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

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Presentation on theme: "Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 1."— Presentation transcript:

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

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

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

5 Slide 5 The Payoff Matrix for an Advertising Game Raise ad spending Leave ad spending the same Raise ad spending Leave ad spending the same $5,500 for American $5,500 for United Americans Choices Uniteds Choices $2,000 for American $8,000 for United $6,000 for American $6,000 for United $8,000 for American $2,000 for United

6 Slide 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 Slide 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 Slide 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 Slide 9 Equilibrium When One Player Lacks a Dominant Strategy Raise ad spending Leave ad spending the same Raise ad spending Leave ad spending the same $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 Americans Choices Uniteds Choices

10 Slide 10 What Should United and American do if Their Payoff Matrix is Modified? Raise ad spending Leave ad spending the same Raise ad spending Leave ad spending the same $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 Americans Choices Uniteds Choices

11 Slide 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 Slide 12 The Payoff Matrix for a Prisoner s Dilemma ConfessRemain Silent Confess Remain Silent Jasper Horace 5 years for each 20 years for Jasper 0 years for Horace 1 year for each 0 years for Jasper 20 years for Horace

13 Slide 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 Slide 14 The Market Demand for Mineral Water Price $/bottle) Bottles/day Assume 2 firms (Aquapure & Mountain Spring MC = 0 Cartel is formed & agree to split output and profits 2,000 D ,000 MR 2.00 Impact of Cartel Q = 1,000 bottles/day P = $1/bottle Each firm makes $500/day

15 Slide 15 The Temptation to Violate a Cartel Agreement Price $/bottle) Bottles/day D ,0002,000 MR , Aquapure lowers P P = $.90/bottle Q = 1,100 bottles/day Mountains Spring retaliates P = $.90/bottle Both firms split 1,100 $.90 Profit = $495/day

16 Slide 16 The Payoff Matrix for a Cartel Agreement Charge $1/bottleCharge $0.90/bottle Charge $1/bottle Charge $0.90/bottle Mountain Spring Aquapure $990/day for Mt. Spring $0 for Aquapure $500/day for each $0 for Mt. Spring $990 for Aquapure $495/day for each

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

18 Slide 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 Prisoners Dilemma

19 Slide 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 Prisoners Dilemma

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

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

22 Slide 22 Cigarette Advertising as a Prisoner s Dilemma Advertise on TVDont advertise on TV Advertise on TV Dont Advertise on TV $5 million/yr for Philip Morris $10 million/yr for each for each $35 million/yr for RJR for RJR Philip Morris RJR $20 million/yr for each for each $35 million/yr for Philip Morris $5 million/yr for RJR for RJR

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 Slide 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 Slide 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 Slide 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 Slide 28 The Advantage of Being Different Offer hybridDont offer hybrid Dodge Viper Chevrolet Corvette Offer hybrid Dont offer hybrid $60 million/yr for Dodge $60 million/yr for Chevrolet for Chevrolet $70 million/yr for Dodge $80 million/yr for Chevrolet for Chevrolet $80 million/yr for Dodge $70 million/yr for Chevrolet for Chevrolet $50 million/yr for Dodge $50 million/yr for Chevrolet for Chevrolet Is there a Nash Equilibrium?

29 Slide 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

30 Slide 30 Decision Tree for Hybrid A Dodge decides Offer hybrid Dont offer hybrid B C $50 million for Chevrolet $50 million for Dodge Offer hybrid Dont offer hybrid Offer hybrid Dont offer hybrid Chevrolet decides $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 Slide 31 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 Slide 32 A promise to take action that is in the promiser s interest to keep Credible Promise

33 Slide 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 Slide 34 Decision Tree for the Remote Office Game A 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 Slide 35 Monopolistic Competition When Location Matters Why do we often see convenience stores located on adjacent street corners?

36 Slide 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 Competition When Location Matters

37 Slide 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 Competition When Location Matters

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

42 Slide 42 The Remote Office Game with an Honest Manager A 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 Slide 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 Role of Preferences

44 End 44


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