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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 3 Using Game Theory to Analyze Strategic Decisions Basic Elements of a Game The players Their strategies The payoffs

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life 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 American’s Choices United’s 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 6 Dominant Strategy One that yields a higher payoff no matter what the other players in a game choose Using Game Theory to Analyze Strategic Decisions

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 7 Dominated Strategy Any other strategy available to a player who has a dominant strategy Using Game Theory to Analyze Strategic Decisions

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 8 Nash Equilibrium Any combination of strategies in which each player’s strategy is her or his best choice, given the other player’s strategies Using Game Theory to Analyze Strategic Decisions

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 9 Nash Equilibrium When each player has a dominant strategy, equilibrium occurs when each player follows that strategy Using Game Theory to Analyze Strategic Decisions

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 10 Nash Equilibrium There can be an equilibrium when players do not have a dominant strategy Using Game Theory to Analyze Strategic Decisions

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 11 The Theory of Games Example Should American spend more on advertising? Assume  United and American are the only carriers serving the Chicago – St. Louis market

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 12 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 American’s Choices United’s Choices

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 13 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 American’s Choices United’s Choices

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 14 The Prisoner’s Dilemma Prisoners 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 15 The Prisoner’s Dilemma Example Should the prisoners confess?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 16 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 17 The Prisoner’s Dilemma Exercise Which of these games is a prisoner’s dilemma?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 18 Which of These Games Is a Prisoner’s Dilemma? Don’t Invest Don’t Invest 12 for Chrysler 10 for each 4 for GM GAME 1 Invest 5 for each 4 for Chrysler 12 for GM Chrysler GM Invest

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 19 Which of These Games Is a Prisoner’s Dilemma? GAME 2 Don’t Invest Don’t Invest 12 for Chrysler 10 for each 4 for GM Chrysler GM Invest 5 for each 4 for Chrysler 12 for GM

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 20 The Economics of Cartels Prisoner’s Dilemmas Confronting Imperfectly Competitive Firms Cartel  A coalition of firms that agrees to restrict output for the purpose of earning an economic profit

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 21 Economic Naturalist Why are cartel agreements notoriously unstable? The Economics of Cartels

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 22 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 23 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 24 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 25 The Prisoner’s Dilemma Economic Naturalist When will the rival firms stop cutting prices?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 26 The Prisoner’s Dilemma Tit-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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 27 The Prisoner’s Dilemma Tit-for-tat strategy for repeated games Tit-for-tat strategy  Players cooperate on the first move, then mimic their partner’s last move on each successive move

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 28 The Prisoner’s Dilemma Tit-for-tat strategy for repeated games 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 29 The Prisoner’s Dilemma Question Why is the tit-for-tat strategy unsuccessful in competitive, monopolistically competitive, and oligopolistic markets?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 30 The Prisoner’s Dilemma Economic Naturalist How did Congress unwittingly solve the television advertising dilemma confronting cigarette producers?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 31 Cigarette Advertising as a Prisoner’s Dilemma Advertise on TVDon’t advertise on TV Advertise on TV Don’t 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 32 The Prisoner’s Dilemma Economic Naturalist Why do people shout at parties?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 33 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 34 Games 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.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 35 Games 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?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 36 The Advantage of Being Different Offer hybridDon’t offer hybrid Dodge Viper Chevrolet Corvette Offer hybrid Don’t 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?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 37 Decision Tree for Hybrid A Dodge decides Offer hybrid Don’t offer hybrid B C $50 million for Chevrolet $50 million for Dodge Offer hybrid Don’t offer hybrid Offer hybrid Don’t 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 38 Games in Which Timing Matters Credible Threats and Promises Credible Threat  A threat to take an action that is in the threatener’s interest to carry out

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 39 Games in Which Timing Matters What Do You Think? Why couldn’t Chevrolet deter Dodge from offering a hybrid by threatening to offer a hybrid of its own, no matter what Dodge did?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 40 Games in Which Timing Matters Credible Promise A promise to take action that is in the promiser’s interest to keep

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 41 Games in Which Timing Matters 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 42 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?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 43 Monopolist Competition When Location Matters Why do we often see convenience stores located on adjacent street corners?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 44 Monopolist Competition When Location Matters 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 on the mile?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 45 Monopolist Competition When Location Matters Differentiation by: Physical location  The choice to locate at B. Location in time  Timing of flight departures  Timing of film showings Produce space  Soft drinks

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 46 Commitment Problems Commitment Problem A situation in which people cannot achieve their goals because of an inability to make credible threats or promises

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 47 Commitment Device A way of changing incentives so as to make otherwise empty threats or promises credible Commitment Problems

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 48 Commitment Problems Prisoner’s dilemma Cartels Remote office Commitment Problems

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 49 Commitment Devices Underworld code, omerta Military arms control agreements Tips for waiters Commitment Problems

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 50 Games in Which Timing Matters What do you think? Will Sylvester leave a tip when dining on the road?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 51 The Strategic Role of Preferences Game theory assumes that the goal of the players is to maximize their outcome. In most games, players do not attain the best outcomes. Altering psychological incentives may also improve the outcome of a game.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 52 Question In a moral society, will the business owner open a remote office? The Strategic Role of Preferences

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 53 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

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 54 The Strategic Role of Preferences Are People Fundamentally Selfish? Do you tip at out-of town restaurants? What would be your first offer in the ultimatum bargaining game? Would you refuse a lopsided offer?

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 55 The Strategic Role of Preferences Are People Fundamentally Selfish? If narrow self-interest is not the only motive for making choices, then the other motives must be understood to predict and explain human behavior.

MBMC Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Strategic Choice in Oligopoly, Monopolistic Competition, and Everyday Life Slide 56 The Strategic Role of Preferences 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.

MBMC End of Chapter End of Chapter