Lecture 4

1. Lecture 4 Strategic Interaction Game Theory Pricing in Imperfectly Competitive markets

2. Game Theory • Tool used for analyzing multiagent economic situations involving strategic interdependence

3. How Do We Describe a Game? • A game is described by: • number of players/agents • the “strategies” available to each player • each player’s preferences over outcomes of the game • For any game, a strategy choice by each one of the players results in a unique outcome of the game

4. What is a Strategy? • A strategy is an action plan for a player. It specifies: • what action the player takes • when the player takes the action • the way that the action choice depends on the information the player has when taking the action • Two action plans that specify different actions represent two different strategies

5. Predicting Behavior in Games • If games are to help us understand observables, we need a way of predicting how agents behave in game settings; i.e., we need a notion of equilibrium for games • The standard notion of equilibrium is the Nash equilibrium • Roughly speaking a Nash equilibrium has the feature that each player’s strategy choice is best for that player given other players’ strategies

6. Pricing in Imperfectly Competitive Markets

7. Determinants of Pricing Decision • Economic analysis of pricing in imperfectly competitive markets identifies the following elements of the market environment as important to pricing decision: • number of competitors/ease of entry • similarity of competitors’ products • capacity limitations • on-going interactions • Information on past pricing decisions

8. Bertrand • Simultaneous price setting • Identical products • No capacity constraints • One time interaction Price competition results in price equal marginal cost for all firms and zero profits

9. Bertrand • Bertrand paradox (p=mc even though few firms in market) can be resolved by relaxing certain assumptions: • No Capacity Constraints • Undifferentiated Products • One-shot competition

10. Capacity Constraints • Suppose each firm has max capacity of Ki • If firm j sets a higher price than firm i, j may get the left-over demand that firm i can’t satisfy if demand exceeds i’s capacity • So setting price above MC may be worthwhile

11. Cournot • Same analysis can be applied to situations where firms decide first on how much to produce and then on what price to set • If total quantity produced is low relative to market demand, then it is as if constrained • Firms will set prices such that total demand just clears total output

12. Cournot • Capacity (or output) constraint limits the usefulness of price competition • Can get p>mc and firms can earn economic profits

13. Cournot vs. Bertrand • Cournot: -when demand is large relative to capacity -when capacity is more difficult to adjust than price • Bertrand: -when demand is small relative to capacity -when capacity is easier to adjust than price