The Economic Framework For our purposes two basic sets of agents: –Consumers –Firms Interact through markets Faced with some economic environment or market structure, each agent makes decisions

Market Structure What is a market? -Set of firms and consumers whose interactions establish the price of products that are viewed as close substitutes by consumers (firms produce different brands)

When are brands ‘close substitutes’? Cross Price Elasticity -Measures how responsive quantity demanded is to changes in price of other goods. -% change in quantity demanded of X / % change in price of Y.

Market Power Ability to raise price above marginal cost Interested in strategies that can be used to obtain and/or preserve market power -pricing strategies -product positioning strategies -choice of quality -advertising strategies -R&D strategies

Market power depends on: i)Demand Elasticity ii)Market concentration iii)Collusive behaviour

Market Structure Perfect Competition vs Monopoly

Perfect Competition Perfectly competitive environment -large number of small producers -identical product -perfect information -free entry into and exit from market - price takers

Firms choose output level to maximize profits: Max Profits=Revenue-Costs Max PxQ-C(Q) What Q should the firm choose? The one that makes MR=MC Q

P,C Q MC AC P h P l At P : eco losses At P : eco profits h l

In the long run 2 things can happen: -firms in industry can adjust their fixed factors to maximize profits -new firms can enter, old firms can leave As a result, all firms break even in the long run

Monopoly A single firm serves an entire market for a good that has no close substitutes Why are some markets monopolized? -Cost advantages over other firms -Government created

Monopolists are price makers Amount of output they sell responds continuously as a function of the price they charge In fact, they can charge a price above MC—they have market power

Operate where MR=MC What is MR? -MR= ∆R /∆Q= ∆(PxQ)/∆Q =P[1+1/E] -So, P[1+1/E]=MC Price is marked-up over marginal cost

What is a Game? A game describes any situation: – involving the interaction of two or more individuals –in which the individuals can make choices that affect the “outcome” of the interaction

How Do We Describe a Game? A game is described by: –number of players/agents –the “strategies” available to each player –each player’s preferences over outcomes of the game For any game, a strategy choice by each one of the players results in a unique outcome of the game

What is a Strategy? A strategy is an action plan for a player. It specifies: – what action the player takes –when the player takes the action –the way that the action choice depends on the information the player has when taking the action Two action plans that specify different actions represent two different strategies

Dominant Strategy -yields at least as high a payoff as any other strategy available to agent regardless of strategy choices of other agents

Predicting Behavior in Games If games are to help us understand observables, we need a way of predicting how agents behave in game settings; i.e., we need a notion of equilibrium for games Some equlibrium notions: Dominant strategy equilibrium Nash equilibrium

Dominant Strategy Equilibrium Roughly speaking a Dominant strategy equilibrium has the feature that each player’s strategy choice is best for that player regardless of other players’ strategy choices

Nash Equilibrium Roughly speaking a Nash equilibrium has the feature that each player’s strategy choice is best for that player given other players’ strategies –each player acts in a purely self-interested way and seeks to be as “well off” as possible –in making a strategy choice, each player forms beliefs about what strategies the other players are choosing –These beliefs are correct in equilibrium