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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

				
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