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Oligopoly and Strategic Behavior

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Oligopoly and Strategic Behavior 13 Lecture tip: Questions to ask students: Can an incumbent firm survive a temporary loss? Probably. Can a new firm survive losses? – PowerPoint PPT presentation

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Title: Oligopoly and Strategic Behavior


1
Oligopoly and Strategic Behavior
  • 13

2
Duopoly
  • Collusion
  • 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

3
Mutual Interdependence
  • Mutual interdependence
  • A market situation in which the actions of one
    firm have an impact on the price and output of
    its competitors
  • AT-Phones response depends on the actions of
    Horizon, and Horizons response depends on the
    actions of AT-Phone
  • Note the difference between interdependence and
    independence

4
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

5
Game Theory
  • Game theory
  • 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

6
Strategic Behavior and the Dominant Strategy
  • Prisoners dilemma
  • Two suspects are interrogated separately
  • They each have the option to confess or keep
    quiet
  • Possible outcomes of prisoners 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

7
Presenting The Prisoners Dilemma
Players
Strategies
Payoffs
Thelma Thelma Thelma Thelma
Confess Confess Keep Quiet Keep Quiet
Louise Confess 10 years in jail 25 years in jail
Louise Confess 10 years in jail goes free
Louise Keep Quiet goes free 1 year in jail
Louise Keep Quiet 25 years in jail 1 year in jail
8
Analyzing The Prisoners 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 Thelma Thelma Thelma
Confess Confess Keep Quiet Keep Quiet
Louise Confess 10 years in jail 25 years in jail
Louise Confess 10 years in jail goes free
Louise Keep Quiet goes free 1 year in jail
Louise Keep Quiet 25 years in jail 1 year in jail
9
Analyzing The Prisoners 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 Thelma Thelma Thelma
Confess Confess Keep Quiet Keep Quiet
Louise Confess 10 years in jail 25 years in jail
Louise Confess 10 years in jail goes free
Louise Keep Quiet goes free 1 year in jail
Louise Keep Quiet 25 years in jail 1 year in jail
10
Interesting Result of this Game
Thelma Thelma Thelma Thelma
Confess Confess Keep Quiet Keep Quiet
Louise Confess 10 years in jail 25 years in jail
Louise Confess 10 years in jail goes free
Louise Keep Quiet goes free 1 year in jail
Louise Keep Quiet 25 years in jail 1 year in jail
11
Game Theory
  • Dominant strategy
  • 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.

12
Duopoly and the Prisoners Dilemma
AT-Phone AT-Phone AT-Phone AT-Phone
Low Low High High
Horizon Low 27,000 30,000
Horizon Low 27,000 22,500
Horizon High 22,500 24,000
Horizon High 30,000 24,000
13
Advertising and the Prisoners Dilemma
Coca-Cola Coca-Cola Coca-Cola Coca-Cola
Advertises Advertises Does Not Advertise Does Not Advertise
Pepsico Advertises 100 M 75 M
Pepsico Advertises 100 M 150 M
Pepsico Does Not Advertise 150 M 125 M
Pepsico Does Not Advertise 75 M 125 M
14
Intuition of Advertising Prisoners Dilemma
  • Advertising
  • Costly
  • Purpose increase product demand
  • If both firms advertise, expenses go up, but
    demand increases each cancels other out
  • Arms race of advertising

15
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 prisoners dilemma of
    advertising

16
Escaping the Prisoners 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

17
Escaping the Prisoners 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.

18
Caution About Game Theory
  • Not all games are like the prisoners 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.

19
No Dominant Strategy
20
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.

21
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

22
Predatory Pricing
  • Predatory pricing
  • 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

23
Predatory Pricing Scheme

Time
24
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?

25
Network Externalities
  • 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

26
Network Externalities
  • 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
    dont want to go.

27
Network Externalities
  • 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

28
Price Taking Price Making Price Making Price Making
Perfect Competition Monopolistic Competition Oligopoly Monopoly
1. Many firms 1. Many firms 1. Few firms 1. One firm
2. Atomistic assumptionfirms 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      
29
More Game Theory in Media
  • This link provides further examples of game
    theory in media and contains links to video clips

30
Conclusion
  • Oligopoly
  • 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

31
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.

32
Summary
  • Oligopolistic markets are socially inefficient
    since P gt 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.

33
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

34
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

35
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

36
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

37
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

38
Practice What You Know
  • How can a pure strategy Nash equilibrium be
    accurately described?
  • It is always the overall best outcome
  • Its an outcome in which neither player wants to
    change strategies
  • It can only be reached by collusion
  • One exists in all games
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