Creating the great business leaders
Managerial Economics
By
Team Teaching FEB
Chapter 13 - Strategic Decision Making in Oligopoly Markets
Christopher Thomas, S. Charles Maurice
2020
Fakultas Ekonomi dan Bisnis
School of Economic and Business Learning Objectives
Telkom University
After reading this chapter, you will be able to:
13.1 Employ concepts of dominant strategies, dominated strategies, Nash
equilibrium, and best-response curves to make simultaneous
decisions.
13.2 Employ the roll-back method to make sequential decisions, determine
existence of first- or second-mover advantages, and employ credible
commitments to gain first- or second-mover advantage.
13.3 Understand and explain why cooperation can sometimes be achieved
when decisions are repeated over time and discuss four types of
facilitating practices for reaching cooperative outcomes.
13.4 Explain why it is difficult, but not impossible, to create strategic
barriers to entry by either limit pricing or capacity expansion.
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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
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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
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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 when all decision makers have dominant strategies
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Prisoners’ Dilemma
■ All rivals have dominant strategies
■ In dominant strategy equilibrium, all are worse off than if they had
cooperated in making their decisions
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Prisoners’ Dilemma (Table 13.1)
Bill
Don’t confess Confess
A B B
Don’t
confess 2 years, 2 years 12 years, 1 year
Jane
C J D JB
Confess 1 year, 12 years 6 years, 6 years
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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
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Successive Elimination of Dominated Strategies (Table 13.3)
Palace’s price
High ($10) Medium ($8) Low ($6)
A B C C C P
High
$1,000, $1,000 $900, $1,100 $500, $1,200
($10)
D E P F
Castle’s Medium
$1,100, $400 $800, $800 $450, $500
price ($8)
G C H I P
Low
$1,200, $300 $500, $350 $400, $400
($6)
Payoffs in dollars of profit per week
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Successive Elimination of Dominated Strategies (Table 13.3)
Reduced Payoff Table Unique Solution
Palace’s price
Medium ($8) Low ($6)
B C C C P
High
$900, $1,100 $500, $1,200
($10)
Castle’s
price H I P
Low
$500, $350 $400, $400
($6)
Payoffs in dollars of profit per week
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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
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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
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Super Bowl Advertising: A Unique Nash Equilibrium (Table 13.4)
Pepsi’s budget
Low Medium High
A C B P C
Low $60, $45 $57.5, $50 $45, $35
D P E C F
Coke’s Medium $50, $35 $65, $30 $30, $25
budget
G H I C P
High $45, $10 $60, $20 $50, $40
Payoffs in millions of dollars of semiannual profit
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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
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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’ best-response curves
intersect
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Deriving Best-Response Curve for Arrow Airlines (Figure 13.1)
Arrow Airline’s price and
marginal revenue
Panel A : Arrow
believes PB = $100
Bravo Airway’s quantity
Arrow Airline’s price
Panel B: Two points on Arrow’s
best-response curve
Bravo Airway’s price
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Best-Response Curves & Nash Equilibrium (Figure 13.2)
Arrow Airline’s price
Bravo Airway’s price
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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
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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
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Sequential Pizza Pricing
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(Figure 13.3)
Panel
Panel A – Game solution
B – Roll-back tree
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First-Mover & Second-Mover Advantages
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■ 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
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First-Mover Advantage in Technology Choice (Figure 13.4)
Telkom University
Motorola’s technology
Analog Digital
A SM B
Analog $10, $13.75 $8, $9
Sony’s
technology C D SM
Digital $9.50, $11 $11.875, $11.25
Panel A – Simultaneous technology decision
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First-Mover Advantage in Technology Choice (Figure 13.4)
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Panel B – Motorola secures a first-mover advantage
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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
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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.”
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Cooperation in Repeated Strategic Decisions
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■ Cooperation occurs when oligopoly firms make individual decisions
that make every firm better off than they would be in a
(noncooperative) Nash equilibrium
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■ 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
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Pricing Dilemma for AMD & Intel (Table 13.5)
Telkom University
AMD’s price
High Low
A: Cooperation B: AMD cheats
High $5, $2.5 $2, $3
Intel’s A
price C: Intel cheats D: Noncooperation
Low $6, $0.5 $3, $1
I I A
Payoffs in millions of dollars of profit per week
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■ 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
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■ 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
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B1 B2 BN
PVBenefits of cheating ...
(1 r )1
(1 r )2
( 1 r )N
Where Bi = πCheat – πCooperate for i = 1,…, N
C1 C2 CP
PVCosts of cheating N 1
N 2
... NP
(1 r ) (1 r ) (1 r )
Where Cj = πCooperate – πNash for j = 1,…, P
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A Firm’s Benefits & Costs of Cheating (Figure 13.5)
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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
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Facilitating Practices
■ Legal tactics designed to make cooperation more likely
■ Four tactics
● Price matching
● Sale-price guarantees
● Public pricing
● Price leadership
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Price Matching
■ Firm publicly announces that it will match any lower prices by rivals
● Usually in advertisements
■ Discourages noncooperative price-cutting
● Eliminates benefit to other firms from cutting prices
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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
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Public Pricing
■ Public prices facilitate quick detection of noncooperative price cuts
● Timely & authentic
■ Early detection
● Reduces PV of benefits of cheating
● Increases PV of costs of cheating
● Reduces likelihood of noncooperative price cuts
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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
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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
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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
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Intel’s Incentive to Cheat (Figure 13.6)
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Tacit Collusion
■ Far less extreme form of cooperation among oligopoly firms
■ Cooperation occurs without any explicit agreement or any other
facilitating practices
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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
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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
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Limit Pricing: Entry Deterred (Figure 13.7)
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Limit Pricing: Entry Occurs (Figure 13.8)
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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
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Excess Capacity Barrier to Entry (Figure 13.9)
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Excess Capacity Barrier to Entry (Figure 13.9)
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TERIMA KASIH….
50 Creating the great business leaders
