Managerial Economics &

Business Strategy
Chapter 10
Game Theory: Inside Oligopoly

Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2002
 Overview
I. Introduction to Game Theory
II. Simultaneous-Move, One-Shot Games
III. Infinitely Repeated Games
IV. Finitely Repeated Games
V. Multistage Games

Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2002
 Elements of Games
• Environment
• Rules
• Players
• Strategies
• Payoffs
 Some Possible Game
•
Structures
0-sum vs. variable sum
• co-operative vs. non-cooperative
• simultaneous mover vs. alternating mover
Important Strategic Considerations
• Credible vs. non-credible threats (strategies)
• Dominating, dominated and non-
dominating strategies
• Equilibria:
■ Nash
■ Sub-game Perfect
 Normal Form Game
(Simultaneous Movers - Prisoner’s Dilemma)
• Environment - Police station after a crime wave. Police
have evidence on a minor crime. Police have insufficient
evidence on major crime
• Players - Bonnie and Clyde
• Rules - no escape is possible
• Strategies - Rat or not rat
• Payoffs -
■ No one rats: both get 3 years
■ One rats and the other stays quiet: rat gets 1 year, Silent partner
gets 23 years
■ Both rat: both get 16 years
 Resolving Bonnie & Clyde
• If Bonnie Rats and
■ Clyde doesn’t rat, then Bonnie gets 1 year
■ Clyde rats, then Bonnie gets 16 years
• If Bonnie doesn’t Rat and
■ Clyde doesn’t rat, then Bonnie gets 3 years
■ Clyde rats, then Bonnie gets 23 years
• If Clyde Rats and
■ Bonnie doesn’t rat, then Clyde gets 1 year
■ Bonnie rats, then Clyde gets 16 years
• If Clyde doesn’t Rat and
■ Bonnie doesn’t rat, then Clyde gets 3 years
■ Bonnie rats, then Clyde gets 23 years
 The Normal Form of Prisoner’s
Dilemma

Bonnie
S tra te g y R a t D o n 't R a t
Rat
D o n 't R a t 16,16 1, 23
Clyde
23,1 3,3
 A Normal Form Game

Player 2
Strategy A B C
a 12,11 11,12 14,13
Player 1

b 11,10 10,11 12,12

c 10,15 10,13 13,14
 Putting Yourself in your Rival’s
Shoes
• What should player 2 do?
■ 2 has no dominant strategy!
■ But 2 should reason that 1 will play “a”.
■ Therefore 2 should choose “C”.

Player 2
Strategy A B C
a 12,11 11,12 14,13
Player 1

b 11,10 10,11 12,12

c 10,15 10,13 13,14
 The Outcome
Player 2

Strategy A B C
a 12,11 11,12 14,13
Player 1

b 11,10 10,11 12,12

c 10,15 10,13 13,14

• This outcome is called a Nash equilibrium:

■ “a” is player 1’s best response to “C”.
■ “C” is player 2’s best response to “a”.
 Key Insights
• Look for dominant strategies
• Put yourself in your rival’s shoes
 A Market Share Game
• Two managers want to maximize market
share (0-sum game)
• Strategies are pricing decisions
■ Customers move to low priced product
■ Limits?
• Capacity
• Loyalty
• Heterogeniety and preferences
• Simultaneous moves
• One-shot game
 The Market-Share Game
in Normal Form
Manager 2

Strategy P=$10 P=$5 P = $1

Manager 1

P=$10 .5, .5 .2, .8 .1, .9

P=$5 .8, .2 .5, .5 .2, .8
P=$1 .9, .1 .8, .2 .5, .5
 Key Insight:
• Game theory can be used to analyze
situations where “payoffs” are non
monetary!
• We will, without loss of generality, focus
on environments where businesses want to
maximize profits.
■ Hence, payoffs are measured in monetary units.
 No and multiple equilibria
• Not all games will have a single equilibrium
■ Scissors, rock, paper
■ Battle of the Sexes
 Child’s play

Player 2
Strategy Scissors Rock Paper
Scissors 0, 0 -1, 1 1, -1
Rock 1, -1 0, 0 -1, 1
Player 1 Paper -1, 1 1, -1 0, 0
 Multiple Equilibria -
Battle of the Sexes

Him
S tra te g y B a lle t B o x in g
B a lle t 4, 5 0 ,0
B o x in g 1, 1 5, 4
Her
 Gain Coordination in a non-
cooperative environment
• Find a coordinating device
• Repeat the game finitely
• Repeat the game infinitely using
■ Grim-trigger strategy
■ Tit-for-tat strategy
 Developing a Coordination Device
• Environment - Pulling groceries to market. Pulling
harder yields higher gross revenues. Effort costs
• Players - Mack and Myer
• Rules - ?
• Strategies - Pull or Shirk
• Payoffs -
■ No one pulls, each nets $15
■ One pulls and the other shirks, puller nets $10, shirker nets $35
■ Both pull, each nets $25
 Mack & Myer’s Game

Mack
S tra te g y P u ll S h irk
P u ll
S h irk 25,25 10, 35
Myer
35,10 15,15

Nash? Payoffs?
 Developing a Coordination Device
• Solution is to hire an enforcer
• Pay the enforcer $5 each to hit anyone who shirks.
• Hospitalization costs $15
Mack
S tra te g y P u ll S h irk
P u ll
S h irk 20,20 5, 15
Myer
15,5 -5,-5

Nash? Payoffs? Damage?

 Examples of Coordination
Games
• Industry standards
■ size of floppy disks
■ size of CDs
■ industry organizations - saferooms
• National standards
■ electric current
■ traffic laws
■ HDTV
 An Advertising Game
• Two firms (Kellogg’s & General Mills)
managers want to maximize profits
• Strategies consist of advertising campaigns
on three levels
• Punishment for non-cooperation?
• Credible punishment?
 Equilibrium to the One-Shot
Advertising Game
General Mills
Strategy None Moderate High
None 12,12 1, 20 -1, 15
Kellogg’s

Moderate 20, 1 6, 6 0, 9
High 15, -1 9, 0 2, 2

Nash Equilibrium
 Can collusion work if the game
is repeated 2 times?
General Mills
Strategy None Moderate High
Kellogg’s

None 12,12 1, 20 -1, 15

Moderate 20, 1 6, 6 0, 9
High 15, -1 9, 0 2, 2
 By backwards induction
• In period 2, the game is a one-shot game, so
equilibrium entails High Advertising in the last
period.
• This means period 1 is “really” the last period,
since everyone knows what will happen in period
2.
• Equilibrium entails High Advertising by each firm
in both periods.
• The same holds true if we repeat the game any
known, finite number of times.
 Can collusion work if firms play the game
each year, forever?
• Consider the following “grim-trigger strategy” by each
firm:
■ “Don’t advertise, provided the rival has not advertised in the past. If the
rival ever advertises, “punish” it by engaging in a high level of
advertising forever after.”
• In effect, each firm agrees to “cooperate” so long as the
rival hasn’t “cheated” in the past. “Cheating” triggers
punishment in all future periods.
• Is this a credible threat?
 Profits in an infinitely repeated game

• Suppose we cooperate forever, then:

∞ π coop π coop (1 + i )
Vcoop =∑ =
t = 0 (1 + i )
t
i
• Suppose we play non-cooperatively forever after, then:
∞ π π non −coop
Vnon −coop = ∑
non − coop
=
t =1 (1 + i ) t
i
• Suppose we cheat once, then we receive:
∞ π non −coop π non −coop
π cheat + ∑ = π cheat +
t =1 (1 + i )
t
i
 Profits in an infinitely repeated game

• Cheat only if it is profitable to do so:

π non −coop π coop (1 + i )
π cheat + >
i i
i ∗ π cheat + π non −coop > π coop (1 + i )
i ∗ π cheat + π non −coop > π coop + i ∗ π coop
π coop − π non −coop
i>
π cheat − π coop
 Suppose General Mills adopts this
trigger strategy. Kellogg’s profits?
VCooperate = 12(1+i)/i
Vnon-coop = 2/i
π cheat = 20

General Mills
Strategy None Moderate High
None 12,12 1, 20 -1, 15
Moderate 20, 1 6, 6 0, 9
Kellogg’s High 15, -1 9, 0 2, 2
 Kellogg’s Gain to Cheating:
π Cheat -π Coop = 20 - 12
π coop -π non-coop = 12 - 2
8/10 > 1/i
If i > 1.25 or 125% interest rate

General Mills
Strategy None Moderate High
Kellogg’s

None 12,12 1, 20 -1, 15

Moderate 20, 1 6, 6 0, 9
High 15, -1 9, 0 2, 2
 Key Insight

• Collusion can be sustained as a Nash

equilibrium when there is no certain “end”
to a game.
• Doing so requires:
■ Ability to monitor actions of rivals
■ Ability (and reputation for) punishing defectors
■ Low interest rate
■ High probability of future interaction
 Real World Examples of
Collusion
• Garbage Collection Industry
• OPEC
• NASDAQ
• Airlines
 Garbage Collection Industry
• Homogeneous products
• Bertrand oligopoly (price-based
competition)
• Identity of customers is known
• Identity of competitors is known
 Normal Form Bertrand Game

Firm 2
Strategy Low Price High Price
Low Price 0,0 20,-1
Firm 1 High Price -1, 20 15, 15
 One-Shot Bertrand
(Nash) Equilibrium

Firm 2
Strategy Low Price High Price
Low Price 0,0 20,-1
Firm 1 High Price -1, 20 15, 15
 Potential Repeated Game
Equilibrium Outcome
Firm 2
Strategy Low Price High Price
Low Price 0,0 20,-1
Firm 1 High Price -1, 20 15, 15
 2. OPEC
• Cartel founded in 1960 by Iran, Iraq, Kuwait, Saudi
Arabia, and Venezuela
• Currently has 11 members
• “OPEC’s objective is to co-ordinate and unify
petroleum policies among Member Countries, in order
to secure fair and stable prices for petroleum
producers…” (www.opec.com)
• Cournot oligopoly (quantity-based competition)
• Absent collusion: PCompetition < PCournot < PMonopoly
Current OPEC Members
 Cournot Game in Normal
Form
Venezuela

Strategy High Q Med Q Low Q

Saudi Arabia

High Q 5, 3 9,4 3, 6
Med Q 6, 7 12,10 20, 8
Low Q 8, 1 10, 18 18, 15
 One-Shot Cournot
(Nash) Equilibrium
Venezuela
Strategy High Q Med Q Low Q
Saudi Arabia

High Q 5, 3 9,4 3, 6
Med Q 6, 7 12,10 20, 8
Low Q 8, 1 10, 18 18, 15
 Repeated Game Equilibrium*
Venezuela
Strategy High Q Med Q Low Q
Saudi Arabia

High Q 5, 3 9,4 3, 6
Med Q 6, 7 12,10 20, 8
Low Q 8, 1 10, 18 18, 15

* (Assuming a Low Interest Rate)

 Effect of Collusion on Oil
Prices
Price

$30

$15

World Demand
for Oil

Low Medium Quantity of Oil

 OPEC’s Demise
40

35
Low Interest High Interest
Rates Rates
30

25

20

15

10

0
1970 1972 1974 1976 1978 1980 1982 1984 1986
-5

Real Interest Rate Price of Oil

 Caveat
• Collusion is a felony under Section 2 of the
Sherman Antitrust Act.
• Conviction can result in both fines and jail-
time (at the discretion of the court).
• OPEC isn’t illegal; US laws don’t apply
• DeBeers?
 U.S. Law
• Sherman Antitrust Act
■ Section 1 Every contract, combination in the form of a trust or
otherwise, or conspiracy , in restraint of trade or
commerce ... is hereby declared to be illegal.
■ Section 2 Every person who shall monopolize, or attempt to
monopolize, or combine or conspire with any person or
persons, to monopolize any part of the trade or commerce
among the several states, or with foreign nations, shall be
deemed guilty of misdemeanor ...
 U.S. Law
• Clayton Antitrust Act
■ Section 2 [I]t shall be unlawful for any person engaged in
commerce ... to discriminate in price between different purchasers
of commodities of like grade and quality ... where the effect of
such discrimination may be substantially to lessen competition or
tend to create a monopoly ...
■ Section 3 It shall be unlawful ... to lease or [sell] goods ... on the
condition, agreement, or understanding that the lessee or purchaser
thereof shall not use or deal in the goods ... of a competitor or
competitors of the lessor or seller, where the effect ... may be to
substantially lessen competition or tend to create a monopoly in
any line of commerce.
■ Section 7 [N]o corporation engaged in commerce shall acquire ...
the whole or any part of the stock or other share capital ... of
another corporation engaged also in commerce, where ... the effect
of such acquisition may be substantially to lessen competition, or
tend to create a monopoly ...
 U.S. Law
• Federal Trade Commission Act
■ Section 5(a)(1) Unfair methods of competition in or
affecting commerce, and unfair or deceptive acts or
practices in or affecting commerce, are hereby declared
unlawful.
• Munn v. Illinois
■ Clothed in public interest
■ Subject to regulation
 Simultaneous-Move Bargaining
• Management and a union are negotiating a wage increase.
• Strategies are wage offers & wage demands
• Successful negotiations lead to $600 million in surplus,
which must be split among the parties
• Failure to reach an agreement results in a loss to the firm
of $100 million and a union loss of $3 million
• Simultaneous moves, and time permits only one-shot at
making a deal.
 The Bargaining Game
in Normal Form

Union
Management

Strategy W = $10 W = $5 W = $1
W = $10 100, 500 -100, -3 -100, -3
W=$5 -100, -3 300, 300 -100, -3
W=$1 -100, -3 -100, -3 500, 100
 Three Nash Equilibria!

Union

Strategy W = $10 W = $5 W = $1
Management

W = $10 100, 500 -100, -3 -100, -3

W=$5 -100, -3 300, 300 -100, -3
W=$1 -100, -3 -100, -3 500, 100
 Fairness: The “Natural” Focal
Point

Union

Strategy W = $10 W = $5 W = $1
Management

W = $10 100, 500 -100, -3 -100, -3

W=$5 -100, -3 300, 300 -100, -3
W=$1 -100, -3 -100, -3 500, 100
 Lessons in
Simultaneous Bargaining
• Simultaneous-move bargaining results in a
coordination problem
• Experiments suggests that, in the absence of
any “history,” real players typically
coordinate on the “fair outcome”
• When there is a “bargaining history,” other
outcomes may prevail
 Alternating Mover Games
• One player acts then the other reacts
• Look forward, reason backward
• Sub-game perfect equilibrium (SPE)
• New elements
■ Information node
■ Information set
■ Order of play
 Pricing to Prevent Entry: An
Application of Game Theory

• Two firms: an incumbent and potential

entrant
• The game in extensive form:
The Entry Game in Extensive
Form
No Price War 10, 10

Incumbent
Enter
Price War
Entrant -20, -10

0, 30
Don’t Enter
 Divide into Sub-games
(each node)
No Price War 10, 10

Incumbent
Enter
Price War
Entrant -20, -10

0, 30
Don’t Enter
 Solve Each Sub-game

No Price War 10, 10

Incumbent
Enter
Price War
Entrant -20, -10

0, 30
Don’t Enter
 One Subgame Perfect
Equilibrium
No Price War 10, 10

Incumbent
Enter
Price War
Entrant -20, -10

0, 30
Don’t Enter
 Pricing to Prevent Entry
• Suppose you want to fight a war to create a
reputation?
■ What’s the price of the reputation?
■ What’s the gain?
• Suppose you want to buy out the entrant?
■ What is an acceptable price?
■ What is an affordable price?
■ What sort of dynamic does this create?
 Technology Adoption
• 2 firms
• Alternating movers
 Technology Adoption
Adopt 70, 40

Follower
Adopt Not Adopt
100, 30

Leader

Adopt 50, 30
Not Adopt

Follower

Not Adopt
80, 40
 Technology Adoption
70, 40
Adopt

Follower
Not Adopt
Adopt 100, 30

Leader

Adopt 50, 30
Not Adopt
Follower

Not Adopt
80, 40
 Technology Adoption
with different timing

Leader
Strategy Adopt Not Adopt
Adopt 40, 70 30, 50
Follower Not Adopt 30, 100 40, 80
Uncertainty and the first-mover
advantage
• First-mover advantage is the gain associated
with being first
• Market foreclosure
• Customer loyalty
• Examine information that is available.
 Uncertainty and the first-mover
advantage in capacity choice
Large 10, 8
Large Follower High
Small 12, 6 Demand
Leader
Large Case
4, 9
Small Follower
6, 4
Large -12, -10
Large Follower
Small -15, 4 Low
Leader Demand
Large 3, 2 Case
Small Follower
Small 5, 3
 Uncertainty and the first-mover
advantage in capacity choice
Large 10, 8
Large Follower High
Small 12, 6 Demand
Leader
Large Case
4, 9
Small Follower
6, 4
Large -12, -10
Large Follower
Small -15, 4 Low
Leader Demand
Large 3, 2 Case
Small Follower
Small 5, 3
 Uncertainty and the first-mover
advantage in capacity choice
Large 10, 8
Large Follower High
Small 12, 6 Demand
Leader
Large Case
4, 9
Small Follower
6, 4
Large -12, -10
Large Follower
Small -15, 4 Low
Leader Demand
Large 3, 2 Case
Small Follower
Small 5, 3
 Single Offer Bargaining
• Now suppose the game is sequential in nature, and
management gets to make the union a “take-it-or-
leave-it” offer.
• Analysis Tool: Write the game in extensive form
■ Summarize the players
■ Their potential actions
■ Their information at each decision point
■ The sequence of moves and
■ Each player’s payoff
 The Game in Extensive Form
Accept 100, 500
Union
Reject -100, -3
10
Accept 300, 300
Firm 5 Union
-100, -3
Reject
1
Accept 500, 100
Union
Reject -100, -3
Find the Subgame Perfect Nash
Equilibrium Outcomes
• Outcomes where no player has an incentive
to change its strategy, given the strategy of
the rival, and
• The outcomes are based on “credible
actions;” that is, they are not the result of
“empty threats” by the rival.
 To Summarize:

• We have identified many combinations of

Nash equilibrium strategies
• In all but one the union does something that
isn’t in its self interest (and thus entail
threats that are not credible)
• Graphically:
 There are 3 Nash
Equilibrium Outcomes!
Accept 100, 500
Union
Reject -100, -3
10
Accept 300, 300
Firm 5 Union
-100, -3
Reject
1
Accept 500, 100
Union
Reject -100, -3
 Only 1 Subgame-Perfect Nash
Equilibrium Outcome!
Accept 100, 500
Union
Reject -100, -3
10
Accept 300, 300
Firm 5 Union
-100, -3
Reject
1
Accept 500, 100
Union
Reject -100, -3
 Re-Cap
• In take-it-or-leave-it bargaining, there is a first-
mover advantage.
• Management can gain by making a take-it or
leave-it offer to the union. But...
• Management should be careful, however; real
world evidence suggests that people sometimes
reject offers on the the basis of “principle” instead
of cash considerations.
 Insights
• Establishing a reputation for being unkind
to entrants can enhance long-term profits
• It is costly to do so in the short-term, so
much so that it isn’t optimal to do so in a
one-shot game.
• Should COSCO join?