Chapter 13: Strategic Decision Making in Oligopoly Markets McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Oligopoly Markets Interdependence of firms’ profits Distinguishing feature of oligopoly Arises when number of firms in market is small enough that every firms’ price & output decisions affect demand & marginal revenue conditions of every other firm in market

Features of oligopoly Fewness of sellers Seller interdependence Feasibility of coordinated action among ostensibly independent firms

Seller interdependence If Kroger offers deep discounts on soft drinks, will Wal-Mart follow suit? Verizon carries unused minutes over the to next month—implications for AT&T, et. al.? If AA discounts fares on its Chicago to NY service, will United follow? If Regions charges swipe fees, how will rival banks react? How will Duracell react to an aggressive marketing campaign by EverReady? Alcoa’s decision to add production capacity is conditioned upon the investment plans of rival aluminum producers.

Measures of seller concentration The concentration ratio is the percentage of total market sales accounted for by an absolute number of the largest firms in the market. The four-firm concentration ratio (CR4) measures the percent of total market sales accounted for by the top four firms in the market. The eight-firm concentration ratio (CR4) measures the percent of total market sales accounted for by the top eight firms in the market.

Concentration Ratios: Very Concentrated Industries Source: U.S. Bureau of the Census, Census of Manufacturers

Concentration Ratios: Less Concentrated Industries Source: U.S. Bureau of the Census, Census of Manufacturers

Game Theory and Competitive Strategy Selecting a course of action in a situation in which rival players are selecting strategies that suit their interests is the basic problem of game theory.

1. Players and their actions A situation of competitive rivalry must involve two or more players whose choice of actions affect each other. A “player” can be a firm, an interest group or coalition, a military leader, government official. Games generally consider only one kind of action—e.g., number of daily departures, fares, in-flight services, schedules, advertising, technology, choice of hubs, ordering planes, expanding terminals, use of computerized reservations systems, mergers and acquisitions, and human resource decisions.

2. Outcomes and Payoffs The firm’s action, together with the actions of its rivals, determine its payoff In the standard “business” game, the payoff can be in the form of profit, market share, ratings points, In war games, the payoff might be measured in enemy killed or territory seized. In political games, payoffs may be measured in votes or campaign contributions.

3. Underlying “rules” The rules of the game define the range of possible outcomes and payoffs For example, collusion to fix prices or a merger among direct rivals in a concentrated market structure may be against the rules. Another set a rules specifies whether players move sequentially or simultaneously, who moves first, and what does each player know about the other players’ preference and prior to actions?

Strategic Decisions Strategic behavior Game theory Actions taken by firms to plan for & react to competition from rival firms Game theory Useful guidelines on behavior for strategic situations involving interdependence Simultaneous Decisions Occur when managers must make individual decisions without knowing their rivals’ decisions

Dominant Strategies Always provide best outcome no matter what decisions rivals make When one exists, the rational decision maker always follows its dominant strategy Predict rivals will follow their dominant strategies, if they exist Dominant strategy equilibrium Exists when all decision makers have dominant strategies

Prisoner’s dilemma Bill and Jane have been charged with bank robbery. But lacking a confession, the DA can only get a “reckless endangerment” charge to stick. So the police play one suspect off against the other.

Let’s make a deal OK, Bill. Confess, give evidence on Jane, and you get a reduced sentence of one year in prison.

What will Jane do? Bill

Prisoners’ Dilemma All rivals have dominant strategies In dominant strategy equilibrium, all are worse off than if they had cooperated in making their decisions

Prisoners’ Dilemma (Table 13.1) Bill Don’t confess Confess Jane A 2 years, 2 years B 12 years, 1 year C 1 year, 12 years D 6 years, 6 years B J J B

Principle: When a firm does not have a dominant strategy but at least one of its rivals does have a dominant strategy, the firm can predict that its rivals will follow their dominant strategies. Thus the problem for the firm is to select the strategy that gives the highest payoff conditional upon rival pursuing their dominant strategies.

Dominated Strategy A strategy is dominated if, regardless of what any other players do, the strategy earns a player a smaller payoff than some other strategy. Hence, a strategy is dominated if it is always better to play some other strategy, regardless of what opponents may do. If a player has a dominant strategy than all others are dominated, but the converse is not always true.

Dominated Strategies Never the best strategy, so never would be chosen & should be eliminated Successive elimination of dominated strategies should continue until none remain Search for dominant strategies first, then dominated strategies When neither form of strategic dominance exists, employ a different concept for making simultaneous decisions

Successive Elimination of Dominated Strategies (Table 13.3) Pizza Pricing Palace’s price High ($10) Medium ($8) Low ($6) Castle’s price High ($10) A $1,000, $1,000 B $900, $1,100 C $500, $1,200 Medium ($8) D $1,100, $400 E $800, $800 F $450, $500 Low ($6) G $1,200, $300 H $500, $350 I $400, $400 C C P P C P Payoffs in dollars of profit per week

Successive Elimination of Dominated Strategies (Table 13.3) Unique Solution Reduced Payoff Table Palace’s price Medium ($8) Low ($6) Castle’s price High ($10) B $900, $1,100 C $500, $1,200 Low ($6) H $500, $350 I $400, $400 C C P P Payoffs in dollars of profit per week

Castle does not have a dominant strategy. But Palace does Castle does not have a dominant strategy. But Palace does. Castle should select its best strategy, given Castle will pursue its dominant strategy

Making Mutually Best Decisions For all firms in an oligopoly to be predicting correctly each others’ decisions: All firms must be choosing individually best actions given the predicted actions of their rivals, which they can then believe are correctly predicted Strategically astute managers look for mutually best decisions

Nash Equilibrium Set of actions or decisions for which all managers are choosing their best actions given the actions they expect their rivals to choose Strategic stability No single firm can unilaterally make a different decision & do better

Nash decisions are likely to chosen because Nash sets of decisions are mutually best and thus, “strategically stable.” No player can do better by unilaterally changing its decision. Non-Nash decisions are unlikely to be chosen because at least one player can improve its payoff by changing its decision. Beautiful Mind

Super Bowl Advertising: A Unique (Non-Cooperative) Nash Equilibrium Note: No dominant or dominated strategies Pepsi’s budget Low Medium High Coke’s budget A $60, $45 B $57.5, $50 C $45, $35 D $50, $35 E $65, $30 F $30, $25 G $45, $10 H $60, $20 I $50, $40 C P P C C P Payoffs in millions of dollars of semiannual profit

Why is High-High Stable? Suppose Coke and Pepsi cooperate—Both choose “low” and maximize joint profit. Pepsi can do better by unilaterally selecting “medium.” In some cells, both Coke and Pepsi can increase their payoffs by changing strategies—Consider cell F, for example.

Nash Equilibrium When a unique Nash equilibrium set of decisions exists Rivals can be expected to make the decisions leading to the Nash equilibrium With multiple Nash equilibria, no way to predict the likely outcome All dominant strategy equilibria are also Nash equilibria Nash equilibria can occur without dominant or dominated strategies

Best-Response Curves Analyze & explain simultaneous decisions when choices are continuous (not discrete) Indicate the best decision based on the decision the firm expects its rival will make Usually the profit-maximizing decision Nash equilibrium occurs where firms’ best-response curves intersect

Deriving Best-Response Curve for Arrow Airlines (Figure 13.1) Arrow Airline’s price and marginal revenue Panel A : Arrow believes PB = $100 Bravo Airway’s quantity Arrow Airline’s price Panel B: Two points on Arrow’s best-response curve Bravo Airway’s price

Best-Response Curves & Nash Equilibrium (Figure 13.2) Arrow Airline’s price Bravo Airway’s price

Sequential Decisions One firm makes its decision first, then a rival firm, knowing the action of the first firm, makes its decision The best decision a manager makes today depends on how rivals respond tomorrow

Game Tree Shows firms decisions as nodes with branches extending from the nodes One branch for each action that can be taken at the node Sequence of decisions proceeds from left to right until final payoffs are reached Roll-back method (or backward induction) Method of finding Nash solution by looking ahead to future decisions to reason back to the current best decision

Sequential Pizza Pricing Panel B – Roll-back solution Panel A – Game tree

First-Mover & Second-Mover Advantages First-mover advantage If letting rivals know what you are doing by going first in a sequential decision increases your payoff Second-mover advantage If reacting to a decision already made by a rival increases your payoff Determine whether the order of decision making can be confer an advantage Apply roll-back method to game trees for each possible sequence of decisions

Cellular Service in Brazil Motorola Sony Annual cost of analog $250 $400 Annual cost of digital $350 $325 Use of incompatible technologies would reduce the market demand for cellular service. Motorola would obviously prefer analog; Sony digital. Brazilian government has imposed a price ceiling—technology is the decision variable.

First-Mover Advantage in Technology Choice Motorola’s technology Analog Digital Sony’s technology A $10, $13.75 B $8, $9 C $9.50, $11 D $11.875, $11.25 S M S M Panel A – Simultaneous technology decision

To determine if a first mover advantage exists, construct a decision tree and then “roll back.”

First-Mover Advantage in Technology Choice Panel B – Motorola secures a first-mover advantage

Strategic Moves & Commitments Actions used to put rivals at a disadvantage Three types Commitments Threats Promises Only credible strategic moves matter Managers announce or demonstrate to rivals that they will bind themselves to take a particular action or make a specific decision No matter what action is taken by rivals

Credible Moves There is no doubt the strategic move will be carried out because it is in the best interest of the player making the move to carry it out.

The NBA Players Association made the decision to decertify its union and bring an anti-trust suit against the NBA owners. Whether this amounts to a credible strategic move is open to debate.

Threats & Promises Conditional statements Threats Promises Explicit or tacit “If you take action A, I will take action B, which is undesirable or costly to you.” Promises “If you take action A, I will take action B, which is desirable or rewarding to you.”

Cooperation in Repeated Strategic Decisions Cooperation occurs when oligopoly firms make individual decisions that make every firm better off than they would be in a (noncooperative) Nash equilibrium

Cheating Making noncooperative decisions One-time prisoners’ dilemmas Does not imply that firms have made any agreement to cooperate One-time prisoners’ dilemmas Cooperation is not strategically stable No future consequences from cheating, so both firms expect the other to cheat Cheating is best response for each

Pricing Dilemma for AMD & Intel AMD’s price High Low Intel’s price A: $5, $2.5 B: $2, $3 C: $6, $0.5 D: $3, $1 Cooperation AMD cheats Intel cheats A Noncooperation I I A Payoffs in millions of dollars of profit per week

Punishment for Cheating With repeated decisions, cheaters can be punished When credible threats of punishment in later rounds of decision making exist Strategically astute managers can sometimes achieve cooperation in prisoners’ dilemmas

In a one-time game, there is no opportunity to punish cheaters In a one-time game, there is no opportunity to punish cheaters. In repeated games, cheaters can be punished. Cooperation in one-time games is unstable.

Deciding to Cooperate Cooperate Cheat When present value of costs of cheating exceeds present value of benefits of cheating Achieved in an oligopoly market when all firms decide not to cheat Cheat When present value of benefits of cheating exceeds present value of costs of cheating

Retaliation for Cheating Legal sanctions or fines levied against cheaters are illegal in most countries. Cheaters are usually “punished” when rival firms push the game back to non-cooperative (Nash) equilibrium.

Deciding to Cooperate Where Bi = πCheat – πCooperate for i = 1,…, N Where Cj = πCooperate – πNash for j = 1,…, P

A Firm’s Benefits & Costs of Cheating (Figure 13.5)

Trigger Strategies A rival’s cheating “triggers” punishment phase Tit-for-tat strategy Punishes after an episode of cheating & returns to cooperation if cheating ends Grim strategy Punishment continues forever, even if cheaters return to cooperation

Facilitating Practices Legal tactics designed to make cooperation more likely Four tactics Price matching Sale-price guarantees Public pricing Price leadership

Price Matching Firm publicly announces that it will match any lower prices by rivals Usually in advertisements Discourages noncooperative price-cutting Eliminates benefit to other firms from cutting prices

Sale-Price Guarantees Firm promises customers who buy an item today that they are entitled to receive any sale price the firm might offer in some stipulated future period Primary purpose is to make it costly for firms to cut prices

Public Pricing Public prices facilitate quick detection of noncooperative price cuts Timely & authentic Example: Shared computerized reservation systems in the airline industry. Early detection Reduces PV of benefits of cheating Increases PV of costs of cheating Reduces likelihood of noncooperative price cuts

Price Leadership Price leader sets its price at a level it believes will maximize total industry profit Rest of firms cooperate by setting same price Does not require explicit agreement Generally lawful means of facilitating cooperative pricing

Cartels Most extreme form of cooperative oligopoly Explicit collusive agreement to drive up prices by restricting total market output Illegal in U.S., Canada, Mexico, Germany, & European Union

Cartels Pricing schemes usually strategically unstable & difficult to maintain Strong incentive to cheat by lowering price When undetected, price cuts occur along very elastic single-firm demand curve Lure of much greater revenues for any one firm that cuts price Cartel members secretly cut prices causing price to fall sharply along a much steeper demand curve

Intel’s Incentive to Cheat (Figure 13.6) Along dIntel, Intel can increase its sales and its market share. Along DIntel, Intel can increase its sales but not its market share.

Tacit Collusion Far less extreme form of cooperation among oligopoly firms Cooperation occurs without any explicit agreement or any other facilitating practices

Strategic Entry Deterrence Established firm(s) makes strategic moves designed to discourage or prevent entry of new firm(s) into a market Two types of strategic moves Limit pricing Capacity expansion

Limit Pricing Established firm(s) commits to setting price below profit-maximizing level to prevent entry Under certain circumstances, an oligopolist (or monopolist), may make a credible commitment to charge a lower price forever

The key is making a credible commitment to a “low” post-entry price Star Coffee The key is making a credible commitment to a “low” post-entry price Manager of Star Coffee

Limit Pricing: Entry Deterred P* is the π-maximizing price PL is the maximum-entry forestalling price.

Limit Pricing: Entry Occurs PN is the Nash price

Star’s Price BRB BRS $3.50 N $3.50 Burned Bean’s Price

Star Coffee The problem is that, if I am unable to make a credible commitment to permanently low prices, the manager of the Burned Bean knows I have an incentive to shift to the Nash price post-entry. Thus entry will not be deterred. Manager of Star Coffee

Capacity Expansion Established firm(s) can make the threat of a price cut credible by irreversibly increasing plant capacity When increasing capacity results in lower marginal costs of production, the established firm’s best response to entry of a new firm may be to increase its own level of production Requires established firm to cut its price to sell extra output

Excess Capacity Barrier to Entry (Figure 13.9)