11

Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 11: Ch. 11: Strategic Choice in Oligopoly, Monopolistic

Competition, and Everyday Life

22

Thinking StrategicallyThinking Strategically

InterdependenciesInterdependencies In making choices, people must consider In making choices, people must consider

the effect of their behavior on others.the effect of their behavior on others. Imperfectly competitive firms may consider Imperfectly competitive firms may consider

how rivals will respond to price changes or how rivals will respond to price changes or new advertising.new advertising.

33

The Payoff Matrix for a GameThe Payoff Matrix for a Game

Raise adspending

Leave adspendingthe same

Raise adspending

Leave adspendingthe same

$5,500 for American

$5,500 for United

American’s Choices

United’s Choices

$2,000 for American

$8,000 for United

$6,000 for American

$6,000 for United

$8,000 for American

$2,000 for United

The airline industry is an oligopoly with an undifferentiated product

44

Dominant StrategyDominant Strategy

One that yields a higher payoff no matter One that yields a higher payoff no matter what the other players in a game choosewhat the other players in a game choose

Dominated StrategyDominated StrategyAny other strategy available to a player who Any other strategy available to a player who

has a dominant strategyhas a dominant strategy

55

Nash EquilibriumNash EquilibriumAny combination of strategies in which Any combination of strategies in which

each player’s strategy is her or his best each player’s strategy is her or his best choice, given the other player’s strategieschoice, given the other player’s strategies

When each player has a dominant When each player has a dominant strategy, equilibrium occurs when each strategy, equilibrium occurs when each player follows that strategyplayer follows that strategy

There can be an equilibrium when players There can be an equilibrium when players do not have a dominant strategydo not have a dominant strategy

66

One Player Lacks a Dominant StrategyOne Player Lacks a Dominant Strategy

Raise adspending

Leave adspendingthe same

Raise adspending

Leave adspendingthe same

$4,000 for American

$3,000 for United

$3,000 for American

$8,000 for United

$2,000 for American

$5,000 for United

$5,000 for American

$4,000 for United

American’s Choices

United’s Choices

Does A have a dominant strategy?

Does U have a dominant strategy?

What is the Nash eqm?

77

The Prisoner’s DilemmaThe Prisoner’s Dilemma

A game in which each player has a A game in which each player has a dominant strategy, and when each dominant strategy, and when each plays it, the resulting payoffs are smaller plays it, the resulting payoffs are smaller than if each had played a dominated than if each had played a dominated strategystrategy

88

Prisoner’s Dilemma ExamplePrisoner’s Dilemma Example

Confess Remain Silent

Confess

RemainSilent

Jasper

Horace

5 yearsfor each 20 years for Jasper

0 years for Horace

1 yearfor each0 years for Jasper

20 years for Horace

99

Is This a Prisoner’s Dilemma?Is This a Prisoner’s Dilemma?

Don’t Invest

Don’tInvest 12 for Chrysler

10 for each 4 for GM

GAME 1

Invest

5 for each4 for Chrysler

12 for GM

Chrysler

GM

Invest

1010

Is This a Prisoner’s Dilemma?Is This a Prisoner’s Dilemma?

GAME 2

Don’t Invest

Don’tInvest

Invest

12 for Chrysler

10 for each

4 for GM

Chrysler

GM

Invest

5 for each

4 for Chrysler12 for GM

1111

Prisoner’s Dilemma and CartelsPrisoner’s Dilemma and Cartels

Cartel: A coalition of firms that agrees to Cartel: A coalition of firms that agrees to restrict output for the purpose of earning restrict output for the purpose of earning an economic profitan economic profit

Why are cartel agreements notoriously Why are cartel agreements notoriously unstable?unstable?

1212

The Market DemandThe Market Demandfor Mineral Waterfor Mineral Water

Pri

ce $

/bo

ttle

)

Bottles/day

Assume• 2 firms (Aquapure &

Mountain Spring• MC = 0• Cartel is formed & agree

to split output and profits

2,000

D

1.00

1,000

MR

2.00

Impact of Cartel• Q = 1,000 bottles/day• P = $1/bottle• Each firm makes $500/day

1313

The Temptation to The Temptation to Violate a Cartel AgreementViolate a Cartel Agreement

Pri

ce $

/bo

ttle

)

Bottles/day

D

1.00

1,000 2,000

MR

2.00

1,100

0.90

Aquapure lowers P• P = $.90/bottle• Q = 1,100 bottles/day

Mountains Spring retaliates• P = $.90/bottle• Both firms split 1,100

bottles/day @ $.90• Profit = $495/day

1414

The Payoff Matrix The Payoff Matrix for a Cartel Agreementfor a Cartel Agreement

Charge $1/bottle Charge $0.90/bottle

Charge$1/bottle

Charge$0.90/bottle

Mountain Spring

Aquapure

$990/day for Mt. Spring

$0 forAquapure$500/day

for each

$0 for Mt. Spring

$990 forAquapure $495/day

for each

1515

The Prisoner’s DilemmaThe Prisoner’s Dilemma

Tit-for-tatTit-for-tat and the Repeated Prisoner’s and the Repeated Prisoner’s DilemmaDilemmaCooperation between players will increase Cooperation between players will increase

the payoff in a prisoner’s dilemma.the payoff in a prisoner’s dilemma.There is a motive to enforce cooperation.There is a motive to enforce cooperation.Players cooperate on the first move, then Players cooperate on the first move, then

mimic their partner’s last move on each mimic their partner’s last move on each successive movesuccessive move

1616

Tit-for-tatTit-for-tat strategy requirements strategy requirements

Two playersTwo playersA stable set of playersA stable set of playersPlayers recall other player’s movesPlayers recall other player’s movesPlayers have a stake in future outcomesPlayers have a stake in future outcomesWhy is the Why is the tit-for-tattit-for-tat strategy unsuccessful strategy unsuccessful

in competitive, monopolistically in competitive, monopolistically competitive, and oligopolistic markets?competitive, and oligopolistic markets?

1717

Cigarette Advertising Cigarette Advertising as a Prisoner’s Dilemmaas a Prisoner’s Dilemma

Advertise on TV Don’t advertise on TV

Advertise on TV

Don’tAdvertiseon TV

$5 million/yrfor Philip Morris

$10 million/yr for each

$35 million/yr for RJR

Philip Morris

RJR

$20 million/yr for each

$35 million/yrfor Philip Morris

$5 million/yr for RJR

How did Congress unwittingly solve the television advertising dilemma

1818

The Advantage of Being DifferentThe Advantage of Being Different

Offer hybrid Don’t offer hybrid

Dodge Viper

Chevrolet Corvette

Offer hybrid

Don’t offer hybrid

$60 million/yrfor Dodge

$60 million/yr for Chevrolet

$70 million/yrfor Dodge

$80 million/yr for Chevrolet

$80 million/yrfor Dodge

$70 million/yr for Chevrolet

$50 million/yrfor Dodge

$50 million/yr for Chevrolet

Is there aNash Equilibrium?

1919

Decision Tree for HybridDecision Tree for Hybrid

A

Dodgedecides

Offer hybrid

Don’t offerhybrid

B

C

$50 million for Chevrolet$50 million for Dodge

Offerhybrid

Don’toffer

hybrid

Offerhybrid

Don’toffer

hybrid

Chevroletdecides

$80 million for Chevrolet$70 million for Dodge

$70 million for Chevrolet$80 million for Dodge

$60 million for Chevrolet$60 million for DodgeD

E

F

G

FinalOutcome

2020

Credible Threat and PromiseCredible Threat and Promise

Credible ThreatCredible ThreatA threat to take an action that is in the A threat to take an action that is in the

threatener’s interest to carry outthreatener’s interest to carry outWhy couldn’t Chevrolet deter Dodge from Why couldn’t Chevrolet deter Dodge from

offering a hybrid by threatening to offer a offering a hybrid by threatening to offer a hybrid of its own, no matter what Dodge did?hybrid of its own, no matter what Dodge did?

Credible PromiseCredible PromiseA promise to take action that is in the A promise to take action that is in the

promiser’s interest to keeppromiser’s interest to keep

2121

Decision Tree for Decision Tree for the Remote Office Gamethe Remote Office Game

A

Owner does not open remote office

Manager manages honestly;owner gets $1,000,manager gets $1,000

Managerial candidatepromises to managehonestly

B

Owner opensremote office

C

Manager manages dishonestly;owner gets -$500,manager gets $1,500

Owner gets $0,manager gets $500 byworking elsewhere

Should a business owner open a remote office?Is the outcome an equilibrium?

2222

The Remote Office The Remote Office Game with an Honest ManagerGame with an Honest Manager

A

Owner does not open remote office

Manager manages honestly;owner gets $1,000,manager gets $1,000

Managerial candidatepromises to managehonestly

B

Owner opensremote office

C

Manager manages dishonestly;owner gets -$500,manager gets -$8,500

Owner gets $0,manager gets $500 byworking elsewhere

The value of dishonesty to the manager is $10,000

2323

Monopolist CompetitionMonopolist CompetitionWhen Location MattersWhen Location Matters

AssumeAssume1 mile street with 1,200 shoppers evenly 1 mile street with 1,200 shoppers evenly

distributeddistributedStore Store AA is located at the West end of the is located at the West end of the

milemileQuestionQuestion

Where would you open a new store on the Where would you open a new store on the mile?mile?

2424

The Curious Tendency of Monopolistic The Curious Tendency of Monopolistic Competitors to ClusterCompetitors to Cluster

2525

Commitment ProblemCommitment Problem

A situation in which people cannot achieve A situation in which people cannot achieve their goals because of an inability to make their goals because of an inability to make credible threats or promisescredible threats or promises

Commitment DeviceCommitment DeviceA way of changing incentives so as to make A way of changing incentives so as to make

otherwise empty threats or promises credibleotherwise empty threats or promises credibleUnderworld code, Underworld code, omertaomertaMilitary arms control agreementsMilitary arms control agreementsTips for waitersTips for waiters

2626

The Strategic Role of PreferencesThe Strategic Role of Preferences

Game theory assumes that the goal of Game theory assumes that the goal of the players is to maximize their the players is to maximize their outcome.outcome.

In most games, players do not attain the In most games, players do not attain the best outcomes.best outcomes.

Altering psychological incentives may Altering psychological incentives may also improve the outcome of a game.also improve the outcome of a game.

2727

Are People Fundamentally Selfish?Are People Fundamentally Selfish?

Do you tip at out-of town restaurants?Do you tip at out-of town restaurants?What would be your first offer in the What would be your first offer in the

ultimatum bargaining game?ultimatum bargaining game?Would you refuse a lopsided offer?Would you refuse a lopsided offer? If narrow self-interest is not the only If narrow self-interest is not the only

motive for making choices, then the other motive for making choices, then the other motives must be understood to predict and motives must be understood to predict and explain human behavior.explain human behavior.

2828

Preferences as Solutions to Preferences as Solutions to Commitment ProblemsCommitment Problems

Concerns about fairness, guilt, humor, Concerns about fairness, guilt, humor, sympathy, etc. do influence the choices sympathy, etc. do influence the choices people make in strategic interactions.people make in strategic interactions.

Commitment to these preferences must be Commitment to these preferences must be communicated for them to influence communicated for them to influence choices.choices.