1. Chapter Oligopoly Game Theory Models 17

2. Oligopoly – Only a few sellers ( M) – Offer similar or identical products No product differentiation – Interdependent Because of small numbers 2

3. 3 Strategic Behavior Perfect Competition – Only strategy is to reduce costs (and earn short-run econ profits) Price-taker => output decisions do not affect market price – cross-price elasticity = -1 (perfect substitutes) – Own-price = - ∞ Monopoly – Price-Searcher: output decision determines price Cross-price = 0 (no substitutes) Own-price: < |1| – Sets market/firm price by output decision (and consumers’ WTP) – May try and prevent entry by new firms (patents, trademarks) Oligopoly – Cross-price elasticity > 0 – Own-price elasticity < |1| – Will have to take into account actions of other similar firms when making output/pricing decisions – Much more strategy

4. Markets with Only a Few Sellers A small group of sellers – Tension between cooperation and self-interest – Cooperation (Cournot strategy) Acting like a monopolist – Produce a smaller quantity of output -> set quotas – Maximizes profit for the industry – Charge P >MC -> creates incentive for “cheating” – Non-cooperative – Self Interest - cares only about its own profit – Powerful incentives ($$$$) not to cooperate/cheat – More elaborate game theory (single and multiple equilibria) 4

5. 5 Oligopoly Behavior Cooperative Oligopoly – Cartels Agree to collude; act/price like a single firm monopolist - Cournot – Price leadership (Stackleberg leader) Dominant firm establishes the price; other firms react to “leader” Non-cooperative Oligopolies – Sticky prices (kinked demand curve) Sticky upward – Single Nash equilibrium (similar outcome as Stackelberg leader model) Characterized by stable prices – Multiple Nash equilibria – more like Perfect Competition Completely rivalarous

6. A Cartel – Collusion Among Suppliers Three steps: (Cournot Strategy –cooperative) – Determine Profit Max Output –same as monopolist (MR(mkt) = MC(both) @ Q=20) – Determine price (at Q=20 -> P= $48) – Allocate quotas and don’t cheat What is Q for each firm at MC(mkt) (=$20)? 6

7. 7 An Economic Application of Game Theory: the Kinked-Demand Curve Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point price war

8. 8 Nash Equilibrium If firm facing kinked demand curve tries to raise price: – Other firms do not – As demand is highly elastic and other firms are “close” substitutes – Loses market share and revenues If firm lowers price – Competitors match price decreases Could be a Stackleberg leader/dominant firm or “passive” collusion

9. Markets with Only a Few Sellers Game Theory – What is it? "the study of mathematical models of conflict and cooperation between intelligent rational decision-makers“mathematical models Examines alternative strategies and payoffs to the “players” in order to determine their incentives/motivation, model their actions/reactions, and determine if there is a “stable” (unchanging) outcome 9

10. Markets with Only a Few Sellers Game Theory – Is the outcome stable (unchanging)? If so then there a single equilibria (one set of choices best for all -> will be stable)? Types of Nash equilibrium – (Single) Dominant Strategy (Stable) – Multiple Equilibria – outcome fluctuates – Stability will require collusion/agreement 10

11. Markets with Only a Few Sellers Types of Nash equilibrium – (Single) Dominant Strategy (Stable) Strategy that is best for a player in a game, Regardless of the strategies chosen by the other players – Multiple Equilibria Best strategy for player A depends on B’s choice Unstable – may require collusion 11

12. 12 Game Theory Game theory is a methodology that can be used to analyze both cooperative and non- cooperative oligopolies. – Recognizes the interdependence of the firms’ actions Using a payoff matrix to describe options (strategies) and payoffs – Firms are profit maximizers!

13. 13 Figure 12.7 Xbox and PlayStation 2 Payoff Matrix for Advertising Only Strategic Choices: Advertise, or Not Payoff matrix shows payoffs under 4 alternative combinations of strategies

14. Markets with Only a Few Sellers Types of Nash equilibrium – (Single) Dominant Strategy (Stable) Strategy that is best for a player in a game, regardless of the strategies chosen by the other player(s) Best strategy – each firm chooses to advertise their products Payoff (profit) is best when one firm advertises, regardless of what the competitor does (ad or not) Each will choose to advertise Does not require an agreement/collusion Just Do It! (Regardless of what the other guy does!) 14

15. 15 Multiple Equilibria Sometimes there are come cases where there are multiple Nash equilibria. – In this case, the outcome is uncertain/unpredictable unless they collude (agree to target only 1 of the markets and not compete in the other’s) An example: – Sony/Microsoft can create games for either one of two new markets One set of games appeals only to YOUTH market (PG) Other set appeals only to TEEN market (R17) Incentive to reach agreement on both firms offering the same new (one only) feature – Compete? Or agree to split the markets?

16. 16 Payoff Table Multiple Nash Equilibria

17. 17 Multiple Equilibria An example: – Sony/Microsoft can add one of two new features One feature appeals only to YOUTH market Other feature appeals only to TEEN market Two Strategies – Produce in the same markets and compete against each other for customers – Each firm produces in the one market where their competitor isn’t producing games Requires agreement on a) which market you will produce games for and b) agree not to compete in the other market If both firms produce games for the same market ( Y or T) then competition drives prices and profits down (it’s a PC world) Howev

18. 18 Multiple Equilibria Two Strategies – Produce in the same market – Produce in different Outcome – If both firms produce games for the same market ( Y or T) then competition drives prices and profits down (it’s a PC world) – If agree to produce in different markets and not compete Monopoly power -> monopoly profits But have to “cede” the other market to your competitor

19. Markets with Only a Few Sellers Game Theory What are we looking for? – Is the outcome stable (unchanging)? – Single or multiple equilibria? – How does it model behavior? – Economic actors interacting with one another – Each choose their best strategy Given the strategies that all the other actors have chosen -use a pay-off matrix to look at options 19

20. Nash Equilibrium 20 Nash equilibrium a solution to a non-cooperative game involving two or more playerssolution non-cooperative game each player is assumed to know the equilibrium strategies of the other playersequilibrium strategies no player has anything to gain by changing only his own strategy unilaterally Hence, a Nash equilibrium will be stable (once you get there!)

21. 21 Prisoner's Dilemma – Unstable Games A prisoner’s dilemma occurs when the dominate strategy leads all players to an undesired outcome. No single dominant strategy, multiple nash equilibria, but requires “strong” cooperation – how would you know what the other party is going to do? – How do you “enforce” their choice – Unstable/unpredictable

22. 22 Figure 12.9 Prisoners’ Dilemma

23. A Cartel – Collusion Among Suppliers Two strategies – 1) cooperate – charge Monopoly price and restrict output to cartel authorized quota – 2) cheat – increase output above quota (price will drop to = MC) And then what does the other firm do? 23

24. Figure Jill gets $1,500 profit Jill gets $1,600 profit Jill gets $1,800 profit Jill gets $2,000 profit Jack gets $1,600 profit Jack gets $1,500 profit Jack gets $2,000 profit Jack gets $1,800 profit Jack and Jill’s Oligopoly Game – Cartel as Game Theory 2 24 Jack’s decision High production: 40 GallonsLow production: 30 Gallons Jill’s Decision High production: 40 Gallons Low production: 30 Gallons In this game between Jack and Jill, the profit that each earns from selling water depends on both the quantity he or she chooses to sell and the quantity the other chooses to sell.

25. The Economics of Cooperation Other examples of prisoners’ dilemma Common resources – Two companies – own a common pool of oil – Strategies Each company drills one well Each company drills a second well – Get more oil – Dominant strategy Each company drills two wells – Lower profit 25

26. Figure Texaco gets $3 million profit Texaco gets $4 million profit Texaco gets $5 million profit Texaco gets $6 million profit Exxon gets $4 million profit Exxon gets $3 million profit Exxon gets $6 million profit Exxon gets $5 million profit A Common-Resources Game 4 26 Exxon’s Decision Drill Two WellsDrill One Well Texaco’s Decision Drill Two Wells Drill One Well In this game between firms pumping oil from a common pool, the profit that each earns depends on both the number of wells it drills and the number of wells drilled by the other firm.

27. Markets with Only a Few Sellers Game Theory – Other factors that affect the outcome (or add details to the game) – What does everybody know? Does each player know the payoff and strategy for all? Who moves first? Or do both move at the same time? – Is this a repeated game? Do you play only once or do we do it again? – Can we “learn” from past moves? 27

28. The Economics of Cooperation The prisoners’ dilemma and the welfare of society Dominant strategy – Noncooperative equilibrium May be bad for society and the players – Arms race game – Common resource game May be good for society – Quantity and price – closer to optimal level 28

29. The Economics of Cooperation Why people sometimes cooperate Game of repeated prisoners’ dilemma – Repeat the game – Agree on penalties if one cheats – Both have incentive to cooperate 29

30. Repeated prisoners’ dilemma – Encourage cooperation Penalty for not cooperating – Better strategy Return to cooperative outcome after a period of noncooperation – Best strategy: tit-for-tat Player - start by cooperating – Then do whatever the other player did last time Starts out friendly Penalizes unfriendly players Forgives them if warranted The prisoners’ dilemma tournament 30

31. Public Policy Toward Oligopolies Restraint of trade and the antitrust laws Common law: antitrust laws – The Sherman Antitrust Act, 1890 Elevated agreements among oligopolists from an unenforceable contract to a criminal conspiracy – The Clayton Act, 1914 Further strengthened the antitrust laws – Used to prevent mergers – Used to prevent oligopolists from colluding 31

32. – Robert Crandall - president of American Airlines – Howard Putnam - president of Braniff Airways CRANDALL: I think it’s dumb as hell... to sit here and pound the @#$% out of each other and neither one of us making a #$%& dime. PUTNAM: Do you have a suggestion for me? CRANDALL: Yes, I have a suggestion for you. Raise your $%*& fares 20 percent. I’ll raise mine the next morning. PUTNAM: Robert, we... CRANDALL: You’ll make more money, and I will, too. PUTNAM: We can’t talk about pricing! CRANDALL: Oh @#$%, Howard. We can talk about any &*#@ thing we want to talk about. An illegal phone call 32

33. The Economics of Cooperation Other examples of prisoners’ dilemma Arms races – After World War II, United States and the Soviet Union Engaged in a prolonged competition over military power – Strategies Build new weapons Disarm – Dominant strategy: Arm 33

34. USSR at risk and weakUSSR at riskUSSR safe USSR safe and powerful U.S. at riskU.S. at risk and weakU.S. safe and powerfulU.S. safe An arms-race game 3 34 Decision of the United States (U.S.) ArmDisarm Decision of the Soviet Union (USSR) Arm Disarm In this game between two countries, the safety and power of each country depend on both its decision whether to arm and the decision made by the other country

35. Markets with Only a Few Sellers How the size of an oligopoly affects the market outcome More sellers – Transaction costs are higher with more Getting to together to set prices, quotas Enforcing agreement – Form a cartel - Maximize profit Produce monopoly quantity Charge monopoly price Difficult to reach & enforce an agreement 35

36. Markets with Only a Few Sellers How the size of an oligopoly affects the market outcome More sellers – Do not form a cartel – Each firm: The output effect – P > MC – Sell one more unit: Increase profit The price effect – Increase production: increase total amount sold – Decrease in price: Lower profit 36

37. Markets with Only a Few Sellers How the size of an oligopoly affects the market outcome – As the number of sellers in an oligopoly grows larger Oligopolistic market - looks more like a competitive market Price - approaches marginal cost Quantity produced – approaches socially efficient level 37

38. Public Policy Toward Oligopolies Controversies over antitrust policies Resale price maintenance (fair trade) – Require retailers to charge customers a given price – Might seem anticompetitive Prevents the retailers from competing on price – Defenders: Not aimed at reducing competition Legitimate goal – Some retailers offer service 38

39. Public Policy Toward Oligopolies Controversies over antitrust policies Predatory pricing – Charge prices that are too low Anticompetitive – Price cuts may be intended to drive other firms out of the market – Skeptics Predatory pricing – not a profitable strategy Price war - to drive out a rival – Prices - driven below cost 39

40. Public Policy Toward Oligopolies Controversies over antitrust policies Tying – Offer two goods together at a single price Expand market power – Skeptics Cannot increase market power by binding two goods together – Form of price discrimination Tying may increase profit 40

41. U.S. government’s suit against the Microsoft Corporation, 1998 – Central issue: tying Should Microsoft be allowed to integrate its Internet browser into its Windows operating system The government’s claim: – Microsoft was bundling - to expand market power into the market of Internet browsers – Would deter other software companies from entering the market and offering new products The Microsoft case 41

42. Microsoft responded – New features into old products - natural part of technological progress Cars - include CD players, air conditioners Cameras - built-in flashes Operating systems - added many features to Windows – Previously stand-alone products – Computers - more reliable and easier to use – Integration of Internet technology, The next natural next step The Microsoft case 42

43. Disagreement – Extent of Microsoft’s market power The government – More than 80% of new personal computers Use a Microsoft operating system Substantial monopoly power Microsoft – Software market is always changing – Competitors: Apple Mac & Linux operating systems – Low price – limited market power The Microsoft case 43

44. November 1999 ruling Microsoft - great monopoly power Illegally abused that power June 2000 Microsoft – to be broken up into two companies – Operating system & Applications software 2001, appeals court – Overturned the breakup order September 2001 – Justice Department - wanted to settle the case quickly The Microsoft case 44

45. Settlement: November 2002 – Microsoft – some restrictions – Government – browser would remain part of the Windows operating system Private antitrust suits Suits brought by the European Union – Alleging a variety of anticompetitive behaviors The Microsoft case 45