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PRICINGSTRATEGICAL
THINKING
Assume no cooperation or war among firms
This model helps explain why the prices in some oligopolistic markets change very slowly over time
individual firms are often very afraid to change price because of what other firms might do.
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On the other hand, if the other firms do follow A’s price changes, then there is going to be less substitution taking place and the demand for A’s product is going to be relatively INELASTIC (steep slope).
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What will you do if I lower price?Follow and also lower price so that I do not capture your market share.This makes my demand INELASTIC (steep) below the current price
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When firms believe that their product is a close substitute for their competitor’s product, they do not have much incentive to change price:
A price decrease will be matched, so they have nothing to gain by lowering price.
A price increase will not be matched, so they have a lot to lose by raising price.
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Basic elements The players The strategies The payoffs
Payoff matrix The fundamental tool of game theory. This is simply a way of organizing the
potential outcomes of a given game in a table that describes the payoffs in a game for each possible combination of strategies
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Duopoly situation – each of the two firms A and B must decide whether to mount an expensive advertising campaign.
If each firm decides not to advertise, each will earn a profit of £50,000.
If one firm advertises and the other does not, the firm that does will increase its profits by 50% to £75,000, and drive the competition into a loss.
If both firms advertise, they will earn £10,000 each because the advertising expense forced by competition wipes out large profits
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If firms could agree to collude (FIX PRICES), the optimal strategy would obviously be to not advertise – maximize joint profits = £100,000 Let’s assume they cannot collude (FIX
PRICES), and therefore do not know what the competition is doing.
A “Dominant Strategy” is the one that is best no matter what the opposition does.
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Firm B Don’t Advertise
Advertise
Don’t Advertise
Firm A
Advertise
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A profit = £50
B profit = £50
A profit = £75
B loss = £25
A profit = £10
B profit = £10
A loss = £25
B profit = £75
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Me Don’t Confess
Confess
Don’t ConfessB
Confess
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B= …
Me =…
B= Free
Me= … years
B = …years
Me= …years
B=…
me= Free
Prisoner’s Dilemma Each player has a dominant strategy It results in payoffs that are smaller
than if each had played a dominated strategy
Produces conflict between narrow self-interest of individuals and the broader interest of larger communities
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Why do people shout at parties?
Why does everyone stand up at concerts?
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A Left Right
Top
B Bottom
A’s behavior is predictable in this case.
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B profit = 100
A profit = 0
B loss = 100
A profit = 0
B profit = 200
A profit = 100
B profit = 100
A profit = 100
A Left Right
Top
B Bottom
Here, A’s behavior is again predictable – choose Right is the dominant strategy – but now B stands to lose a great deal if by chance A chooses left instead
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B profit = 100
A profit = 0
B loss = 10,000
A profit = 0
B profit = 200
A profit = 100
B profit = 100
A profit = 100
Cartel A group of firms who sell a similar
product who have joined together in an agreement to act as a monopoly – restrict output and raise price
Normally cartels involve several firms▪ Make retaliation against a dissenter difficult
Agreements are not legally enforceable and are hence inherently unstable
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to reduce the uncertainty of a noncooperative situation – competition over market share makes firms unsure of what to do with regard to pricing decisions – they’re afraid to change prices – so to avoid the possibility of a price war, firms might try to cooperate.
to increase profits – this need for profit can turn out to be the downfall of most cartels – GREED
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Where do the big profits come from at large state schools? sports
Is it a competitive market? many schools… but the large profits suggest that there is
some monopoly power. The NCAA creates this market power and profit by
restricting output – limit the number of games per season, limit the number of teams per division, strict eligibility guidelines for schools…
Up until 1984 the NCAA restricted the number of games on TV and charged very high prices compared to today – but the supreme court called it illegal collusion and as a result we have much more games on TV today than 20 years ago.
Can we say the same things can be said for professional sports?
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2 firms sell bottled water with MC = 0The firms agree to act as a
monopolist and set price in order to maximize joint profits (P*).
Each will produce ½ of the output.No enforcement mechanism.Cheating by 1 firm = selling the
water at < P* => that firm gains entire market.
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Firms 1 & 2 Options: collude (price = £1.00) or cheat (price = 0.90)
Is there a dominant strategy for each firm?
Is there an incentive to cut prices even more?
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Previously we assumed that players moved at the same time However, timing is of the essence
Decision tree or game tree A diagram that▪ Describes the possible moves in a
game in sequence▪ Lists the payoffs that correspond to
each possible combination of moves40
Assuming people are narrowly self-interested does not always capture the full range of motives Restaurants frequented mainly by out-of-
towners have the same tipping rates as those with mainly repeat customers
People care about being treated justly Sympathy for a trading partner can make
a business person trustworthy
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