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Mid-trimester Exam: Monday Students Only

Mid-trimester Examination
Date: Week 6, Monday 17th August 2015
Venue: CR 101 + CR 102
Time: 4:30pm- 6:40pm (including 10mins
Reading Time)
Coverage: Lectures 1 5.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Mid-trimester Exam: Thursday Students


Mid-trimester Examination
Date: Week 6, Wednesday 19th August
2015
Venue: CR 101 + CR 102
Time: 4:30pm- 6:40pm (including 10mins
Reading Time)
Coverage: Lectures 1 5.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

OLIGOPOLY
&
GAME THEORY

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Oligopoly and barriers to entry


Oligopoly: A market structure in which a small number of
interdependent firms compete.
It is difficult to know what an oligopolists demand and
marginal revenue curves look like.
It is not known what quantity an oligopolist will sell at a
particular price, as the price charged depends on the
prices and actions of competitors.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Oligopoly and barriers to entry


Barrier to entry: Anything that keeps new firms from
entering an industry.
Examples are economies of scale, ownership of
a key input, and government-imposed barriers.
Economies of scale: Economies of scale exist when a
firms long-run average costs fall as it increases scale of
production and the quantity of output it produces.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Using game theory to analyse oligopoly


As the demand and marginal revenue curves of an
oligopolist may be unknown, the profit-maximising level
of output and price cannot be calculated in the same way
as for competitive markets.
Game theory: The study of how people make decisions
in situations where attaining their goals depends on their
interactions with others; in economics, the study of the
decisions of firms in industries where the profits of each
firm depend on its interactions with other firms.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Game Theory: Key Characteristics


Players
The actors/participant/opponents
Rules
Describe how the game works
Actions
Available choices to each player
Strategies
A contingent plan of action taken by a player to achieve a
goal, such as a firm maximising profit

Payoffs
Rewards or results of the interaction between the players
strategies.

Using game theory to analyse oligopoly

Dominant strategy: A player has a dominant


strategy when it has one strategy that works best
(that is optimal) no matter what an opponent does.

Payoff matrix: A table that shows the payoffs that


each firm earns from every combination of strategies
adopted by the firms.

A duopoly game is price competition between two


firms.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Using game theory to analyse oligopoly


Firm behaviour and the prisoners dilemma
Cooperative equilibrium: An equilibrium in a game in
which players cooperate to increase their mutual payoff.

Non-cooperative equilibrium: An equilibrium in a game


in which players do not cooperate but pursue their own selfinterest.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Strategic Interaction: Payoff Matrix


and Dominant Strategy
The Payoff Matrix describes the payoffs to both
player for every possible outcome (see next slide)

A dominant strategy

A player has a dominant strategy when it has one strategy that


works best (that is optimal) no matter what an opponent does.

Example: A firm (e.g. Woolworths) has a dominant


strategy when it has one strategy that WORKS BEST
(that maximises its payoff) NO MATTER what its rival
(e.g. Coles) does.
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Firm B
Advertise
Firm A

Advertise
Dont
advertise

Dont advertise

10, 5

15, 0

6, 8

10, 2

In

this game there are 2 players (Firm A and Firm B)


Each firm can take 2 different actions Advertise or Dont
advertise
Each firm has 4 different payoffs
The payoff matrix shows how the payoff achieved by each firm
depends on its own actions and the actions of its rival
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Firm B

Firm A

Advertise

Dont advertise

Advertise

10, 5

15, 0

Dont
advertise

6, 8

10, 2

Firm

A considers its payoffs to formulate its strategy:


1) if B advertises (column 1)
2) if B doesnt advertise (column 3)
NB Firm A looks up and down the payoff matrix to to formulate its strategy
Firm B considers its payoffs to formulate its strategy:
1) if A advertises (row 1)
2) if B doesnt advertise (row 2)
NB Firm B looks across the payoff matrix to to formulate its strategy
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Dominant Strategy (Firm A)


Firm B

Advertise
Firm A

Dont advertise

Advertise

10, 5

15, 0

Dont
advertise

6, 8

10, 2

Firm A has a dominant strategy in this game

If B advertises, A should advertise (10>6)

If B doesnt advertise, A should advertise (15>10).

As Dominant Strategy is to Advertise.

Because 10>6 & 15>10, A will always choose Advertise.


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Dominant Strategy (Firm B)


Firm B
Advertise
Firm A

Firm

Dont advertise

Advertise

10, 5

15, 0

Dont
advertise

6, 8

10, 2

B also has a dominant strategy in this game

If A advertises, B should advertise (5>0)


If A doesnt advertise, B should advertise (8>2).
Bs Dominant Strategy is to Advertise.
Because 5>0 & 8>2, B should always choose Advertise.
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Dominant Strategy (A & B)

Does A have a dominant strategy?


YES Regardless of what B does, As best strategy is still TO
ADVERTISE.
Does B have a dominant strategy?
YES Regardless of what A does, Bs best strategy is still TO
ADVERTISE.

When both firms have dominant strategies, there STABILITY.


We call the outcome a DOMINANT STRATEGY EQUILIBRIUM.

BUT Sometimes a firm does not have a dominant


strategy
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Example of a situation where a firm does NOT


have a Dominant Strategy
Firm B
Advertise
Firm A

Dont Advertise

Advertise

10, 5

15, 0

Dont

6, 8

20, 2

Advertise

If B Advertise, A should Advertise (10>6)


However, if B Dont Advertise, A should play Dont Advertise
(20>15).
A does not have a dominant strategy.
Thus, it is more difficult to PREDICT As actions in these
circumstances
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Nash Equilibrium (NE)

A situation where each firm chooses the best strategy,


given the strategies chosen by other firms.

Occurs where NEITHER PLAYER HAS INCENTIVE


TO DEVIATE UNILATERALLY from its chosen
strategy

Implies stability EQUILIBRIUM

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Firm A does not have a Dominant


Strategy. What is the Nash Equilibrium?
Firm B
Advertise
Firm A

Dont advertise

Advertise

10, 5

15, 0

Dont
advertise

6, 8

20, 2

(B:

Advertise, A: Dont advertise) Not NE, because A has


incentive to unilaterally deviate and play Advertise (10>6)
(B:

Dont advertise, A: Dont advertise) Not NE, because B has


incentive to unilaterally deviate and play Advertise (8>2).
>>>>>next slide
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Firm A does not have a Dominant


Strategy. What is the Nash Equilibrium?
Firm B
Advertise
Firm A

Dont advertise

Advertise

10, 5

15, 0

Dont
advertise

6, 8

20, 2

(B:

Dont advertise, A: Advertise) Not NE, because B has


incentive to unilaterally deviate and play Advertise (5>0).
(B:

Advertise, A: Advertise) Is NE, because A has no incentive


to unilaterally deviate and play Dont advertise (6<8). Also, B has
no incentive to unilaterally deviate and play Dont advertise (0<5).
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The prisoners dilemma


Prisoners dilemma: A game where pursuing dominant
strategies results in non-cooperation that leaves everyone
worse off.
OR

A game in which each player has a dominant strategy,


and when each plays their dominant strategy the
resulting payoffs are smaller than if each had played a
dominated strategy.

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Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

The Prisoners Dilemma


The setting

Two bank robbers (Alf and Bob) have been captured by


the police

Without a confession, the police have insufficient


evidence to convict them of a robbery

They can prosecute for possession of unlicensed weapons

The police have a cunning plan


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The Prisoners Dilemma

Rules of the game

Prisoners are put in separate rooms and cannot


communicate with each other.

They are told

If one of the prisoners confesses, he can go free

The partner will then be convicted and face a heavy


sentence for uncooperative behaviour

If both prisoners confess, they will be convicted and


face a moderate sentence
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The Prisoners Dilemma


Possible actions

Confess

Deny

Strategies (contingent plan of action)

Confess
Deny

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The Prisoners Dilemma


Payoffs

4 outcomes are possible:


Both confess.
Both deny.
Alf confesses and Bob denies.
Bob confesses and Art denies.

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The Prisoners Dilemma


Payoffs

If both confess, they will get 5 years.

If one confesses and the other does not, the confessor


will be set free while the other gets 10.

If neither confesses, they each get 1 year for the minor


crime

The Payoff Matrix describes the payoffs to both player for


every possible outcome

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Payoff Matrix
Alfs strategies

Confess

Deny

5 years

10 years

Confess
5 years

Bobs

0 (Free)

strategies

0 (Free)

1 year

Deny
10 years

1 year
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The Prisoners Dilemma


Alf
Confess

Confessing is a dominant
strategy for Alf and Bob

If Alf denies
Bob goes free if he

5 yrs

If Alf confesses
confesses and 10 years if
he denies

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10 yrs

Confess

confesses and gets 1 year


Bob
if he denies

Bob gets 5 years if he

Deny

5 yrs

(0) Free

(0) Free

1 yr

Deny
10 yrs

1 yr

The Prisoners Dilemma


Alf
Confess

Bob is better off

confessing no matter what


Alf does

Deny

5 yrs

10 yrs

Confess

Confessing is a dominant
strategy for Bob

5 yrs
Bob
(0) Free

The same reasoning

suggests that confessing is


a dominant strategy for Alf

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(0) Free

1 yr

Deny
10 yrs

1 yr

Advertising Dilemma
Coles
Advertise
Advertise
Woolworths
Dont
advertise

Dont advertise

10, 10

17, 8

8, 17

15, 15

If

Coles Advertise, Woolworths should Advertise (10>8).

If

Coles Dont advertise, Woolworths should Advertise (17>15).

Woolworths
By

Dominant Strategy is Advertise.

the same logic, Coles Dominant Strategy is Advertise.

Therefore,

both firms play a dominant strategy equilibrium,


(Advertise, Advertise), whose pay offs are less than (Dont advertise,
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Dont advertise).

Using game theory to analyse oligopoly


Can firms escape the prisoners dilemma?
The prisoners dilemma is not always applicable as it
assumes the game will only be played once.

Most of the time, managers are playing a repeated


game.
Losses for not cooperating are greater in a repeated
game.

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Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Using game theory to analyse oligopoly


Retaliation strategies can be used against those who
dont cooperate.
A tit-for-tat strategy: is one in which one player
cooperates this period if the other player cooperated in
the previous period but cheats in the current period if
the other player cheated in the previous period.

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A trigger strategy is one in which a player cooperates


if the other player cooperates but plays the Nash
equilibrium strategy forever thereafter if the other
player cheats.

Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e

Using game theory to analyse oligopoly


Can firms escape the prisoners dilemma?, cont.

These are more likely to see cooperative behaviour in


repeated games.

Price leadership: A form of implicit collusion in which


one firm in an oligopoly announces a price change and
the other firms in the industry match the change.

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Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e