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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.