Firm behavior in concentrated market structures

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Firm behavior in concentrated market structures

• Outline
• The prisoners dilemma
• Advertising rivalry
• Bundling
• Mixed bundling
• Tying

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Game theory
Game theory is useful for illustratingthe
principle of seller interdependenceand also for
analyzing the behaviorof firms in tightly
concentratedmarket structures
3
Prisoners dilemma
Ralph and Gertie have been charged with bank
robbery. But lacking a confession, the DA can
only get a recklessendangerment charge to
stick. So thepolice play one suspect off against
the other.
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Lets make a deal
OK, Ralph. Confess,rat on Gertie, and you get a
reduced sentence of one year in prison.
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What will Gertie do?
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The payoff matrix
Gertie
Ralph
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Dominant strategy
A dominant strategy yields the best possible
payoff for any strategy selected by the other
player(s).
Confess is the dominantstrategy in this case,
since it gives the shortest sentence
irrespective of whether the other
prisonerselects the confess or stay mum
strategy
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Ma has 1st mover advantage. Does this game have
a predictable outcome?
Pa
NotConfess
Confess
6 years for Ma1 year for Pa
5 years for Ma3 years for Pa
Confess
Ma
4 years for Ma2 years for Pa
NotConfess
8 years for Ma0 years for Pa
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Price wars in a duopoly
The preceding is what we call a non-cooperative
game. Cooperation among duopolists is a strategy
that maximizes joint profitsas the Cournot model
will verify. So why do price wars break out?
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The payoff matrix for a running shoe duopoly
NIKE
REEBOK
Notice that low price is the dominant strategy
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Advertising rivalry

• Pizza Planet and Luigis are rivals in the
  market for home-delivered pizza. Each rival seeks
  to gain an advantage through advertising (product
  differentiation).
• Advertising is presumed NOT to affect market
  demand--only market share.
• Market share depends on the intensity of
  advertising relative to ones rival.

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• Let
• P 15
• Q 100 pizzas (market quantity-demanded)
• AC (w/o advertising expense) 5.

Hence?/Pizza (TR - TC)/Q (1500 -
500)/100 10
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If neither seller advertises, each will sell 50
pizzas and earn a profit of 500. However,
advertising could potentially increase sales to
75 pizzas.
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Pizza Planet and Luigis may select a low
strategy (meaning a 100 outlay for advertising)
or a high strategy(200 outlay for
advertising)
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The payoff matrix for a pizza duopoly
PIZZA PLANET
LUIGIS
Notice that high advertising is the dominant
strategy
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Bundling
Bundling is the practice of selling two or more
products as a package

• Cable TV companies (such as Cox Cable) bundle the
  Food Channel with CNN and ESPN.
• Lawn services bundle fertilizer service with weed
  killing service.
• Film distributors bundle flops with hits.

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Bundling films

• A distributor has 2 films to distribute (X and Y)
  to 2 theater chains, each of which has 500
  multi-screen theaters.
• Chain 1 is willing to pay up to 13,000 per
  screen per week for film X and 6,000 film Y.
• Chain 2 is willing to pay up to 7,000 per screen
  per week for film X and 11,000 for film Y.
• The differences are explained by regional
  variations in how films play.
• We assume the distributor does not engage in
  price discrimination.

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The incentive to bundle
The bundle column indicates the maximum amount
each chain would pay per screen per week for a
bundle containing films X and Y.
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The results

• You can verify that, without bundling, the
  optimal price for film X is 7,000 and the
  optimal price for film Y is 6,000. The unbundled
  maximum revenue isR (7,000 ? 1,000 screens)
  (6,000 ? 1,000 screens) 13,000,000
• You can also verify the distributor could
  maximize revenue from both films by bundling them
  at a price of 18,000 per week. The bundled
  revenue is given byR (18,000 ? 1,000
  screens) 18,000,000

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Mixed Bundling
Firms often offer customers the option to
purchase products as a bundle or to buy them
separately. This policy is called mixed bundling.

• Now we add a third chain (with 500 multi-screen
  theaters) that attaches a low value to film Y
  (assume film Y is Horror on Prom Night and
  Chain 3 has a number of theaters in retirement
  communities).
• We now assume that the distributor has a marginal
  cost of 5,000the cost of printing an additional
  copy of each film.

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Mixed bundling options
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Mixed bundling results

• The best pure bundling option is a price of
  17,000. Profits (?) from this strategy are given
  by ? (17,000- 10,000) ? 1,500 screens
  10,500,000You can verify that this strategy
  is superior to a price of 18,000, where Chain 3
  is priced out of the the market.
• The best mixed bundling strategy is to set a
  bundled price of 18,000 and a separate price of
  15,000 for film X and 12,000 for film Y. ?
  (18,000 - 10,000) ? 1,000 screens
  (15,000 - 5,000) ? 500 screens 13,000,000

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Tying
Seller requires as a condition of sale of good X
that the customer also buy good Y.

• Good X is the tying product.
• Good Y is the tied product.

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The practice of tying allows a firm to leverage
its dominant position in the tying product to
foreclose the market in the tied product.
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Examples of Tying

• Xerox copier leases required lessee to purchase
  all copying paper from Xerox.
• IBM once had a policy to give price quotes for
  full line systems only i.e., CPUs and
  plug-compatible peripherals.
• Microsoft licensing agreements with Dell, Compaq,
  Gateway, and other PC makers stipulated that the
  Internet Explorer icon appear on the desktop
  after the initial boot up sequence. These
  licensing agreements created a barrier to entry
  into the browser segment (or so claimed the
  DOJ).
• International Salt tied industrial rock salt to
  the lease of salt dispensing machines.