Managerial Economics
eighth edition
Thomas
Maurice
Chapter 13
Strategic Decision Making
in Oligopoly Markets
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
2
Managerial Economics
Oligopoly Markets
• Interdependence of firms’ profits
• Distinguishing feature of oligopoly
• 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
2
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
3
Managerial Economics
Strategic Decisions
• Strategic behavior
• Actions taken by firms to plan for &
react to competition from rival firms
• Game theory
• Useful guidelines on behavior for
strategic situations involving
interdependence
3
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
4
Managerial Economics
Simultaneous Decisions
• Occur when managers must make
individual decisions without
knowing their rivals’ decisions
4
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
5
Managerial Economics
Dominant Strategies
• Always provide best outcome no matter
what decisions rivals make
• When one exists, the rational decision
maker always follows its dominant
strategy
• Predict rivals will follow their dominant
strategies, if they exist
• Dominant strategy equilibrium
• Exists when when all decision makers have
dominant strategies
5
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
6
Managerial Economics
Prisoners’ Dilemma
• All rivals have dominant strategies
• In dominant strategy equilibrium,
all are worse off than if they had
cooperated in making their
decisions
6
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
7
Managerial Economics
Prisoners’ Dilemma (Table 13.1)
Bill
Don’t confess
Don’t A
confes 2 years, 2
s
years
Jan
e
C
Confes
1
year,
12
s
years
7
McGraw-Hill/Irwin
Confess
B
B
12 years, 1
year
J
D
JB
6 years, 6
years
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
8
Managerial Economics
Dominated Strategies
• Never the best strategy, so never would
be chosen & should be eliminated
• Successive elimination of dominated
strategies should continue until none
remain
• Search for dominant strategies first,
then dominated strategies
• When neither form of strategic dominance
exists, employ a different concept for
making simultaneous decisions
8
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
9
Managerial Economics
Successive Elimination of
Dominated Strategies (Table 13.3)
Palace’s price
High ($10)
High
($10)
Castle’
s price
Medium
($8)
Low
($6)
Medium ($8)
Low ($6)
A
$1,000, $1,000
C
B
$900, $1,100
C P
C
$500, $1,200
D
$1,100, $400
E
P
$800, $800
F
$450, $500
C
G
$1,200, $300
H
$500, $350
I
P
$400, $400
Payoffs in dollars of profit per week.
9
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
10
Managerial Economics
Successive Elimination of
Dominated Strategies (Table 13.3)
Reduced Payoff
Table
Palace’s price
Medium ($8)
Castle’s
price
High
($10)
Low
($6)
Unique
Solution
Low ($6)
C
B
$900, $1,100
C
CP
$500, $1,200
H
$500, $350
I
P
$400, $400
Payoffs in dollars of profit per week.
10
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
11
Managerial Economics
Making Mutually Best Decisions
• For all firms in an oligopoly to be
predicting correctly each others’
decisions:
• All firms must be choosing individually
best actions given the predicted
actions of their rivals, which they can
then believe are correctly predicted
• Strategically astute managers look for
mutually best decisions
11
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
12
Managerial Economics
Nash Equilibrium
• Set of actions or decisions for
which all managers are choosing
their best actions given the actions
they expect their rivals to choose
• Strategic stability
• No single firm can unilaterally make a
different decision & do better
12
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
13
Managerial Economics
Super Bowl Advertising: A Unique
Nash Equilibrium (Table 13.4)
Pepsi’s budget
Low
C
A
D
Medium
P
C
C
F
$45, $35
$65, $30
H
$45, $10
High
P
$57.5, $50
E
$50, $35
G
High
B
$60, $45
Low
Coke’s
budget
Medium
$30, $25
I
$60, $20
C P
$50, $40
Payoffs in millions of dollars of semiannual profit.
13
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
14
Managerial Economics
Nash Equilibrium
• When a unique Nash equilibrium set of
decisions exists
• Rivals can be expected to make the
decisions leading to the Nash equilibrium
• With multiple Nash equilibria, no way to
predict the likely outcome
• All dominant strategy equilibria are also
Nash equilibria
• Nash equilibria can occur without dominant
or dominated strategies
14
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
15
Managerial Economics
Best-Response Curves
• Analyze & explain simultaneous
decisions when choices are continuous
(not discrete)
• Indicate the best decision based on the
decision the firm expects its rival will
make
• Usually the profit-maximizing decision
• Nash equilibrium occurs where firms’
best-response curves intersect
15
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
16
Managerial Economics
Bravo Airway’s quantity
Arrow Airline’s price
Panel A –
Arrow believes PB =
$100
Arrow Airline’s price and
marginal revenue
Deriving Best-Response Curve
for Arrow Airlines (Figure 13.1)
Panel B – Two points on
Arrow’s best-response
curve
16
McGraw-Hill/Irwin
Bravo Airway’s price
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
17
Managerial Economics
Arrow Airline’s price
Best-Response Curves & Nash
Equilibrium (Figure 13.2)
17
Bravo Airway’s
price
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
18
Managerial Economics
Sequential Decisions
• One firm makes its decision first,
then a rival firm, knowing the
action of the first firm, makes its
decision
• The best decision a manager makes
today depends on how rivals respond
tomorrow
18
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
19
Managerial Economics
Game Tree
• Shows firms decisions as nodes with
branches extending from the nodes
• One branch for each action that can be
taken at the node
• Sequence of decisions proceeds from left to
right until final payoffs are reached
• Roll-back method (or backward
induction)
• Method of finding Nash solution by looking
ahead to future decisions to reason back to
the current best decision
19
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
20
Managerial Economics
Sequential Pizza Pricing
(Figure 13.3)
Panel
– Game
Panel
B –ARoll-back
tree
solution
20
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
21
Managerial Economics
First-Mover & Second-Mover
Advantages
• First-mover advantage
• If letting rivals know what you are
doing by going first in a sequential
decision increases your payoff
• Second-mover advantage
• If reacting to a decision already made
by a rival increases your payoff
21
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
22
Managerial Economics
First-Mover & Second-Mover
Advantages
• Determine whether the order of
decision making can be confer an
advantage
• Apply roll-back method to game trees
for each possible sequence of
decisions
22
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
23
Managerial Economics
First-Mover Advantage in
Technology Choice (Figure 13.4)
Motorola’s technology
Analog
Sony’s
technology
Analo
g
SM B
A
$10, $13.75
C
Digital
Digital
$9.50, $11
$8, $9
SM
D
$11.875, $11.25
Panel A – Simultaneous technology decision
23
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
24
Managerial Economics
First-Mover Advantage in
Technology Choice (Figure 13.4)
24
Panel B – Motorola secures a first-mover
advantage
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
25
Managerial Economics
Strategic Moves
• Actions used to put rivals at a
disadvantage
• Three types
• Commitments
• Threats
• Promises
• Only credible strategic moves
matter
25
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
26
Managerial Economics
Commitments
• Managers announce or
demonstrate to rivals that they will
bind themselves to take a
particular action or make a specific
decision
• No matter what action or decision is
taken by rivals
26
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
27
Managerial Economics
Threats & Promises
• Conditional statements
• Threats
• Explicit or tacit
• “If you take action A, I will take
action B, which is undesirable or costly
to you.”
• Promises
• “If you take action A, I will take
action B, which is desirable or
rewarding to you.”
27
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
28
Managerial Economics
Cooperation in Repeated
Strategic Decisions
• Cooperation occurs when
oligopoly firms make individual
decisions that make every firm
better off than they would be in a
(noncooperative) Nash equilibrium
28
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
29
Managerial Economics
Cheating
• Making noncooperative decisions
• Does not imply that firms have made
any agreement to cooperate
• One-time prisoners’ dilemmas
• Cooperation is not strategically stable
• No future consequences from
cheating, so both firms expect the
other to cheat
• Cheating is best response for each
29
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
30
Managerial Economics
Pricing Dilemma for AMD & Intel
(Table 13.5)
AMD’s price
High
Intel’
s
price
Low
A: Cooperation
High
$5, $2.5
B: AMD cheats
$2, $3
A
C: Intel cheats
Low
$6, $0.5
D: Noncooperation
$3, $1
I
I A
Payoffs in millions of dollars of profit per week.
30
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
31
Managerial Economics
Punishment for Cheating
• With repeated decisions, cheaters
can be punished
• When credible threats of
punishment in later rounds of
decision making exist
• Strategically astute managers can
sometimes achieve cooperation in
prisoners’ dilemmas
31
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
32
Managerial Economics
Deciding to Cooperate
• Cooperate
• When present value of costs of cheating
exceeds present value of benefits of
cheating
• Achieved in an oligopoly market when all
firms decide not to cheat
• Cheat
• When present value of benefits of
cheating exceeds present value of costs
of cheating
32
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
33
Managerial Economics
Deciding to Cooperate
PVBenefits of cheating
B1
B2
BN


 ... 
1
2
(1  r ) (1  r )
( 1  r )N
Where Bi   Cheat   Cooperate for i  1, ..., N
PVCosts of cheating
C1
C2
CP


 ... 
N 1
N 2
(1  r )
(1  r )
( 1  r )N  P
Where C j   Cooperate   Nash for j  1, ..., P
33
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
34
34
Managerial Economics
A Firm’s Benefits & Costs of
Cheating (Figure 13.5)
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
35
Managerial Economics
Trigger Strategies
• A rival’s cheating “triggers”
punishment phase
• Tit-for-tat strategy
• Punishes after an episode of cheating
& returns to cooperation if cheating
ends
• Grim strategy
• Punishment continues forever, even if
cheaters return to cooperation
35
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
36
Managerial Economics
Facilitating Practices
• Legal tactics designed to make
cooperation more likely
• Four tactics
•
•
•
•
36
Price matching
Sale-price guarantees
Public pricing
Price leadership
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
37
Managerial Economics
Price Matching
• Firm publicly announces that it will
match any lower prices by rivals
• Usually in advertisements
• Discourages noncooperative pricecutting
• Eliminates benefit to other firms from
cutting prices
37
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
38
Managerial Economics
Sale-Price Guarantees
• 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
• Primary purpose is to make it costly
for firms to cut prices
38
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
39
Managerial Economics
Public Pricing
• Public prices facilitate quick
detection of noncooperative price
cuts
• Timely & authentic
• Early detection
• Reduces PV of benefits of cheating
• Increases PV of costs of cheating
• Reduces likelihood of noncooperative
price cuts
39
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
40
Managerial Economics
Price Leadership
• Price leader sets its price at a level
it believes will maximize total
industry profit
• Rest of firms cooperate by setting
same price
• Does not require explicit
agreement
• Generally lawful means of facilitating
cooperative pricing
40
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
41
Managerial Economics
Cartels
• Most extreme form of cooperative
oligopoly
• Explicit collusive agreement to
drive up prices by restricting total
market output
• Illegal in U.S., Canada, Mexico,
Germany, & European Union
41
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
42
Managerial Economics
Cartels
• Pricing schemes usually strategically
unstable & difficult to maintain
• Strong incentive to cheat by lowering price
• When undetected, price cuts occur
along very elastic single-firm demand
curve
• Lure of much greater revenues for any one
firm that cuts price
• Cartel members secretly cut prices causing
price to fall sharply along a much steeper
demand curve
42
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
43
Managerial Economics
Intel’s Incentive to Cheat
(Figure 13.6)
43
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.
44
Managerial Economics
Tacit Collusion
• Far less extreme form of
cooperation among oligopoly firms
• Cooperation occurs without any
explicit agreement or any other
facilitating practices
44
McGraw-Hill/Irwin
Copyright © 2005 by the McGraw-Hill Companies, Inc. All rights reserved.