Chapter 10: Oligopoly

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Chapter 10 Oligopoly Game Theory
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Introduction

• We have looked at two ends of the spectrum
• Very competitive markets (perfect competition)
• Very uncompetitive markets (monopoly)
• Now we are going to look somewhere in the middle
  (Oligopoly)
• Well look at firms with some market power (like
  a monopolist), but with strong competitors (like
  perfect competition)

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Oligopoly

• Oligopoly refers to a market with a small number
  of firms (2, 3, 4, 5) whose behavior is
  interdependent
• Interdependent means that Firm As choices effect
  Firm B
• For example Subways new ad campaign (Good, so
  you dont always have to be) certainly impacts
  the demand for Subway, but it will also affect
  the demand for Quiznos, McDonalds, Burger King,
  etc.)
• The price Pepsi charges effects not only their
  sales, but also Cokes sales

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Types of Oligopoly

• There are a variety of different types of
  oligopoly
• In oligopoly, the firms can make identical
  (homogeneous) products or differentiated products
• How can products be differentiated?
• Physical qualities (this cereal has a better
  taste)
• Sales locations (you can only get this online)
• Services (this bank charges 2 to see a teller)
• Image (advertising)

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Barriers to Entry

• There are (by definition) only a handful of firms
  in an oligopolistic market
• Why arent there more firms?
• Usually, there are only a few firms because of
  some barrier to entry
• The two common barriers to entry are economies
  of scale and high cost of entry
• These two things are really tied together,
  however you need to be big or efficient to
  compete with the established brands

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Barriers to Entry

• In most cases, there are no legal barriers to
  entry (although some may exist)the efficiency
  and cost aspects usually keep other away
• How expensive would it be to try and start a new
  cell phone service?
• How difficult would it be to try and take on
  Coke and Pepsi by marketing a brand new cola?
• Kola Real example (WSJ article)

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By cutting out frills and skimping in areas such
as advertising, Kola Realoffers ultra-low prices
that appeal to the regions poor majority.
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Models of Oligopoly

• Most of the widely-used models of oligopoly are
  too quantitative to describe here
• HOWEVER, the key element to consider is the fact
  that the strong interdependence among firms
  results in strategic behavior
• How much should I advertise if my rival?
• If I cut my price, I know my rival will
• A useful way to handle this strategic behavior is
  through the use of GAME THEORY

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Game Theory

• Game Theory is a method we can use to analyze the
  decision-making process for these strategic firms
• Each game has (a) players, (b) strategies, and
  (c) payoffs
• Players these will be the firms
• Strategies the choices the players have (what
  price should I charge, should I enter the market)
• Payoffs what the player receives for playing
  the game (profits)

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Example Prisoners Dilemma

• Two thieves, Dave and Wes, are arrested as
  suspects in a jewelry heist
• Police Detective Lennie Briscoe believes them to
  be guilty, but cant prove it without a
  confession
• The two suspects are interrogated in separate
  rooms and given the same speech
• If you confess and testify against your buddy,
  well let you go free
• If your buddy turns you in, well ask for the
  maximum sentence
• If neither confess, then there wont be enough
  evidence to convict them and theyll only go to
  jail for a minor offense (drug possession,
  underage drinking, etc.)
• If both confess, theyll both go to jail for the
  crime but they wont do the maximum

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The Payoff Matrix

• We will represent this game in a matrix form
  (like a table)
• In the matrix, we have all of the following
  information
• Each player (Dave and Wes)
• Each strategy available (Confess, Remain Silent)
• The payoff for each possible combination (the
  amount of time in jail)
• We will use game theory to try and
  anticipate/predict the optimal choices for both
  players

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Payoff Matrix
DAVE
Confess Silent
FOR EXAMPLE If Dave confesses and Wes stays
silent, then the payoffs are Dave goes free (no
jail time) and Wes serves 10 years in prison
0
5
Confess
10
5
W E S
10
1
Silent
0
1

• How do we read this matrix/table?
• Daves strategies and payoffs are represented in
  BLUE
• Wes strategies and payoffs are represented in
  GREEN

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Equilibrium

• Now that we understand each players choices
  (strategies), we need to figure out what is the
  optimal choice for each player to make
• To help us determine the optimal strategies, we
  will look for the NASH EQUILIBRIUM

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Many of you are probably at least vaguely
familiar with the concept of the Nash Equilibrium
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Nash Equilibrium

• Nash Equilibrium The strategies or actions in
  which each firm does the best it can given its
  competitors actions
• The key is that the Nash Equilibrium gives us the
  best strategy given what the others are doing
• This implies that you have no incentive to change
  your behavior because you are doing the best
  thing you can, given what everyone else is doing
• The explanation in the movie is wrong

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If Dave confesses, what is Wes best
response? Wes goes to jail for 10 years if he
stays silent, but he only goes to jail for 5
years if he confesses, too So, confess is Wes
best response
DAVE
Confess Silent
0
5
Confess
10
5
W E S
What is Dave stays silent? What is Wes best
response now? Wes goes to jail for a year if he
stays silent, but he goes free if he
confesses So, confess is Wes best response
10
1
Silent
0
1
For either of Daves choices, Wes best response
is to CONFESS Using the same logic for Daves
best responses, we can find the Nash Equilibrium
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DAVE
Confess Silent
The Nash Equilibrium occurs where both peoples
best responses overlap The Nash Equilibrium is
that both players should Confess and receive 5
years in prison
0
5
Confess
10
5
W E S
10
1
Silent
0
1
But Adam, couldnt they BOTH be BETTER OFF if
they both stayed SILENT? Yes, they could BUT
both players would have an incentive to change
their strategy. If I knew you were going to stay
Silent, Id be better off Confessing (and vice
versa). So, the NASH EQUILIBRIUM point is the
only stable (sustainable) outcome
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Price-Setting Game Coke vs. Pepsi

• Lets examine a potential situation where Coke
  and Pepsi simultaneously choose what price to
  charge
• To make this simple, suppose each firm can choose
  whether to charge a high price or a low price
• If they charge the same price, they split sales
  in the market and earn equal profit
• If one firm charges a lower price
  (undercutting), that lower price firm earns
  more profit than the high priced firm

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Price-Setting Payoff Matrix
Pepsis perspective If Coke charges the low
price, Pepsi earns 500 charging the low price
but only 200 by charging the high price ? better
off by charging the low price. If Coke charges
the high price, Pepsi earns 1,000 by charging
the low price and 700 charging the high price ?
earn more by charging the low price. Coke faces
the same incentives Each seller will charge the
low price, regardless of what the other does ?
each earns 500 a day
Pepsi
Low Price High Price
1000
500
Low Price
500
200
Coke
200
700
High Price
1000
700
Just like the Prisoners dilemma, both firms
would be BETTER OFF if they both charged the HIGH
PRICE, but that strategy is not sustainable
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Extending the Game

• Weve looked at just two choices up until this
  point (Confess/Stay Silent OR High Price/Low
  Price)
• The same technique for finding the Nash
  Equilibrium applies to situations where there are
  more than two moves
• Consider the following example about Coke and
  Pepsi choosing how much to spend on advertising

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Pepsis Advertising Level
Cokes Advertising Level
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Other Examples

• The concept of a Nash Equilibrium can be used in
  other situationseven when there is no payoff
  matrix to examine
• As an example, lets think of two firms choosing
  where to build their stores
• Example Lets think of two coffee shops
  (Starbucks and Bucks County Coffee) trying to
  decide where along Lancaster Avenue to build
  their new coffee shops
• We will think of modeling Lancaster Ave. as a Line

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Linear Model

• Lancaster Ave. will be modeled as a LINE
• Starbucks and Bucks County Coffee must decide
  where along the line to set up their shop
• In the linear model, there are consumers all
  along the line
• Consumers purchase from the store that is closest
  to them
• The point, therefore, is to choose the optimal
  location so that the most consumers visit your
  store

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Linear Model
Consumers that buy from Bucks
Consumers that buy from Starbucks
Wynnewood
Villanova
Starbucks
Bucks Coffee
How does this model work? The consumers purchase
from the store that is closest to them For
example, suppose Starbucks and Bucks C.C. are
located here
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Nash Equilibrium
In order to find the Nash Equilibrium, we need to
determine each firms BEST RESPONSE (just as we
did when looking at a payoff matrix)
Wynnewood
Villanova
Bucks Coffee
Starbucks
If Bucks County Coffee is located at the location
above, where would Starbucks want to locate?
Remember that they want to get the most customers
as possible. Starbucks would want to locate as
close to Bucks Coffee as possible (so that they
are the closest store for all of the people out
towards Villanova)
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Nash Equilibrium
Bucks Coffee
Starbucks
Wynnewood
Villanova
The Nash Equilibrium strategy is for both firms
to locate NEXT TO EACH OTHER in the middle of the
line they each get half of the customers This
choice is the only STABLE strategy (there is no
incentive for either firm to move) No firm can
gain more customers by switching their location
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Minimum Differentiation

• This idea that firms want to locate close to each
  other is something that we see all the time
• Gas stations are usually at an intersection with
  other gas stations
• One block in Charlottesville has three coffee
  shops but there isnt another one for over a mile
• Coke and Pepsi make their colas almost identical
  (locating close to their rival)
• The Nash Equilibrium helps us determine what the
  optimal strategies are, given what our rivals are
  going to do
• Extra credit problem

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Multi-period (Sequential) Games

• In multi-period games, there is a timing element
• One firm chooses their price, then the other
  firms set their price
• Your firm is trying to decide which pricing
  strategy to adopt to keep out future (potential)
  rivals
• The Stackelberg model was an example of a
  sequential game
• In the simultaneous-move game (static), we used
  the normal form representation
• For sequential games, we will use an extensive
  form representation (tree diagram)

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Player 1
DOWN
UP
Player 2
Player 2
UP
DOWN
UP
DOWN
(10, 15)
(5, 5)
(0, 0)
(6, 20)
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Solution Technique

• To solve for the Nash equilibrium strategies in
  sequential games, we use backward induction
• We solve the game from the end to the beginning
• How? Start at the final stage of the game and
  figure out what the firm would do if the game was
  at the point
• After considering all the final choices, move up
  to the preceding stage of the game and figure
  what that firm would do knowing how the other
  firm would behave in the final stage of the game

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Player 1
DOWN
UP
Player 2
Player 2
UP
DOWN
UP
DOWN
(10, 15)
(5, 5)
(0, 0)
(6, 20)
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Nash Equilibrium

• The Nash equilibrium in this game is for Player 1
  to choose UP and then Player 2 to choose UP
• Playing these strategies gives Player 1 a pay-off
  of 10 and Player 2 a pay-off of 20
• Now try one on your own
• Firm A is a pharmaceutical company thinking about
  developing a new cancer drug
• Firm B is a generic drug manufacturer that may
  (or may not) clone Firm 1s drug

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Firm A
Introduce Drug
Dont Introduce Drug
Firm B
Clone
Dont Clone
(1, 1)
(100, 0)
(-5, 20)
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Oligopoly vs. Perfect Competition

• As we did with monopoly, it is useful to measure
  oligopoly against perfect competition
• Unfortunately, we havent used equations or
  graphs to characterize oligopoly, so the
  comparison isnt quite as easybut we can still
  make some predictions based on what we do know
• Lets look at price and profits

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Oligopoly vs. Perfect Competition

• Either because (a) there are fewer firms or (b)
  firms often have some sort of market power,
  prices under oligopoly tend to be higher than
  perfect competition
• Higher prices also imply less less output
• Because there are barriers to entry in oligopoly
  which keep out potential competitors, there is
  the possibility of positive long run profits
• Oligopoly is usually better for consumers than
  monopoly, however

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The last words on market structure and consumer
welfare

• As markets become more competitive, the consumer
  usually benefits through lower prices and
  increased output