Oligopoly: Introduction to Game Theory
Oligopoly: Introduction to Game Theory 251
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Microeconomics Notes Oligopoly Introduction to Game Theory Characteristics of an Oligopoly 1 Few Firms could be as few as 2 firms in which case the oligopoly is called a duopoly High concentration ratios High HHI Products may or may not be differentiated Example gt Cereal differentiated 0 Kellogg39s corn akes vs Post Toasties gt Natural Resources not differentiated 0 There is almost no differentiation of products when firms supply a natural resource like natural gas because the quality of natural gas cannot really be changed Significant barriers to entry a Legal barriers to entry eg taxicab drivers need a special license to enter the taxicab industry These licenses are in limited supply to limit the number of taxicabs b Natural barriers to entry ie economies of scale make it more worthwhile to have a few firms produce all of the industry39s output c Artificial barriers to entry eg use of advertisements pricing strategies etc to prevent competitors from being successful and to keep potential competitors from entering the industry Because there are so few firms in an oligopoly and no other firms can enter the industry there is a lot of direct interaction among firms in the industry If there are just a few companies in the industry and one decides to reduce the prices for example the other forms must respond to that action lower prices too This is not the case in perfect competition because each firm has such an insignificant market share that their decision wouldn39t really affect the rest of the industry We cannot really draw a diagram to explain what decisions firms should make in an oligopoly Instead we use the concept of Game Theory Game Theory gt The Game Theory explains that you find something called strategic interdependence in an oligopolistic industry This means that the actions of one firm have an affect on the outcomes of other firms decisions Characteristics of a game 1 Players number of firms Rules what prices to charge for example 2 Strategies a Pricing game b Advertising game c RampD game 3 Payoffs illustrated by a payoff matrix Payoff Matrix Example gt The rows and the columns of correspond to the strategy of each player For example let39s say that there are 0 Two players Player 1 and Player 2 and 0 Two strategies high price low price Microeconomics Notes Chapter 1 Scarcity is our inability to get everything we want An incentive is a reward that encourages an action or a penalty that discourages one For example price acts as an incentive to buy or not to by a product Economics is the social science that studies the choices that individuals businesses governments and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices Microeconomics is the study of the choices that individuals and businesses make the way these choices interact in markets and the influence of governments Macroeconomics is the study of the performance of the national economy and the global economy Goods and services are the objects that people value and produce to satisfy human wants Factors of Production 0 Land the gifts of nature that we use to produce goods and services For example minerals oil gas coal water air forests and fish 0 Labor the work time and work effort that people devote to producing goods and services For example labor includes the physical and mental efforts of all the people who work on farms and construction sites and in factories shops and offices 0 Capital the tools instruments machines buildings and other constructions that businesses use to produce goods and services 0 Entrepreneurship the human resource that organizes labor land and capital Entrepreneurs come up with new ideas about what and how to produce make business decisions and bear the risks that arise from these decisions Human capital is the knowledge and skill that people obtain from education on thej ob training and work experience Financial capital refers to money stocks and bonds Financial capital enables businesses to buy physical capital People earn their incomes by selling the services of the factors of production they own Land earns rent Labor earns wages Capital earns interest 0 Entrepreneurship earns profit 000 Economic way of thinking 0 A choice is a tradeoff 0 People make rational choices by comparing benefits and costs 0 Benefit is what you gain from something 0 Cost is what you must give up to get something 0 Most choices are hoWmuch choices made at the margin 0 Choices respond to incentives A tradeoff is an exchange giving up something to get something else You face a tradeoff when you have to decide to either study for a test or hang out with your friends A rational choice is one that compares costs and benefits and achieves the greatest benefit over cost for the person making the choice The benefit someone gains from something is determined by preferences Economists measure benefit as the most that a person is willing to give up to get something For example you are Willing to give up a lot to go to school but your are only giving up an iTunes download for a pizza Hence going to school offers more benefit to you The opportunity cost of something is the highest valued alternative that must be given up to get it The opportunity cost of going to school could be the time you could spend with friends the tuition fees which you could have used for a car and the salary you could have earned from a job The benefit that arises from the increase of an activity is called marginal benefit For example the marginal benefit of one more night of study before the test is the boost it gives your grade The opportunity cost of an increase in an activity is called marginal cost For example the marginal cost of one more night of study is not being able to hang out With friends that night Is the marginal benefit of studying one extra night are greater than the marginal cost then you should study one extra night A positive statement is about What is It says What is currently believed about the Way the World operates A positive statement might be right or Wrong but We can test it by checking it against the facts An example of a positive statement is our planet is Warming due to the burning of coal A normative statement is about What ought to be It depends on values that cannot be tested You may agree or disagree with a normative statement An example of a normative statement is We ought to cut our use of coal by 50 percent Normative statements cannot be tested and do not assert a fact that can be checked Chapter 2 0 The production possibility frontier is the boundary between those combinations of goods and services that can be produced and those that cannot 0 The PPF illustrates scarcity because We cannot attain the points outside the frontier re wr 0 We achieve production efficiency if We produce goods and services at the lowest possible cost 0 Production efficiency is achieved on the PPF 0 At points inside the PPF production is inefficient because We re giving up more than necessary of one good to produce a given quantity of the other good Production is inefficient inside the PPF because resources are either not used misallocated or both Resources are unused when they are idle but could be working For example we might leave some factories idle or some workers unemployed Resources are misallocated when they are assigned to tasks for which they are not the best match For example we might skilled pizza chefs in a coke factory causing lower amounts of pizzas and cokes to be made Every choice on the PPF involves a tradeoff All tradeoffs involve an opportunity cost In the PPF above one pizza costs 3 colas hence on cola costs 13 pizzas point C and D only Opportunity cost is a ratio It is the decrease in the quantity produced of one good divided by the increase in quantity produced of another good as we move along the PPF The opportunity cost of a pizza increases as the quantity of pizzas produced increases The outwardbowed shape of the PPF re ects increasing opportunity cost The opportunity cost of producing more pizza increases because as we increase production of pizza some resources that are more appropriate for producing cola are used For example more people who are better at producing cola now produce pizza So the production of pizzas increases slightly but the production of cola decreases drastically Allocative efficiency is achieved when goods and services are produced at the lowest possible cost and in the quantities that provide the greatest possible benefit The marginal cost of a good is the opportunity cost of producing on more unit it We calculate MC from the slope of the PPF As the quantity of pizzas produced increases the PPF gets steeper and the MC of a pizza increases E i i 391 f F E 2 I quot39Hquot Marginal benefit is the benefit received by consuming one more unit of a good Marginal benefit is subjective which means it depends on people s individual preferences We use the marginal benefit curve to describe the marginal benefit of a good This is unrelated to the PPF and cannot be derived from it We measure the MB from a product by the most that people are willing to pay for an additional unit of it People are willing to pay less for a good than What it is Worth but not more than What it is Worth The most people are willing to pay for a good is its MB The principle of decreasing marginal benefit describes how people are Willing to pay less for a product when they receive more of it Decreasing MB occurs because people Want variety WFquot39 afEI39 I 1EEEa and l1 iEi Mulrgln l Enna Ei 1 Cum 5 5 quot L u aim Will m rhair 0 all PH P a quotFinger vgrwiliimams his P hWh ir gm as 8 GL5 I A 5 8 5 3 53 2115 1 39 E E L 2 a V mn 15 JVIV 717 Tji5quot 0 I he diagram above shovvs ovv people Willing to giv up less cla when more pizza is available With 05 million pizzas available people are Willing to pay 5 cans of cola per pizza But with 45 million pizzas people are Willing to pay only 1 can of cola per pizza FE 9 E5 57 E A 39tEILI rrre a 5 1iU e Jarl n gIiasiI 39a1H quot7 g quotE r i 3 P E L AJ I kt 3931 L r1 u uu11 it 3 H g r ad J quot TI ag 39 5 egtquotamr39L1 4 quotF 5 E39quotT ES 5it cf EquotFJquot nrI r 4 3 b i av gt J a g L ff L 3 1 5quot 39 pH ff L2 Z 35 P14 ruin r 39 uE Li gtL i gf quotV a H 39v Jquot 2 uh gs 5 J EH Ea u11 an 5 0K quotha s 39L 2 PI391E EquotgI E5 EEi 39Jquot E irIjlT39 g15I1ai E39l i 5 1r p39IjrIiL l En a r The diagrams above show that as the quantity of pizzas produced increases the marginal benefit falls because people are willing to give up fewer cans of cola The diagrams above show that as the quantity of pizzas produced increases the marginal cost increases because people must give up more cola to get each additional pizza When MB MC resources are being used efficiently and allocative efficiency is achieved Economic growth comes from technological change and capital accumulation Technological change is the development of new goods and of better ways of producing goods and services Capital accumulation is the growth of capital resources including human capital WHEURE 25 Ecommie Ifir wiih 6 Pi ran swam E 0 The graph above shows that you can rotate the PPF outward by producing more ovens By producing 5 million pizzas and O ovens we would be at point A and the PPF wouldn t rotate outwards However if we increased production of ovens to 6 and produced only 3 million pizzas we would allow the PPF to rotate outwards due to technological advancements We can now produce more pizzas by giving up fewer ovens The marginal cost reduces an so does the opportunity cost in the future However we have an opportunity cost in the present because we have to give up 2 million pizzas to produce 6 ovens 0 Specialization is producing only one or a few products 0 A person has a comparative advantage in an activity if that person can perform that activity at a lower opportunity cost than anyone else 0 Differences in opportunity costs arise from differences in individual abilities and from differences in characteristics of other resources 0 No one excels at everything No resource can provide everything For example a piece of land can be very fertile but Won t have rich mineral deposits A person who is more productive production per hour than others has an absolute advantage A person who has an absolute advantage cannot have a comparative advantage at all activities Because ability and resource vary from person to person people have different opportunity costs of producing various goods These differences in opportunity costs are the source of comparative advantage Llfs Flrmrlfuetfn Fmasibiliitis TAHLLE EJJ 1ij nuf En urniilr Mm IFdl39l3939EHI E pgir 3 E 3 AELE 2 Jo c Pmd Imzlfn iliifit a MIin iE flu llm iFI39I39dli39EiiE 13 Smliflzli i ll b b p Liz s opportunity cost of producing one salad is 1 and of producing one smoothie is one J oe s opportunity cost of producing one smoothie is 5 salads and of producing one salad is 15 smoothies Liz has the comparative advantage in producing smoothies because her opportunity cost of producing a smoothie is lower Joe has a comparative advantage in producing salads 11 Liz and Joe decide to specialize and make the things that each of them have to lowest opportunity cost to produce Joe now produces 30 salads and Liz now produces 30 smoothies F J bth ain sthis an salads an hour 0 Liz and Joe trade smoothies and salads at a rate of 2 salads per smoothie Joe gets smoothies for 2 salads each which is less than the 5 smoothies it cost him before Liz gets a salad for every half smoothie which is less than the 1 smoothie it cost her before xPE 4 5 E2 04 9 r 39E i39i ii E1 Mi O n in gp En J39TglF39p P B B um amp Li j4 as J A an I Ff rn aw l I gtL 1 Nil 4 39 F e u 1 i r B an 1 Ir 39r 3 r 39 v 39IiI39D m B t Bu atmy J I Wi il 1J I 1 J I I E Q8 4 r uu39n V U V J 7 if I J I J I L r u 9 mg Ei PM i srg 4 8 it 9O Ea mm i l39quot m V U T P J a I he un xM p Ufi gt4 h J J P at J 39iJr zn1quot 5 F it aims lair w HI E J 1 JLv I J V F X L I 397 1 I r39 w T I L w J u 1 IV Y n H 39 L 1 A A quot 55 El J Microeconomics Notes Oli2oDolv Introduction to Game Theorv Characteristics of an Oligopolv 1 Few Firms could be as few as 2 firms in which case the oligopoly is called a duopoly 2 High concentration ratios High HHI 3 Products may or may not be differentiated Example gt Cereal differentiated O Kellogg s corn akes vs Post Toasties gt Natural Resources not differentiated 0 There is almost no differentiation of products when firms supply a natural resource like natural gas because the quality of natural gas cannot really be changed 4 Significant barriers to entry a Legal barriers to entry e g taxicab drivers need a special license to enter the taxicab industry These licenses are in limited supply to limit the number of taxicabs b Natural barriers to entry ie economies of scale make it more worthwhile to have a few firms produce all of the industry s output c Artificial barriers to entry e g use of advertisements pricing strategies etc to prevent competitors from being successful and to keep potential competitors from entering the industry 0 Because there are so few firms in an oligopoly and no other firms can enter the industry there is a lot of direct interaction among firms in the industry 0 If there are just a few companies in the industry and one decides to reduce the prices for example the other forms must respond to that action lower prices too This is not the case in perfect competition because each firm has such an insignificant market share that their decision wouldn t really affect the rest of the industry 0 We cannot really draw a diagram to explain what decisions firms should make in an oligopoly Instead we use the concept of Game Theory Game Theory gt The Game Theory explains that you find something called strategic interdependence in an oligopolistic industry This means that the actions of one firm have an affect on the outcomes of other firms decisions Characteristics of a game 1 Players number of firms Rules What prices to charge for example 2 Strategies a Pricing game b Advertising game c RampD game 3 Payoffs illustrated by a payoff matrix 0 Payoff Matrix Structure gt The rows and the columns of correspond to the strategy of each player For example let s say that there are 0 Two players Player 1 and Player 2 and 0 Two strategies high price low price or pT 0 UW2 I F It P P wwme lOMW A il9lCf0V13r 23 high o V Ul tgOW l o r s Wax t W 0 XPVW m m g l a g Wrur ampP19fzrzrzi p W j9o1vrdW quot 2m rm 1 yUw V WW zzxu Payoff Matrix Example Use of hypothetical figures 0 2 Firms Proctor and Gamble Kimberly Clark 0 2 Strategies high price low price payoffs in this case is profit earned by each firm ow p8 p Wf 1 C39ei39 n oM 1quot l low We 3 W We can see from the payoff matrix above that is a company wants to earn the maximum possible profit it needs to charge a low price However if both companies charge a low price each company ends up making just 5M So the next best alternative would be for both of them to charge high and for each of them to earn 8M However when one company finds out that the other is charging a high price it would decide to charge a low price to try to make 10M in profit Again they both would end up charging low and earn 5M Obviously this cycle would not continue indefinitely we would have to achieve a state of equilibrium in the industry So how would the industry achieve equilibrium Both the companies could decide to charge a high price and have an agreement not to lower the price However this is illegal and they would not be allowed to do that We can see from the payoff matrix that if KC decided to choose a high price PampG would choose a low price We can also see that if KC chooses a low price PampG still chooses a low price We say that PampG s dominant strategy is to choose a low price A dominant strategy is where a that is always best to choose Since the payoff matrix is symmetric we see that KC s dominant strategy is also to charge a lower price If both companies charge a lower price regardless of what the other company does we say that there is a dominant strategy equilibrium where both companies charge low and earn 5M each Dominant strategy equilibrium is a set of strategies where each player chooses the best possible action regardless of the actions chosen by other players Even though it is illegal for both firms to have a mutual agreement to charge high both firms may still come to an agreement and earn 8M each When firms do this they behave like a cartel A cartel is a group of firms that acts like a monopolist Members of a cartel agree to supply less in order to raise prices and each earn a higher profit than they would have if they allowed a dominant strategy equilibrium to be achieved Example Prisoner s Dilemma Let s assume that there are two players Nick and Rachel who have won a reality game show and have together won 250000 They can each decided to either share or keep the money However if they both decide to keep the money neither of them would end up with any money and the 25000 would be spilt amongst all the losing contestants p p aw 5 quotCL K P N y R r2 ZoQol 2 7300 i 5 l JIZ5 0o0 p pA RM 0 If Nick chose to share the money Rachel would Want to choose keep in order to get all of the 250000 However if Nick chose to keep the money regardless of What Rachel does she would end up With 0 So Rachel is never going to be Worse off choosing keep over share Hence Rachel has a Weakly dominant strategy of choosing keep 0 Hence the equilibrium is 00 Where they both choose to keep the money