OLIGOPOLY II

By: GROUP 4 Ekta Suri Anirban Chakraborty Vishal Mohla Sumit Swati Karki
When I am getting ready to reason with a man I spend one-third of my time onethinking about myself and what I am going to say, and two-thirds thinking twoabout him and what he is going to say.
-Abraham Lincoln

FLOW OF PRESENTATION
Oligopoly and Game Theory What is Game Theory? Payoff Matrix Nash Equilibrium Strategies employed in Game Theory Types Of Games Prisoners Dilemma Cournot Model

Oligopoly and Game Theory

y

Oligopoly is a market structure in which the number of sellers is small. Oligopoly requires strategic thinking, unlike perfect competition, monopoly, and monopolistic competition. The techniques of game theory are used to solve for the equilibrium of an oligopoly market.

Game Theory
y

Developed in 1950s by mathematicians John von Neumann and economist Oskar Morgenstern Designed to evaluate situations where individuals and organizations can have conflicting objectives

What is Game Theory?

GAME:

Any situation with two or more people requiring decision making

STRATEGY: A course of action taken by one of the participants in a game PAYOFF: Result or outcome of the strategy

A game is a description of strategic interaction that includes the constraints on the actions that the players can take and the players interests, but does not specify the actions that players do take Game theory is about finite choices Game theory cannot often determine the best possible strategy, but it can determine whether there exists one Game theorists may assume players always act in a way to directly maximize their wins

Payoff Matrix
Firm 2
No Price Change Price Increase

No Price Change 10, 10

100, -30 140, 35

Firm 1
Price Increase

-20, 30

Objective Increase profits by price change Strategies:

1. Maintain prices at the present level 2. Increase prices

Above matrix shows the outcomes or payoffs that result from each combination of strategies adopted by the two participants in the game

NASH EQUILIBRIUM

Defined as a set of strategies such that none of the participants in the game can improve their payoff, given the strategies of the other participants. Identify equilibrium conditions where the rates of output allowed the firms to maximize profits and hence no need to change. No price change is an equilibrium because neither firm can benefit by increasing its prices if the other firm does not

Limitations of Nash Equilibrium

For some games, there may be no Nash equilibrium; continuously switch from one strategy to another y There can be more than one equilibrium
y
No Price Change 10, 10 Price -20, 30 Increase No Price Change

Firm 2

Price Increase

Firm 1

100, -30 140, 25

Both firms increasing their price is also a Nash equilibrium

STRATEGIES EMPLOYED IN GAME THEORY

Dominant Strategies
y

One firms best strategy may not depend on the choice made by the other participants in the game Leads to Nash equilibrium because the player will use the dominant strategy and the other will respond with its best alternative Firm 2s dominant strategy is not to change price regardless of what Firm 1 does

Dominated Strategies
y

An alternative that yields a lower payoff than some other strategies a strategy is dominated if it is always better to play some other strategy, regardless of what opponents may do It simplifies the game because they are options available to players which may be safely discarded as a result of being strictly inferior to other options.

Continued.
A strategy s in set S is strictly dominated for player i if there exists another strategy, s in S such that, i(s) > i(s) y In this case, we say that s strictly dominates s y In the previous example for Firm 2 no price change is a dominant strategy and price change is a dominated strategy
y

Maximin Strategies
y

Highly competitive situations (oligopoly) Risk-averse strategy worst possible outcome is as beneficial as possible, regardless of other players Select option that maximizes the minimum possible profit

Firm 2
No New Product New Product Firm 1 Minimum 3 2 2

Firm 1

No New Product 4, 4 New Product Firm 2 Minimum

3, 6 2, 2
3

6, 3

Each firm first determines the minimum profit that could result from each strategy Second, selects the maximum of the minimums Hence, neither firm should introduce a new product because guaranteed a profit of at least $3 million Maximin outcome not Nash equilibrium- loss avoidance rather than profit maximization

Mixed Strategies
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Pure strategy Each participant selects one course of action Mixed strategy requires randomly mixing different alternatives Every finite game will have at least one equilibrium

Types of Games
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Non cooperative games Cooperative games Repeated games Sequential games

Non Co-operative Games Co

Not possible to negotiate with other participants

(Prisoners Dilemma)

Because the two participants are interrogated separately, they have no idea whether the other person will confess or not

The Prisoners Dilemma



The prisoner's dilemma is a fundamental problem in game theory

A simple game that has become the dominant paradigm for social scientists since it was invented about 1960


How the game works -- a simple narrative.

Modeling PD games
 PD

addresses the decision making of two prisoners  Prisoners aim is to minimize the years of imprisonment  Decide individually to confess or deny the crime but depend upon the possible decisions of the other prisoner  Each one chooses his dominant strategy

Which are the dominant strategies in this game?

From the point of view of prisoner A y If B confesses, I should also confess (5 years are less than 20 years) y If B denies, I should again confess (0 year is less than 1 years) Strategy of A: y I confess irrespective of the decision of B y "Confess" is the dominant strategy of A (5 years imprisonment). From the point of view of prisoner B If A confesses, I should also confess (5 years are less than 20 years) If B denies, I should again confess (0 year is less than 1 years) Strategy of B: "Confess" is his dominant strategy, too (5 years imprisonment).

CoCo-Operative Games
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Possibility of negotiations between participants for a particular strategy If prisoners jointly decide on not confessing, they would avoid spending any time in jail Such games are a way to avoid prisoners dilemma

DILEMMA MODEL APPLIED TO OLIGOPOLY

Contd..
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FIRM A's PAYOFF IS HIGHER IF IT ADVERTISES REGARDLESS OF THE STRATEGY USED BY FIRM B IF FIRM B CHOOSES TO ADVERTISE, FIRM A WOULD BE BETTER OFF, BY 70 TO 40, IF FIRM A ADVERTISES FIRM B CHOOSES NOT TO ADVERTISE, FIRM A WOULD BE BETTER OFF, BY 100 TO 80, IF FIRM A ADVERTISES EITHER WAY, FIRM A WOULD BE BETTER OFF IF IT CHOOSES TO ADVERTISE

Contd..
y

IF EACH FIRM IN THIS EXAMPLE CHOOSES ITS DOMINANT STRATEGY, EACH WILL CHOOSE TO ADVERTISE. FIRM A WILL EARN A PAYOFF OF 70, AND FIRM B WILL EARN A PAYOFF OF 80 IF COOPERATION WERE POSSIBLE: EACH WOULD BE BETTER OFF BY CHOOSING THE OPPOSITE STRATEGY,WHICH IS NOT TO ADVERTISE FIRM A WOULD EARN A PAYOFF OF 80, AND FIRM B WOULD EARN A PAYOFF OF 90. ONE STRATEGY BASED ON COMPETITION. THE OPPOSITE STRATEGY BASED ON COOPERATION.

THAT IS THE PRISONER'S DILEMMA.

Repeated Games

Yet another way to escape prisoners dilemma If exercise is repeated multiple times, reactions become predictable

According to eg in PD, both firms select high advertising & capture max. profit But, if this exercise is repeated, outcomes may change

Advantage becomes temporary Winning strategy- tit for tat

Sequential Games
y

One player acts first & then the other responds 2 firms contemplating the introduction of an identical product in the market 1st firm- develop brand loyalties, associate product with the firm in minds of consumers Thus, first mover advantage

An example for sequential games

No new product $2, $2 $10, $-5 Firm 2 Introduce new product $-5, $10 $-7, $-7

Firm 1

No new product Introduce new product

Assume firms use maximum criterion, so neither should introduce a new product and earn $2 mn each Firm 1 introduces a new product, firm 2 will still decide to stay out because right now it is losing $5 mn, opposed to $7 mn otherwise.

Cournot Model of Oligopoly

Assumptions: Only two firms y They compete on basis of price. y Market demand curve is linear. y Marginal costs are constant.
y

Cournot Model of Oligopoly

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We determine how each firm reacts to a change in the output of the other firm. A point is reached where neither firm desires to change what it is doing. The equilibrium is the intersection of the two firms reaction functions. The reaction function shows how one firm reacts to the quantity choice of the other firm.

As 90 Output

Bs Reaction Function As Reaction Function Bs Output

45

45

90

The firm 1s demand function is P = (M - Q2) - Q1 Assume M=60 is the market marginal cost is CM=12 y By following the profit maximization rule of equating marginal revenue to marginal costs y Firm 1s total revenue function is RT = Q1 P = Q1(M - Q2 - Q1) = M Q1- Q1 Q2 - Q12
y

RM= M-Q2-2Q1 RM = CM M - Q2 - 2Q1= CM 2Q1 = (M-CM) - Q2 Q1 = (M-CM)/2 - Q2/2 = 24 - Q2/2(1) Similarly, Q2 = 2(M-CM) - 2Q2 = 96 - 2 Q1..(2) To determine the equilibrium you can solve the equations simultaneously