Lecture 5

1. Managerial Economics ECON 511 Lecture 5 Oligopoly and Strategic Behavior Professor Changqi Wu

2. Topics for Today • Oligopolistic competition • Prisoners’ dilemma and Nash equilibrium • Games with sequential moves Oligopoly

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

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

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

6. Prisoners’ Dilemma Player 2 noncoopetative Cooperative -1 5 Noncooperative -1 -5 Player 1 -5 3 Cooperative 5 3 Oligopoly

7. 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

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

9. Matching Pennies Player 2 Head Tail 1 -1 Head -1 1 Player 1 -1 1 Tail 1 -1 Oligopoly

10. Battle of Sexes Husband Opera Football 5 1 Opera 3 1 Wife 0 3 Football 0 5 Oligopoly

11. Business Application Firm 2 Price war No price war -1 5 Price war -1 -5 Firm 1 -5 3 No price war 5 3 Oligopoly

12. How to Resolve the Prisoners’ Dilemma • Changing payoffs • Introducing a third player • Game with repeat play • Detecting the cheater • Punishment of cheaters Oligopoly

13. Detecting Cheater • Difficulties in cheating detection • price may fall because of changes in demand • multi-dimensional interactions • it is harder to identify the cheater than to detect cheating • Detection device: • “lowest price guarantee” Oligopoly

14. Strategies to Punish the Cheater • Trigger strategy • Tit-for-tat strategy • Step 1: Begin with cooperation • Step 2: Mimic rival's action • Business applications • “meet-competition clauses" Oligopoly

15. The Tit-For-Tat Strategy Player 1 Player 2 Round Payoff Action Action Payoff 1 3 C C 3 2 -5 C NC 5 3 -1 NC NC -1 4 -1 NC NC -1 5 5 NC C -5 6 3 C C 3 7 3 C C 3 . . . . . . . . . . Oligopoly

16. Advantages of the TFT Strategy • Simplicity and clarity • Niceness • Provocability • Forgiveness Oligopoly

17. 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

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. Oligopoly

19. Battle for the Evening News Payoffs TVB, ATV 1, 1 6:00 6:00 ATV 6:30 3, 4 TVB 6:00 4, 3 6:30 ATV ATV 6:30 2.5, 2.5 Oligopoly

20. First Mover Advantage • First-mover advantage: the gains from the right to move first • To take the best position in the market • A firm can enjoy the first mover advantage when it moves is credible. Oligopoly

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 move • Burning the bridge Oligopoly

22. Empty Threat Payoffs Incumbent Entrant Incumbent Entrant Price cut 2, 0 Enter 5, 5 Output cut No entry 15, 0 Oligopoly

23. Credible Commitment Payoffs Incumt Entrant. Incumbent Price cut -5, -1 Entrant Incumbent Enter -10, 2 Output cut Expand capacity 10, 0 No entry Price cut 2, 0 Enter Do nothing 5, 5 Output cut No entry 15, 0 Oligopoly

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

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

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. Oligopoly