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Micro Chapter 23 Presentation 2- Game Theory

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Homogeneous Oligopoly An oligopoly in which the firm produces a standardized product Ex- steel, cement, copper, aluminum

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Differentiated Oligopoly An oligopoly in which the firms produce a differentiated product Considerable non-price competition through heavy advertising Ex- automobiles, sporting goods, tires

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Control Over Price Oligopolies are “price makers” and can set price and output levels to maximize profit Oligopolies have few rivals but must consider how they will react to any change in price, output, product characteristics or advertising

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Mutual Interdependence A situation in which each firm’s profit depends not entirely on its own price and sales strategies but also on those of the other firms Ex- McDonald’s considers Burger King, Rawlings considers the reactions of Wilson

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Barriers to Entry 1. Economies of Scale 2. Large expenditure of capital (human- made resources)- industries such as jet engine, auto, petroleum refineries 3. Ownership and control of raw materials- mining and electronics

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Mergers Combining of two or more competing firms may substantially increase their market share leading to economies of scale and lower costs on production inputs

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Concentration Ratio The percentage of total output produced and sold by an industry’s largest firms **When the 4 largest firms in an industry control 40% of the market, that industry is considered oligopolistic Ex- the 4 largest cereal producers make 78% of American breakfast cereals

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Shortcomings of Concentration Ratios 1. Localized markets- ratios are measured nationally 2. Interindustry Competition- between two products associated with different industries (ex- copper and aluminum) 3. World Trade- doesn’t take into account imports

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Herfindahl Index A measure of the concentration and competitiveness of an industry Sum of the squared percentage market shares of all of the firms in an industry Index=(%S1^2)+(%S2^2)+….(%Sn^2) Where %S1 is the percentage of the market share of firm 1

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Herfindahl Index Cont’d Ex- Single firm industry= 100^2= 10,000 Ex- 4 firms with equal 25% market share (25^2)+(25^2)+(25^2)+(25^2)= 2500 ***the larger the Herfindahl Index, the greater the market power within an industry ***the closer to zero, the more competitive

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Game Theory Oligopoly pricing behavior has the characteristics of certain games of strategy such as chess The best way to play the game depends on the way one’s opponent plays Shown in a payoff matrix (2 firms)

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Collusion A situation in which firms act together in agreement to fix prices, divide a market, or otherwise restrict competition Both firms could agree to a high pricing strategy

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Dominant Strategy One strategy is better for a given player, regardless of what his/her opponent chooses to do

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Game Theory Video http://www.youtube.com/watch?v=AOEbJ F0k8vMhttp://www.youtube.com/watch?v=AOEbJ F0k8vM

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Uptown: Dominant Strategy = Low Rareair: Dominant Strategy = Low Game Theory Game Theory Model to Analyze Behavior RareAir’s Price Strategy Uptown’s Price Strategy AB CD $12 $15 $6 $8 $6 $15 High Low 2 Competitors 2 Price Strategies Each Strategy Has a Payoff Matrix O 23.2

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Incentive to Cheat In the previous example, both firms could increase profit by utilizing a low price strategy Each firm could increase profit from $12 million to $15 million by breaking the agreement with low prices

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Nash Equilibrium NASH EQUILIBRIUM : when each player is pursuing their best possible strategy in the full knowledge of the other players’ strategies. A Nash equilibrium is reached when nobody has any incentive to change their strategy. It is named after John Nash, a mathematician and Nobel prize-winning economist. https://www.youtube.com/watch?v=Cem LiSI5ox8 John F. Nash, 1928 - Russell Crow portrays John Nash in A Beautiful Mind

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An Example of a Nash Equilibrium ab b 2,1 0,1 1,0 1,2 Row Column a (b,a) is a Nash equilibrium. To prove this: Given that column is playing a, row’s best response is b. Given that row is playing b, column’s best response is a.

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Prisoners’ Dilemma Video https://www.youtube.com/watch?v=t9Lo2f gxWHwhttps://www.youtube.com/watch?v=t9Lo2f gxWHw

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Prisoner’s Dilemma An illustration of Nash Equilibrium Art’s Strategies Bob’s Strategies Confess Deny Confess Deny 10 yrs. 1 yr. 3 yrs. 1 yr. 10 yrs. 2 yrs. Consider Art’s options… 1. If Bob denies and Art denies, then Art will get two years. Art is better off confessing and getting one year. 2. If Bob confesses and Art denies, then Art will get ten years, so Art is much better off confessing and taking three years. Consider Bob’s options… 1. If Art denies and Bob denies, then Bob will get two years. Bob is better off confessing and getting one year. 2. If Art confesses and Bob denies, then Bob will get ten years, so Bob is much better to confess and take three years. Thus, both parties will rationally choose to confess, and take three years – even though they could have been better off denying. Each party does this because, considering the possible options of the other party, they always found the better option was to confess. When neither party has an incentive to change their strategy, they are in “Nash Equilibrium.” Art and Bob are both suspects in a crime, and they are both offered the following deal if they confess…

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Cartels A cartel is an organization of independent firms whose purpose is to control and limit production and maintain or increase prices and profits. EX- OPEC controlling oil production Like collusion, cartels are illegal in the United States.

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Coffee Problem Don’t Advertise Advertise Don’t Advertise15/1510/20 Advertise20/1012/12 STARBUCKS SF COFFEE 1.What is Starbuck’s dominant strategy 2.What is SF Coffee’s dominant strategy 3.Is there a Nash Equilibrium? 4.If they collude what is their profit? 5.If no collusion, what is their profit?

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