Lecture 5

Oligopoly and Strategic Behavior

Oligopoly and Strategic Behavior

Managerial EconomicsECON 511

Professor Changqi Wu

Oligopoly Slide 2

Topics for Today

Oligopolistic competition

Prisoners’ dilemma and Nash equilibrium

Games with sequential moves

Oligopoly Slide 3

1. Oligopolistic Competition

What’s common in these industries? Newspaper publishing, internet browsers, credit

cards, property development

A few sellers in the market, each commands a substantial market share

High barriers to entry

Interdependence among the few

A firm must conjecture about its rival's action and reaction to its own action

Oligopoly Slide 4

Game Theory and Strategy

Game theory is a branch of mathematics that studies strategic interactions among rational players

Strategy is an action plan that leads to successful achievement of the goal

Game theory has been used in economics to analyze interactions between rivals.

An illustration: Prisoners’ dilemma

Oligopoly Slide 5

2. Prisoners’ Dilemma

There are two players

Each player wants to maximize her own payoff

Communication between two players is not allowed and both players move simultaneously

There are two possible strategies: cooperation (deny any wrongdoing) and noncooperation (confess to the police)

Oligopoly Slide 6

-5

Noncooperative

Cooperative

Cooperative

Player 1

Player 2

Prisoners’ Dilemma

noncoopetative

-1

-1

3

3

5

5

-5

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Observations

Payoffs to each and every player depend on other player’s action

A dominant strategy produces a better payoff than alternative course of action

Both players end up worse-off at the equilibrium

Oligopoly Slide 8

Nash Equilibrium

A combination of strategies such that each and every player's strategy is an optimal response to the other player’s strategy

No one is willing to deviate unilaterally from a Nash equilibrium.

Some game may not have a pure strategy Nash equilibrium, but will have a randomized Nash equilibrium

Oligopoly Slide 9

1

Head

Tail

Tail

Player 1

Player 2

Matching Pennies

Head

1

-1

-1

1

-1

1

-1

Oligopoly Slide 10

1

Opera

Football

Football

Wife

Husband

Battle of Sexes

Opera

5

3

5

3

1

0

0

Oligopoly Slide 11

-5

Price war

No price war

No price war

Firm 1

Firm 2

Business Application

Price war

-1

-1

3

3

5

5

-5

Oligopoly Slide 12

How to Resolve the Prisoners’ Dilemma

Changing payoffs

Introducing a third player

Game with repeat playDetecting the cheater

Punishment of cheaters

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Detecting Cheater

Difficulties in cheating detectionprice may fall because of changes in

demandmulti-dimensional interactionsit is harder to identify the cheater than to

detect cheating

Detection device: “lowest price guarantee”

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Strategies to Punish the Cheater

Trigger strategy

Tit-for-tat strategyStep 1: Begin with cooperation

Step 2: Mimic rival's action

Business applications “meet-competition clauses"

Oligopoly Slide 15

The Tit-For-Tat Strategy

Player 1 Player 2

Round Action Action Payoff

C C1

2

3

4

5

6

7

C-5

NC-1

NC 5

NC -1

NC-1 NC -1

NC5 C -5

C3 C 3

C3 C 3..

.

...

.

...

3 3

Payoff

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Advantages of the TFT Strategy

Simplicity and clarity

Niceness

Provocability

Forgiveness

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When to Play the TFT Strategy?

The objective is to achieve a high payoff, NOT to win the contest

The game must repeat many times

Cheating detection is not a problem

Discount factor cannot be too small

There is a good chance that other players play TFT strategy.

Oligopoly Slide 18

3. Game with Sequential Moves

Players move in sequence in choosing their strategies

The second mover can observe the action of the first mover

The first mover must look forward and think backward: backward induction.

Slide 19Oligopoly

Battle for the Evening News

TVB

ATV

ATVATV

1, 1

3, 4

4, 3

2.5, 2.5

6:00

6:306:00

6:30

6:00

6:30

PayoffsTVB, ATV

Oligopoly Slide 20

First Mover Advantage

First-mover advantage: the gains from the right to move firstTo take the best position in the market

A firm can enjoy the first mover advantage when it moves is credible.

Oligopoly Slide 21

Credible Commitment

Can ATV do better by threatening TVB that it will broadcast news at 6:30 anyway?

An empty threat works against a player’s own interest

A player can make her threat credible by taking a costly and irreversible moveBurning the bridge

Oligopoly Slide 22

Empty Threat

Enter

No entry

Price cut

Output cut

2, 0

5, 5

15, 0

Entrant

Payoffs

Incumbent Entrant

Incumbent

Oligopoly Slide 23

Credible Commitment

Expandcapacity

Do nothing

Enter

No entry

Enter

No entry

Price cut

Output cut

Price cut

Output cut

-5, -1

-10, 2

10, 0

2, 0

5, 5

15, 0

IncumbentEntrant

Payoffs

Incumt Entrant.Incumbent

Oligopoly Slide 24

Key Learning Points

Nash equilibrium describes the combinations of strategies that nobody wants to deviate from.

Prisoners’ dilemma hurts the interests of both players. Some devices can be used to resolve such a dilemma.

Firms can gain advantages by acting as the first mover.

Oligopoly Slide 25

References

Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life, by Avinash Dixit and Barry Nalebuff

Co-Opetition: By Barry Nalebuff and Adam Brandenburger.

Oligopoly Slide 26

Key Learning Points

Strategic interaction is an important element in business.

The Cambridge Zoo provides a taxonomy of business strategies.

One should take into account the nature of the investment in the first stage (tough or soft) and the nature of the strategic relationship between the rivals in the second stage (strategic substitute and strategic complement) when making investment decisions.