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Econ 145 Section 4-Chapter 5 Econ 145-Daniela Ielceanu, UNC-Ch 1 Theories of business strategy in oligopoly markets Example: fast food market(short analysis of McDonald’s decision to increase prices in 1996) Oligopoly: market structure in which firms have visible rivals with whom they interact strategically. Each firm is aware of the fact that its actions affect others. Each firm must therefore take these interactions into account when making a decision about prices, output or business decisions. Strategic decisions:Decision is an interactive setting as the one described above are called strategic decisions Definitions Oligopoly: a small group of firms in the market with substantial barriers to entry Cartel: a group of firms that agree to coordinate their activities Market structure refers to the number of firms in the market, price ,profits, ease of entry and exit, ability of firms to differentiate their products. Types of market structures: Monopoly Oligopoly Competition The three market structure can be characterized in the next table: Econ 145-Daniela Ielceanu, UNC-Ch 2 Oligopoly and monopolistic competition Definitions Oligopoly: a small group of firms in the market with substantial barriers to entry Cartel: a group of firms that agree to coordinate their activities Monopoly Oligopoly Perfect Competition Profit max condition Ability to set price Market power Entry conditions Number of firms Long run profit Strategy Products Example Econ 145-Daniela Ielceanu, UNC-Ch 3 Game theory Game theory : branch of social sciences that analyzes and models these decisions. Game theory can be divided in: non-cooperative and cooperative Non-cooperative game theory: Cooperative game theory: Assumptions needed in order to apply non-cooperative game theory to oligopoly 1. Firms are rational 2. Firms apply their rationality to the process of reasoning strategically. Introduction to game theory Players: firms, countries, individuals, etc Strategy: decision or plan of action(e.g. choosing price or price) Strategy combination: a list of strategies showing one particular strategy choice foe each player Outcome: payoffs or final net gains earned by each player Equilibrium: strategy combination so that no player has an incentive to change its current strategy (Nash equilibrium) Timing in game theory: sequential and simultaneously interaction Econ 145-Daniela Ielceanu, UNC-Ch 4 Game theory-examples Suppose that market research has shown that 70% of the potential clientele for the flight Boston-Budapest would prefer to leave Boston in the evening and arrive in Budapest next morning. The remaining 30% prefer a morning Boston departure. There are 2 firms that offer the flight: Delta and American. Both firms know the distribution of consumer preferences. Both firms know that if the 2 airlines choose the same flight time,they split the market. Profits at each carrier are directly proportional to the number of passengers carried and each wishes to maximize its share of the market. e.g. 1 Assume there are 20 consumers in the market, each with reservation price of $500 and 160 consumers with reservation price of $220. The average(marginal) cost of serving a passenger is $200. Find the optimal decision for Delta and American. Econ 145-Daniela Ielceanu, UNC-Ch 5 More examples Dominant strategy- a strategy that offers higher payoffs no matter what strategy the rival chooses. Dominated strategy- a strategy that offers lower payoffs then another strategy, no matter what the rival chooses. e.g. 2 Consider the previous example with one modification: assume that if the companies choose both the same time for the flight they split the market 60:40 60% for Delta, 40% for American. Find the payoff matrix and Nash equilibrium. Econ 145-Daniela Ielceanu, UNC-Ch 6 The Nash equilibrium as a solution concept Change the previous game: We assume that consumers are indifferent about the time of departure and care only about price.We assume that there are 20 consumers with reservation price of 500$ and 160 consumers with reservation price of 220$. If the 2 carriers set the same price, they share the market equally. The cost of serving a passenger by any airline is 200$. The two airline companies have to choose the price of their tickets. Find the equilibrium of this game. Econ 145-Daniela Ielceanu, UNC-Ch 7 Nash equilibrium as a solution concept Suppose that there are 2 firms that offer the flight Boston-Budapest: Delta and American. Suppose that there are 60 people that are willing to pay 500$ and 120 people that are willing to pay 220$ . Find the prices the 2 firms should charge.(find the Nash equilibrium) Step1: Understand the game Players: Payoffs: Strategy: Step2: Construct the payoff matrix American PH=$500 PL=$220 PH=$500 Delta PL=$220 Step3: Find the equilibrium Notes: The structure of payoffs in the games analyzed reveal a very important tension in situations of non-cooperative strategic interaction. Playing the best strategy leads to a worse outcome than if the firms cooperated and each set a high price.Games that would have a conflict between competing as individual players and cooperating are called Prisoner Dilemma games. Econ 145-Daniela Ielceanu, UNC-Ch 8 Some considerations Notes: The structure of payoffs in the games analyzed reveal a very important tension in situations of non-cooperative strategic interaction. Playing the best strategy leads to a worse outcome than if the firms cooperated and each set a high price.Games that would have a conflict between competing as individual players and cooperating are called Prisoner Dilemma games. In the last game analyzed(multiple Nash equilibria) , taking into account other factors such as the past experience and learning of each may be helpful. If the managers of the companies have dealt with each other in the past, they may be able to coordinate and Achieve the more profitable equilibrium.If the management of the companies is new and/or inexperienced it will be harder to predict which one of the two Nash equilibria will occur. Our examples refer to pure strategy equilibria. In game theory, a strategy choice is pure if a player selects it with certainty. These strategies should be distinguished from mixed strategies in which the player uses a probalistically weighted mixture of two or more strategies. Assigned work in class: Practice problem 5.1/ page 237 Econ 145-Daniela Ielceanu, UNC-Ch 9 Single period models of oligopoly: Cournot, Stackelberg, Bertrand Cournot Model(1838), Bertrand Model(1883) and Stackelberg model(1934) are all models of oligopoly, named after their authors. Features of these models 1. Number of firms in the market is given and does not change over the period 2. Firms produce a homogenous good 3. Firms have constant marginal cost of production Differences among the three models 1. In Cournot and Stackleberg models, the firms focus on the quantity of production 2. In Bertrand Model, the firms focus on prices 3. In Cournot and Bertrand models the firms act simultaneously while in Stackelberg the firms interact sequentially. Cournot Olipoly Model The story behind the model Example Suppose that there are two firms Untel and Cyrox, who supply the market for computer chips for toaster ovens.Untel’s chips are perfect substitutes for Cyrox’s chips and vice versa. Market demand for chips is estimated to be P=120-20Q, where Q ia the total quantity(in millions) of chips bought.Both firms have a constant marginal cost equal to $20/unit of output.Untel and Cyrox independently choose what quantity of output to Produce. The price then adjusts to clear the market of chips. What quantity of chips will each firm produce? Econ 145-Daniela Ielceanu, UNC-Ch 10 Solving the game Econ 145-Daniela Ielceanu, UNC-Ch 11 Comparison between monopoly, perfect competition and Cournot duopoly models Monopoly Perfect competition Price Quantity Consumers Producer surplus surplus Perfect competition Cournot Duopoly Monopoly Econ 145-Daniela Ielceanu, UNC-Ch 12 More on Cournot Model The Cournot Model can be enriched in several ways. 1. Various number of competitors 2. Different marginal cost for the participant firms Problems: problem 6/page 279 Concentration and profitability: implications of the Cournot Model Econ 145-Daniela Ielceanu, UNC-Ch 13 Stackelberg model of oligopoly Short reminder: Cournot Model - Characteristic: Model of oligopoly - Players: two firms - Strategies: choose quantity of output - Timing: the firms choose the quantity of output they produce simultaneously The story of the model: One entrant firm enters a market served by only one firm. Both firms choose the quantity of output they produce so that it maximizes their profits. The firms take the output decision simultaneously. Both firms gain duopoly profits. Stackelberg Model - Characteristic: Model of oligopoly - Players: two firms - Strategies: choose quantity of output - Timing: the firms choose quantities sequentially not simultaneously Story of the model: Consider a market served by only one firm. Let this firm be called “the leader” firm. There is one potential entrant, “the follower” firm. At time 1: the leader firm chooses its output At time 2: the follower firm chooses its output. After observing the choice of the leader In other words, the firms take the output decision sequentially. Why is timing important? e.g. Econ 145-Daniela Ielceanu, UNC-Ch 14 Solve a problem Example Suppose that there are two firms Untel and Cyrox who may supply the market for computer chips for toaster ovens.Untel’s chips are perfect substitutes for Cyrox’s chips and vice versa. Market demand for chips is estimated to be P=120-20Q, where Q ia the total quantity(in millions) of chips bought.Both firms have a constant marginal cost equal to $20/unit of output. At time 1, Untel or the leader firm, choose what quantity of output to produce. At time 2, Cyrox chooses what quantity of output to produce, after observing the choice of Untel. The price then adjusts to clear the market of chips. What quantity of chips will each firm produce? Econ 145-Daniela Ielceanu, UNC-Ch 15