Oligopoly and Strategic Behavior

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Lecture 5
Managerial Economics ECON 511

• Oligopoly and Strategic Behavior

Professor Changqi Wu
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Topics for Today

• Oligopolistic competition
• Prisoners dilemma and Nash equilibrium
• Games with sequential moves

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1. Oligopolistic Competition

• Whats common in these industries?
• Newspaper publishing, internet browsers, credit
  cards, property development
• A few sellers in the market, each commands a
  substantial market share
• High barriers to entry
• Interdependence among the few
• A firm must conjecture about its rival's action
  and reaction to its own action

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Game Theory and Strategy

• Game theory is a branch of mathematics that
  studies strategic interactions among rational
  players
• Strategy is an action plan that leads to
  successful achievement of the goal
• Game theory has been used in economics to analyze
  interactions between rivals.
• An illustration Prisoners dilemma

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2. Prisoners Dilemma

• There are two players
• Each player wants to maximize her own payoff
• Communication between two players is not allowed
  and both players move simultaneously
• There are two possible strategies cooperation
  (deny any wrongdoing) and noncooperation (confess
  to the police)

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Prisoners Dilemma
Player 2
noncoopetative
Cooperative
-1
5
Noncooperative
-5
-1
Player 1
3
-5
Cooperative
5
3
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Observations

• Payoffs to each and every player depend on other
  players action
• A dominant strategy produces a better payoff than
  alternative course of action
• Both players end up worse-off at the equilibrium

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Nash Equilibrium

• A combination of strategies such that each and
  every player's strategy is an optimal response to
  the other players strategy
• No one is willing to deviate unilaterally from a
  Nash equilibrium.
• Some game may not have a pure strategy Nash
  equilibrium, but will have a randomized Nash
  equilibrium

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Matching Pennies
Player 2
Tail
Head
1
-1
Head
1
-1
Player 1
1
-1
Tail
1
-1
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Battle of Sexes
Husband
Football
Opera
5
1
Opera
1
3
Wife
3
0
Football
0
5
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Business Application
Firm 2
Price war
No price war
-1
5
Price war
-5
-1
Firm 1
3
-5
No price war
5
3
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How to Resolve the Prisoners Dilemma

• Changing payoffs
• Introducing a third player
• Game with repeat play
• Detecting the cheater
• Punishment of cheaters

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Detecting Cheater

• Difficulties in cheating detection
• price may fall because of changes in demand
• multi-dimensional interactions
• it is harder to identify the cheater than to
  detect cheating
• Detection device
• lowest price guarantee

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Strategies to Punish the Cheater

• Trigger strategy
• Tit-for-tat strategy
• Step 1 Begin with cooperation
• Step 2 Mimic rival's action
• Business applications
• meet-competition clauses"

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The Tit-For-Tat Strategy
Player 1
Player 2
Round
Action
Action Payoff
Payoff
C
C
1
3
3
2
C
-5
NC
5
3
NC
-1
NC
-1
4
NC
-1
NC
-1
5
NC
5
C
-5
6
C
3
C
3
7
C
3
C
3
.
.
.
.
.
.
.
.
.
.
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Advantages of the TFT Strategy

• Simplicity and clarity
• Niceness
• Provocability
• Forgiveness

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When to Play the TFT Strategy?

• The objective is to achieve a high payoff, NOT to
  win the contest
• The game must repeat many times
• Cheating detection is not a problem
• Discount factor cannot be too small
• There is a good chance that other players play
  TFT strategy.

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3. Game with Sequential Moves

• Players move in sequence in choosing their
  strategies
• The second mover can observe the action of the
  first mover
• The first mover must look forward and think
  backward backward induction.

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Battle for the Evening News
Payoffs TVB, ATV
1, 1
600
600
ATV
3, 4
630
TVB
600
4, 3
630
ATV
ATV
630
2.5, 2.5
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First Mover Advantage

• First-mover advantage the gains from the right
  to move first
• To take the best position in the market
• A firm can enjoy the first mover advantage when
  it moves is credible.

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Credible Commitment

• Can ATV do better by threatening TVB that it will
  broadcast news at 630 anyway?
• An empty threat works against a players own
  interest
• A player can make her threat credible by taking a
  costly and irreversible move
• Burning the bridge

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Empty Threat
Payoffs
Incumbent
Entrant
Incumbent Entrant
Price cut
2, 0
Enter
5, 5
Output cut
No entry
15, 0
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Credible Commitment
Payoffs
Incumt Entrant.
Incumbent
Price cut
-5, -1
Entrant
Incumbent
Enter
-10, 2
Output cut
Expand capacity
10, 0
No entry
Price cut
2, 0
Enter
Do nothing
5, 5
Output cut
No entry
15, 0
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Key Learning Points

• Nash equilibrium describes the combinations of
  strategies that nobody wants to deviate from.
• Prisoners dilemma hurts the interests of both
  players. Some devices can be used to resolve such
  a dilemma.
• Firms can gain advantages by acting as the first
  mover.

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References

• Thinking Strategically The Competitive Edge in
  Business, Politics, and Everyday Life, by Avinash
  Dixit and Barry Nalebuff
• Co-Opetition By Barry Nalebuff and Adam
  Brandenburger.

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Key Learning Points

• Strategic interaction is an important element in
  business.
• The Cambridge Zoo provides a taxonomy of business
  strategies.
• One should take into account the nature of the
  investment in the first stage (tough or soft) and
  the nature of the strategic relationship between
  the rivals in the second stage (strategic
  substitute and strategic complement) when making
  investment decisions.