OLIGOPOLY AND GAME THEORY

Ref. 1. Pindyck & Rubinfeld: microeconomics, chapter 11 &12. 2. A koutsoyiannis: modern microeconomics: chapter 9, 10

OLIGOPOLY
An oligopoly is a market in which a few firms produce a large fraction of total supply Firms price and output decisions affect competitors profits Taxonomy of cases 1. Possible strategies Choose a quantity of output Choose a price 2. Timing of firms actions Simultaneous decisions Sequential decisions

Cournot competition
Firms 1 and 2 produce quantities y1and y2, respectively Total quantity is y1+y2, and the market-clearing price is p(y1+y2) The firms cost functions are c1(y1) and c2(y2) Their individual profits are p1(y1+y2) = p(y1+y2) y1c1(y1)
and

p2(y1+y2) = p(y1+y2) y2c2(y2)

Cournot competition..
Firms choose profit-maximizing quantities simultaneously Their choices constitute a Nash equilibrium Given firm 2 s output, y2, firm 1 maximizes its profit Given firm 1 s output, y1, firm 2 maximizes its profit Firm 1 s reaction function The profit-maximizing output for firm 1 depends on firm 2 s output: y1 = f1(y2) for some function f1 f1 is firm 1 s reaction function

The combinations of y1 and y2 that yield the same level of profits to Firm 1. This is called an Iso-Profit Curve IsoFeatures of Iso-Profit Curves Iso Every point on the curve yields the same level of profit Lower Iso-profit curves correspond to HIGHER profits for Firm 1 (opposite for Firm 2) because we are moving closer towards the Monopoly output level Iso-Profit curves reach their peak when they intersect the reaction function (since the reaction function gives the firms most profitable output choices) Iso-profit curves do not intersect each other

OLIGOPOLY The Cournot Model

reaction curve Relationship between a firms profit-maximizing output and the amount it thinks its competitor will produce.
Figure 12.4 Reaction Curves and Cournot Equilibrium

Firm 1s reaction curve shows how much it will produce as a function of how much it thinks Firm 2 will produce. Firm 2s reaction curve shows its output as a function of how much it thinks Firm 1 will produce. In Cournot equilibrium, each firm correctly assumes the amount that its competitor will produce and thereby maximizes its own profits. Therefore, neither firm will move from this equilibrium.

Cournot equilibrium Equilibrium in the Cournot model in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly.

OLIGOPOLY The Linear Demand Curve An Example

Two identical firms face the following market demand curve P = 30 Q Also, MC1 = MC2 = 0 Total revenue for firm 1: R1 = PQ1 = (30 Q)Q1 then MR1 = R1/Q1 = 30 2Q1 Q2 Setting MR1 = 0 (the firms marginal cost) and solving for Q1, we find Firm 1s reaction curve: Q ! 15- 1 Q 1 2 2 By the same calculation, Firm 2s reaction curve: Cournot equilibrium: Q1 ! Q2 !10 Total quantity produced: Q ! Q1 ! Q2 ! 20 Q2 ! 15- 1 Q2 2

OLIGOPOLY The Linear Demand Curve An Example

If the two firms collude, then the total profit-maximizing quantity can be obtained as follows: Total revenue for the two firms: R = PQ = (30 Q)Q = 30Q Q2, then MR1 = R/Q = 30 2Q Setting MR = 0 (the firms marginal cost) we find that total profit is maximized at Q = 15. curve. Then, Q1 + Q2 = 15 is the collusion curve. If the firms agree to share profits equally, each will produce half of the total output: Q1 = Q2 = 7.5

OLIGOPOLY The Linear Demand Curve An Example

Duopoly Example

The demand curve is P = 30 Q, and both firms have zero marginal cost. In Cournot equilibrium, each firm produces 10. The collusion curve shows combinations of Q1 and Q2 that maximize total profits. If the firms collude and share profits equally, each will produce 7.5. Also shown is the competitive equilibrium, in which price equals marginal cost and profit is zero.

 First Mover Advantage The Stackelberg Model

Stackelberg model Oligopoly model in which one firm sets its output before other firms do. Suppose Firm 1 sets its output first and then Firm 2, after observing Firm 1s output, makes its output decision. In setting output, Firm 1 must therefore consider how Firm 2 will react. P = 30 Q Also, MC1 = MC2 = 0 1 Firm 2s reaction curve: Q2 ! 15- 2 Q2 Firm 1s revenue:
2 R1 ! PQ1 ! 30Q1  Q1  Q2Q1

And MR1 = R1/Q1 = 15 Q1 Setting MR1 = 0 gives Q1 = 15, and Q2 = 7.5 We conclude that Firm 1 produces twice as much as Firm 2 and makes twice as much profit. Going first gives Firm 1 an advantage.

PRICE COMPETITION Price Competition with Homogeneous Products The Bertrand Model
Bertrand model Oligopoly model in which firms produce a homogeneous good, each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge. P = 30 Q MC1 = MC2 = $3 Q1=Q2 = 9, and in Cournot equilibrium, the market price is $12, so that each firm makes a profit of $81. Nash equilibrium in the Bertrand model results in both firms setting price equal to marginal cost: P1=P2=$3. Then industry output is 27 units, of which each firm produces 13.5 units, and both firms earn zero profit. In the Cournot model, because each firm produces only 9 units, the market price is $12. Now the market price is $3. In the Cournot model, each firm made a profit; in the Bertrand model, the firms price at marginal cost and make no profit.

Strategic oligopoly

In an oligopolistic market, a firm sets price/output (strategic variables) based partly on the strategic contradictions regarding the behaviour of the competitors. Here to maximise ones own objective function, one need to guess or conjecture regarding the rivals behaviour. This interdependence between firms gives rise to strategic behaviour.
Strategic interdependence: action taken by one agent has some influence on the objective function of other agent(s). Strategic interactions in game theory: - co-operative (coalition/collusive) - non-cooperative (strategic/competitive)

To describe a strategic interaction we need the following 4 thing: 1. Players: agents involve in the game. 2. Rules: a). who will move when simultaneous move game (static) & sequential move (dynamic) b). What do they know when they move? - Level of information: i). Information regarding Strategy Set., ii). Information regarding objective function, and iii). Information regarding the exact strategy choice of rival. Information wise game is of two types: A. incomplete information i and ii are not available Bayesian games, B. complete information: i and ii are available I. perfect information: iii is available II. Imperfect information iii is not available along with I and ii. 3. 4. Outcome: for each possible set of actions by the player, what is the outcome of the game? Payoffs: evaluation of agents utility from realisation of different outcomes.

Some concepts
Strategy: Rule or plan of action for playing a game. optimal strategy: Strategy that maximizes a players expected payoff Noncooperative versus Cooperative Games cooperative game: Game in which participants can negotiate binding contracts that allow them to plan joint strategies. noncooperative game: Game in which negotiation and enforcement of binding contracts are not possible.

DOMINANT STRATEGIES
Dominant Strategy: Strategy that is optimal no matter what an opponent does. Equilibrium in Dominant Strategies: Outcome of a game

in which each firm is doing the best it can regardless of what its competitors are doing. Nash equilibrium/ Mutual coincidence of best response: NE is non-cooperative equilibrium each firm makes its decision that gave it the highest possible outcome, given the actions of the competitors.

REPEATED GAMES
repeated game: Game in which actions are taken and payoffs received over and over again. tit-for-tat strategy: Repeated-game strategy in which a player responds in kind to an opponents previous play, cooperating with cooperative opponents and retaliating against uncooperative ones. Infinitely Repeated Game Suppose the game is infinitely repeated. In other words, my competitor and I repeatedly set prices month after month, forever. With infinite repetition of the game, the expected gains from cooperation will outweigh those from undercutting.

REPEATED GAMES
Finite Number of Repetitions Now suppose the game is repeated a finite number of timessay, N months. Because Firm 1 is playing tit-for-tat, I (Firm 2) cannot undercutthat is, until the last month. I should undercut the last month because then I can make a large profit that month, and afterward the game is over, so Firm 1 cannot retaliate. Therefore, I will charge a high price until the last month, and then I will charge a low price. However, since I (Firm 1) have also figured this out, I also plan to charge a low price in the last month. Firm 2 figures that it should undercut and charge a low price in the next-to-last month. And because the same reasoning applies to each preceding month, the game unravels: The only rational outcome is for both of us to charge a low price every month.

REPEATED GAMES
Tit-for-Tat in Practice Since most of us do not expect to live forever, the unraveling argument would seem to make the tit-for-tat strategy of little value, leaving us stuck in the prisoners dilemma. In practice, however, tit-for-tat can sometimes work and cooperation can prevail. There are two primary reasons. Most managers dont know how long they will be competing with their rivals, and this also serves to make cooperative behavior a good strategy. My competitor might have some doubt about the extent of my rationality. In a repeated game, the prisoners dilemma can have a cooperative outcome.

SEQUENTIAL GAMES
sequential game Game in which players move in turn, responding to each others actions and reactions. As a simple example, lets return to the product choice problem.

SEQUENTIAL GAMES The Extensive Form of a Game

extensive form of a game Representation of possible moves in a game in the form of a decision tree.
Product Choice Game in Extensive Form

SEQUENTIAL GAMES The Advantage of Moving First

THREATS, COMMITMENTS, AND CREDIBILITY Empty Threats

Suppose Firm 1 produces personal computers that can be used both as word processors and to do other tasks. Firm 2 produces only dedicated word processors.

THREATS, COMMITMENTS, AND CREDIBILITY Commitment and Credibility

Race Car Motors, Inc., produces cars, and Far Out Engines, Ltd., produces specialty car engines. Far Out Engines sells most of its engines to Race Car Motors, and a few to a limited outside market. Nonetheless, it depends heavily on Race Car Motors and makes its production decisions in response to Race Cars production plans.

THREATS, COMMITMENTS, AND CREDIBILITY Commitment and Credibility

Suppose Far Out threatens to produce big engines no matter what Race Car does. If Race Car believed Far Outs threat, it would produce big cars: Otherwise, it would have trouble finding engines for its small cars. Far Out can make its threat credible by visibly and irreversibly reducing some of its own payoffs in the matrix, thereby constraining its own choices. Far Out must reduce its profits from small engines. It might do this by shutting down or destroying some of its small engine production capacity.

THREATS, COMMITMENTS, AND CREDIBILITY Commitment and Credibility

The Role of Reputation Developing the right kind of reputation can also give one a strategic advantage. Suppose that the managers of Far Out Engines develop a reputation for being irrationalperhaps downright crazy. They threaten to produce big engines no matter what Race Car Motors does. Now the threat might be credible without any further action; after all, you cant be sure that an irrational manager will always make a profitmaximizing decision. In gaming situations, the party that is known (or thought) to be a little crazy can have a significant advantage.

THREATS, COMMITMENTS, AND CREDIBILITY Bargaining Strategy

Our discussion of commitment and credibility also applies to bargaining problems. The outcome of a bargaining situation can depend on the ability of either side to take an action that alters its relative bargaining position. Consider two firms that are each planning to introduce one of two products which are complementary goods.

THREATS, COMMITMENTS, AND CREDIBILITY Bargaining Strategy

Suppose that Firms 1 and 2 are also bargaining over a second issue whether to join a research consortium that a third firm is trying to form

THREATS, COMMITMENTS, AND CREDIBILITY

How did Wal-Mart Stores succeed where others failed? The key was Wal-Marts expansion strategy. The conventional wisdom held that a discount store could succeed only in a city with a population of 100,000 or more. Sam Walton disagreed and decided to open his stores in small Southwestern towns. The stores succeeded because Wal-Mart had created local monopolies. Discount stores that had opened in larger cities were competing with other discount stores. Other discount chains realized that Wal-Mart had a profitable strategy, so the issue became who would get to each town first. Wal-Mart now found itself in a preemption game.

ENTRY DETERRENCE Empty Threats

To deter entry, the incumbent firm must convince any potential competitor that entry will be unprofitable.

But what if you can make an irrevocable commitment that will alter your incentives once entry occursa commitment that will give you little choice but to charge a low price if entry occurs?

ENTRY DETERRENCE Strategic Trade Policy and International Competition

The Commercial Aircraft Market The development and production of a new line of aircraft are subject to substantial economies of scale; it would not pay to develop a new aircraft unless a firm expected to sell many of them. Suppose it is only economical for one firm to produce the new aircraft.

ENTRY DETERRENCE Strategic Trade Policy and International Competition

The Commercial Aircraft Market European governments, of course, would prefer that Airbus produce the new aircraft. Can they change the outcome of this game? Suppose they commit to subsidizing Airbus and make this commitment before Boeing has committed itself to produce. If the European governments commit to a subsidy of 20 to Airbus if it produces the plane regardless of what Boeing does, the payoff matrix would change.

13.7

ENTRY DETERRENCE

In the early 1970s, DuPont and National Lead each accounted for about a third of U.S. titanium dioxide sales; another seven firms produced the remainder. DuPont was considering whether to expand capacity. The industry was changing, and those changes might enable DuPont to capture more of the market and dominate the industry Three factors had to be considered: Future demand was expected to grow substantially. New environmental regulations would be imposed. The prices of raw materials used to make titanium dioxide were rising. The new regulations and the higher input prices would have a major effect on production cost and give DuPont a cost advantage, both because its production technology was less sensitive to the change in input prices and because its plants were in areas that made disposal of corrosive wastes much less difficult than for other producers.

13.7

ENTRY DETERRENCE

DuPont anticipated that other producers would have to shut down part of their capacity. Competitors would in effect have to reenter the market by building new plants. Could DuPont deter them from taking this step? DuPont considered the strategy to invest nearly $400 million in increased production capacity to try to capture 64 percent of the market by 1985. The idea was to deter competitors from investing. Scale economies and movement down the learning curve would give DuPont a cost advantage. By 1975, things began to go awry. Because demand grew by much less than expected, there was excess capacity industrywide. Because the environmental regulations were only weakly enforced, competitors did not have to shut down capacity as expected. DuPonts strategy led to antitrust action by the Federal Trade Commission in 1978.

13.7

ENTRY DETERRENCE

The disposable diaper industry in the United States has been dominated by two firms: Procter & Gamble, with an approximately 50-percent market share, and KimberlyClark, with another 3040 percent. How do these firms compete? And why havent other firms been able to enter and take a significant share of this $5-billion-per-year market? The competition occurs mostly in the form of cost-reducing innovation. As a result, both firms are forced to spend heavily on research and development in a race to reduce cost.