Demand and Supply Analysis

1
Road Map for Prices and Markets

• Demand and Supply Analysis
• Elasticity of demand
• Costs
• Competitive Markets
• Pricing under competition (P MR MC)
• Short run and long run decisions
• Strategies to survive in a competitive market
• Forecasting in the context of entry decisions
• Monopoly Pricing and Price Discrimination
• Pricing by a monopolist (MR MC)
• Not all gains from trade realized or extracted
• Explicit market segmentation
• Implicit market segmentation

TOOLS
2
Road Map for Prices and Markets

• Real world somewhere between the polar cases of
  monopoly and perfect competition. Unfortunately,
  this is a much harder problem to solve and
  requires the techniques of GAME THEORY
• More Tools Game Theory
• Importance of Strategic Thinking
• Simultaneous Games
• Predictions ? Nash equilibrium
• Oligopoly (finite number of firms)
• Price games and Quantity games
• Implicit Collusion with Repeated Games
• Sequential Games and backward induction
• Leader-Follower games and First Mover Advantage

Topic 10 (Session 11)
Topics 11,12,13 (Sessions 12,13,14)
3
Understanding Cost (session 3)
Revenue Understanding Demand (session 2)
Profit Revenue Cost
Pricing
Monopoly Trade off b/w high P and low Q
(session 6)
Perfect Competition Supply and entry decisions
(session 4 5)
What if we can price discriminate? (i.e.,
different consumers pay different
prices) (session 9 10)
How pricing depends on demand through the
elasticities (session 7)
Strategic Competition Solving for the NE
price and quantity competition (session 12)
How timing matters Stackelberg (session 14)
Exotic topics Strategic Demand Network
externalities and Auctions. (session 15)
Tools Games Theory (session 11)
Externalities and Strategic interaction
Collusion (session 13)
4
Today

• Game Theory
• Importance of Strategic Thinking
• Dominant Strategies
• Iteration of Dominated Strategies
• Nash Equilibrium
• Additional Review Sessions
• Mainly Problem Solving and Clarifications No New
  Concepts
• Section E1 Wednesday 19th Oct from 10h15 11h45
  in Amphi O.
• Section E2 Wednesday 19th Oct from 12h00 13h30
  in Amphi P.
• Market Power Games
• Log in and enter your decisions before 5pm

5
What is Game Theory?

• Study of rational behavior in interactive or
  interdependent situations
• Bad news
• Knowing game theory does not guarantee winning
• Good news
• Framework for thinking about strategic
  interaction
• Helps you predict your competitors actions or
  the outcome of game
• How can I change rules of the game to my
  advantage?

6
Decision Theory vs. Game Theory

• Ten of you go to a restaurant.
• Assume each person pays for her own meal
• This is a decision problem
• Assume all agree prior to the meal to split the
  bill equally ten ways.
• Now, this is a game. How??

7
Why Study Game Theory?

• Because the press tells us to
• Game Theory, long an intellectual pastime, came
  into its own as a business tool.
• Forbes, July 3, 1995, p. 62.
•  
• Game theory is hot.
• The Wall Street Journal, 13 February 1995,
  p. A14
• As do consultants
• McKinsey
• John Stuckey David White - Sydney
• To help predict competitor behavior and
  determine optimal strategy, our consulting teams
  use techniques such as pay-off matrices and
  competitive games.
• Tom Copeland - Director of Corporate Finance
• Game theory can explain why oligopolies tend to
  be unprofitable, the cycle of over capacity and
  overbuilding, and the tendency to execute real
  options earlier than optimal.

8
A Lack of Strategic Thinking

• Indiana Jones
• Arrives at a room full of chalices. Pick the
  right one, the drink it contains saves his dying
  father. Pick the wrong one, die an ugly death.
• What did he do?
• Whats the best strategy?

• PG vs. Unilever in the Chilean soap market
• In 1993 Unilever is the largest seller of shampoo
  (Sedal brand)
• In late 1993 PG introduces its Pantene brand,
  eventually capturing a market share equal to
  Sedals
• In 1995 Pantenes brand management team proposes
  cutting prices
• by 20
• Will this strategy work?

9
Strategic Thinking is Important

• Me and 26 of you are playing a card game (52
  cards)
• I keep 26 black cards and distribute 26 red
  cards to each of you
• The Dean feeling guilty about all the money you
  are paying puts
• up 2600 in prize money. Pays 100 to every
  pair of black and
• red cards turned in
• Who is in a stronger bargaining position in
  terms of splitting the
• 100?

• I offer you 20 for your red card. Would you
  take it?

Oops!! I just lost three cards. How does the
game change? Real life application??
10
Game Theory and Economics

• To maximize profits set MC MR
• Marginal analysis Leibniz - Newton 17th century
• Now we have to address issues of strategic
  interaction
• What I do depends on what you do, which in turn
  depends on what I do, which in turn
• ? Game Theory von Neumann, Nash 20th century

11
Game Theory and Economics Motivation

• Consider two duopolists, Microsoft (A) - Netscape
  (B)
• My price depends on your price, which depends on
  my price, which depends on your price

12
Game Theory Concepts

• Basic game theory tools to solve
  competitive/strategic interactions between
• a finite number of firms
• Games
• Simultaneous vs. Sequential
• One-shot vs. Repeated
• Players
• The participants in a strategic interaction
• Strategies
• Choices available to each of the players
• Payoffs
• Some numerical representation of the objectives
  of each player
• Maximize payoffs (dont care about others
  payoffs, just own payoff)

13
CPU Competition

• Intel and AMD compete fiercely to develop
  innovations in CPUs for PCs
• As a result of this, CPU speeds have increased
  dramatically, but there are few differences
  between the products of the two companies
• Even though both companies expended huge amounts
  of money to gain a competitive advantage, their
  relative competitive position ends up unchanged.
• Both companies are worse off than if they had
  each slackened the pace of innovation
• This is an example of the most famous game of all
  time Prisoners Dilemma
• Players Strategies Payoffs

14
Cigarette Advertising on TV

• All US tobacco companies advertised heavily on TV
• Surgeon General issues official warning
• Cigarette smoking may be hazardous
• Cigarette companies reaction
• Fear of potential liability lawsuits
• Companies strike agreement
• Carry the warning label and cease TV advertising
  in exchange for immunity from federal lawsuits.

1964
1970
15
Cigarette Advertising Game
Players RJR and Philip Morris. Strategies
Advertise Not advertise. Payoffs
Profits Each firm earns 50 million from its
customers Advertising costs a firm 20
million Advertising captures 30 million from
competitor
Philip Morris
RJR
Dominant Strategy??
16
Cigarette Advertising Prisoners Dilemma

• After the 1970 agreement, cigarette advertising
  decreased by 63 million
• Profits rose by 91 million
• Prisoners Dilemma
• An equilibrium is NOT necessarily efficient
• Games with dominant strategies are easy to play
  (no need for what if thinking)

17
Why is there an OPEC Cartel?
Strategies 2m or 4m barrels per day World
price 4m - 25 6m - 15 8m - 10 Extraction
cost per barrel 2 for Iran 4 for
Iraq Payoffs
Iraqs output
Irans output
18
Golden Rules

• Dominant Strategy A player has a dominant
  strategy if this strategy gives
• him higher payoffs regardless of what others do.
  It is uniformly better than
• all other strategies.
• If you have a dominant strategy use it. Expect
  your opponent to
• use his dominant strategy if he has one.
• Caveat Both of you may be worse off!

19
Iterative Elimination of Dominated
Strategies Example 1
Firm B
Firm A
20
Iterative Elimination of Dominated
Strategies Example 2
Firm B
Firm A
21
Golden Rules

• Dominated Strategy A player has a dominated
  strategy if he has some
• other strategy that gives him higher payoffs
  regardless of what others do.
• It is uniformly worse than some other strategy.
• If you have a dominant strategy use it. Expect
  your opponent to use his dominant strategy if he
  has one.
• If you have dominated strategies avoid them.
  Successively eliminate dominated strategies to
  predict outcome.

22
Multiple Equilibria Coordination Game
Intel
Windows
Two Possible Outcomes Invest, Invest Not
Invest, Not Invest
NASH Equilibria
23
Multiple Equilibria Battle of the Sexes
Me
Husband
Strategy??
24
Battle of the Sexes Application
Airbus
Boeing
25
Golden Rules

• Nash Equilibrium A Nash equilibrium is a pair
  of strategies (one for each
• player in a 2 player game) when neither player
  has a unilateral incentive
• to change their strategies. Alternatively, each
  is playing their best
• response to the others strategy.
• If you have a dominant strategy use it. Expect
  your opponent to use his dominant strategy if he
  has one.
• If you have dominated strategies avoid them.
  Successively eliminate dominated strategy to
  predict outcome.
• Having exhausted the simple avenues of looking
  for dominant strategies and eliminating dominated
  strategies, look for a Nash equilibrium.

26
(No Transcript)
27
Interpretation of Nash Equilibrium

• Self-enforcing agreement.
• Social norm or convention.
• Steady state of repeated interaction.

28
Wrap Up

• Game Theory is a systematic framework to think of
  strategic interactions
• In strategic interactions
• You need to forecast actions of others in order
  to make your own decisions.
• ? You need to put yourself in others shoes.
• This is strategic reasoning.
• Golden Rules
• Look for dominant actions, so that you dont
  have to reason strategically.
• In simultaneous move games, try to iteratively
  eliminate dominated strategies.
• With a strategically sophisticated rival,
  mutual best responses are good predictors
• of outcomes. Mutual best responses form a
  Nash Equilibrium
• When there are multiple equilibria, try to make
  the one most favorable to you
• the focal.