Title: Oligopoly and Strategic Behavior
1Oligopoly and Strategic Behavior
2Duopoly
- 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
3Mutual 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
4Nash 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
5Game 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
6Strategic 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
7PresentingThe 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
8AnalyzingThe 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
9AnalyzingThe 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
10Interesting 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
11Game 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.
12Duopoly 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
13Advertising 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
14Intuition 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
15Cigarette 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
16Escaping 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
17Escaping 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.
18Caution 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.
19No Dominant Strategy
20Oligopoly 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.
21Oligopoly 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
22Predatory 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
23Predatory Pricing Scheme
Time
24Network 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?
25Network 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
26Network 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.
27Network 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
28Price 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
29More Game Theory in Media
- This link provides further examples of game
theory in media and contains links to video clips
30Conclusion
- 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
31Summary
- 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.
32Summary
- 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.
33Summary
- 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
34Practice 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
35Practice 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
36Practice 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
37Practice 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
38Practice 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