Presentation on theme: "Thinking Strategically"— Presentation transcript:
1Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life
2Thinking Strategically InterdependenciesIn 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.
3Using Game Theory to Analyze Strategic Decisions Basic Elements of a GameThe playersTheir strategiesThe payoffs
4Using Game Theory to Analyze Strategic Decisions ExampleShould United Airlines spend more on advertising?NoteThe airline industry is an oligopoly with an undifferentiated product.
5The Payoff Matrix for an Advertising Game American’s ChoicesLeave adspendingthe sameRaise adspending$5,500 for United$8,000 for UnitedRaise adspending$5,500 for American$2,000 for AmericanUnited’s ChoicesLeave adspendingthe same$2,000 for United$6,000 for United$8,000 for American$6,000 for American
6Dominant and Dominated Strategies Dominant StrategyOne that yields a higher payoff no matter what the other players in a game chooseDominated StrategyAny other strategy available to a player who has a dominant strategy
7Nash EquilibriumAny combination of strategies in which each player’s strategy is her or his best choice, given the other player’s strategiesWhen each player has a dominant strategy, equilibrium occurs when each player follows that strategy
8Nash Equilibrium Example There can be an equilibrium when players do not have a dominant strategyExampleShould American spend more on advertising?Assume United and American are the only carriers serving the Chicago – St. Louis market
9Equilibrium When One Player Lacks a Dominant Strategy American’s ChoicesLeave adspendingthe sameRaise adspending$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 UnitedRaise adspendingUnited’s ChoicesLeave adspendingthe same
10What Should United and American do if Their Payoff Matrix is Modified? American’s ChoicesLeave adspendingthe sameRaise adspending$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 UnitedRaise adspendingUnited’s ChoicesLeave adspendingthe same
11The 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 strategyExampleShould the prisoners confess?
12The Payoff Matrix for a Prisoner’s Dilemma JasperConfessRemain Silent0 years for HoraceConfess5 yearsfor each20 years for JasperHorace20 years for HoraceRemainSilent1 yearfor each0 years for Jasper
13The Economics of Cartels A coalition of firms that agrees to restrict output for the purpose of earning an economic profit like a monopolyYet, cartel agreements are notoriously unstable. Why?Prisoner’s Dilemmas Confronting Imperfectly Competitive Firms
14The Market Demand for Mineral Water Assume2 firms (Aquapure & Mountain SpringMC = 0Cartel is formed & agree to split output and profits2,000D1.001,000MR2.00Impact of CartelQ = 1,000 bottles/dayP = $1/bottleEach firm makes $500/dayPrice $/bottle)Bottles/day
15The Temptation to Violate a Cartel Agreement 1,1000.90Aquapure lowers PP = $.90/bottleQ = 1,100 bottles/day2.00Mountains Spring retaliatesP = $.90/bottleBoth firms split 1,100 $.90Profit = $495/dayPrice $/bottle)1.00MRD1,0002,000Bottles/day
16The Payoff Matrix for a Cartel Agreement Mountain SpringCharge $1/bottleCharge $0.90/bottle$0 forAquapure$500/day for eachCharge$1/bottle$990/day forMt. SpringAquapure$990 forAquapureCharge$0.90/bottle$495/day for each$0 forMt. Spring
17Food For ThoughtWhen will the rival firms stop cutting prices?
18Tit-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 strategyPlayers cooperate on the first move, then mimic their partner’s last move on each successive move
19Tit-for-tat and the Repeated Prisoner’s Dilemma Tit-for-tat strategy requirementsTwo playersA stable set of playersPlayers recall other player’s movesPlayers have a stake in future outcomes
20Food For ThoughtWhy is the tit-for-tat strategy unsuccessful in competitive, monopolistically competitive, and oligopolistic markets?
21Cigarette Advertising as a Prisoner’s Dilemma Why did the ban on television advertising beneficial to cigarette producers?
22Cigarette Advertising as a Prisoner’s Dilemma Philip MorrisAdvertise on TVDon’t advertise on TV$35 million/yrfor RJR$10 million/yrfor eachAdvertiseon TV$5 million/yrfor Philip MorrisRJR$5 million/yrfor RJRDon’tAdvertiseon TV$20 million/yrfor each$35 million/yrfor Philip Morris
23Determinants of a Successful Cartel A successful cartel requires a good enforcement mechanism: detect cheating and punish cheating sellers.Determinants of cost of detecting price chiselingNumber of buyersCustomer turnoverAvailability of price information
24Food for ThoughtWhich 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?
25Games in Which Timing Matters Should Dodge build a hybrid viper?Dodge Viper and Chevrolet Corvette compete for the domestic sports car marketBoth know the other is considering a hybridIf both build the hybrid they each make $60 millionIf neither build they make $50 million
26Games 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.
27Games 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?
28The Advantage of Being Different Dodge ViperIs there aNash Equilibrium?Offer hybridDon’t offer hybrid$60 million/yrfor Chevrolet$80 million/yrfor ChevroletOffer hybrid$60 million/yrfor Dodge$70 million/yrfor DodgeChevrolet Corvette$70 million/yrfor Chevrolet$50 million/yrfor ChevroletDon’t offer hybrid$80 million/yrfor Dodge$50 million/yrfor Dodge
29Multiple EquilibriaIf Dodge and Chevrolet make their decisions independently and simultaneously, two equilibria arise.Dodge offers viper while Chevrolet does notChervorlet offers viper while Dodge does notWhat will happen if Dodge gets to choose first?Slide 29
30Decision Tree for Hybrid ADodgedecidesOffer hybridDon’t offerhybridBC$50 million for Chevrolet$50 million for DodgeOfferDon’tofferChevrolet$80 million for Chevrolet$70 million for Dodge$70 million for Chevrolet$80 million for Dodge$60 million for Chevrolet$60 million for DodgeDEFGFinalOutcome
31Credible Threats Credible Threats A threat to take an action that is in the threatener’s interest to carry outWhy couldn’t Chevrolet deter Dodge from offering a hybrid by threatening to offer a hybrid of its own, no matter what Dodge did?
32Credible PromiseA promise to take action that is in the promiser’s interest to keep
33Should a business owner open a remote office? Credible PromiseShould a business owner open a remote office?Pay the manager $1,000Make an additional $1,000If the manager is dishonest, she can make $500 more and cost the owner $500
34Decision Tree for the Remote Office Game Owner does notopen remote officeManager manages honestly;owner gets $1,000,manager gets $1,000Managerial candidatepromises to managehonestlyBOwner opensremote officeCManager manages dishonestly;owner gets -$500,manager gets $1,500Owner gets $0,manager gets $500 byworking elsewhereShould a business owneropen a remote office?Is the outcome an equilibrium?
35Monopolistic Competition When Location Matters Why do we often see convenience stores located on adjacent street corners?
36Monopolistic Competition When Location Matters Assume1 mile street with 1,200 shoppers evenly distributedStore A is located at the West end of the mileQuestionWhere 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?
37Monopolistic Competition When Location Matters Differentiation by:Physical locationThe choice to locate at B.Location in timeTiming of flight departuresTiming of film showingsProduct space (product differentiation)Soft drinks
38Commitment ProblemsA situation in which people cannot achieve their goals because of an inability to make credible threats or promisesExamplePrisoner’s dilemmaCartelsRemote office
39Commitment DeviceA way of changing incentives so as to make otherwise empty threats or promises credibleExampleUnderworld code, omertaMilitary arms control agreementsTips for waiters
40The 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.
41The Strategic Role of Preferences QuestionIn a moral society, will the business owner open a remote office?
42The Remote Office Game with an Honest Manager Owner does notopen remote officeManager manages honestly;owner gets $1,000,manager gets $1,000Managerial candidatepromises to managehonestlyBOwner opensremote officeCManager manages dishonestly;owner gets -$500,manager gets -$8,500Owner gets $0,manager gets $500 byworking elsewhereThe value of dishonesty to themanager is $10,000
43The Strategic Role of Preferences Preferences as Solutions to Commitment ProblemsConcerns 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.