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Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life

Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life. Thinking Strategically. Interdependencies In making choices, people must consider the effect of their behavior on others.

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Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life

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  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 toAnalyze Strategic Decisions Basic Elements of a Game The players Their strategies The payoffs

  4. Example Should United Airlines spend more on advertising? Note The airline industry is an oligopoly with an undifferentiated product. Using Game Theory toAnalyze Strategic Decisions

  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 $2,000 for United $6,000 for United Leave ad spending the same $8,000 for American $6,000 for American

  6. 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 Dominant and Dominated Strategies

  7. 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 Nash Equilibrium

  8. Nash Equilibrium 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 $3,000 for United $8,000 for United $4,000 for American $3,000 for American $4,000 for United $5,000 for United $5,000 for American $2,000 for American American’s Choices Leave ad spending the same Raise ad spending Raise ad spending United’s Choices Leave ad spending the same

  10. What Should United and American do if Their Payoff Matrix is Modified? $3,000 for United $4,000 for United $8,000 for American $5,000 for American $8,000 for United $5,000 for United $4,000 for American $2,000 for American American’s Choices Leave ad spending the same Raise ad spending 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 5 years for each Confess 20 years for Jasper Horace 20 years for Horace 1 year for each Remain Silent 0 years for Jasper

  13. The Economics of Cartels Cartel 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 Demandfor Mineral Water 2.00 • Impact of Cartel • Q = 1,000 bottles/day • P = $1/bottle • Each firm makes $500/day 1.00 MR D 1,000 2,000 • Assume • 2 firms (Aquapure & Mountain Spring • MC = 0 • Cartel is formed & agree to split output and profits Price $/bottle) Bottles/day

  15. The Temptation to Violate a Cartel Agreement • Aquapure lowers P • P = $.90/bottle • Q = 1,100 bottles/day 0.90 1,100 2.00 • Mountains Spring retaliates • P = $.90/bottle • Both firms split 1,100 bottles/day @ $.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. 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 Tit-for-tat and the Repeated Prisoner’s Dilemma

  19. 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 Tit-for-tat and the Repeated Prisoner’s Dilemma

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

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

  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. 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. Games in Which Timing Matters

  27. Should Dodge build a hybrid viper? Does either have a dominant strategy? What will happen if Dodge gets to choose first? Games in Which Timing Matters

  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. 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? Multiple Equilibria Slide 29

  30. Decision Tree for Hybrid $60 million for Chevrolet $60 million for Dodge D Offer hybrid B Don’t offer hybrid $70 million for Chevrolet $80 million for Dodge Offer hybrid E A F $80 million for Chevrolet $70 million for Dodge Don’t offer hybrid Offer hybrid C Don’t offer hybrid $50 million for Chevrolet $50 million for Dodge G Dodge decides Chevrolet decides 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. A promise to take action that is in the promiser’s interest to keep Credible Promise

  33. 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 Credible Promise

  34. Decision Tree for the Remote Office Game Manager manages honestly; owner gets $1,000, manager gets $1,000 Should a business owner open a remote office? Is the outcome an equilibrium? C Owner opens remote office Manager manages dishonestly; owner gets -$500, manager gets $1,500 A B Managerial candidate promises to manage honestly Owner does not open remote office Owner gets $0, manager gets $500 by working elsewhere

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

  36. 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? Monopolistic CompetitionWhen Location Matters

  37. 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 Monopolistic CompetitionWhen Location Matters

  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. 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 Commitment Device

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

  42. The Remote Office Game with an Honest Manager Manager manages honestly; owner gets $1,000, manager gets $1,000 C Owner opens remote office Manager manages dishonestly; owner gets -$500, manager gets -$8,500 A B Managerial candidate promises to manage honestly Owner does not open remote office Owner gets $0, manager gets $500 by working elsewhere The value of dishonesty to the manager is $10,000

  43. 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. The Strategic Roleof Preferences

  44. End

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