Strategic Decision Making in Oligopoly Markets

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Chapter 13: Strategic Decision
Making in Oligopoly Markets
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
Oligopoly Markets
• Interdependence of firms’ profits
• Distinguishing feature of oligopoly
• Arises when number of firms in market is
small enough that every firms’ price & output
decisions affect demand & marginal revenue
conditions of every other firm in market
13-2
Features of oligopoly
•Fewness of sellers
•Seller interdependence
•Feasibility of coordinated action among
ostensibly independent firms
13-3
Seller interdependence
•If Kroger offers deep discounts on soft drinks,
will Wal-Mart follow suit?
•Verizon carries unused minutes over the to
next month—implications for AT&T, et. al.?
•If AA discounts fares on its Chicago to NY
service, will United follow?
•If Regions charges swipe fees, how will rival
banks react?
•How will Duracell react to an aggressive
marketing campaign by EverReady?
•Alcoa’s decision to add production capacity is
conditioned upon the investment plans of rival
aluminum producers.
13-4
Measures of seller
concentration
The concentration ratio is the
percentage of total market sales
accounted for by an absolute number of
the largest firms in the market.
The four-firm concentration ratio (CR4)
measures the percent of total market
sales accounted for by the top four firms
in the market.
The eight-firm concentration ratio (CR4)
measures the percent of total market
sales accounted for by the top eight firms
in the market.
13-5
Concentration Ratios: Very Concentrated Industries
Industry or Product
Refrigerators
Motor vehicles
Soft drinks
Long distance telephone
Laundry machines
Breakfast foods
Vaccuum cleaners
Running shoes
Beer
Aircraft engines
Domestic air flights
Tires
Aluminum
Soap
Pet food
CR4
CR8
94
94
94
92
91
88
80
79
77
72
68
66
64
60
52
98
98
97
97
NA
93
96
97
94
83
82
86
88
73
71
Source: U.S. Bureau of the Census, Census of Manufacturers
13-6
Concentration Ratios: Less Concentrated Industries
Industry or Product
Fast food
Personal computers
Office furniture
Toys
Bread
Lawn equipment
Machine tools
Paint
Newspapers
Furniture
Boat building
Concrete
Women's dresses
CR4
CR8
44
45
45
41
34
40
30
24
22
17
14
8
6
57
63
59
58
47
57
44
36
34
25
22
12
10
Source: U.S. Bureau of the Census, Census of Manufacturers
13-7
Game Theory and
Competitive Strategy
Selecting a course of
action in a situation in
which rival players
are selecting strategies
that suit their interests
is the basic problem
of game theory.
13-8
1. Players and
their actions
A situation of competitive rivalry must involve two or
more players whose choice of actions affect each
other.
•A “player” can be a firm, an interest group or coalition,
a military leader, government official.
•Games generally consider only one kind of action—
e.g., number of daily departures, fares, in-flight services,
schedules, advertising, technology, choice of hubs,
ordering planes, expanding terminals, use of
computerized reservations systems, mergers and
acquisitions, and human resource decisions.
13-9
2. Outcomes and Payoffs
The firm’s action, together with the actions of
its rivals, determine its payoff
•In the standard “business” game, the payoff can be
in the form of profit, market share, ratings points,
•In war games, the payoff might be measured in
enemy killed or territory seized.
•In political games, payoffs may be measured in
votes or campaign contributions.
13-10
3. Underlying “rules”
The rules of the game define the range of
possible outcomes and payoffs
•For example, collusion to fix prices or a merger
among direct rivals in a concentrated market
structure may be against the rules.
•Another set a rules specifies whether players move
sequentially or simultaneously, who moves first, and
what does each player know about the other players’
preference and prior to actions?
13-11
Strategic Decisions
• Strategic behavior
• Actions taken by firms to plan for & react to
competition from rival firms
• Game theory
• Useful guidelines on behavior for strategic
situations involving interdependence
• Simultaneous Decisions
• Occur when managers must make individual
decisions without knowing their rivals’
decisions
13-12
Dominant Strategies
• Always provide best outcome no matter what
decisions rivals make
• When one exists, the rational decision maker
always follows its dominant strategy
• Predict rivals will follow their dominant
strategies, if they exist
• Dominant strategy equilibrium
• Exists when all decision makers have dominant
strategies
13-13
Prisoner’s dilemma
Bill and Jane have been charged with
bank robbery. But lacking a confession,
the DA can only get a “reckless
endangerment” charge to stick. So the
police play one suspect off against the other.
13-14
Let’s make a deal
OK, Bill. Confess,
give evidence on Jane,
and you get a
reduced sentence of one
year in prison.
13-15
What will
Jane do?
13-16
Prisoners’ Dilemma
• All rivals have dominant strategies
• In dominant strategy equilibrium, all are
worse off than if they had cooperated in
making their decisions
13-17
Prisoners’ Dilemma
(Table 13.1)
Bill
Don’t confess
Don’t
confess
Jane
A
B
2 years, 2 years
C
Confess
Confess
12 years, 1 year
J D
1 year, 12 years
B
JB
6 years, 6 years
13-18
Principle: When a firm does not
have a dominant strategy but at least
one of its rivals does have a
dominant strategy, the firm can
predict that its rivals will follow
their dominant strategies. Thus the
problem for the firm is to select the
strategy that gives the highest
payoff conditional upon rival
pursuing their dominant strategies.
13-19
Dominated Strategy
A strategy is dominated if, regardless
of what any other players do, the
strategy earns a player a smaller
payoff than some other strategy.
Hence, a strategy is dominated if it is
always better to play some other
strategy, regardless of what
opponents may do. If a player has a
dominant strategy than all others are
dominated, but the converse is not
always true.
13-20
Dominated Strategies
• Never the best strategy, so never would be
chosen & should be eliminated
• Successive elimination of dominated
strategies should continue until none
remain
• Search for dominant strategies first, then
dominated strategies
• When neither form of strategic dominance
exists, employ a different concept for making
simultaneous decisions
13-21
Successive Elimination of
Dominated Strategies (Table 13.3)
Pizza Pricing
Palace’s price
High ($10)
High
($10)
Castle’s
price
Medium
($8)
Low
($6)
Medium ($8)
Low ($6)
A
$1,000, $1,000
C
B
$900, $1,100
C P
C
$500, $1,200
D
$1,100, $400
E
P
$800, $800
F
$450, $500
C
G
$1,200, $300
H
$500, $350
I
P
$400, $400
Payoffs in dollars of profit per week
13-22
Successive Elimination of
Dominated Strategies (Table 13.3)
Unique
Palace’s price Solution
Reduced Payoff
Table
Medium ($8)
Castle’s
price
High
($10)
Low
($6)
Low ($6)
C
B
$900, $1,100
C
CP
$500, $1,200
H
$500, $350
I
P
$400, $400
Payoffs in dollars of profit per week
13-23
Castle does not have a
dominant strategy. But Palace
does. Castle should select its
best strategy, given Castle will
pursue its dominant strategy
13-24
Making Mutually Best Decisions
• For all firms in an oligopoly to be
predicting correctly each others’
decisions:
• All firms must be choosing individually best
actions given the predicted actions of their
rivals, which they can then believe are
correctly predicted
• Strategically astute managers look for
mutually best decisions
13-25
Nash Equilibrium
• Set of actions or decisions for which all
managers are choosing their best
actions given the actions they expect
their rivals to choose
• Strategic stability
• No single firm can unilaterally make a
different decision & do better
13-26
Nash decisions are likely to
chosen because Nash sets of
decisions are mutually best and
thus, “strategically stable.” No
player can do better by
unilaterally changing its
decision. Non-Nash decisions
are unlikely to be chosen
because at least one player can
improve its payoff by changing
its decision.
13-27
Super Bowl Advertising: A Unique (NonCooperative) Nash Equilibrium
Note: No dominant or
dominated strategies
Pepsi’s budget
Low
C
A
D
Medium
P
C
C
F
$45, $35
$65, $30
H
$45, $10
High
P
$57.5, $50
E
$50, $35
G
High
B
$60, $45
Low
Coke’s
budget
Medium
$30, $25
I
$60, $20
C P
$50, $40
Payoffs in millions of dollars of semiannual profit
13-28
Why is High-High Stable?
• Suppose Coke and Pepsi cooperate—Both
choose “low” and maximize joint profit.
• Pepsi can do better by unilaterally selecting
“medium.”
• In some cells, both Coke and Pepsi can increase
their payoffs by changing strategies—Consider
cell F, for example.
13-29
Nash Equilibrium
• When a unique Nash equilibrium set of
decisions exists
• Rivals can be expected to make the decisions
leading to the Nash equilibrium
• With multiple Nash equilibria, no way to predict
the likely outcome
• All dominant strategy equilibria are also
Nash equilibria
• Nash equilibria can occur without dominant or
dominated strategies
13-30
Best-Response Curves
• Analyze & explain simultaneous decisions
when choices are continuous (not discrete)
• Indicate the best decision based on the
decision the firm expects its rival will make
• Usually the profit-maximizing decision
• Nash equilibrium occurs where firms’ bestresponse curves intersect
13-31
Bravo Airway’s quantity
Arrow Airline’s price
Panel A :
Arrow believes PB = $100
Arrow Airline’s price and
marginal revenue
Deriving Best-Response Curve for
Arrow Airlines (Figure 13.1)
Panel B: Two points on
Arrow’s best-response
curve
Bravo Airway’s price
13-32
Arrow Airline’s price
Best-Response Curves & Nash
Equilibrium (Figure 13.2)
Bravo Airway’s price
13-33
Sequential Decisions
• One firm makes its decision first, then a
rival firm, knowing the action of the first
firm, makes its decision
• The best decision a manager makes today
depends on how rivals respond tomorrow
13-34
Game Tree
• Shows firms decisions as nodes with
branches extending from the nodes
• One branch for each action that can be taken at
the node
• Sequence of decisions proceeds from left to right
until final payoffs are reached
• Roll-back method (or backward induction)
• Method of finding Nash solution by looking ahead
to future decisions to reason back to the current
best decision
13-35
Sequential Pizza Pricing
Panel
– Game tree
Panel
B –ARoll-back
solution
13-36
First-Mover & Second-Mover
Advantages
• First-mover advantage
• If letting rivals know what you are doing by going
first in a sequential decision increases your payoff
• Second-mover advantage
• If reacting to a decision already made by a rival
increases your payoff
• Determine whether the order of decision
making can be confer an advantage
• Apply roll-back method to game trees for each
possible sequence of decisions
13-37
Cellular Service in Brazil
Motorola
Sony
Annual cost of analog
$250
$400
Annual cost of digital
$350
$325
•Use of incompatible technologies would
reduce the market demand for cellular service.
•Motorola would obviously prefer analog; Sony
digital.
•Brazilian government has imposed a price
ceiling—technology is the decision variable.
13-38
First-Mover Advantage in
Technology Choice
Motorola’s technology
Analog
SM B
A
$10, $13.75
Analog
Sony’s
technology
C
Digital
Digital
$9.50, $11
$8, $9
SM
D
$11.875, $11.25
Panel A – Simultaneous technology decision
13-39
To determine if a first
mover advantage
exists, construct a
decision tree and then
“roll back.”
13-40
First-Mover Advantage in
Technology Choice
Panel B – Motorola secures a first-mover advantage
13-41
Strategic Moves & Commitments
• Actions used to put rivals at a disadvantage
• Three types
• Commitments
• Threats
• Promises
• Only credible strategic moves matter
• Managers announce or demonstrate to rivals
that they will bind themselves to take a
particular action or make a specific decision
• No matter what action is taken by rivals
13-42
Credible Moves
There is no doubt
the strategic move
will be carried out
because it is in the
best interest of the
player making the
move to carry it out.
13-43
The NBA Players
Association made the
decision to decertify its
union and bring an
anti-trust suit against
the NBA owners.
Whether this amounts
to a credible strategic
move is open to debate.
13-44
Threats & Promises
• Conditional statements
• Threats
• Explicit or tacit
• “If you take action A, I will take action B, which
is undesirable or costly to you.”
• Promises
• “If you take action A, I will take action B, which
is desirable or rewarding to you.”
13-45
Cooperation in Repeated
Strategic Decisions
• Cooperation occurs when oligopoly firms
make individual decisions that make
every firm better off than they would be
in a (noncooperative) Nash equilibrium
13-46
Cheating
• Making noncooperative decisions
• Does not imply that firms have made any
agreement to cooperate
• One-time prisoners’ dilemmas
• Cooperation is not strategically stable
• No future consequences from cheating, so
both firms expect the other to cheat
• Cheating is best response for each
13-47
Pricing Dilemma for AMD & Intel
AMD’s price
High
Low
A: Cooperation
High
$5, $2.5
Intel’s
price
B: AMD cheats
$2, $3
A
C: Intel cheats
Low
$6, $0.5
D: Noncooperation
$3, $1
I
I A
Payoffs in millions of dollars of profit per week
13-48
Punishment for Cheating
• With repeated decisions, cheaters can
be punished
• When credible threats of punishment in
later rounds of decision making exist
• Strategically astute managers can
sometimes achieve cooperation in
prisoners’ dilemmas
13-49
In a one-time game,
there is no
opportunity to
punish cheaters. In
repeated games,
cheaters can be
punished.
Cooperation in one-time
games is unstable.
13-50
Deciding to Cooperate
• Cooperate
• When present value of costs of cheating
exceeds present value of benefits of
cheating
• Achieved in an oligopoly market when all
firms decide not to cheat
• Cheat
• When present value of benefits of cheating
exceeds present value of costs of cheating
13-51
Retaliation for Cheating
• Legal sanctions or fines levied
against cheaters are illegal in
most countries.
• Cheaters are usually “punished”
when rival firms push the game
back to non-cooperative (Nash)
equilibrium.
13-52
Deciding to Cooperate
P V B enefits of cheating 
B1
(1  r )
1

B2
(1  r )
2
 ... 
BN
(1  r )
N
Where Bi = πCheat – πCooperate for i = 1,…, N
P V C osts of cheating 
C1
(1  r )
N 1

C2
(1  r )
N 2
 ... 
CP
(1  r )
N P
Where Cj = πCooperate – πNash for j = 1,…, P
13-53
A Firm’s Benefits & Costs of
Cheating (Figure 13.5)
13-54
Trigger Strategies
• A rival’s cheating “triggers” punishment
phase
• Tit-for-tat strategy
• Punishes after an episode of cheating &
returns to cooperation if cheating ends
• Grim strategy
• Punishment continues forever, even if
cheaters return to cooperation
13-55
Facilitating Practices
• Legal tactics designed to make
cooperation more likely
• Four tactics
•
•
•
•
Price matching
Sale-price guarantees
Public pricing
Price leadership
13-56
Price Matching
• Firm publicly announces that it will
match any lower prices by rivals
• Usually in advertisements
• Discourages noncooperative pricecutting
• Eliminates benefit to other firms from
cutting prices
13-57
Sale-Price Guarantees
• Firm promises customers who buy an
item today that they are entitled to
receive any sale price the firm might
offer in some stipulated future period
• Primary purpose is to make it costly for
firms to cut prices
13-58
Public Pricing
• Public prices facilitate quick detection of
noncooperative price cuts
• Timely & authentic
• Example: Shared computerized reservation
systems in the airline industry.
• Early detection
• Reduces PV of benefits of cheating
• Increases PV of costs of cheating
• Reduces likelihood of noncooperative price
cuts
13-59
Price Leadership
• Price leader sets its price at a level it
believes will maximize total industry
profit
• Rest of firms cooperate by setting same
price
• Does not require explicit agreement
• Generally lawful means of facilitating
cooperative pricing
13-60
Cartels
• Most extreme form of cooperative
oligopoly
• Explicit collusive agreement to drive up
prices by restricting total market output
• Illegal in U.S., Canada, Mexico,
Germany, & European Union
13-61
Cartels
• Pricing schemes usually strategically
unstable & difficult to maintain
• Strong incentive to cheat by lowering price
• When undetected, price cuts occur along
very elastic single-firm demand curve
• Lure of much greater revenues for any one firm
that cuts price
• Cartel members secretly cut prices causing
price to fall sharply along a much steeper
demand curve
13-62
Intel’s Incentive to Cheat
(Figure 13.6)
• Along dIntel, Intel can increase its
sales and its market share.
• Along DIntel, Intel can increase
its sales but not its market share.
13-63
Tacit Collusion
• Far less extreme form of cooperation
among oligopoly firms
• Cooperation occurs without any explicit
agreement or any other facilitating
practices
13-64
Strategic Entry Deterrence
• Established firm(s) makes strategic
moves designed to discourage or
prevent entry of new firm(s) into a
market
• Two types of strategic moves
• Limit pricing
• Capacity expansion
13-65
Limit Pricing
• Established firm(s) commits to setting
price below profit-maximizing level to
prevent entry
• Under certain circumstances, an oligopolist
(or monopolist), may make a credible
commitment to charge a lower price forever
13-66
Star Coffee
Manager of
Star Coffee
The key is
making a
credible
commitment
to a “low”
post-entry
price
13-67
Limit Pricing: Entry Deterred
• P* is the π-maximizing
price
• PL is the maximumentry forestalling price.
13-68
Limit Pricing: Entry Occurs
PN is the Nash price
13-69
Star’s
Price
BRB
BRS
$3.50
0
N
$3.50
Burned Bean’s
Price
13-70
Star Coffee
Manager of
Star Coffee
The problem is that, if I
am unable to make a
credible commitment to
permanently low prices,
the manager of the
Burned Bean knows I
have an incentive to
shift to the Nash price
post-entry. Thus entry
will not be deterred.
13-71
Capacity Expansion
• Established firm(s) can make the threat of
a price cut credible by irreversibly
increasing plant capacity
• When increasing capacity results in lower
marginal costs of production, the
established firm’s best response to entry of
a new firm may be to increase its own level
of production
• Requires established firm to cut its price to sell
extra output
13-72
Excess Capacity Barrier to Entry
(Figure 13.9)
13-73
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