1. Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Managerial Economics & Business Strategy Chapter 10 Game Theory: Inside Oligopoly

2. 10-2 Figure 1 The Four Types of Market Structure Copyright © 2004 South-Western Tap water Cable TV Monopoly (Chapter 15) Novels Movies Monopolistic Competition (Chapter 17) Tennis balls Crude oil Oligopoly (Chapter 16) Number of Firms? Perfect Wheat Milk Competition (Chapter 14) Type of Products? Identical products Differentiated products One firm Few firms Many firms

3. 10-3 MARKETS WITH ONLY A FEW SELLERS  Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest.

4. 10-4 MARKETS WITH ONLY A FEW SELLERS  Characteristics of an Oligopoly Market –Few sellers offering similar or identical products –Interdependent firms –Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost

5. 10-5 A Duopoly Example  A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly.

6. 10-6 Table 1 The Demand Schedule for Water Copyright © 2004 South-Western

7. 10-7 A Duopoly Example  Price and Quantity Supplied –The socially efficient quantity of water is 120 gallons, but a monopolist would produce only 60 gallons of water. –So what outcome then could be expected from duopolists?

8. 10-8 Competition, Monopolies, and Cartels  The duopolists may agree on a monopoly outcome. –Collusion An agreement among firms in a market about quantities to produce or prices to charge. –Cartel A group of firms acting in unison.

9. 10-9 Competition, Monopolies, and Cartels  Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy.

10. 10-10 The Equilibrium for an Oligopoly  A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen.

11. 10-11 The Equilibrium for an Oligopoly  When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition.

12. 10-12 Equilibrium for an Oligopoly  Summary –Possible outcome if oligopoly firms pursue their own self-interests: Joint output is greater than the monopoly quantity but less than the competitive industry quantity. Market prices are lower than monopoly price but greater than competitive price. Total profits are less than the monopoly profit.

13. 10-13 How the Size of an Oligopoly Affects the Market Outcome  As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market.  The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

14. 10-14 GAME THEORY AND THE ECONOMICS OF COOPERATION  Game theory is the study of how people behave in strategic situations.  Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action.

15. 10-15 Game Environments  Players’ planned decisions are called strategies.  Payoffs to players are the profits or losses resulting from strategies.  Order of play is important: –Simultaneous-move game: each player makes decisions without knowledge of other players’ decisions. –Sequential-move game: one player observes its rival’s move prior to selecting a strategy.

16. 10-16 Game Environments  Frequency of rival interaction –One-shot game: game is played once. –Repeated game: game is played more than once; either a finite or infinite number of interactions.

17. 10-17 Theory  Normal Form Game – representation indicating the players, their possible strategies, and the strategy payoffs.

18. 10-18 The Prisoners’ Dilemma  The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation.  Often people (firms) fail to cooperate with one another even when cooperation would make them better off.

19. 10-19 Figure 2 The Prisoners’ Dilemma Copyright©2003 Southwestern/Thomson Learning Bonnie’ s Decision Confess Bonnie gets 8 years Clyde gets 8 years Bonnie gets 20 years Clyde goes free Bonnie goes free Clyde gets 20 years gets 1 yearBonnie Clyde gets 1 year Remain Silent Remain Silent Clyde’s Decision

20. 10-20 A Normal Form Game Player 2 Player 1 12,11 11,1214,13 11,1010,1112,12 10,1510,1313,14

21. 10-21 Dominant Strategy  Regardless of whether Player 2 chooses A, B, or C, Player 1 is better off choosing “a”!  “a” is Player 1’s Dominant Strategy! Player 2 Player 1 12,11 11,1214,13 11,1010,1112,12 10,1510,1313,14

22. 10-22 Putting Yourself in your Rival’s Shoes  What should player 2 do? – 2 has no dominant strategy! – But 2 should reason that 1 will play “a”. –Therefore 2 should choose “C”. Player 2 Player 1 12,11 11,1214,13 11,1010,1112,12 10,1510,1313,14

23. 10-23 The Outcome  This outcome is called a Nash equilibrium: –“a” is player 1’s best response to “C”. –“C” is player 2’s best response to “a”. Player 2 Player 1 12,11 11,1214,13 11,1010,1112,12 10,1510,1313,14

24. 10-24 Secure Strategy  Suppose a player has no dominant strategy?  Secure strategy – guarantees the highest payoff given the worst possible scenario.  In the following table the secure strategy for B is RIGHT.  A guaranteed payoff of 8 is better than a guaranteed payoff of 7.

25. 10-25 Normal-Form Game PLAYER B StrategyLEFTRIGHT PLAYER AUP10, 2015, 8 DOWN-10, 710, 10

26. 10-26 The Prisoners’ Dilemma  The dominant strategy is the best strategy for a player to follow regardless of the strategies chosen by the other players.

27. 10-27 The Prisoners’ Dilemma  Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player.

28. 10-28 Figure 3 An Oligopoly Game Copyright©2003 Southwestern/Thomson Learning Iraq’s Decision High Production High Production Iraq gets $40 billion Iran gets $40 billion Iraq gets $30 billion Iran gets $60 billion Iraq gets $60 billion Iran gets $30 billion Iraq gets $50 billion Iran gets $50 billion Low Production Low Production Iran’s Decision

29. 10-29 Figure 4 An Arms-Race Game Copyright©2003 Southwestern/Thomson Learning Decision of the United States (U.S.) Arm U.S. at risk USSR at risk U.S. at risk and weak USSR safe and powerful U.S. safe and powerful USSR at risk and weak U.S. safe USSR safe Disarm Decision of the Soviet Union (USSR)

30. 10-30 Figure 5 An Advertising Game Copyright©2003 Southwestern/Thomson Learning Marlboro’ s Decision Advertise Marlboro gets $3 billion profit Camel gets $3 billion profit Camel gets $5 billion profit Marlboro gets $2 billion profit Camel gets $2 billion profit Marlboro gets $5 billion profit Camel gets $4 billion profit Marlboro gets $4 billion profit Don’t Advertise Don’t Advertise Camel’s Decision

31. 10-31 Figure 7 Jack and Jill Oligopoly Game Copyright©2003 Southwestern/Thomson Learning Jack’s Decision Sell 40 Gallons Sell 40 Gallons Jack gets $1,600 profit Jill gets $1,600 profit Jill gets $2,000 profit Jack gets $1,500 profit Jill gets $1,500 profit Jack gets $2,000 profit Jill gets $1,800 profit Jack gets $1,800 profit Sell 30 Gallons Sell 30 Gallons Jill’s Decision

32. 10-32 Key Insights  Look for dominant strategies.  Put yourself in your rival’s shoes.

33. 10-33 Infinitely Repeated Games  A game that is repeated forever in which players receive a payoff after each play of the game.  A dollar earned during the first repetition of the game is worth more than a dollar earned later.  Players must discount future earnings when making current decisions.

34. 10-34 Infinitely Repeated Games  Trigger strategy – contingent on the past plays of players in a game.  Continue to choose the same action as you have in the past as long as everyone else does the same.  If someone “cheats” then trigger a punitive strategy which will continue forever or until the players trust each other again.

35. 10-35 Infinitely Repeated Games  There is a short term benefit to cheating on an agreement.  The cheater must determine whether that short term benefit warrants triggering punitive actions by competitors.  If the discounted value of the income stream realized by complying with an agreement is less than the one-time gain from cheating, then it is worthwhile to cheat.

36. 10-36 Multi-Stage Games  Allows players to make sequential rather than simultaneous decisions.  Extensive-form game – summarizes who the players are, information available at each stage of the game, strategies available, order of the moves of the game, and the payoffs that result.

37. 10-37 Pricing to Prevent Entry: A Multi-Stage Game  Two firms: an incumbent and potential entrant.  Potential entrant’s strategies: –Enter. –Stay Out.  Incumbent’s strategies: –{if enter, play hard}. –{if enter, play soft}. –{if stay out, play hard}. –{if stay out, play soft}.  Move Sequence: –Entrant moves first. Incumbent observes entrant’s action and selects an action.

38. 10-38 The Pricing to Prevent Entry Game in Extensive Form Entrant Out Enter Incumbent Hard Soft -1, 1 5, 5 0, 10

39. 10-39 Identify Nash Equilibrium Entrant Out Enter Incumbent Hard Soft -1, 1 5, 5 0, 10

40. 10-40 Two Nash Equilibria Entrant Out Enter Incumbent Hard Soft -1, 1 5, 5 0, 10 Nash Equilibria Strategies {player 1; player 2}: {enter; If enter, play soft} {stay out; If enter, play hard}

41. 10-41 Insights  Establishing a reputation for being unkind to entrants can enhance long-term profits.  It is costly to do so in the short-term, so much so that it isn’t optimal to do so in a one-shot game.

42. 10-42 Coordination Games  In many games, players have competing objectives: One firm gains at the expense of its rivals.  However, some games result in higher profits by each firm when they “coordinate” decisions.

43. 10-43 Examples of Coordination Games  Industry standards –DVD format –size of Compact Discs.  National standards –electric current. –traffic laws.

44. 10-44 A Coordination Game in Normal Form FIRM B 120 VOLTS90 VOLTS FIRM A120 VOLTS$100, 100$0, 0 90 VOLTS$0, 0$100, 100

45. 10-45 Key Insights:  Not all games are games of conflict.  Communication can help solve coordination problems.  Sequential moves can help solve coordination problems.

46. 10-46 PUBLIC POLICY TOWARD OLIGOPOLIES  Cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too low and prices that are too high.

47. 10-47 Restraint of Trade and the Antitrust Laws  Antitrust laws make it illegal to restrain trade or attempt to monopolize a market. –Sherman Antitrust Act of 1890 –Clayton Act of 1914

48. 10-48 Controversies over Antitrust Policy  Antitrust policies sometimes may not allow business practices that have potentially positive effects: –Resale price maintenance –Predatory pricing –Tying