Oligopoly and Strategic Behavior

Oligopoly and Strategic Behavior
13 Oligopoly and Strategic Behavior

Duopoly Collusion Cartel
Agreement among rivals specifying prices or quantities Firms ask: “What would a monopoly do?” and then do that action Cartel Two or more firms acting in unison to form a joint monopoly Lecture notes: A monopoly is just one firm. A duopoly has just two firms. The duopolists say “We’re so close to a monopoly What would a monopolist do with price and quantity? Let’s agree and cooperate (instead of compete) to get to the monopoly price and output.” A cartel is a joint monopoly among multiple firms. The industry profits will be equal to monopoly profits, and then these profits are split among the firms in the cartel.

Mutual Interdependence
A market situation in which the actions of one firm have an impact on the price and output of its competitors AT-Phone’s response depends on the actions of Horizon, and Horizon’s response depends on the actions of AT-Phone Note the difference between interdependence and independence Lecture notes: Interdependence occurs in oligopoly due to the size of each individual firm. When one firm owns a sizable share of the market, the decisions made by that one firm affect the market in a noticeable way, and therefore affect the decisions of competing firms. Independence occurs in perfect competition. If each firm is just a “drop in the bucket” compared to the size of the industry, one competitor’s actions will have no noticeable effect on the market, and thus firms will choose actions independently of other firms.

Nash Equilibrium Nash Equilibrium
An economic decision maker has nothing to gain by changing its own strategy without collusion Nobody wants to change their strategy given that the other firm does not change their strategy A “stable” outcome where nobody wants to move from their current position Often discussed with game theory, and easier to see when games are drawn in matrix form Lecture notes: The example we just explored above, featuring AT-Phone and Horizon, was an example of a Nash Equilibrium. The best strategy for AT-Phone and Horizon is to increase their output to 400 customers each. When both firms reach that level of output, neither has an incentive to change. Bear in mind that the rivals can do better if they collude. Under collusion, each rival serves 300 customers and their combined profits rise. However, as we saw, if one rival is willing to break the cartel, it will make more profit if it services 400 customers ($30,000) while the other firm continues to serve only 300 ($22,500). The firms continue to challenge each other until they reach a combined output level of 800 customers. At this point the market reaches Nash Equilibrium and neither firm has a reason to change its short-term profit-maximizing strategy.

Game Theory Game theory Basic components of a game
Branch of mathematics that economists use to analyze the strategic behavior of decision makers Can help us determine what level of cooperation is most likely among players in a game Basic components of a game Players Strategies Payoffs Lecture notes: For game theory, note that we can often represent simultaneous games (where players make a decision at the same time) as a matrix. The matrix can show clearly the three elements of game theory we can examine in this chapter. Players Strategies Payoffs

Strategic Behavior and the Dominant Strategy
Prisoner’s dilemma Two suspects are interrogated separately They each have the option to confess or keep quiet Possible outcomes of prisoner’s dilemma If both suspects keep quiet, each suspect will serve only a small time in jail If both confess, both will serve 10 years in jail If one suspect confesses and the other remains quiet, the suspect who confesses goes free, while the suspect who kept quiet serves 25 years in jail Lecture tip: You can briefly explain the game here, but it may be best to go over the players, strategies, and payoffs while showing the game in matrix form on the next slide. The story here is important because students need to know the following: The prisoners are separated (they don’t know what choice the other prisoner will make) The prisoners are aware of their choices, the other prisoner’s choices, and all the possible payoffs.

Presenting The Prisoner’s Dilemma
Players Strategies Payoffs Thelma Confess Keep Quiet Louise 10 years in jail 25 years in jail goes free 1 year in jail Lecture tip: This slide is just about presenting the game, and defining elements of the game. No intuition about dominant strategies is given until the next slide. Discuss the three parts of the game shown in the matrix: Players (Louise and Thelma) Strategies (Confess and Keep Quiet) In this game, each player has the same two strategies. However, note that there are games where players may have different strategies or even a different number of strategies. I may have two strategies, and you may have three strategies. The strategies are not always the same for all players. Payoffs (Years in jail, or going free) The players, strategies, and payoffs are color-coordinated to help understanding of the matrix. Information: the players each know their own strategies, the other player’s strategies, and the possible payoffs. Examining payoffs: Note that there are four possible outcomes of this game. For example: If Louise confesses and Thelma confesses, Louise gets 10 years in jail, and Thelma gets 10 years in jail. If Louise keeps quiet and Thelma confesses, Louise gets 25 years in jail, and Thelma goes free.

Analyzing The Prisoner’s Dilemma
Louise Best to Confess or Keep Quiet? Best for Louise to Confess no matter what Thelma does! Thelma Best to Confess or Keep Quiet? Best for Thelma to Confess no matter what Louise does! Thelma Confess Keep Quiet Louise 10 years in jail 25 years in jail goes free 1 year in jail IMPORTANT Lecture tip: Click through this slide one “animation” at a time, and explain each step thoroughly. This may be a long slide… Every time you see (*) in the teaching notes, you should click to the next animation. Ask the students: Which outcome do you think we will arrive at? What is the “best” strategy for each player (Louise and Thelma) to choose? (*)Start with Louise: Louise needs to ask herself: What my best response to Thelma’s possible strategies? In other words, what is the best thing for Louise to do if Thelma confesses? What is the best thing for Louise to do if Thelma keeps quiet? (*)Suppose Thelma confesses: (looking at the LEFT COLUMN) (*)If Louise had confessed, Louise would get 10 years in jail. (*)If Louise had kept quiet, Louise would get 25 years in jail. (*)Thus, confessing is the best response for Louise if Thelma confesses. (10 years in jail is better than 25 years in jail) (*)Suppose Thelma kept quiet: (looking at the RIGHT COLUMN) (*)If Louise had confessed, Louise would get go free and get 0 years in jail! (*)If Louise had kept quiet, Louise would get 1 year in jail. (*)Thus, confessing is best response for Louise if Thelma kept quiet. (0 years in jail is better than 1 year in jail) (*)We see that it is best for Louise to confess, NO MATTER WHAT THELMA DOES!!! This is what we call a dominant strategy. (*)Now, we examine Thelma. Thelma needs to ask herself: What my best response to Louise’s possible strategies? In other words, what is the best thing for Thelma to do if Louise confesses? What is the best thing for Thelma to do if Louise keeps quiet? (*)Suppose Louise confesses: (looking at the TOP ROW) (*)If Thelma had confessed, Thelma would get 10 years in jail. (*)If Thelma had kept quiet, Thelma would get 25 years in jail. (*)Thus, confessing is the best response for Thelma if Louise confesses. (*)Suppose Louise kept quiet: (looking at the BOTTOM ROW) (*)If Thelma had confessed, Thelma would get go free and get 0 years in jail! (*)If Thelma had kept quiet, Thelma would get 1 year in jail. (*)Thus, confessing is best response for Thelma if Louise kept quiet. (*)We see that it is best for Thelma to confess, NO MATTER WHAT LOUISE DOES!!! Thelma also has a dominant strategy of confess. Each player will play their dominant strategy, because each player is a rational individual that wants to maximize HER OWN payoffs.

Interesting Result of this Game
Nash equilibrium Payoffs that will result Thelma Confess Keep Quiet Louise 10 years in jail 25 years in jail goes free 1 year in jail Outcome with the overall best sum of payoffs Lecture tip: Examine the table again. Each player decides to confess, but this means they each spend 10 years in jail. If you examine the table closely, you’ll see that there is another outcome (both keeping quiet) in which BOTH players will be better off by spending only one year in jail. Thus, the Nash equilibrium of the game is NOT Pareto optimal, because there is another outcome in which both players could be better off. That is why it’s called the “dilemma.” Both prisoners could spend just a small time in jail, but we’ll end up at an equilibrium where they both spend a lot of time in jail. The reason for this outcome is that confessing is a dominant strategy for both players. It’s better for each player to confess, no matter what the other player does.

Game Theory Dominant strategy Nash equilibrium implications?
A best response for a player to choose no matter what the other player chooses Not all games or players in a game have a dominant strategy Nash equilibrium implications? If both players have a dominant strategy, the intersection of those dominant strategies will be the Nash equilibrium. Neither player will want to unilaterally deviate. Lecture notes: A rational player will always choose their dominant strategy. An individual will always want to maximize his payoffs (utility). Unilaterally deviate means that I would want to change my strategy if you don’t. If I do NOT want to unilaterally deviate, it means that I do NOT want to change (deviate) from my current strategy, given that you don’t change your strategy.

Duopoly and the Prisoner’s Dilemma
AT-Phone Low High Horizon $27,000 $30,000 $22,500 $24,000 An outcome that is better for both players Nash equilibrium payoffs that will result Lecture notes: This is a duopoly firm game, similar to the prisoner’s dilemma. Each firm can choose LOW or HIGH production. LOW = 300 consumers HIGH = 400 consumers The payoffs are given in profits for the firm. Higher profits are better! Examine the table. Ask the students the following questions: What is the dominant strategy for each firm? What is the Nash equilibrium of this game? How is this similar to the prisoner’s dilemma? Then, analyze the table: The dominant strategy is to produce HIGH. Look at Horizon. $30,000 >$27,000 (if AT-Phone produces low), and $24,000 > $22,500 (if AT-Phone produces HIGH). The same numbers are compared for AT-Phone. The dominant strategy for each firm is HIGH production. The Nash equilibrium is (HIGH, HIGH), with payoffs of ($24,000; $24,000). This is shown by the purple box. Click to animate. This is similar to the prisoner’s dilemma because both firms would be better if they chose (LOW, LOW). There is a strong incentive to produce HIGH, since HIGH is the dominant strategy, even though this Nash equilibrium of (HIGH, HIGH) is not Pareto optimal. (There exists another outcome in which both players are better off). This is shown by the yellow box. Click to animate. (LOW, LOW) would be a cartel outcome if the firms colluded to become a joint monopoly. However, each firm would have a strong incentive to “break” that deal and overproduce.

Advertising and the Prisoner’s Dilemma
Coca-Cola Advertises Does Not Advertise Pepsico $100 M $75 M $150 M $125 M Nash equilibrium payoffs that will result An outcome that is better for both players Lecture notes: This is a duopoly firm game, similar to the prisoner’s dilemma. Each firm can choose Advertise or Do Not Advertise production. Examine the table. Ask the students the following questions: What is the dominant strategy for each firm? What is the Nash equilibrium of this game? How is this similar to the prisoner’s dilemma? Short analysis: The dominant strategy for Pepsico is advertise > 75, and 150 > 25. The dominant strategy for Coca-Cola is advertise > 75, and 150 > 25. The intersection of the dominant strategies is the Nash equilibrium. Long analysis: The dominant strategy is to Advertise. Look at Pepsico. $100M >$75M (if Coca-Cola Advertises), and $150M > $125M (if Coca-Cola does NOT advertise). The same numbers are compared for Coca-Cola. The dominant strategy for each firm is Advertise. The Nash equilibrium is (Advertise, Advertise), with payoffs of ($100M; $100M). This is similar to the prisoner’s dilemma because both firms would be better if they each chose NOT to advertise. There is a strong incentive to Advertise, since Advertise is the dominant strategy, even though this Nash equilibrium of (Advertise, Advertise) is not Pareto optimal. (There exists another outcome in which both players are better off, and that outcome is for no one to advertise).

Intuition of Advertising Prisoner’s Dilemma
Costly Purpose: increase product demand If both firms advertise, expenses go up, but demand increases; each cancels other out “Arms race” of advertising Lecture notes: End result: If both firms advertise, there is no real demand increase for either product. However, both firms still have to pay for the ad campaign, so costs are higher, and profits are lower. Picture: Two firms are advertising right next to each other! In the picture, this type of advertising is pretty cheap, but most advertising (TV, radio, Internet), can get very expensive.

Cigarette Advertising on TV
In 1970, Congress enacted a law making cigarette advertising on TV illegal Reasoning: too many ads being seen by children and teens Goal: reduce smoking among all ages Unintended consequence This actually increased the economic profits of cigarette makers The law ended their prisoner’s dilemma of advertising “Beyond the Book” Slide Before the law was passed manufacturers spent $300 million on advertising—$60 million more than they spent the year after the law was enacted. Much of this saving in advertising expense was reflected in higher profits at the end of the year. But if eliminating advertising made them more profitable, why didn’t they do it on their own? Once again, because advertising was a dominant strategy.

Escaping the Prisoner’s Dilemma in the Long Run
The Nash equilibrium in prisoner dilemma games may give the best short run payoffs However, Many games are repeated This repetition occurs over a longer time span Dominant strategies may not consider long-run benefits of cooperation Lecture notes: An individual must consider short run and long run payoffs. What if we play the game more than once? If I hurt the opponent today, will he hurt me back tomorrow?

Escaping the Prisoner’s Dilemma in the Long Run
Tit for tat A long run strategy designed to create cooperation among participants Strategy: mimic the decision your opponent made in the previous round. Changes the incentives and encourages cooperation Useful because interactions in life occur over the long run. Relationships between people and businesses involve mutual trust. Lecture notes: Key idea: A game is played multiple times. At the end of each “round,” the strategies chosen are revealed and payoffs are given. If you hurt me in round 1, I hurt you in round 2. We eventually see that hurting each other is bad in the long run, so we start to cooperate.

Caution About Game Theory
Not all games are like the prisoner’s dilemma Not all games have a dominant strategy Not all games have a pure strategy like the Nash equilibrium Think about Paper, Rock, Scissors Your best response is different, depending on what your opponent throws. There is no dominant hand to play. Lecture tip: Here just emphasize that not all games have a dominant strategy. Not all games have a clear “best” strategy to always play. If that was the case, the outcome of all games would be extremely predictable, assuming rational players participate. In addition, realize that some games involve certain levels of random events each with various probabilities as well (coin flipping, dice rolling).

No Dominant Strategy Lecture notes:
Basically, Joey’s and Rachel’s best responses are different depending on what the opponent does. There is no dominant strategy. In addition, at all outcomes, one player will always want to change strategy. There is no pure strategy Nash Equilibrium in this game as well. Note that this particular game is zero-sum. One person’s win is equal to the other person’s loss. From the Text: In this competition neither Rachel nor Joey has a dominant strategy that guarantees success. Sometimes Joey wins when hitting right, other times he loses the point. Sometimes Rachel wins when she guesses left, other times she loses. When guessing where the ball will be hit each player will only guess correctly half the time. Since we cannot say what each player will do from one point to another there is no Nash equilibrium. Any of the four outcomes are equally likely on successive points and there is no way to predict how the next point will be played. This example was included here so that you would not grow to expect every game to include a prisoner’s dilemma and produce a Nash equilibrium. Game theory, like real life, has many different possible outcomes.

Oligopoly Policy: Antitrust
Antitrust policy Government efforts that attempt to prevent oligopolies from behaving like monopolies Sherman Act of 1890 “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony.” From the Text: Efforts to curtail the adverse consequences of oligopolistic cooperation began with the Sherman Antitrust Act of This was the first federal law to place limits on cartels and monopolies. The Sherman Act was created in response to the increase in the concentration ratios in many leading U.S. industries, including steel, railroads, mining, textiles, and oil. Prior to the passage of the Sherman Act, firms were free to pursue contracts that created mutually beneficial outcomes. Once the act took effect, certain cooperative actions became criminal.

Oligopoly Policy: Antitrust
Clayton Act of 1914 added a few more items that were considered detrimental Price discrimination that lessens competition Exclusive dealings that restrict the ability of a buyer to deal with competitors Tying arrangements (similar to bundling) Mergers that lessen competition Prevents a person from serving as a director on more than one board in the same industry From the Text: Additional legislation, and court interpretations of existing antitrust law, have made it difficult to determine whether or not a company has violated the law. The U.S. Justice Department is charged with oversight but it often lacks the resources to be able to fully investigate every case. Antitrust law is complex and cases are hard to prosecute, but these laws are essential to maintain a competitive business environment. Without effective restraints on excessive market power, firms would organize into cartels more often or find ways to restrict competition.

Predatory Pricing Predatory pricing Examples:
Firms set prices below AVC with the intent of driving rivals from the market Illegal, but difficult to prosecute Often difficult to distinguish between predatory pricing and intense market competition Examples: Wal-Mart is often assumed to be a predator but is never prosecuted Microsoft was prosecuted eventually for tying, but not for predatory pricing Lecture tip: Questions to ask students: Can an incumbent firm survive a temporary loss? Probably. Can a new firm survive losses? Not as likely. What does the incumbent firm do to prices after the newcomer leaves? Raises prices again. The person in the photo is Bill Gates, CEO of Microsoft.

Predatory Pricing Scheme
$ Incumbent Firm’s Price Competitor Enters Competitor Leaves AVC,MC “Beyond the Book” Slide Spirit Airlines accused Northwest Airlines of doing this sort of pricing scheme in the NWA hubs of Minneapolis and Detroit. Story: An incumbent firm is operating its business profitably. A rival enters, hoping to make profits. The incumbent lowers prices so low that they are below AVC. The incumbent firm is even experiencing losses. Eventually, the new competitor leaves. He can’t compete with the super-low price. (Remember that prices send a signal about the profitability of a market.) The incumbent firm raises its prices after the potential competitor exits. Time

Network Externalities
Network externality Occurs when the number of customers who purchase a good influences the quantity demanded Often is a factor in whether the resulting market structure is oligopoly Classic examples include technologies such as cell phones and fax machines A new technology has to reach “critical mass” before it is effective for consumers How useful would a fax machine be if only 10 people had the machine? Lecture notes: Picture: an old-school cell phone. Network externalities allow cell phones to be useful for many people. For example, the sheer size of Facebook makes it a better place to do social networking than MySpace. As a result, Facebook will be able to grow its business even if MySpace, Google, or another rival builds a social networking site with better features. Without enough users the best social networking site is simply an empty shell with no value to the consumer. As a result, the first firm to enter the market is often the one that ends up dominating the industry.

Positive network externalities Bandwagon effect Individual preferences for a good increase as the number of people buying the good increases Internet, social networks, cell phones, fax machines, MMORPGs, video game consoles, fads, night clubs Lecture notes: Positive network externalities The bandwagon effect is a positive feedback loop—popularity makes the good more popular, and it seems like demand can grow rapidly once a tipping point is reached. MMORPRG = Massively multiplayer online role playing game. Think World of Warcraft. The game is popular partly because there are so many people playing it online. It’s even become an advertising point for the game. Facebook is a great example as well. The value of it increases when there are more people you can connect with. These types of externalities can help a product “dominate” the industry when it becomes so large that all other competitors seem small and undesirable by comparison. This domination may lead to the elimination of a competitor with incompatible products. Think about HD-DVD being eliminated by Blu-ray, and Betamax being eliminated by the VCR.

Negative network externalities Snob effect Individual preferences for a good decrease as the number of people buying the good increases Exotic pets and sports cars Hipsters Services that are prone to “congestion.” Pool, beach, student union gets “too crowded,” and you don’t want to go. Lecture notes: Negative network externalities. Beyond high-end pricey stuff like luxury cars, sometimes goods, services, or activities just don’t seem as appealing if there are already a bunch of people consuming the good. Many people don’t like going to clubs, bars, restaurants, or beaches if it will be very loud or crowded. Thus, you could often see that certain goods (perhaps a night club) may have both positive AND negative network externalities at some point as a function of the number of people in the club. Increasing the number of people in the club may make it more desirable (positive), but if it gets TOO crowded, you may not want to go (negative).

Switching costs Costs that are incurred by a consumer when he switches suppliers Another advantage to a firm having a large network Demand for existing product becomes more inelastic if costs of switching to a new product are higher Example: cellphone providers Early termination fees Free in-network calls FTC reduced switching costs in 2003 by requiring phone companies to allow a consumer to take their old phone number to a new provider From the Text: For instance, the transition from listening to music on CDs to using digital music files involved a substantial switching cost for many users. Today, among the many digital music options there are switching costs as well. Once a consumer has established a library of MP3s or uses iTunes, the switching costs of transferring the music from one format to another creates a significant barrier to change. Oligopolists leverage not only the number of customers they maintain in their network, but they also try to make switching to another network more difficult.

Monopolistic Competition
Price Taking Price Making Perfect Competition Monopolistic Competition Oligopoly Monopoly 1. Many firms 1. Few firms 1. One firm 2. Atomistic assumption—firms are so small that no single buyer or seller has ANY control over price 2. Each firm has some control over price 2. Medium to high entry barriers to entry. The firm has more control over price. 2. Extremely high barriers to entry. The firm has significant control over price. 3. Firms are so small that no single buyer or seller has ANY control over price 3. Product differentiation 3. Mutual interdependence 3. The firm IS the industry 4 Homogeneous output 4. Easy entry/exit 4. Long run economic profit possible 4. Long run economic profit probable 5. There is perfect information about product price and quantity 5. Output can be homogenous or differentiated 6. Easy entry/exit Lecture notes: This slide is a concise but informative review of the characteristics of all four market structures.

More Game Theory in Media
This link provides further examples of game theory in media and contains links to video clips “Beyond the Book” Slide Link: Recommendations: the Princess Bride clip and the Murder by Numbers clip.

Conclusion Oligopoly Antitrust policies
A market structure in which there are a small number of firms Firms interact strategically Can be competitive (results closer to monopolistic competition) Can be collusive (results closer to monopoly) Antitrust policies Restrain excessive market power Give incentives to compete instead of collude Each industry examined on a case-by-case basis

Summary Oligopoly: a small number of firms sell a differentiated product in a market with significant barriers to entry. The small number of sellers in oligopoly leads to mutual interdependence. An oligopolist is like a monopolistic competitor in that it sells differentiated products. It is also like a monopolist in that it enjoys significant barriers to entry. Oligopolists have a tendency to collude and to form cartels in hope of achieving monopolylike profits.

Summary Oligopolistic markets are socially inefficient since P > MC. The result under oligopoly will fall somewhere between the competitive and monopoly outcomes. Game theory helps determine when cooperation among oligopolists is most likely. In many cases, cooperation fails to materialize because decision-makers have dominant strategies that lead them to be uncooperative. This causes firms to compete with price, advertising, or R & D when they could potentially earn more profit by curtailing these activities.

Summary A dominant strategy ignores the long run benefits of cooperation and focuses solely on the short run gains Whenever repeated interaction exists, decision-makers fare better under tit for tat, an approach that maximizes the long run profit Antitrust laws are complex and cases are hard to prosecute, but they provide firms an incentive to compete rather than collude The presence of significant positive network externalities causes small firms to be driven out of business or to merge with larger competitors

Practice What You Know Which of the following is most likely to become an oligopoly industry? An industry without entry barriers An industry where economies of scale are very small An industry with sizeable network effects An industry with hundreds of competitors Clicker Question Correct answer: C Noticeable network effects mean that there is only room for a small number of large networks. Oligopoly will develop after networks that are “too small” either go out of business or merge with other networks.

Practice What You Know Which of the following is true about oligopoly?
Oligopolies are illegal in the United States All oligopoly industries will try to collude Oligopoly industries generally have a high concentration ratio Firms in an oligopoly act independently from other firms in the oligopoly Clicker Question Correct answer: C When the industry is very concentrated with the size and power of the market owned by a few firms, we have an oligopoly.

Practice What You Know Why do cartel deals tend not to last?
Each firm in the cartel has a dominant strategy to be uncooperative and defect from the cartel agreement Cartel profits are lower than competitive profits Cartels create more competition Firms know that cartels are often illegal so they break the deal to escape Clicker Question Correct answer: A Looking at a payoff matrix, each firm has a dominant strategy to either overproduce quantity or undercut the price of competitors.

Practice What You Know What is an example of a good with a positive network effect? An online multiplayer game A fast-food burger A dry-cleaning service A cable TV subscription Clicker Question Correct answer: A Online gaming may have a higher demand if you can play with more people (a larger network).

Practice What You Know How can a pure strategy Nash equilibrium be accurately described? It is always the overall best outcome It’s an outcome in which neither player wants to change strategies It can only be reached by collusion One exists in all games Clicker Question Correct answer: B Just by definition, the Nash equilibrium is where no player wants to change strategies, given that the other player isn’t changing his strategy. In other words, nobody wants to unilaterally deviate. Not all games have a pure strategy Nash equilibrium. Paper, Rock, Scissors is an example of a game without an equilibrium.

Oligopoly and Strategic Behavior

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