Lecture Managerial economics (Ninth edition): Chapter 13 – Thomas, Maurice

Chapter 13 - Strategic decision making in oligopoly markets. this chapter introduced you to game theory, an indispensable tool for thinking about strategic decision making. We focused on three types of strategic decision situations: (1) simultaneous decisions, in which managers make their individual decisions without knowing the decisions of their rivals; (2) sequential decisions, in which one manager makes a decision before the other; and (3) repeated decisions, in which strategic decisions are made repeatedly over time by the same firms.

Managerial Economics ninth edition Thomas Maurice Chapter 13 Strategic Decision Making in Oligopoly Markets McGraw­Hill/Irwin McGraw­Hill/Irwin Managerial Economics, 9e Managerial Economics, 9e Copyright © 2008 by the McGraw­Hill Companies, Inc. All rights reserved Managerial Economics 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 13­2 Managerial Economics 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 13­3 Managerial Economics Simultaneous Decisions • Occur when managers must make individual decisions without knowing their rivals’ decisions 13­4 Managerial Economics 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 13­5 Managerial Economics Prisoners’ Dilemma • All rivals have dominant strategies • In dominant strategy equilibrium, all are worse off than if they had cooperated in making their decisions 13­6 Managerial Economics Prisoners’ Dilemma (Table 13.1)               Bill Don’t confe s s Do n’t  c o nfe s s Jane 13­7 A Confe s s B   2 ye ars , 2 ye ars B   12 ye ars , 1 ye ar C D J Co nfe s s    1 ye ar, 12 ye ars JB   6 ye ars , 6 ye ars Managerial Economics 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 13­8 Managerial Economics Successive Elimination of Dominated Strategies (Table 13.3) Palace ’s  price High ($10) Hig h ($10) Cas tle ’s   pric e Me dium ($8) Lo w ($6) Me dium  ($8) A   $1,000, $1,000 B C   $900, $1,100 C C P   $500, $1,200 D   $1,100, $400 E P   $800, $800 F   $450, $500 G C   $1,200, $300 H   $500, $350 I P   $400, $400 Payoffs in dollars of profit per week 13­9 Low ($6) Managerial Economics Successive Elimination of Dominated Strategies (Table 13.3) Unique   Re duc e d Payo ff                              Palace ’s  price S o lutio n Table Me dium  ($8) Cas tle ’s   pric e Hig h ($10) Lo w ($6) Low ($6) B C   $900, $1,100 C CP   $500, $1,200 H   $500, $350 I   $400, $400 Payoffs in dollars of profit per week 13­10 P Managerial Economics Price Matching • Firm publicly announces that it will match any lower prices by rivals • Usually in advertisements • Discourages noncooperative pricecutting • Eliminates benefit to other firms from cutting  prices 13­37 Managerial Economics 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 13­38 Managerial Economics 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 13­39 Managerial Economics 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 13­40 Managerial Economics 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 13­41 Managerial Economics 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 13­42 Managerial Economics Intel’s Incentive to Cheat (Figure 13.6) 13­43 Managerial Economics Tacit Collusion • Far less extreme form of cooperation among oligopoly firms • Cooperation occurs without any explicit agreement or any other facilitating practices 13­44 Managerial Economics 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 13­45 Managerial Economics Limit Pricing • Established firm(s) commits to setting price below profitmaximizing level to prevent entry • Under certain circumstances, an oligopolist (or  monopolist), may make a credible commitment to  charge a lower price forever 13­46 Managerial Economics Limit Pricing: Entry Deterred (Figure 13.7) 13­47 Managerial Economics Limit Pricing: Entry Occurs (Figure 13.8) 13­48 Managerial Economics 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 13­49 Managerial Economics Excess Capacity Barrier to Entry (Figure 13.9) 13­50 Managerial Economics Excess Capacity Barrier to Entry (Figure 13.9) 13­51 ... future decisions to reason back to the current best decision 13 19 Managerial Economics Sequential Pizza Pricing (Figure 13. 3) Pane l B – Ro ll­bac k  s o lutio n 13 20 Managerial Economics First-Mover & Second-Mover...   $11.875, $11.25 Pane l A – S imultane o us  te c hno lo g y de c is io n 13 23 Managerial Economics First-Mover Advantage in Technology Choice (Figure 13. 4) 13 24 Pane l B – Mo to ro la s e c ure... situations involving interdependence 13 3 Managerial Economics Simultaneous Decisions • Occur when managers must make individual decisions without knowing their rivals’ decisions 13 4 Managerial Economics Dominant