-takers (close to the Bertrand model) than like Cournotoligopolists or pricefixers. The three firms that dominate the Japanese plate-glass industry, by contrast, have followed either Cournot or price-fixing behavior and have definitely not been price-takers. Leader-follower relationships have been found in industries as different as chemicals in the United Kingdom and coffee roasting in the United States. (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.