UNIT III: COMPETITIVE STRATEGY

1. UNIT III: COMPETITIVE STRATEGY Monopoly Oligopoly Strategic Behavior

2. Market Structure Perfect Comp Oligopoly Monopoly No. of Firms infinite (>)2 1 Output MR = MC = P ??? MR = MC < P Profit No ? Yes Efficiency Yes ? ???

3. Oligopoly We have no general theory of oligopoly. Rather, there are a variety of models, differing in assumptions about strategic behavior and information conditions. All the models feature a tension between: Collusion: maximize joint profits Competition: capture a larger share of the pie Firms have an interest to get together and discuss their profit maximizing decisions with one another, to collude; or even to form a cartel e.g., OPEC and set prices or production quotas.Firms have an interest to get together and discuss their profit maximizing decisions with one another, to collude; or even to form a cartel e.g., OPEC and set prices or production quotas.

4. Duopoly Models Cournot Duopoly Nash Equilibrium Leader/Follower Model Price Competition

5. Duopoly Models Cournot Duopoly Nash Equilibrium Stackelberg Duopoly Bertrand Duopoly

6. Monopoly Cyberstax is the only supplier of Vidiot, a hot new computer game. The market for Vidiot is characterized by the following demand and cost conditions:   P = 30 - 1/6Q TC = 40 + 8Q   a) Find the equilibrium level of output, price and profits and draw a graph of your answer. What levels of consumer and total surplus would result? a) Find the equilibrium level of output, price and profits and draw a graph of your answer. What levels of consumer and total surplus would result?

7. Monopoly P = 30 - 1/6Q TC = 40 + 8Q MR = 30 - 1/3Q MC = 8 => Q* = 66 P* = 19 P = TR – TC = PQ – (40 + 8Q) = (19)(66) – 40 -(8)(66) P = 686 So here’s a monopolist that looks at its cost conditions and its demand conditions, calculates its profit maximizing output and expects to earn profits of $686. Now what happens when another firm arrives on the scene? So here’s a monopolist that looks at its cost conditions and its demand conditions, calculates its profit maximizing output and expects to earn profits of $686. Now what happens when another firm arrives on the scene?

8. Duopoly Megacorp is thinking of moving into the Vidiot business with a clone which is indistinguishable from the original. It has access to the same production technology, reflected in the following total cost function:   TC2 = 40 + 8q2   Notation: I will use small q to refer to a firm’s output and capital Q for the industry output. Will Megacorp enter the market for Vidiot? If it assumes Cyberstax’s output is given, how much will it produce and what will be the new market price? What level of profits will the two firms earn? Does this maximize their profits?   Notation: I will use small q to refer to a firm’s output and capital Q for the industry output. Will Megacorp enter the market for Vidiot? If it assumes Cyberstax’s output is given, how much will it produce and what will be the new market price? What level of profits will the two firms earn? Does this maximize their profits?  

9. Duopoly If Megacorp (Firm 2) takes Cyberstax’s (Firm 1) output as given, its residual demand curve is P = 30 - 1/6Q Q = q1+ q2; q1 = 66 P = 30 - 1/6(q1+ q2) P = 19 - 1/6q2

10. Duopoly P = 19 - 1/6q2 TC2 = 40 + 8q2 MR2 = 19 - 1/3q2 = MC2 = 8 => q2* = 33 q1* = 66 P = 30 – 1/6(q1 + q2) P* = $13.50 P2 = 141.5 Before entry, P* = 19; P1 = 686 Now, P1’ = 323 ow, PC‘ = 297

11. Duopoly What will happen now that Cyberstax knows there is a competitor? Will it change its level of output? How will Megacorp respond? Where will this process end? We need to specify some behavioral or strategic assumption about how each firm will respond to the actions of the other. What if Cyberstax were to reoptimize given qMega? The Cournot model is based on the simplest strategic assumption.We need to specify some behavioral or strategic assumption about how each firm will respond to the actions of the other. What if Cyberstax were to reoptimize given qMega? The Cournot model is based on the simplest strategic assumption.

12. Cournot Duopoly Reaction curves (or best response curves) show each firm’s profit maximizing level of output as a function of the other firm’s output.

13. Cournot Duopoly To find R1, set MR = MC. Now, MR is a (-) function not only of q1 but also of q2: q1* Firm 1’s profit maximizing output as a function of Firm 2’s output. q1* Firm 1’s profit maximizing output as a function of Firm 2’s output.

14. Cournot Duopoly The outcome (q1*, q2*) is an equilibrium in the following sense: neither firm can increase its profits by changing its behavior unilaterally. q1*, q2*: Each firm’s profit maximizing level of output, given the other’s profit maximizing output. A Nash Equilibrium exists in an oligopolistic market, if each firm is basing its pmax output on a correct assumption (consistent) about the rivals’ behavior. On Dynamics: We arrive at the NE in logical time not historical time. Convergence to the NE is not the result of a series of actions but a series of conjectures, or beliefs. I think-that you think-that I think … [I]f game theory is to provide a unique solution to a game-theoretic problem then the solution must be a Nash equilibrium in the following sense. Suppose that game theory makes a unique prediction about the strategy each player will choose. In order for this prediction to be correct, it is necessary that each player be willing to choose the strategy predicted by the theory. Thus each player’s predicted strategy must be that player’s best response to the predicted strategies of the other players. Such a prediction could be called strategically stable or self-enforcing, because no single player wants to deviate from his or her predicted strategy (Gibbons: 8). q1*, q2*: Each firm’s profit maximizing level of output, given the other’s profit maximizing output. A Nash Equilibrium exists in an oligopolistic market, if each firm is basing its pmax output on a correct assumption (consistent) about the rivals’ behavior. On Dynamics: We arrive at the NE in logical time not historical time. Convergence to the NE is not the result of a series of actions but a series of conjectures, or beliefs. I think-that you think-that I think … [I]f game theory is to provide a unique solution to a game-theoretic problem then the solution must be a Nash equilibrium in the following sense. Suppose that game theory makes a unique prediction about the strategy each player will choose. In order for this prediction to be correct, it is necessary that each player be willing to choose the strategy predicted by the theory. Thus each player’s predicted strategy must be that player’s best response to the predicted strategies of the other players. Such a prediction could be called strategically stable or self-enforcing, because no single player wants to deviate from his or her predicted strategy (Gibbons: 8).

15. Nash Equilibrium A Nash Equilibrium exists in an oligopolistic market, if each firm is basing its pmax output on a correct assumption (consistent) about the rivals’ behavior. On Dynamics: We arrive at the NE in logical time not historical time. Convergence to the NE is not the result of a series of actions but a series of conjectures, or beliefs. I think-that you think-that I think … [I]f game theory is to provide a unique solution to a game-theoretic problem then the solution must be a Nash equilibrium in the following sense. Suppose that game theory makes a unique prediction about the strategy each player will choose. In order for this prediction to be correct, it is necessary that each player be willing to choose the strategy predicted by the theory. Thus each player’s predicted strategy must be that player’s best response to the predicted strategies of the other players. Such a prediction could be called strategically stable or self-enforcing, because no single player wants to deviate from his or her predicted strategy (Gibbons: 8). A Nash Equilibrium exists in an oligopolistic market, if each firm is basing its pmax output on a correct assumption (consistent) about the rivals’ behavior. On Dynamics: We arrive at the NE in logical time not historical time. Convergence to the NE is not the result of a series of actions but a series of conjectures, or beliefs. I think-that you think-that I think … [I]f game theory is to provide a unique solution to a game-theoretic problem then the solution must be a Nash equilibrium in the following sense. Suppose that game theory makes a unique prediction about the strategy each player will choose. In order for this prediction to be correct, it is necessary that each player be willing to choose the strategy predicted by the theory. Thus each player’s predicted strategy must be that player’s best response to the predicted strategies of the other players. Such a prediction could be called strategically stable or self-enforcing, because no single player wants to deviate from his or her predicted strategy (Gibbons: 8).

16. Nash Equilibrium

17. Nash Equilibrium

18. Nash Equilibrium The duopolists have an incentive to collude: to restrict their output – below the NE level – and increase their profits. What is socially optimalThe duopolists have an incentive to collude: to restrict their output – below the NE level – and increase their profits. What is socially optimal

19. Stackelberg Duopoly Firm 1 is the dominant firm, or Leader, (e.g., GM) and moves first. Firm 2 is the subordinate firm, or Follower. 1934 Firm 1 knows Firm 2’s cost structure and hence can calculate its reaction curve R2.1934 Firm 1 knows Firm 2’s cost structure and hence can calculate its reaction curve R2.

20. Stackelberg Duopoly Firm 1 is the dominant firm, or Leader, (e.g., GM) and moves first. Firm 2 is the subordinate firm, or Follower.

21. Stackelberg Duopoly Firm 1 is the dominant firm, or Leader, (e.g., GM) and moves first. Firm 2 is the subordinate firm, or Follower.

22. Bertrand Duopoly Under Bertrand duopoly, firms compete on the basis of price, not quantity (as in Cournot and Stackelberg).

23. Bertrand Duopoly Under Bertrand duopoly, firms compete on the basis of price, not quantity (as in Cournot and Stackelberg).

24. Bertrand Duopoly Under Bertrand duopoly, firms compete on the basis of price, not quantity (as in Cournot and Stackelberg).

25. Duopoly Models If we compare these results, we see that qualitatively different outcomes arise out of the finer-grained assumptions of the models:

26. Duopoly Models If we compare these results, we see that qualitatively different outcomes arise out of the finer-grained assumptions of the models:

27. Duopoly Models Summary Oligopolistic markets are underdetermined by theory. Outcomes depend upon specific assumptions about strategic behavior. Nash Equilibrium is strategically stable or self-enforcing, b/c no single firm can increase its profits by deviating. In general, we observe a tension between Collusion: maximize joint profits Competition: capture a larger share of the pie Examples of CollusionExamples of Collusion

28. Game Theory Game Trees and Matrices Games of Chance v. Strategy The Prisoner’s Dilemma Dominance Reasoning Best Response and Nash Equilibrium Mixed Strategies

29. Games of Chance E.g., Lottery, roulette. E.g., Lottery, roulette.

30. Games of Chance E.g., Lottery, roulette. E.g., Lottery, roulette.

31. Games of Strategy E.g., Lottery, roulette. E.g., Lottery, roulette.

32. Games of Strategy Start with Firm 2. Firm 1 has 2 strategies; Firm 2 has 4.Start with Firm 2. Firm 1 has 2 strategies; Firm 2 has 4.

33. Games of Strategy

34. Games of Strategy Extensive Form GamesExtensive Form Games

35. Matrix Games

36. Matrix Games

37. Games of Strategy Games of strategy require at least two players. Players choose strategies and get payoffs. Chance is not a player! In games of chance, uncertainty is probabilistic, random, subject to statistical regularities. In games of strategy, uncertainty is not random; rather it results from the choice of another strategic actor. Thus, game theory is to games of strategy as probability theory is to games of chance.

38. A Brief History of Game Theory Minimax Theorem 1928 Theory of Games & Economic Behavior 1944 Nash Equilibrium 1950 Prisoner’s Dilemma 1950 The Evolution of Cooperation 1984 Nobel Prize: Harsanyi, Selten & Nash 1994

39. The Prisoner’s Dilemma In years in jail Player 2 Confess Don’t Confess Player 1 Don’t

40. The Prisoner’s Dilemma Each player has a dominant strategy. Yet the outcome (-10, -10) is pareto inefficient. Is this a result of imperfect information? What would happen if the players could communicate? What would happen if the game were repeated? A finite number of times? An infinite or unknown number of times? What would happen if rather than 2, there were many players?

41. Next Time 11/3 Strategic Behavior Pindyck and Rubenfeld, Ch 13. Besanko, Ch. 14.