Lecture 4

Strategic Interaction

Game Theory

Pricing in Imperfectly Competitive markets

Game Theory

• Tool used for analyzing multiagent economic situations involving strategic interdependence

How Do We Describe a Game?

• A game is described by:– number of players/agents– the “strategies” available to each player– each player’s preferences over outcomes of

the game

• For any game, a strategy choice by each one of the players results in a unique outcome of the game

What is a Strategy?

• A strategy is an action plan for a player. It specifies:– what action the player takes – when the player takes the action – the way that the action choice depends on the

information the player has when taking the action

• Two action plans that specify different actions represent two different strategies

Predicting Behavior in Games

• If games are to help us understand observables, we need a way of predicting how agents behave in game settings; i.e., we need a notion of equilibrium for games

• The standard notion of equilibrium is the Nash equilibrium

• Roughly speaking a Nash equilibrium has the feature that each player’s strategy choice is best for that player given other players’ strategies

Pricing in Imperfectly Competitive Markets

Determinants of Pricing Decision

• Economic analysis of pricing in imperfectly competitive markets identifies the following elements of the market environment as important to pricing decision:– number of competitors/ease of entry– similarity of competitors’ products– capacity limitations– on-going interactions– Information on past pricing decisions

Bertrand

• Simultaneous price setting

• Identical products

• No capacity constraints

• One time interaction

Price competition results in price equal marginal cost for all firms and zero profits

Bertrand

• Bertrand paradox (p=mc even though few firms in market) can be resolved by relaxing certain assumptions:

• No Capacity Constraints

• Undifferentiated Products

• One-shot competition

Capacity Constraints

• Suppose each firm has max capacity of Ki

• If firm j sets a higher price than firm i, j may get the left-over demand that firm i can’t satisfy if demand exceeds i’s capacity

• So setting price above MC may be worthwhile

Cournot

• Same analysis can be applied to situations where firms decide first on how much to produce and then on what price to set

• If total quantity produced is low relative to market demand, then it is as if constrained

• Firms will set prices such that total demand just clears total output

Cournot

• Capacity (or output) constraint limits the usefulness of price competition

• Can get p>mc and firms can earn economic profits

Cournot vs. Bertrand

• Cournot:

-when demand is large relative to capacity

-when capacity is more difficult to adjust than price

• Bertrand:

-when demand is small relative to capacity

-when capacity is easier to adjust than price