FOUR MARKET MODELS. Characteristics of Oligopolies:

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1 FOUR MARKET MODELS Perfect Competition Monopolistic Competition Oligopoly Pure Monopoly Characteristics of Oligopolies: A Few Large Producers (Less than 10) Identical or Differentiated Products High Barriers to Entry Control Over Price (Price Maker) Mutual Interdependence Firms must observe and predict the behavior of other firms

2 HOW DO OLIGOPOLIES OCCUR? Oligopolies occur when only a few large firms start to control an industry. High barriers to entry keep others from entering. Types of Barriers to Entry 1. Economies of Scale Ex: The car industry is difficult to enter because only large firms can make cars at the lowest cost 2. High Start-up Costs 3. Ownership of Raw Materials

3 How do these wireless carriers interact with one another? Mutual Interdependence Interdependence exists due to the fact that each firm s profits depends on the actions of the other firms. Watch each other very closely Differentiate their products and use non-price competition Work with each other and act like a monopolist (collusion) 4

4 If not regulated, firms would likely become a CARTEL (an alliance of firms) and collude (set prices). Illegal under U.S. Antitrust policy 5

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7 Game Theory The study of how people and firms act strategically in the context of a game. Players try to reach an optimal position through the use of strategic behavior by anticipating the moves of the other decision markers.

8 A contestant selects and opens a prize worth thousands of dollars: dream prizes such as luxury cars, exotic trips, jewelry and VIP experiences. Then, the next player is faced with a dilemma: do they steal a prize that has already been revealed, or do they take a chance with another unopened prize, hoping what's inside is worth more? When there are only two contestants left, the players have a life-changing choice to make: keep the prizes they have - or try to take all the prizes. If both players choose to "keep mine," they will each keep the prizes they have won in the prior rounds. If one player chooses "keep mine" and the other chooses to "take it all," the player that chose "take it all" will go home with all the prizes - theirs and their opponents. But if both choose "take it all," they both go home with nothing. 9

9 What would have been the best strategy? Why didn t the two players choose this strategy? 10

10 Payoff Matrix Shows how the payoff to each participant depends on the action of both. This matrix helps us analyze the situation of interdependence. Split Josie Steal Split Terrence Steal Half, Half All, None None, All None, None

11 Dominant Strategy The dominant strategy is the best move to make regardless of what your opponent does. If there is no way to make an enforceable agreement, the dominant strategy is best alternative. River Queen Ace Current Premium Regular Premium $400, $100 $450, $200 Regular $150, $400 $200, $ What is River Queen s dominant strategy? produce premium canoes. 2. What is Ace Current s dominant strategy? Ace does not have a dominant strategy b/c its strategy depends on River.

12 River Queen vs. Ace Current. 1.River Queen does have a dominant strategy produce premium canoes. If Ace produces a premium canoe, River earns $400 compared to $150 if it produced a regular canoe. If Ace produces a regular canoe, River earns $450 by making a premium compared to only $200 if it produce a regular canoe No matter what Ace does River is better off producing premium canoes dominant strategy. 2. Ace does not have a dominant strategy b/c its strategy depends on River. If River produces a premium, then it is best for Ace to produce a regular. If River produces a regular, it is best for Ace to produce a premium canoe. Assuming Ace knows that River will produce premium canoes, it will produce regular canoes.

13 Lysine is an animal feed additive and is supplied by two firms How much lysine should be produced and sold for? How much should each firm produce? 60 million and earn a TR of $180 million 14

14 1. What is Ajinomoto s dominant strategy? 2. What is ADM s dominant strategy? 15

15 Each firm has an incentive, regardless of what the other play does, to cheat b/c in doing so, they serve their best interest but at the expense of the other firm. When both players cheat, both are worse off then if they had worked together (non-cooperative behavior). 16

16 The Prisoner s Dilemma Illustrates a case where individually rational behavior (dominant strategy) leads to a jointly inefficient outcome. *occurs as long the two prisoners have no way to make an enforceable agreement.

17 2007 FRQ #3 Payoff matrix for two competing bus companies No DS $900

18 2009 FRQ-B #3 Payoff matrix for two competing bus companies

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20 Game theory helps predict human behavior 1. You are a ice cream salesmen at the beach 2. You have identical prices as another salesmen. 3. Beachgoers will purchase from the closest salesmen 4. People are evenly distributed along the beach. 5. Each morning the two firms pick locations on the beach Where is the best location?

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22 Where should you put your firm? A B Firm A decides where to goes first. What is the best strategy for choosing a location each day? Can you predict the end result each day?

23 Where should you put your firm? A B The best place is right in the middle. The best place for firm B is right next to firm A.if firm B puts theirs anywhere other than right next to firm A they will be less profitable What is firm B go to choose first? Where do you see this in the real world?

24 Nash Equilibrium (non-cooperative equilibrium) each player takes the action that is best for them, given the actions taken by other players. Equilibrium in that there is no incentive to cheat since players cannot do any better. The game ends since both sides volunatariy choose the same cell. John Forbes Nash 25

25 Nash Equilibrium Step by Step Guide Step 1. Figure out Player A s best response to all of player B s actions Step 2. Figure out Player B s best response to all of player A s actions Step 3. A Nash equilibrium exists where Player B s best response is the same as Player A s best response 26

26 Practice Problem There are two firms that produce fiberglass canoes. River Queen and Ace Current must decide whether to make a Premium canoe or a Regular Canoe. Premium Ace Current Regular River Queen Premium $400, $100 $450, $200 Regular $150, $400 $200, $150 Is there a Nash Equilibrium? River will produce premium canoes and Ace will produce regular canoes.

27 The Prisoner s Dilemma Thelma and Louise have been charged with a crime, each has one of two choices: Deny or Confess *occurs as long the two prisoners have no way to make an enforceable agreement.

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29 Overcoming the Prisoner s Dilemma Most games are not one-shot games. In most cases, players play the game over and over and must engage in strategic behavior in the LR. Firms take into account the effects of its actions on the future actions of the other players. Tit for Tat a strategy where firms play cooperatively at first, and then do whatever the other player did in the previous round. Offers a reward for cooperative behavior. If you play cooperatively, so will I If you cheat, don t expect me to be nice in the future. 30

30 Over time, the TR gained by always cheat is less than the TR by tit for tat. Understood by firms that is better for them to work together instead of against one another Collusion 31

31 Problems with Collusion There is always an incentive to produce more than the agreed upon quantity. As the number of firms increase, it is difficult to coordinate efforts to set prices, output levels and to monitor one another. 32