INDUSTRIAL ORGANIZATION

ECON 5700

Infinitely Repeated Games

Nash-in-Prices: Final Model of Oligopoly
In the real world, we think the following assumptions are most realistic:

1. Firms set price, not

quantity Monopolistic Competition is where firms set
prices on products that are imperfect
2. Products are never fully substitutes for one another.
undifferentiated

Example: are FedEx and UPS good substitutes? Are their prices set above marginal cost?
FedEx and UPS
Suppose both FedEx (f) and UPS (u) have marginal costs for home delivery of $14.
They face demand curves from consumers:
𝑞 1.5 0.1𝑝 0.02𝑝
𝑞 1.5 0.08𝑝 0.03𝑝
Where quantities are in millions of packages per day and prices are per item.
This demand curves show that the two goods are imperfect substitutes. How?
Given my competitor’s price, I’m just back at the uniform pricing problem.
Nash-in-Prices
Step 1: Solve for Reaction Functions

Step 1A Write out FedEx Profit: 𝜋 𝑝 14 1.5 0.1𝑝 0.02𝑝

Choose FedEx Price to maximize profit: take derivative, rearrange.

Step 1B
𝜕𝜋
𝜕𝑝 : 1.5 0.1𝑝 0.02𝑝 0.1 𝑝 14 0
𝑝 14.5 0.1𝑝
Step 1C Repeat for other firm (UPS) to get their reaction function:
𝑝 16.375 0.1875𝑝
Step 2: Find Equilibrium as the Intersection of Reaction Functions
Substitute UPS’ reaction function into FedEx’s:
Step 2A
𝑝 14.5 0.1 16.375 0.1875𝑝
Solve for FedEx’s price:
Step 2B
𝑝 16.45
Substitute this price into UPS’ reaction function to get their price:
Step 2C 𝑝 19.46
Nash-in-Prices: Graphic

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FedEx Best Response

to UPS Price
30 At Equilibrium, both
firms are playing their
“best response” to
UPS Price

each other’s price.

20

UPS Best Response

to FedEx Price
10

Market Equilibrium
0
0 10 20 30 40
FedEx Price
From Last Class: :
Equilibrium when both
40 have cost of $14:
FedEx Best Response • 𝑝 16.45
to UPS Price
35 • 𝑝 19.46
30 When UPS’ cost fall to
25 UPS Best Response $9:
UPS Price

to FedEx Price • They want to drop

20 their price by $2.50…
• Which makes FedEx
15 want to drop their
10 UPS Best Response price by $0.25…
if their MC falls $5 • Which makes UPS
5 want to drop…

0 New equilibrium:
0 10 20 30 40 • 𝑝 16.19
FedEx Price • 𝑝 16.91
Both prices fall.
Summary of Oligopoly Models

Bertrand Cournot Nash-in-Prices

Firms set price Firms set quantity Firms set price

Firm Actions

Products are Products are Products are

Products undifferentiated undifferentiated imperfect substitutes

Market price is Firms earn positive Firms earn positive

Outcome
marginal cost; or the profits. profits due to the
marginal cost of the As this would attract differentiation of
2nd-lowest cost entrants, this model their product.
producer. fits best when there
Firms earn zero are barriers to entry.
profits.
Recap and Today’s Plan
Since Midterm

Theme 1: A New • Intro to game theory: what’s a game? Types of games.

Paradigm • Solving simultaneous and sequential move games
Lessons:
• “Changing the game”: make a simultaneous game sequential via
a credible threat; commit to an action. Add a pre-game.

Theme 2: The Calculus • Models of oligopoly: Bertrand, Cournot, Nash-in-Prices

Strikes Back • Using game theory to study industry dynamics
Lessons:
• How do you respond to your rival’s actions? How will they
respond to you? What is an equilibrium? Strategic thinking.

Theme 3: The Return • We observe a lot of “cooperation”. Doesn’t reputation matter?

of the Humanity • Some games don’t look like they have an equilibrium, and yet
people play them well!
Lessons:
• You will see people again and again. Reputation matters.
• Coordination is natural, understand it.
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From Finite to Infinite
Recall: so far we have considered “finitely repeated games”; there is always an
endpoint where we can use backward induction.

Lessons from the finitely repeated model

• It may not be possible to sustain “cooperation”
• In experiments, players tend toward limited cooperation, with defection coming as
the endpoint becomes more salient.

Suppose there is no “endpoint”? We need a way of discounting future payoffs.

Some math review: consider a discount rate 𝛿 0

$
• A payoff of $X in the next time period is worth today.
$
• A payoff of $X two time periods from now is worth today.
$
• A stream of payoffs of $X starting now and lasting forever is worth
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Discounting Exercises

Example: Discounting Cash Flows

• Suppose your company can earn $100K in profit every year. Your discount rate is 𝛿
0.10, or 10%.
• What is the value today of this year’s profit? Next year’s profit?
• What is the value today of the total profits over 3 years? To infinity?

$100K $100K $100K $100K $100K

Today 1 Year from 2 Years 3 Years …

Today from Today from Today

• Value today of this year’s profit: $100K

• Value today of next year’s profit: $100𝐾 ⋅ $90.9𝐾
.
$ $
• Value today of three years’ profits: $100𝐾 $273.55𝐾
. .
.
• Value today of total profits starting today, forever: $100𝐾 ⋅ $1,100𝐾
.

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Discounting Payoffs Example: Google Fiber
Google Fiber and Gigabit Home Internet
Google launched its first “Fiber” internet service in Kansas City in Sept 2012. Fiber-optic
speeds to the home for $70 per month. They then asked cities to apply to be the next sites,
selecting Austin, TX on April 9 2013. Under two hours later, AT&T announced it would bring
“GigaPower” internet to Austin.

AT&T Google

• Incumbent provider of internet services; • Potential entrant in high-speed internet

active in many markets. access.
• Does not typically offer gigabit Ethernet • Started with a pilot program in Kansas
speeds. City; priced aggressively.
• Existing infrastructure is aging. • Starting from scratch: cost disadvantage.

• Strong interest in protecting its • … unclear motivation.

monopoly over existing wired • Perhaps they want to make money?
infrastructure • Perhaps they want to prod incumbents
to upgrade their infrastructure?
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Google Fiber and Game Theory
Can think of this as a game with two players: Google and AT&T (or other incumbent)

Google • Actions could be “enter market” or “stay out”

• Actions could be “fight” (upgrade infrastructure to gigabit)

Incumbent
or “ignore”

Key point: this game is going to be played in sequential markets, say annually, forever
(i.e. there are infinitely many markets. )

Stage game: played Google

sequentially across markets
Enter Market Stay Out

Ignore (5,2) (10, 0)

Incumbent
Fight ( 10, 12) (2,0)

Incumbent (AT&T) would like to threaten to fight; however, it is not very credible.
• If they “ignore” in the first few markets, threatening to fight later is even less
credible.
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Discounting Future Payoffs
Stage game: played Google
sequentially
Enter Market Stay Out

Ignore (5,2) (10, 0)

Incumbent
Fight ( 10, 12) (2,0)

Suppose AT&T would need to “fight” only in the first market in order for Google to give up.
What is the value to AT&T today if 𝛿 0.05?
.
Payoff 10 10 ⋯ 10 ⋅ 10 ⋅ 190
. .

What if they had to fight in the first 20 markets before Google would give up?

Payoff 10 ⋯ 10 ⋯
51.7
It wouldn’t be worth fighting if it took 20 cities to get Google to give up.
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Google’s Real Goal
Why is Google becoming an ISP? Why do they care?
• Google makes money when you use the Internet.
• They want the cost of using the Internet to be very low.
• They see the current landscape as being complacent: no need to upgrade existing
infrastructure.

• Their goal is to get incumbents to upgrade infrastructure and offer competitive pricing.
Their way of achieving this: become a viable potential entrant in all markets.

Suppose the incumbents could make some smaller investments to upgrade their
infrastructure, and also offer competitive pricing on internet products – making “fight”
less costly for them, and making Google’s entry less profitable for Google? They
wouldn’t have to play “fight” as long to earn their reputation.
• This could be Google’s plan - Use the threat of entry to get incumbents to do
upgrades.

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Infinitely Repeated Games
Strategies in Infinitely Repeated Games
When a strategic interaction is repeated, it may be possible to sustain an equilibrium
where both players play dominated strategies and increase their payoff over the one-shot
equilibrium. For example, we could have an equilibrium of (cooperate, cooperate) in a
repeated prisoner’s dilemma.
Examples of strategies in repeated prisoners’ dilemma:
• Always choose “Cooperate”.
“Nice” • Opponent will quickly learn to always defect.
• Always choose “Defect”.
“Mean” • Opponent will do best to always defect.

• If my opponent ever chooses to “defect”, I will choose to

“Grim Trigger” “defect” forever.

• My move this turn is whatever my opponent’s move was last

“Tit-for-Tat” turn.
• “Cooperate”, but if you “Defect”, I will “Defect” until you
“Eye for an Eye” “Cooperate” again.
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Recall: Hertz-Avis Collusion
In Lecture 3 (after the midterm), we derived the following payoff matrix for Hertz
and Avis: Avis

Compete Collude
𝑞 30 𝑞 22.5
Compete
(900, 900) (1139, 759)
𝑞 30
Hertz
Collude
(759, 1139) (1012.5, 1012.5)
𝑞 22.5

The Nash Equilibrium of this game is (“compete”, “compete”)

• Notice the similarity to the Prisoner’s Dilemma

Question: At what discount rate could these firms sustain collusion by

announcing a “grim trigger” strategy?
Step 1 • Determine payoffs from always colluding

Step 2 • Determine payoffs from defecting once and being punished

• Solve for the inequality.
Step 3
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Recall: Hertz-Avis Collusion
Avis

Compete Collude
𝑞 30 𝑞 22.5
Compete
(900, 900) (1139, 759)
𝑞 30
Hertz
Collude
(759, 1139) (1012.5, 1012.5)
𝑞 22.5

Payoff from continuing with Payoff from playing “Compete” for a

“Collude” single period
=Payoff of $1,012.50 forever =Payoff of $1,139 this period, then
$900 forever starting next period
1 𝛿 $900 1 𝛿
$1,012.50 $1,139
𝛿 1 𝛿 𝛿
$1,012.50 1 𝛿 $1,139𝛿 $900
$112.50 $126.50𝛿
0.889 𝛿

Given this, it should be easy to sustain “collude” with a grim trigger strategy.
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Do Firms Play These Kinds of Strategies?

Back when there were many major

airlines:
• “In the early 1990s, during the
heyday of airline pricing battles,
several airlines were known to
include "FU'' in fare codes as a way
to signal displeasure to
competitors.”
• “Airline price signaling became such
an issue that the Justice
Department ended the industry
practice of proposing fare changes
in computer reservation systems.
Instead, airlines can only offer fares
that are immediately available for
sale.”

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What Might a Punishment Strategy Look Like?

Example of a “punishment” strategy (WSJ 2002):

1. “American increased the advance-purchase

requirement on discounted business-travel tickets …
The change amounted to a de-facto fare increase for
business travelers.”

2. “Only Continental Airlines matched American's Clear “punishment”

change in all the markets” against those that do not
cooperate.
3. “American responded late last week by putting $99
one-way fares in 10 markets flown non-stop by
Northwest, 10 flown non-stop by United Airlines, 10
Delta Air Lines markets and 10 US Airways Group Inc.
markets, … Notably, American excluded Continental
markets from its $99 one-way fares”

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Firms Leveraging Consumer Reputation

“Web 1.0” companies that used reputation to overcome problems:

• You’re buying/selling with a stranger

• Worry is that one side would “defect”
• Approach: create reputation system,
have certified sellers.
• Ebay also provided guarantees and
a payment system.

• You’re looking for a particular type of

business.
• Yelp let’s you read reviews from other
people.
• Reviewers have “ratings” themselves.
• Challenge: Yelp is also selling
advertising to businesses.

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Firms Leveraging Consumer Reputation
Challenge is the “stranger” aspect of reputation. Also, there can be incentives to lie.
Use of reputation is increasing and evolving:

• Drivers rate passengers, passengers rate drivers.

• On the driver side: relatively small number of drivers
make it easier for reviews to have meaning. Also, no
incentive to lie.

• Adds social network dimension.

• Less likely to be a bad guest/host to someone that is a
“friend of a friend”.
• Potentially makes “punishment” a viable threat after a
one-off interaction.

• Adds the social network dimension to dating apps.

• How might this change behavior?

Great opportunities in “Web 2.0” to improve interactions

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Advertising Spillovers

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Example: Advertising Spillovers
The Setting
Royal Caribbean and Carnival compete
every year on the New England cruise
market, sailing out of east coast ports,
stopping in Maine and Atlantic Canada.
• Each firm could choose to advertise in
a given year, which increases overall
demand (i.e. benefits my competitor).
• Firms have marginal costs of $400 per
ticket for each.
Demand
Consumer demand for New England
cruises is given by
𝑃 𝑋 2𝑄
Where Q is in thousands, and X is:
• 𝑋 900 if neither firm advertises.
• 𝑋 975 if one firm advertises.
• 𝑋 1050 if both firms advertise.
Advertising campaigns are costly: it would
cost either firm $8M to advertise

Firms simultaneously decide at the beginning of the year whether to advertise or not;
after, they simultaneously set quantities on the route.

What is the one-shot equilibrium?

Could the firms do better if they could commit to different strategies?

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Graphic of Demand
Demand for Cruises When…
1200
1 Advertises
1000
Both Advertise
800 • Either of us advertising
increases demand for
both of us, since our
Price

600 goods are substitutes.

MC • Even though both of us
400 benefit, the cost falls only
on those that advertise.

200
No Advertising
0
0 200 400 600
Quantity

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Roadmap

Overview

• Players are Carnival and Royal Caribbean; game is infinitely repeated.

Game Structure • Each firm chooses an action: advertise (“A”), or not advertise (“NA”).
• They make this choice simultaneously, every year. Discount rate is 𝛿.

1. Single-Period • Given a set of actions for a year, we can use the Cournot model to
Game compute payoffs for each possible set of actions.
• We can solve for the equilibrium in every period using a game board.

• With the game board, we can solve for discount rates that might
2. Solving sustain a higher equilibrium using a strategy such as “Grim Trigger”
or “Eye-for-an-Eye”.

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<OPTIONAL>: Single-Period Equilibrium Outcome
Carnival Best Response Royal Caribbean Best Response
Find residual demand, then set MR=MC: Same approach:
𝑃 𝑋 2𝑞 2𝑞 𝑃 𝑋 2𝑞 2𝑞
𝑅 𝑋𝑞 2𝑞 2𝑞 𝑞 𝑅 𝑋𝑞 2𝑞 2𝑞 𝑞
𝑀𝑅 𝑋 4𝑞 2𝑞 𝑀𝑅 𝑋 4𝑞 2𝑞
𝑀𝐶 400 𝑀𝐶 400
400 𝑋 4𝑞 2𝑞 400 𝑋 4𝑞 2𝑞
∗ ∗
𝑞 0.25𝑋 0.5𝑞 100 𝑞 0.25𝑋 0.5𝑞 100

Equilibrium: sub RC best response into Carnival best response

𝑞∗ 0.25𝑋 0.5 0.25𝑋 0.5𝑞 ∗ 100 100
𝑞∗ 0.25𝑞 ∗ 0.125𝑋 50
∗
1
𝑞 ⋅ 𝑋 400
6
Similarly, 𝑞 ∗ ⋅ 𝑋 400 , so we will have an equilibrium market price of
1 1 1
𝑃 𝑋 2 ⋅ 𝑋 400 2 ⋅ 𝑋 400 ⋅ 𝑋 800
6 6 3
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<OPTIONAL>: Single-Period Payoffs

Carnival Single-Period Profits Royal Caribbean Single-Period Profits

Substitute in optimal quantity and Substitute in optimal quantity and
equilibrium market price: equilibrium market price:
𝜋 𝑞 ∗ ⋅ 𝑃 𝑀𝐶 𝜋 𝑞 ∗ ⋅ 𝑃 𝑀𝐶
𝑋 400 𝑋 800 1200 𝑋 400 𝑋 800 1200
𝑋 400 𝑋 400

If we know the advertising decisions of each firm, we will know 𝑋. Recall that X is:
𝑋=900 if neither firm advertises.
𝑋=975 if one firm advertises.
𝑋=1050 if both firms advertise.

Then we know the single-period payoffs for advertising: these profits, less any
advertising costs. We can now complete a game board.
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Advertising: One-Shot Game
Advertising costs $8M, and 𝑋 900 if neither firm advertises, 𝑋 975 if one firm
advertises, and 𝑋 1050 if both firms advertise.
Royal Caribbean

Advertise Don’t Advertise

Advertise
(𝜋 ∗ 1050 -$8M, 𝜋 ∗ 1050 -$8M) (𝜋 ∗ 975 -$8M, 𝜋 ∗ 975 )
Carnival
Don’t Advertise (𝜋 ∗ 975 , 𝜋 ∗ 975 -$8M) (𝜋 ∗ 900 , 𝜋 ∗ 900 )

Evaluated: Royal Caribbean

Advertise Don’t Advertise

Advertise
($15.5M, $15.5M) ($10.4M, $18.4M)
Carnival
Don’t Advertise ($18.4M, $10.4M) ($13.9M, $13.9M)

Dominant Strategies? Equilibrium?

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Repeated Games Strategy 1: “Grim Trigger”
The “Grim Trigger” Strategy
One possible strategy is to announce that you will play “Advertise”, but if your opponent
ever chooses “Don’t Advertise”, you will choose “Don’t Advertise” forever after. Is this an
equilibrium? Your opponent has announced “Grim Trigger”…

• I earn $15.5M each year, forever.

If I always play “Advertise”…
•𝜋 15.5

• I earn $18.4M that period, then $13.9M forever after.

If I ever play “Don’t”… .
•𝜋 18.4

I would only be willing to deviate and play “Don’t” if:

1 𝛿 13.9 1 𝛿
15.5 18.4
𝛿 1 𝛿 𝛿
Solving, we get that if 𝛿 0.552, I will deviate. That is very short-sighted!

Both firms announcing “Grim Trigger” sustains the higher equilibrium.

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Strategy 2: “Eye for an Eye”
The “Eye for an Eye” Strategy
I will always play “Advertise”. However, if you “Don’t” on me, I will get back at you by
choosing “Don’t” until you “Advertise” again.

• I earn $15.5M each year, forever.

If I always play “Advertise”…
•𝜋 15.5

If I play “Don’t” for a single • I earn $18.4M, then $10.4M, then $15.5M forever after.
period… . .
•𝜋 18.4

I would be willing to play “Don’t” for a single period if

1 𝛿 10.4 15.5 1 𝛿
15.5 18.4
𝛿 1 𝛿 1 𝛿 𝛿
Solving, we get that if 𝛿 0.759, I will deviate. That is very short-sighted!

Both firms announcing “Eye for an Eye” sustains the higher equilibrium.

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Why Else Might We See “Cooperate”?
Experimental Evidence on Cooperation
As we saw in the finitely-repeated prisoner’s dilemma, subjects in lab experiments tend to
“cooperate” more than theory suggests, even when they’ll never see their rival again.
Some suggest it is because subjects get value from the “actions” themselves, aside from the
payoffs.

Social preferences:

• Some subjects may simply value being “nice”, above

Altruism
whatever payoffs they get from it.

• Some other subjects may simply value choosing actions

Fairness
they believe are “fair”

• Finally, some subjects may value “revenge” against

Vindictiveness
actions that they perceive as mean or unfair.
• If others know this, we’d expect even more
cooperation.

Human interactions exhibit plenty of “cooperation”.

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Review of Advanced Oligopoly Topics
Four advanced examples: How to Solve:

• Determine my follower’s optimal response to me

First Mover Advantage • Make my decision expecting him to do his optimal
response.
• Determine the entrant’s optimal response and profits
Limit Pricing given my decision
• See if it makes sense to change my decision so that the
entrant cannot profit from entry.
• Solve for what the discounted flow of payoffs are from
Staying in a Price War each action in the repeated game.
• See what this implies about my expectations of your
future behavior.

• Look at strategies like “Grim Trigger” and “Eye for an Eye”

Sustaining Cooperation • Check if they are an equilibrium: compare the discounted
payoff flow from cooperating vs deviating from the strategy.

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Summary & Direction

Today
Leveraging Repeated Interactions
• Grim Trigger and Eye for an Eye strategies use the threat of future punishment to create
an incentive for cooperation
• This is why many firms to not fall into the prisoner’s dilemma trap.

Lesson for understanding competition:

• Take the long view.
• Think before choosing “defect” both as a person and as a firm.
• Your reputation is valuable.

Next Lecture

• Mixed strategies in game theory. Randomizing among actions instead of using only
a single strategy.

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