1. Economics of the Firm Strategic Pricing Techniques

2. Market Structures Recall that there is an entire spectrum of market structures Perfect Competition Many firms, each with zero market share P = MC Profits = 0 (Firm’s earn a reasonable rate of return on invested capital) NO STRATEGIC INTERACTION! Monopoly One firm, with 100% market share P > MC Profits > 0 (Firm’s earn excessive rates of return on invested capital) NO STRATEGIC INTERACTION!

3. Most industries, however, don’t fit the assumptions of either perfect competition or monopoly. We call these industries oligopolies Oligopoly Relatively few firms, each with significant market share STRATEGIES MATTER!!! Mobile Phones (2011) Nokia: 22.8% Samsung: 16.3% LG: 5.7% Apple: 4.6% ZTE:3.0% Others: 47.6% US Beer (2010) Anheuser-Busch: 49% Miller/Coors: 29% Crown Imports: 5% Heineken USA: 4% Pabst: 3% Music Recording (2005) Universal/Polygram: 31% Sony: 26% Warner: 15% Warner: 10% Independent Labels: 18%

4. The key difference in oligopoly markets is that price/sales decisions can’t be made independently of your competitor’s decisions Monopoly Oligopoly Your Price (-) Your N Competitors Prices (+) Oligopoly markets rely crucially on the interactions between firms which is why we need game theory to analyze them! Strategy Matters!!!!!

5. Prisoner’s Dilemma…A Classic! Jake Two prisoners (Jake & Clyde) have been arrested. The DA has enough evidence to convict them both for 1 year, but would like to convict them of a more serious crime. Clyde The DA puts Jake & Clyde in separate rooms and makes each the following offer:  Keep your mouth shut and you both get one year in jail  If you rat on your partner, you get off free while your partner does 8 years  If you both rat, you each get 4 years.

6. Jake Clyde ConfessDon’t Confess Confess -4 -4 0 -8 Don’t Confess -8 0 Jake is choosing rows Clyde is choosing columns

7. Jake Clyde ConfessDon’t Confess Confess -4 -4 0 -8 Don’t Confess -8 0 Suppose that Jake believes that Clyde will confess. What is Jake’s best response? If Clyde confesses, then Jake’s best strategy is also to confess

8. Jake Clyde ConfessDon’t Confess Confess -4 -4 0 -8 Don’t Confess -8 0 Suppose that Jake believes that Clyde will not confess. What is Jake’s best response? If Clyde doesn’t confesses, then Jake’s best strategy is still to confess

9. Jake Clyde ConfessDon’t Confess Confess -4 -4 0 -8 Don’t Confess -8 0 Dominant Strategies Jake’s optimal strategy REGARDLESS OF CLYDE’S DECISION is to confess. Therefore, confess is a dominant strategy for Jake Note that Clyde’s dominant strategy is also to confess

10. Nash Equilibrium Jake Clyde ConfessDon’t Confess Confess -4 -4 0 -8 Don’t Confess -8 0 The Nash equilibrium is the outcome (or set of outcomes) where each player is following his/her best response to their opponent’s moves Here, the Nash equilibrium is both Jake and Clyde confessing

11. “Winston tastes good like a cigarette should!” “Us Tareyton smokers would rather fight than switch!” AdvertiseDon’t Advertise Advertise 10 30 5 Don’t Advertise 5 3020

12. Price Fixing and Collusion Prior to 1993, the record fine in the United States for price fixing was $2M. Recently, that record has been shattered! DefendantProductYearFine F. Hoffman-LarocheVitamins1999$500M BASFVitamins1999$225M SGL CarbonGraphite Electrodes1999$135M UCAR InternationalGraphite Electrodes1998$110M Archer Daniels MidlandLysine & Citric Acid1997$100M Haarman & ReimerCitric Acid1997$50M HeereMacMarine Construction1998$49M In other words…Cartels happen!

13. Cartel Formation While it is clearly in each firm’s best interest to join the cartel, there are a couple problems:  With the high monopoly markup, each firm has the incentive to cheat and overproduce. If every firm cheats, the price falls and the cartel breaks down  Cartels are generally illegal which makes enforcement difficult! Note that as the number of cartel members increases the benefits increase, but more members makes enforcement even more difficult!

14. Cartels - The Prisoner’s Dilemma Jake Clyde CooperateCheat Cooperate$20 $10 $40 Cheat$40 $10$15 The problem facing the cartel members is a perfect example of the prisoner’s dilemma !

15. Perhaps cartels can be maintained because the members are interacting over time – this brings is a possible punishment for cheating. Time 012345 Make Strategic Decision CooperateCheat Cooperate$20 $10 $40 Cheat$40 $10$15 Jake Clyde Make Strategic Decision Jake “I plan on cooperating…if you cooperate today, I will cooperate tomorrow, but if you cheat today, I will cheat forever!”

16. Time 012345 Make Strategic Decision Jake “I plan on cooperating…if you cooperate today, I will cooperate tomorrow, but if you cheat today, I will cheat forever!” Clyde Cooperate: Cheat: CooperateCheat Cooperate$20 $10 $40 Cheat$40 $10$15 $20 $40$15 Cooperate: $120 Cheat: $115 Clyde should cooperate, right?

17. JakeClyde We need to use backward induction to solve this. Time 012345 Make Strategic Decision CooperateCheat Cooperate$20 $10 $40 Cheat$40 $10$15 What should Clyde do here? Regardless of what took place the first four time periods, what will happen in period 5?

18. JakeClyde We need to use backward induction to solve this. Time 012345 Make Strategic Decision CooperateCheat Cooperate$20 $10 $40 Cheat$40 $10$15 What should Clyde do here? Cheat Given what happens in period 5, what should happen in period 4?

19. JakeClyde We need to use backward induction to solve this. Time 012345 Make Strategic Decision CooperateCheat Cooperate$20 $10 $40 Cheat$40 $10$15 Knowing the future prevents credible promises/threats! Cheat

20. Where is collusion most likely to occur? High profit potential The more profitable a cartel is, the more likely it is to be maintained Inelastic Demand (Few close substitutes, Necessities) Cartel members control most of the market Entry Restrictions (Natural or Artificial) Its common to see trade associations form as a way of keeping out competition (Florida Oranges, Got Milk!, etc)

21. Where is collusion most likely to occur? Low cooperation/monitoring costs If it is relatively easy for member firms to coordinate their actions, the more likely it is to be maintained Small Number of Firms with a high degree of market concentration Similar production costs Little product differentiation Some cartels might require explicit side payments among member firms. This is difficult to do when cartels are illegal!

22. StagRabbit Stag 4 4 0 1 Rabbit1 01 The Stag Hunt: Two individuals are out on a hunt. Each must make a decision on what to hunt without knowledge of the other individual’s choice  Only one hunter is required to catch a rabbit – a small, sure reward  Two hunters are required to take down a stag – a bigger but riskier reward What’s the equilibrium here?

23. StagRabbit Stag 4 4 0 1 Rabbit1 01 The Stag Hunt: Two individuals are out on a hunt. Each must make a decision on what to hunt without knowledge of the other individual’s choice If both hunt the stag, neither has an incentive to deviate – an equilibrium! If both hunt the rabbit, neither has an incentive to deviate – an equilibrium!

24. A quick detour: Expected Value Suppose that I offer you a lottery ticket: This ticket has a 2/3 chance of winning $100 and a 1/3 chance of losing $100. How much is this ticket worth to you? Suppose you played this ticket 6 times: AttemptOutcome 1$100 2 3-$100 4$100 5-$100 6$100 Total Winnings: $200 Attempts: 6 Average Winnings: $200/6 = $33.33

25. A quick detour: Expected Value Given a set of probabilities, Expected Value measures the average outcome Expected Value = A weighted average of the possible outcomes where the weights are the probabilities assigned to each outcome Suppose that I offer you a lottery ticket: This ticket has a 2/3 chance of winning $100 and a 1/3 chance of losing $100. How much is this ticket worth to you?

26. StagRabbit Stag4 0 1 Rabbit1 01 Suppose that you believed that your fellow hunter was equally likely to hunt the stag or the rabbit what would you do? 50% If you hunt the rabbit: You are guaranteed a reward of 1 with certainty If you hunt the stag: 50% of the time you get 2, 50% of the time you get 0 In this example, hunting the stag is reward dominant, while hunting the rabbit is risk dominant

27. StagRabbit Stag4 0 1 Rabbit1 01 What if we change the odds…? 10%90% If you hunt the rabbit: You are guaranteed a reward of 1 with certainty If you hunt the stag: 10% of the time you get 2, 90% of the time you get 0 Now, hunting the rabbit is both reward dominant and risk dominant!! Choosing the stag would never be a good idea here.

28. StagRabbit Stag4 0 1 Rabbit1 01 Let’s find the odds that make the stag and rabbit equally attractive on average… X%Y% If you hunt the rabbit: You are guaranteed a reward of 1 with certainty If you hunt the stag: For them to be equal on average: X = 25%, Y = 75%

29. StagRabbit Stag4 0 1 Rabbit1 01 Therefore, in this example, you will hunt the stag if your fellow hunter hunts the stag at least 25% of the time. 25% Similarly, your fellow hunter will hunt the stag if you hunt the stag at least 25% of the time. 25% 75% 6.25% 56.25%18.75% 75%

30. The Airline Price Wars $500 $220 60180 Suppose that American and Delta face the given demand for flights to NYC and that the unit cost for the trip is $200. If they charge the same fare, they split the market P = $500P = $220 P = $500$9,000 $3,600 $0 P = $220$0 $3,600 $1,800 American Delta What will the equilibrium be?

31. The Airline Price Wars P = $500P = $220 P = $500$9,000 $3,600 $0 P = $220$0 $3,600 $1,800 American Delta If American follows a strategy of charging $500 all the time, Delta’s best response is to also charge $500 all the time If American follows a strategy of charging $220 all the time, Delta’s best response is to also charge $220 all the time This game has multiple equilibria and the result depends critically on each company’s beliefs about the other company’s strategy

32. The Airline Price Wars: A Stag Hunt! P = $500P = $220 P = $500$9,000 $3,600 $0 P = $220$0 $3,600 $1,800 American Delta Charge $500: Charge $220: Suppose American charges $500 with probability Charges $220 with probability (75%) (25%) (56%)(19%) (6%)

33. RockPaperScissors Rock0000 1 Paper1 0000 1 Scissors 1 0000 Player 1 Player 2 Lets take the game we started out with…what are the strategies?

34. Don’t Audit Audit Cheat 5 -5 -25 5 Don’t Cheat 0 What is the equilibrium to this game? Ever Cheat on your taxes? In this game you get to decide whether or not to cheat on your taxes while the IRS decides whether or not to audit you

35. If the IRS never audited, your best strategy is to cheat (this would only make sense for the IRS if you never cheated) There is no pure strategy equilibrium (i.e. there are no certain strategies)! Don’t Audit Audit Cheat 5 -5 -25 5 Don’t Cheat 0 If the IRS always audited, your best strategy is to never cheat (this would only make sense for the IRS if you always cheated)

36. Cheating on your taxes! Don’t Audit Audit Cheat 5 -5 -25 5 Don’t Cheat 0 Suppose that the IRS Audits 25% of all returns. What should you do? Cheat: Don’t Cheat: If the IRS audits 25% of all returns, you are better off not cheating. But if you never cheat, they will never audit, …

37. Don’t AuditAudit Cheat 5 -5 -25 5 Don’t Cheat0 The only way this game can work is for you to cheat sometime, but not all the time. That can only happen if you are indifferent between the two! Cheat: Don’t Cheat: Suppose the government audits with probability Doesn’t audit with probability If you are indifferent… (83%)(17%)

38. Don’t AuditAudit Cheat 5 -5 -25 5 Don’t Cheat0 We also need for the government to audit sometime, but not all the time. For this to be the case, they have to be indifferent! Audit: Don’t Audit: Suppose you cheat with probability Don’t cheat with probability If they are indifferent… (91%)(9%)

39. Don’t AuditAudit Cheat 5 -5 -25 5 Don’t Cheat0 Now we have an equilibrium for this game that is sustainable! The government audits with probability Doesn’t audit with probability Suppose you cheat with probability Don’t cheat with probability We can find the odds of any particular event happening…. You Cheat and get audited:(1.5%) (7.5%) (15%)(75%)

40. Suppose that we make the game sequential. That is, one side makes its decision (and that decision is public) before the other Cheat Audit Don’t Cheat Don’t Audit (-25, 5)(5, -5)(-1, -1)(0, 0) Don’t AuditAudit Cheat 5 -5 -25 5 Don’t Cheat0 Your reward is on the left

41. If the IRS observes you cheating, their best choice is to Audit Cheat Audit Don’t Cheat Don’t Audit (-25, 5)(5, -5)(-1, -1)(0, 0) Don’t AuditAudit Cheat 5 -5 -25 5 Don’t Cheat0 Your reward is on the left vs

42. If the IRS observes you not cheating, their best choice is to not audit Cheat Audit Don’t Cheat Don’t Audit (-25, 5)(5, -5)(-1, -1)(0, 0) Don’t AuditAudit Cheat 5 -5 -25 5 Don’t Cheat0 Your reward is on the left vs

43. Knowing how the IRS will respond, you never cheat and they never audit!! Cheat Audit Don’t Cheat Don’t Audit (-25, 5)(5, -5)(-1, -1)(0, 0) Don’t AuditAudit Cheat 5 -5 -25 5 Don’t Cheat0 Your reward is on the left vs (0%) (100%)

44. Now, lets switch positions…suppose the IRS chooses first Audit Cheat Don’t Audit Don’t Cheat (-25, 5)(-1, -1)(5, -5)(0, 0) Don’t AuditAudit Cheat 5 -5 -25 5 Don’t Cheat0 Your reward is on the left (0%) (100%)(0%)

45. Terrorists President Take Hostages Negotiate Kill Don’t Take Hostages Don’t Kill Don’t Negotiate (1, -.5) (-.5, -1)(-1, 1) (0, 1) In the Movie Air Force One, Terrorists hijack Air Force One and take the president hostage. Can we write this as a game? (Terrorists payouts on left) In the third stage, the best response is to kill the hostages Given the terrorist response, it is optimal for the president to negotiate in stage 2 Given Stage two, it is optimal for the terrorists to take hostages

46. Terrorists President Take Hostages Negotiate Kill Don’t Take Hostages Don’t Kill Don’t Negotiate (1, -.5) (-.5, -1)(-1, 1) (0, 1) The equilibrium is always (Take Hostages/Negotiate). How could we change this outcome? Suppose that a constitutional amendment is passed ruling out hostage negotiation (a commitment device) Without the possibility of negotiation, the new equilibrium becomes (No Hostages)

47. A bargaining example…How do you divide $20? Two players have $20 to divide up between them. On day one, Player A makes an offer, on day two player B makes a counteroffer, and on day three player A gets to make a final offer. If no agreement has been made after three days, both players get $0. Player A Player B Offer AcceptReject Player B Offer Player A AcceptReject Player A Offer Player B AcceptReject (0,0) Day 1 Day 2 Day 3

48. Player A Player B Offer AcceptReject Player B Offer Player A AcceptReject Player A Offer Player B AcceptReject (0,0) Day 1 Day 2 Day 3 If day 3 arrives, player B should accept any offer – a rejection pays out $0! Player A: $19.99 Player B: $.01 Player B knows what happens in day 3 and wants to avoid that! Player A: $19.99 Player B: $.01 Player A knows what happens in day 2 and wants to avoid that! Player A: $19.99 Player B: $.01

49. Player A Player B Offer AcceptReject Player B Offer Player A AcceptReject Player A Offer Player B AcceptReject (0,0) Day 1 Day 2 Day 3 Lets consider a couple variations… Variation #1: Negotiations take a lot of time and each player has an opportunity cost of waiting: Player A has an investment opportunity that pays 20% per year. Player B has an investment strategy that pays 10% per year

50. Player A Player B Offer AcceptReject Player B Offer Player A AcceptReject Player A Offer Player B AcceptReject (0,0) Year 1 Year 2 Year 3 If year 3 arrives, player B should accept any offer – a rejection pays out $0! Player A: $19.99 Player B: $.01 If player A rejects, she gets $19.99 in one year. That’s worth $19.99/1.20 today Player A: $16.65 Player B: $3.35 If player B rejects, she gets $3.35 in one year. That’s worth $3.35/1.10 today Player A: $16.95 Player B: $3.05

51. Player A Player B Offer AcceptReject Player B Offer Player A AcceptReject Player A Offer Player B AcceptReject (0,0) Day 1 Day 2 Day 3 Lets consider a couple variations… Variation #2 (The Shrinking Pie Game): Negotiations are costly. After each round, the pot gets reduced by 50%: $20 $10 $5

52. Player A Player B Offer AcceptReject Player B Offer Player A AcceptReject Player A Offer Player B AcceptReject (0,0) Day 1 Day 2 Day 3 If day 3 arrives, player B should accept any offer – a rejection pays out $0! Player A: $4.99 Player B: $.01 If player A rejects, she gets $4.99 in one year. She will accept anything better than $4.99 Player A: $5.00 Player B: $5.00 If player B rejects, she gets $5 tomorrow. She will accept anything better than $5 Player A: $5.01 Player B: $14.99 $20 $10 $5

53. Did someone say Batman?

54. Back to pricing… Consider the following example. We have two competing firms in the marketplace.  These two firms are selling identical products.  Each firm has constant marginal costs of production. What are these firms using as their strategic choice variable? Price or quantity?

55. Consider the following scenario…We call this Cournot competition Two manufacturers choose a production target Q2 Q1 P Q1 + Q2 Q S D P* A centralized market determines the market price based on available supply and current demand Two manufacturers earn profits based off the market price Profit = P*Q1 - TC Profit = P*Q2 - TC

56. For example…suppose both firms have a constant marginal cost of $20 Two manufacturers choose a production target Q2 = 2 Q1 = 1 P 3 Q S D $60 A centralized market determines the market price based on available supply and current demand Two manufacturers earn profits based off the market price Profit = 60*1 – 20 = $40 Profit = 60*2 – 40 = $80

57. Let’s figure out the strategies… Suppose that you are firm 1. You know that firm #2 has set a production level of 1 Q2Q1QPTRMR 1011000 1.251.259523.7595 1.51.5904585 1.751.758563.7575 11280 65 11.252.257593.7555 11.52.57010545 11.752.7565113.7535 12.0036012025 12.253.2555123.7515

58. Q1 Recall, firm 2 has set its production at 1 P $100 D MR MC$20 2

59. Let’s figure out the strategies… Now, Suppose that you are firm 1. You know that firm #2 has set a production level of 2 Q2Q1QPTRMR 202800 2.252.257518.7575 2.52.5703565 2.752.756548.7555 21260 45 21.252.255568.7535 21.52.5507525 21.752.754578.7515 22.00240755 22.25 3568.75-5

60. Q1 An increase in production by firm 1 shifts the demand curve faced by firm #1 down which causes production by firm 1 to drop P $100 D MR MC$20 2 $80 1.5 Whenever firm #2 increases its production, firm 1’s best response is to reduce its production

61. In Game Theory Lingo, this is Firm One’s Best Response Function To Firm 2 0 Q2Q1 02.5.252.375.502.25.752.125 12 1.251.875 1.51.75 1.625 21.5 2.252.375 2.51.25 Firm 2 chooses 1.5 Firm 1 chooses 1.75

62. The game is symmetric with respect to Firm two… Firm 1 chooses a production target of 1.75 Firm 2 responds with a production target of 1.675 Q1Q2 02.5.252.375.502.25.752.125 12 1.251.875 1.51.75 1.625 21.5 2.252.375 2.51.25

63. Firm 1 Firm 2 Eventually, these two firms converge on production levels such that neither firm has an incentive to change

64. MonopolyPerfect Competition 2 Firms

65. Suppose Firm 2’s marginal costs increase to $30 Q1 P D MR MC$20 1.67 Firm 2’s production drops…

66. Q1 P $100 D MR MC$20 $80 1.67 Firm 1’s best response is to increase it’s production Firm 2’s production drops…

67. Firm 1 Firm 2 Firm 2’s market share drops 42% 58% Firm #2 loses market share to Firm #1

68. Now, consider another example. Both firms have a constant marginal cost of $20 Two manufacturers choose a Price P2 P1 Two manufacturers earn profits based off the market price Profit = ?? Potential customers observe the prices offered and choose how much/from whom to buy With Identical products, consumers choose the cheapest!

69. D Industry Demand D Firm Level Demand Firm level demand curves look very different when we are competing in price. If you are underpriced, you lose the whole market If you are the low price you capture the whole market At equal prices, you split the market

70. Firm One’s Best Response Function Case #1: Firm 2 sets a price above the pure monopoly price: Case #3: Firm 2 sets a price below marginal cost Case #2: Firm 2 sets a price between the monopoly price and marginal cost Case #4: Firm 2 sets a price equal to marginal cost What’s the Nash equilibrium of this game?

71. However, the Bertrand equilibrium makes some very restricting assumptions…  Firms are producing identical products (i.e. perfect substitutes)  Firms are not capacity constrained MonopolyPerfect Competition 2 Firms

72. An example…capacity constraints Consider two theatres located side by side. Each theatre’s marginal cost is constant at $10. Both face an aggregate demand for movies equal to Each theatre has the capacity to handle 2,000 customers per day. What will the equilibrium be in this case?

73. If both firms set a price equal to $10 (Marginal cost), then market demand is 5,400 (well above total capacity = 2,000) Note: The Bertrand Equilibrium (P = MC) relies on each firm having the ability to make a credible threat: “If you set a price above marginal cost, I will undercut you and steal all your customers!” At a price of $33, market demand is 4,000 and both firms operate at capacity. Now, how do we choose capacity?

74. Campbell’s Soup has accounted for 60% of the canned soup market for over 50 years Market Dominance Sotheby’s and Christie’s have controlled 90% of the auction market for two decades (each holds 50% of its own domestic market) Intel has held 90% of the computer chip market for 10 years. Microsoft has held 90% of the operating system market over the last 10 years On average, the number one firm in an industry retains that rank for 17 – 28 years!

75. Entry/Exit and Profitability D D SS D’ Its normally assumed that as demand patterns shift, resources are moved across sectors – as the price of bananas rises relative to apples, there is exit in the apple industry and entry in the banana industry (bananas are more profitable) Bananas Apples THIS IS INCONSISTANT WITH THE FACTS!!

76. Evolving Market Structures….Some Facts Entry is common: Entry rates for industries in the US between 1963 – 1982 averaged 8-10% per year. Entry occurs on a small scale: Entrants for industries in the US between 1963 – 1982 averaged 14% of the industry. Survival Rates are Low: 61% of entrants will exit within 5 years. 79.6% exit within 10 years. Entry is highly correlated with exit across industries: Industries with high entry rates also have high exit rates Entry/Exit Rates vary considerably across industries: Clothing and Furniture have high entry/exit, chemical and petroleum have low entry/exit.

77. Entrants Market Dominated by Incumbents Exits The data suggests that most industries are like revolving doors – there is always a steady supply of new entrants trying to survive. The key source of variation across industries is the rate of entry (which controls the rate of exit) Is this a result of predatory practices by the incumbents?

78. Suppose that McDonald’s is currently the only restaurant in town, but Burger King is considering opening a location. Should McDonald's fight for it’s territory? IN Out Fight Cooperate 0 2 1 5 0 2

79. Now, suppose that this game is played repeatedly. That is, suppose that McDonald's faces possible entry by burger King is 20 different locations. Can entry deterrence be a credible strategy? Enter Don’t Fight 2 EnterDon’t Enter FightDon’t Enter 0 OR 22 5555 Total =2*20 = 40 Total =19*5 = 95

80. Enter Don’t Enter Enter Don’t Enter Enter Don’t Enter Fight Don’t Fight Fight Don’t Fight Fight Don’t Fight End of Time Does McDonald’s have an incentive to fight here? What will Burger King do here? If there is an “end date” then McDonald's threat loses its credibility!! Now, suppose that this game is played repeatedly. That is, suppose that McDonald's faces possible entry by burger King is 20 different locations. Can entry deterrence be a credible strategy?

81. There have been numerous cases involving predatory pricing throughout history. There are two good reasons why we would most likely not see predatory pricing in practice 1.It is difficult to make a credible threat (Remember the Chain Store Paradox)! 2.A merger is generally a dominant strategy!!  Standard Oil  American Sugar Refining Company  Mogul Steamship Company  Wall Mart  AT&T  Toyota  American Airlines