Markets and Strategy. Topics. Strategic Behavior. Intermediate Microeconomics

Transcription

1 Markets and Strategy Intermediate Microeconomics Topics What is strategic behavior? Under what conditions do firms behave strategically? Two examples to introduce game theory as a tool for analyzing strategic behavior. Two examples: Strategic price-quantity decisions of oligopolists. Entry deterrence tactics by a monopolist. Strategic Behavior Whenever firms explicitly take the decisions of rival firms into account, we refer to that as strategic behavior In general, we think firms act strategically when the number of firms is small, or when a firm is a large player relative to the market. when market power is high. Markets that exhibit any of these structures are usually thought of as oligopolistic.

2 Oligopoly literally means few sellers. Oligopolies can occur in either homogeneous or differentiated product markets. Oligopolists generally behave strategically to exercise their market power. What this means is: In making pricing or production decisions, an oligopolistic firm will take into account what it expects its competitors to do. i.e. it will take into account the expected sales or the expected price (or both) of rival firms. Rival firms can be: (i) other large competing firms, (ii) potential entrants, or (iii) a competitive fringe. Example : Does Daimler-Chrysler s pricing policy matter for GM s pricing decisions? Scenario: GM needs to set its pricing policy for the current year s new model of Llumina minivans. Chrysler Corp. pricing policy for its rival Caravan minivan: past behavior: skimming setting a high price, p M. An alternative could be an aggressive price of p A to capture market share. When Daimler acquired Chrysler, there was a change of management. Will there also be a fundamental change in pricing policy or not? What happens if GM anticipates incorrectly? What happens if Daimler-Chrysler adopts an aggressive price, but GM keeps the status quo? P M Price y GM P A 2 Average household s indifference curve slope = - p DC /p GM y M y A Daimler-Chrysler 2 y DC 2

3 Behaving strategically means acting on expectations about rivals behavior. Price Price P M P A Daimler-Chrysler In this case, we imagine that GM is trying to anticipate DC s pricing strategy. The reason is that its own best strategy depends on what DC does. And vice versa. GM Some Terminology about Strategic Behavior Rivals competitors who behave strategically toward one another Strategies [a sequence of] actions a firm takes as a function of what they expect their rivals to do. Games any competition between two or more players in which strategic behavior plays an important role. Games can be: cooperative parties can form an agreement that is enforceable by legal contract. non-cooperative any agreement is not enforceable by legal contract. The Price War Game Outline of the game: Strategies: Daimler-Chrysler decides whether to choose the status quo monopoly price, p M, or to price aggressively, p A. GM makes a similar decision between p M and p A. Payoffs: (See next slide) Assume that, if they both choose the same strategy, they split the market equally; but if one chooses to price aggressively and the other does not, the aggressive pricer takes over the market. 3

4 Payoffs in the Price-War Game 3 2 GM s demand curve If DC adopts same strategy If GM adopts p A and DC adopts p M Suppose each firm s MC =, and fixed costs are. Suppose p M = 3 and p A = 2. If GM and DC both choose the same pricing strategy, they share the market. If not, then customers buy from the one offering the lowest price. Payoff Matrix for the Price War Game Daimler-Chrysler GM p M p A p M GM: 3 DC: 3 GM: 5 DC: - p A GM: - DC: 5 GM: 2 DC: 2 The Two Most Important Equilibrium Concepts in Games Dominant strategy If GM has a best move regardless of DC s move, GM has a dominant strategy. Nash equilibrium If, ex post, both players prefer the strategy played to all other possible strategies, taking its rival s choice as given, the outcome is a Nash equilibrium. 4

5 The Prisoners Dilemma The game just described is a class of game known as the prisoners dilemma. (See Mansfield and Yohe, pp ) In a prisoners dilemma, all players have dominant strategies that lead to a payoff that is inferior to what they could have achieved if they had cooperated. Entry Strategies Suppose two rival pharmacies, Duane Reade and CVS, are simultaneously considering ing a new local market on the Upper West Side in Manhattan. Each knows the other is considering entry. Consider two cases: the market can support both firms the market can only support one firm Entry: Room for Two Firms CVS Duane Reade CVS: $3 DR: $3 CVS: $ DR: $ 5

6 Entry: Room for One Firm CVS Duane Reade CVS: $3 DR: $3 CVS: -$ DR: -$ Some Facts about Equilibria Not all games have dominant strategies. If either player has a dominant strategy, the dominant strategy is a unique Nash equilibrium. Games can have multiple Nash equilibria. Game can have no Nash equilibria. Since games of strategy involve an element of surprise, no equilibrium concept is without its weaknesses. Guidelines for Finding Nash Equilibria. Pick one of the possible outcomes. 2. Ask, if this were the outcome, if Player assumes Player 2 s move will remain unchanged, would Player prefer to move, if given the chance? 3. If so, this outcome is not a Nash equilibrium. If not, 4. ask, if Player 2 assumes Player s move will remain unchanged, would Player 2 prefer to move, if given the chance? 5. If so, this is not a Nash equilbrium. If not, it is a Nash equilibrium. 6. Do this for each possible outcome, since it is possible to have more than one Nash equilibrium. 6

7 Guidelines for Finding Dominant Strategies Does Player have a dominant strategy? Look at each strategy Player 2 can make, and ask, If this were Player s move, what would be Player s best move? If you find that Player s best strategy is always the same (for all possible Player 2 strategies), then Player has a dominant strategy. If both players have full information, then Player 2 will be able to predict that Player will play its dominant strategy. If either player has a dominant strategy, you know that only one Nash equilibrium is possible and the dominant strategy is it. 7