Oligopoly and Strategic Behavior

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Oligopoly and Strategic Behavior

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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

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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

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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

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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

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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

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PresentingThe 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
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AnalyzingThe 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
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AnalyzingThe 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
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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
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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.

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Duopoly and thePrisoners 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
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Advertising and thePrisoners 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
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Intuition of AdvertisingPrisoners 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

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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

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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

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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.

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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.

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No Dominant Strategy
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Oligopoly PolicyAntitrust

• 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.

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Oligopoly PolicyAntitrust

• 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

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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

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Predatory Pricing Scheme

Time
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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?

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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

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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.

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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

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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      
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More Game Theory in Media

• This link provides further examples of game
  theory in media and contains links to video clips

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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

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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.

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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.

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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

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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

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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

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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

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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

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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