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ECON 3305 Managerial Economics

Nazif Durmaz

University of Houston-Victoria

April, 2015

Chapter 13:Strategic Decision Making in Oligopoly Markets

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ECON 3305 Managerial Economics

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Oligopoly Markets

I Interdependence of firms’ profits I Distinguishing feature of oligopoly I Arises when number of firms in market is small enough that

every firms’ price & output decisions affect demand & marginal revenue conditions of every other firm in market

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ECON 3305 Managerial Economics

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Strategic Decisions

I Strategic behavior I Actions taken by firms to plan for & react to competition from

rival firms

I Game theory I Useful guidelines on behavior for strategic situations involving

interdependence

I Simultaneous Decisions I Occur when managers must make individual decisions without

knowing their rivals’ decisions

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ECON 3305 Managerial Economics

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Dominant Strategies

I Always provide best outcome no matter what decisions rivals make

I When one exists, the rational decision maker always follows its dominant strategy

I Predict rivals will follow their dominant strategies, if they exist I Dominant strategy equilibrium

I Exists when all decision makers have dominant strategies

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ECON 3305 Managerial Economics

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Prisoners Dilemma

I All rivals have dominant strategies

I In dominant strategy equilibrium, all are worse off than if they had cooperated in making their decisions

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ECON 3305 Managerial Economics

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Dominant Strategies

I Never the best strategy, so never would be chosen & should be eliminated

I Successive elimination of dominated strategies should continue until none remain

I Search for dominant strategies first, then dominated strategies

I When neither form of strategic dominance exists, employ a different concept for making simultaneous decisions

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ECON 3305 Managerial Economics

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Successive Elimination of Dominated Strategies (Table 13.3)

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ECON 3305 Managerial Economics

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Successive Elimination of Dominated Strategies (Table 13.3)

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ECON 3305 Managerial Economics

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Making Mutually Best Decisions

I For all firms in an oligopoly to be predicting correctly each others’ decisions:

I All firms must be choosing individually best actions given the predicted actions of their rivals, which they can then believe are correctly predicted

I Strategically astute managers look for mutually best decisions

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ECON 3305 Managerial Economics

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Nash Equilibrium

I Set of actions or decisions for which all managers are choosing their best actions given the actions they expect their rivals to choose

I Strategic stability I No single firm can unilaterally make a different decision & do

better

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ECON 3305 Managerial Economics

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Successive Elimination of Dominated Strategies (Table 13.3)

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ECON 3305 Managerial Economics

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Nash Equilibrium

I When a unique Nash equilibrium set of decisions exists I Rivals can be expected to make the decisions leading to the

Nash equilibrium I With multiple Nash equilibria, no way to predict the likely

outcome

I All dominant strategy equilibria are also Nash equilibria I Nash equilibria can occur without dominant or dominated

strategies

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ECON 3305 Managerial Economics

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Best-Response Curves

I Analyze & explain simultaneous decisions when choices are continuous (not discrete)

I Indicate the best decision based on the decision the firm expects its rival will make

I Usually the profit-maximizing decision

I Nash equilibrium occurs where firms’ best-response curves intersect

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ECON 3305 Managerial Economics

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Deriving Best-Response Curve for Arrow Airlines (Figure 13.1)

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ECON 3305 Managerial Economics

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Best-Response Curves & Nash Equilibrium (Figure 13.2)

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ECON 3305 Managerial Economics

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Sequential Decisions

I One firm makes its decision first, then a rival firm, knowing the action of the first firm, makes its decision

I The best decision a manager makes today depends on how rivals respond tomorrow

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ECON 3305 Managerial Economics

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Game Tree

I Shows firms decisions as nodes with branches extending from the nodes

I One branch for each action that can be taken at the node I Sequence of decisions proceeds from left to right until final

payoffs are reached

I Roll-back method (or backward induction) I Method of finding Nash solution by looking ahead to future

decisions to reason back to the current best decision

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ECON 3305 Managerial Economics

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Sequential Pizza Pricing (Figure 13.3)

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ECON 3305 Managerial Economics

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Game Tree

I First-mover advantage I If letting rivals know what you are doing by going first in a

sequential decision increases your payoff

I Second-mover advantage I If reacting to a decision already made by a rival increases your

payoff

I Determine whether the order of decision making can be confer an advantage

I Apply roll-back method to game trees for each possible sequence of decisions

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ECON 3305 Managerial Economics

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Sequential Pizza Pricing (Figure 13.3)

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ECON 3305 Managerial Economics

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Sequential Pizza Pricing (Figure 13.3)

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ECON 3305 Managerial Economics

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Strategic Moves & Commitments

I Actions used to put rivals at a disadvantage I Three types

I Commitments I Threats I Promises

I Only credible strategic moves matter I Managers announce or demonstrate to rivals that they will

bind themselves to take a particular action or make a specific decision

I No matter what action is taken by rivals

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ECON 3305 Managerial Economics

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Threats & Promises

I Conditional statements I Threats

I Explicit or tacit I “If you take action A, I will take action B, which is undesirable

or costly to you.”

I Promises I “If you take action A, I will take action B, which is desirable or

rewarding to you.”

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ECON 3305 Managerial Economics

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Cooperation in Repeated Strategic Decisions

I Cooperation occurs when oligopoly firms make individual decisions that make every firm better off than they would be in a (noncooperative) Nash equilibrium

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ECON 3305 Managerial Economics

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Cheating

I Making noncooperative decisions I Does not imply that firms have made any agreement to

cooperate

I One-time prisoners’ dilemmas I Cooperation is not strategically stable I No future consequences from cheating, so both firms expect

the other to cheat I Cheating is best response for each

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ECON 3305 Managerial Economics

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Sequential Pizza Pricing (Figure 13.3)

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ECON 3305 Managerial Economics

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Punishment for Cheating

I With repeated decisions, cheaters can be punished I When credible threats of punishment in later rounds of

decision making exist I Strategically astute managers can sometimes achieve

cooperation in prisoners’ dilemmas

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ECON 3305 Managerial Economics

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Deciding to Cooperate

I Cooperate I When present value of costs of cheating exceeds present value

of benefits of cheating I Achieved in an oligopoly market when all firms decide not to

cheat

I Cheat I When present value of benefits of cheating exceeds present

value of costs of cheating

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ECON 3305 Managerial Economics

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Measurement of Market Power

PVBenefitsofCheating = B1

(1 + r)1 +

B2 (1 + r)2

+ ... + BN

(1 + r)N

Where Bi = πCheatπCooperate for i = 1, ,N

PVCostsofCheating = C1

(1 + r)N+1 +

C2 (1 + r)N+2

+...+ CP

(1 + r)N+P

Where Cj = πCooperateπNash for j = 1, ,P

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ECON 3305 Managerial Economics

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A Firms Benefits & Costs of Cheating (Figure 13.5)

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ECON 3305 Managerial Economics

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Measurement of Market Power

I A rival’s cheating “triggers” punishment phase I Tit-for-tat strategy

I Punishes after an episode of cheating & returns to cooperation if cheating ends

I Grim strategy I Punishment continues forever, even if cheaters return to

cooperation

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ECON 3305 Managerial Economics

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Facilitating Practices

I Legal tactics designed to make cooperation more likely I Four tactics

I Price matching I Sale-price guarantees I Public pricing I Price leadership

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ECON 3305 Managerial Economics

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Price Matching

I Firm publicly announces that it will match any lower prices by rivals

I Usually in advertisements

I Discourages noncooperative price-cutting I Eliminates benefit to other firms from cutting prices

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ECON 3305 Managerial Economics

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Sale-Price Guarantees

I Firm promises customers who buy an item today that they are entitled to receive any sale price the firm might offer in some stipulated future period

I Primary purpose is to make it costly for firms to cut prices

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ECON 3305 Managerial Economics

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Public Pricing

I Public prices facilitate quick detection of noncooperative price cuts

I Timely & authentic

I Early detection I Reduces PV of benefits of cheating I Increases PV of costs of cheating I Reduces likelihood of noncooperative price cuts

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ECON 3305 Managerial Economics

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Price Leadership

I Price leader sets its price at a level it believes will maximize total industry profit

I Rest of firms cooperate by setting same price

I Does not require explicit agreement I Generally lawful means of facilitating cooperative pricing

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ECON 3305 Managerial Economics

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Cartels

I Most extreme form of cooperative oligopoly

I Explicit collusive agreement to drive up prices by restricting total market output

I Illegal in U.S., Canada, Mexico, Germany, & European Union I Pricing schemes usually strategically unstable & difficult to

maintain I Strong incentive to cheat by lowering price

I When undetected, price cuts occur along very elastic single-firm demand curve

I Lure of much greater revenues for any one firm that cuts price I Cartel members secretly cut prices causing price to fall sharply

along a much steeper demand curve

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ECON 3305 Managerial Economics

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Intels Incentive to Cheat (Figure 13.6)

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ECON 3305 Managerial Economics

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Tacit Collusion

I Far less extreme form of cooperation among oligopoly firms

I Cooperation occurs without any explicit agreement or any other facilitating practices

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ECON 3305 Managerial Economics

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Strategic Entry Deterrence

I Established firm(s) makes strategic moves designed to discourage or prevent entry of new firm(s) into a market

I Two types of strategic moves I Limit pricing I Capacity expansion

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ECON 3305 Managerial Economics

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Limit Pricing

I Established firm(s) commits to setting price below profit-maximizing level to prevent entry

I Under certain circumstances, an oligopolist (or monopolist), may make a credible commitment to charge a lower price forever

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ECON 3305 Managerial Economics

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Limit Pricing: Entry Deterred (Figure 13.7)

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ECON 3305 Managerial Economics

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Limit Pricing: Entry Occurs (Figure 13.8)

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ECON 3305 Managerial Economics

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Limit Pricing

I Established firm(s) can make the threat of a price cut credible by irreversibly increasing plant capacity

I When increasing capacity results in lower marginal costs of production, the established firm’s best response to entry of a new firm may be to increase its own level of production

I Requires established firm to cut its price to sell extra output

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ECON 3305 Managerial Economics

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Excess Capacity Barrier to Entry (Figure 13.9)

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ECON 3305 Managerial Economics

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Excess Capacity Barrier to Entry (Figure 13.9)

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ECON 3305 Managerial Economics

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Summary

Concluding Remarks

I Simultaneous decision games occur when managers must make their decisions without knowing the decisions of their rivals

I A dominant strategy is a strategy that always provides the best outcome no matter what decisions rivals make

I A prisoners’ dilemma arises when all rivals possess dominant strategies, and in dominant strategy equilibrium, they are all worse off than if they cooperated in making their decisions

I In Nash equilibrium, no single firm can unilaterally make a different decision and do better

I Best-response curves are used to analyze simultaneous decisions when choices are continuous rather than discrete

Nazif Durmaz University of Houston-Victoria

ECON 3305 Managerial Economics

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Summary

Concluding Remarks

I Sequential decisions occur when one firm makes its decision first, and then a rival firm makes its decision

I Three types of strategic moves: commitments, threats, promises

I When decisions are repeated over and over, managers get a chance to punish cheaters, and, through credible threat of punishment, rivals may be able to achieve the cooperative outcome in prisoners’ dilemma situations

I Strategic entry deterrence occurs when an established firm makes a strategic move designed to discourage or prevent the entry of a new firm(s)

I Two types of strategic moves designed to manipulate the beliefs of potential entrants about the profitability of entering are limit pricing and capacity expansion

Nazif Durmaz University of Houston-Victoria

ECON 3305 Managerial Economics