Oligopoly Game Theory Models

1. 17 OligopolyGame Theory Models

2. Oligopoly • Oligopoly • Only a few sellers (< MC < PC, > M) • Offer similar or identical products • No product differentiation • Interdependent • Because of small numbers • Competitors’ prices/output decisions affect your firm (if you’re in an Oligopoly market/situation)

3. Perfect Competition Only strategy is to reduce costs (and earn short-run econ profits) Price-taker => output decisions do not affect market price cross-price elasticity = -1 (perfect substitutes) Own-price = -∞ Monopoly Price-Searcher: output decision determines price Cross-price = 0 (no substitutes) Own-price: < |1| Sets market/firm price by output decision (and consumers’ WTP) May try and prevent entry by new firms (patents, trademarks) Oligopoly Cross-price elasticity > 0 Own-price elasticity < |1| Will have to take into account actions of other similar firms when making output/pricing decisions Much more strategy Strategic Behavior

4. Markets with Only a Few Sellers • A small group of sellers • Tension between cooperation and self-interest • Cooperation (Cournot strategy) • Acting like a monopolist • Produce a smaller quantity of output -> set quotas • Maximizes profit for the industry • Charge P >MC -> creates incentive for “cheating” • Non-cooperative • Self Interest - cares only about its own profit • Powerful incentives ($$$$) not to cooperate/cheat • More elaborate game theory (single and multiple equilibria)

5. Previously… • Oligopoly • A market structure in which there are a small number of firms • Firms interact strategically • Can be competitive or collusive • Game theory helps determine when cooperation among oligopolists is most likely • In many cases, cooperation fails to materialize because decision-makers have dominant strategies that lead them to be uncooperative.

6. Two Alternate Theories • Two alternative theories argue that oligopolists will form long-lasting cartels. • Kinked demand curve • Price leadership

7. A Cartel – Collusion Among Suppliers • Three steps: (Cournot Strategy –cooperative) • Determine Profit Max Output –same as monopolist (MR(mkt) = MC(both) @ Q=20) • Determine price (at Q=20 -> P= $48) • Allocate quotas and don’t cheat • What is Q for each firm at MC(mkt) (=$20)?

8. Above the kink, demand is relatively elastic because all other firm’s prices remain unchanged. Below the kink, demand is relatively inelastic because all other firms will introduce a similar price cut, eventually leading to a price war. Therefore, the best option for the oligopolist is to produce at point E which is the equilibrium point An Economic Application of Game Theory: the Kinked-Demand Curve

9. Price Leadership • Kinked Demand Theory • Doesn’t explain price changes • Price leadership • A dominant firm sets the price that maximizes profits and the smaller firms follow • Explains price changes • Not illegal since it does not involve explicit collusion • Involves tacit collusion where there is an understanding among firms that attempts to fight the changes made by the leader that will lead to lower profits for everyone

10. Price Leadership • Example: airlines • Leader airline sets the fare for a given route, and others follow • Each firm knows that lowering the price will hurt everyone, so the price stays where it was set by the leader

11. The Kinked Demand Curve • Kinked Demand Curve Theory • A group of oligopolists has established an output level and price • Firms will mostly ignore a rival’s price increases • Firms hold their prices steady to capture rival’s customers who don’t want to pay more • Rival who raised price will see a big sales decrease • Firms have a greater tendency to respond aggressively to a rival’s price cuts • A price decrease by a rival will be matched by competitors • No one firm is able to pick up very many new customers

12. Markets with Only a Few Sellers • Game Theory • What is it? • "the study of mathematical models of conflict and cooperation between intelligent rational decision-makers“ • Examines alternative strategies and payoffs to the “players” in order to determine their incentives/motivation, model their actions/reactions, and determine if there is a “stable” (unchanging) outcome

13. Markets with Only a Few Sellers • Game Theory • Is the outcome stable (unchanging)? If so then there a single equilibria (one set of choices best for all -> will be stable)? • Types of Nash equilibrium • (Single) Dominant Strategy (Stable) • Multiple Equilibria – outcome fluctuates • Stability will require collusion/agreement

14. Markets with Only a Few Sellers • Types of Nash equilibrium • (Single) Dominant Strategy (Stable) • Strategy that is best for a player in a game, Regardless of the strategies chosen by the other players • Multiple Equilibria • Best strategy for player A depends on B’s choice • Unstable – may require collusion

15. Figure 12.7 Xbox and PlayStation 2 Payoff Matrix for Advertising Only Strategic Choices: Advertise, or Not Payoff matrix shows payoffs under 4 alternative combinations of strategies

16. Markets with Only a Few Sellers • Types of Nash equilibrium • (Single) Dominant Strategy (Stable) • Strategy that is best for a player in a game, regardlessof the strategies chosen by the other player(s) • Best strategy – each firm chooses to advertise their products • Payoff (profit) is best when one firm advertises, regardless of what the competitor does (ad or not) • Each will choose to advertise • Does not require an agreement/collusion • Just Do It! (Regardless of what the other guy does!)

17. Sometimes there are come cases where there are multiple Nash equilibria. In this case, the outcome is uncertain/unpredictable unless they collude (agree to target only 1 of the markets and not compete in the other’s) An example: Sony/Microsoft can create games for either one of two new markets One set of games appeals only to YOUTH market (PG) Other set appeals only to TEEN market (R17) Incentive to reach agreement on both firms offering the same new (one only) feature Compete? Or agree to split the markets? Multiple Equilibria

18. Payoff TableMultiple Nash Equilibria

19. An example: Sony/Microsoft can add one of two new features One feature appeals only to YOUTH market Other feature appeals only to TEEN market Two Strategies Produce in the same markets and compete against each other for customers Each firm produces in the one market where their competitor isn’t producing games Requires agreement on a) which market you will produce games for and b) agree not to compete in the other market Multiple Equilibria

20. Two Strategies Produce in the same market Produce in different Outcome If both firms produce games for the same market ( Y or T) then competition drives prices and profits down (it’s a PC world) If agree to produce in different markets and not compete Monopoly power -> monopoly profits But have to “cede” the other market to your competitor Multiple Equilibria

21. Markets with Only a Few Sellers • Game Theory • What are we looking for? • Is the outcome stable (unchanging)? • Single or multiple equilibria? • How does it model behavior? • Economic actors interacting with one another • Each choose their best strategy • Given the strategies that all the other actors have chosen -use a pay-off matrix to look at options

22. A prisoner’s dilemma occurs when the dominate strategy leads all players to an undesired outcome. No single dominant strategy, multiple nash equilibria, but requires “strong” cooperation how would you know what the other party is going to do? How do you “enforce” their choice Unstable/unpredictable Prisoner's Dilemma – Unstable Games

23. Figure 12.9 Prisoners’ Dilemma

24. A Cartel – Collusion Among Suppliers • Two strategies • 1) cooperate – charge Monopoly price and restrict output to cartel authorized quota • 2) cheat – increase output above quota (price will drop to = MC) • And then what does the other firm do?

25. 2 Jack and Jill’s Oligopoly Game – Cartel as Game Theory Jack gets $1,600 profit Jack gets $2,000 profit Jack gets $1,500 profit Jack gets $1,800 profit Jill gets $1,800 profit Jill gets $1,500 profit Jill gets $1,600 profit Jill gets $2,000 profit In this game between Jack and Jill, the profit that each earns from selling water depends on both the quantity he or she chooses to sell and the quantity the other chooses to sell.

26. The Economics of Cooperation • Other examples of prisoners’ dilemma • Common resources • Two companies – own a common pool of oil • Strategies • Each company drills one well • Each company drills a second well • Get more oil • Dominant strategy • Each company drills two wells • Lower profit

27. 4 A Common-Resources Game Exxon gets $4 million profit Exxon gets $3 million profit Exxon gets $6 million profit Exxon gets $5 million profit Texaco gets $3 million profit Texaco gets $4 million profit Texaco gets $5 million profit Texaco gets $6 million profit In this game between firms pumping oil from a common pool, the profit that each earns depends on both the number of wells it drills and the number of wells drilled by the other firm.

28. Markets with Only a Few Sellers • Game Theory • Other factors that affect the outcome (or add details to the game) • What does everybody know? • Does each player know the payoff and strategy for all? • Who moves first? Or do both move at the same time? • Is this a repeated game? • Do you play only once or do we do it again? • Can we “learn” from past moves?

29. An illegal phone call • Robert Crandall - president of American Airlines • Howard Putnam - president of Braniff Airways • CRANDALL: I think it’s dumb as hell . . . to sit here and pound the @#$% out of each other and neither one of us making a #$%& dime. • PUTNAM: Do you have a suggestion for me? • CRANDALL: Yes, I have a suggestion for you. Raise your $%*& fares 20 percent. I’ll raise mine the next morning. • PUTNAM: Robert, we . . . • CRANDALL: You’ll make more money, and I will, too. • PUTNAM: We can’t talk about pricing! • CRANDALL: Oh @#$%, Howard. We can talk about any &*#@ thing we want to talk about.

30. The Economics of Cooperation • Other examples of prisoners’ dilemma • Arms races • After World War II, United States and the Soviet Union • Engaged in a prolonged competition over military power • Strategies • Build new weapons • Disarm • Dominant strategy: Arm

31. 3 An arms-race game U.S. safe and powerful U.S. at risk and weak U.S. at risk U.S. safe USSR at risk and weak USSR at risk USSR safe USSR safe and powerful In this game between two countries, the safety and power of each country depend on both its decision whether to arm and the decision made by the other country

32. Markets with Only a Few Sellers • How the size of an oligopoly affects the market outcome • More sellers • Transaction costs are higher with more • Getting to together to set prices, quotas • Enforcing agreement • Form a cartel - Maximize profit • Produce monopoly quantity • Charge monopoly price • Difficult to reach & enforce an agreement

33. Markets with Only a Few Sellers • How the size of an oligopoly affects the market outcome • More sellers • Do not form a cartel – Each firm: • The output effect • P > MC • Sell one more unit: Increase profit • The price effect • Increase production: increase total amount sold • Decrease in price: Lower profit

34. Markets with Only a Few Sellers • How the size of an oligopoly affects the market outcome • As the number of sellers in an oligopoly grows larger • Oligopolistic market - looks more like a competitive market • Price - approaches marginal cost • Quantity produced – approaches socially efficient level

35. Public Policy Toward Oligopolies • Controversies over antitrust policies • Resale price maintenance (fair trade) • Require retailers to charge customers a given price • Might seem anticompetitive • Prevents the retailers from competing on price • Defenders: • Not aimed at reducing competition • Legitimate goal • Some retailers offer service

36. Public Policy Toward Oligopolies • Controversies over antitrust policies • Predatory pricing • Charge prices that are too low • Anticompetitive • Price cuts may be intended to drive other firms out of the market • Skeptics • Predatory pricing – not a profitable strategy • Price war - to drive out a rival • Prices - driven below cost

37. Public Policy Toward Oligopolies • Controversies over antitrust policies • Tying • Offer two goods together at a single price • Expand market power • Skeptics • Cannot increase market power by binding two goods together • Form of price discrimination • Tying may increase profit

38. The Microsoft case • U.S. government’s suit against the Microsoft Corporation, 1998 • Central issue: tying • Should Microsoft be allowed to integrate its Internet browser into its Windows operating system • The government’s claim: • Microsoft was bundling - to expand market power into the market of Internet browsers • Would deter other software companies from entering the market and offering new products

39. The Microsoft case • Microsoft responded • New features into old products - natural part of technological progress • Cars - include CD players, air conditioners • Cameras - built-in flashes • Operating systems - added many features to Windows • Previously stand-alone products • Computers - more reliable and easier to use • Integration of Internet technology, • The next natural next step

40. The Microsoft case • Disagreement • Extent of Microsoft’s market power • The government • More than 80% of new personal computers • Use a Microsoft operating system • Substantial monopoly power • Microsoft • Software market is always changing • Competitors: Apple Mac & Linux operating systems • Low price – limited market power

41. The Microsoft case • November 1999 ruling • Microsoft - great monopoly power • Illegally abused that power • June 2000 • Microsoft – to be broken up into two companies • Operating system & Applications software • 2001, appeals court • Overturned the breakup order • September 2001 • Justice Department - wanted to settle the case quickly

42. The Microsoft case • Settlement: November 2002 • Microsoft – some restrictions • Government – browser would remain part of the Windows operating system • Private antitrust suits • Suits brought by the European Union • Alleging a variety of anticompetitive behaviors