Frank & Bernanke
rd
3 edition, 2007
Ch. 11: Strategic Choice in
Oligopoly, Monopolistic
Competition, and Everyday Life
1
Thinking Strategically

Interdependencies
In making choices, people must consider
the effect of their behavior on others.
 Imperfectly competitive firms may consider
how rivals will respond to price changes or
new advertising.

2
The Payoff Matrix for a Game
The airline industry
is an oligopoly with
an undifferentiated
product
Raise ad
spending
American’s Choices
Raise ad
spending
Leave ad
spending
the same
$5,500 for United
$8,000 for United
$5,500 for American
$2,000 for American
United’s Choices
Leave ad
spending
the same
$2,000 for United
$6,000 for United
$8,000 for American
$6,000 for American
3
Dominant Strategy
One that yields a higher payoff no matter
what the other players in a game choose
 Dominated Strategy


Any other strategy available to a player who
has a dominant strategy
4
Nash Equilibrium
Any combination of strategies in which
each player’s strategy is her or his best
choice, given the other player’s strategies
 When each player has a dominant
strategy, equilibrium occurs when each
player follows that strategy
 There can be an equilibrium when players
do not have a dominant strategy

5
One Player Lacks a Dominant Strategy
Does A have a dominant strategy?
American’s Choices
Does U have a dominant strategy?
What is the Nash
eqm?
Raise ad
spending
Raise ad
spending
Leave ad
spending
the same
$3,000 for United
$8,000 for United
$4,000 for American
$3,000 for American
$4,000 for United
$5,000 for United
$5,000 for American
$2,000 for American
United’s Choices
Leave ad
spending
the same
6
The Prisoner’s Dilemma

A game in which each player has a
dominant strategy, and when each plays
it, the resulting payoffs are smaller than
if each had played a dominated strategy
7
Prisoner’s Dilemma Example
Jasper
Confess
Confess
Remain Silent
5 years
for each
0 years for Horace
20 years for Jasper
Horace
Remain
Silent
20 years for Horace
0 years for Jasper
1 year
for each
8
Is This a Prisoner’s Dilemma?
Chrysler
GAME 1
Don’t Invest
Don’t
Invest
10 for each
Invest
4 for GM
12 for Chrysler
GM
Invest
12 for GM
4 for Chrysler
5 for each
9
Is This a Prisoner’s Dilemma?
Chrysler
GAME 2
Don’t
Invest
Don’t Invest
Invest
4 for GM
12 for Chrysler
5 for each
GM
Invest
10 for each
12 for GM
4 for Chrysler
10
Prisoner’s Dilemma and Cartels
Cartel: A coalition of firms that agrees to
restrict output for the purpose of earning
an economic profit
 Why are cartel agreements notoriously
unstable?

11
The Market Demand
for Mineral Water
Assume
• 2 firms (Aquapure &
Mountain Spring
• MC = 0
• Cartel is formed & agree
to split output and
profits
Price $/bottle)
2.00
Impact of Cartel
• Q = 1,000 bottles/day
• P = $1/bottle
• Each firm makes $500/day
1.00
MR
D
1,000
2,000
Bottles/day
12
The Temptation to
Violate a Cartel Agreement
Aquapure lowers P
• P = $.90/bottle
• Q = 1,100 bottles/day
Price $/bottle)
2.00
Mountains Spring retaliates
• P = $.90/bottle
• Both firms split 1,100
bottles/day @ $.90
• Profit = $495/day
1.00
0.90
MR
D
1,000 1,100
2,000
Bottles/day
13
The Payoff Matrix
for a Cartel Agreement
Mountain Spring
Charge $1/bottle
Charge
$1/bottle
$500/day
for each
Charge $0.90/bottle
$0 for
Aquapure
$990/day for
Mt. Spring
Aquapure
Charge
$0.90/bottle
$990 for
Aquapure
$0 for
Mt. Spring
$495/day
for each
14
The Prisoner’s Dilemma

Tit-for-tat and the Repeated Prisoner’s
Dilemma
Cooperation between players will increase
the payoff in a prisoner’s dilemma.
 There is a motive to enforce cooperation.
 Players cooperate on the first move, then
mimic their partner’s last move on each
successive move

15
Tit-for-tat strategy requirements
Two players
 A stable set of players
 Players recall other player’s moves
 Players have a stake in future outcomes
 Why is the tit-for-tat strategy unsuccessful
in competitive, monopolistically
competitive, and oligopolistic markets?

16
Cigarette Advertising
as a Prisoner’s Dilemma
How did Congress
unwittingly solve the
television advertising
dilemma
Advertise
on TV
Philip Morris
Advertise on TV
$10 million/yr
for each
Don’t advertise on TV
$35 million/yr
for RJR
$5 million/yr
for Philip Morris
RJR
Don’t
Advertise
on TV
$5 million/yr
for RJR
$35 million/yr
for Philip Morris
$20 million/yr
for each
17
The Advantage of Being Different
Is there a
Nash Equilibrium?
Dodge Viper
Offer hybrid
Offer hybrid
Don’t offer hybrid
$60 million/yr
for Chevrolet
$80 million/yr
for Chevrolet
$60 million/yr
for Dodge
$70 million/yr
for Dodge
$70 million/yr
for Chevrolet
$50 million/yr
for Chevrolet
$80 million/yr
for Dodge
$50 million/yr
for Dodge
Chevrolet Corvette
Don’t offer hybrid
18
Decision Tree for Hybrid
D
$60 million for Chevrolet
$60 million for Dodge
E
$70 million for Chevrolet
$80 million for Dodge
F
$80 million for Chevrolet
$70 million for Dodge
G
$50 million for Chevrolet
$50 million for Dodge
Offer
hybrid
B
Offer hybrid
Don’t
offer
hybrid
A
Don’t offer
hybrid
Offer
hybrid
C
Dodge
decides
Chevrolet
decides
Don’t
offer
hybrid
Final
Outcome
19
Credible Threat and Promise

Credible Threat
A threat to take an action that is in the
threatener’s interest to carry out
 Why couldn’t Chevrolet deter Dodge from
offering a hybrid by threatening to offer a
hybrid of its own, no matter what Dodge did?


Credible Promise

A promise to take action that is in the
promiser’s interest to keep
20
Decision Tree for
the Remote Office Game
Should a business owner
open a remote office?
Is the outcome an equilibrium?
Manager manages honestly;
owner gets $1,000,
manager gets $1,000
C
Owner opens
remote office
A
Managerial candidate
promises to manage
honestly
B
Manager manages dishonestly;
owner gets -$500,
manager gets $1,500
Owner does not
open remote office
Owner gets $0,
manager gets $500 by
working elsewhere
21
The Remote Office
Game with an Honest Manager
Manager manages honestly;
owner gets $1,000,
manager gets $1,000
The value of dishonesty to the
manager is $10,000
C
Owner opens
remote office
A
Managerial candidate
promises to manage
honestly
B
Manager manages dishonestly;
owner gets -$500,
manager gets -$8,500
Owner does not
open remote office
Owner gets $0,
manager gets $500 by
working elsewhere
22
Monopolist Competition
When Location Matters

Assume
1 mile street with 1,200 shoppers evenly
distributed
 Store A is located at the West end of the
mile


Question

Where would you open a new store on the
mile?
23
The Curious Tendency of Monopolistic
Competitors to Cluster
24
Commitment Problem
A situation in which people cannot achieve
their goals because of an inability to make
credible threats or promises
 Commitment Device

A way of changing incentives so as to make
otherwise empty threats or promises credible
 Underworld code, omerta
 Military arms control agreements
 Tips for waiters

25
The Strategic Role of Preferences
Game theory assumes that the goal of
the players is to maximize their
outcome.
 In most games, players do not attain the
best outcomes.
 Altering psychological incentives may
also improve the outcome of a game.

26
Are People Fundamentally Selfish?
Do you tip at out-of town restaurants?
 What would be your first offer in the
ultimatum bargaining game?
 Would you refuse a lopsided offer?
 If narrow self-interest is not the only
motive for making choices, then the other
motives must be understood to predict and
explain human behavior.

27
Preferences as Solutions to
Commitment Problems
Concerns about fairness, guilt, humor,
sympathy, etc. do influence the choices
people make in strategic interactions.
 Commitment to these preferences must be
communicated for them to influence
choices.

28