1 / 114

Economics of the Firm

Economics of the Firm. Strategic Pricing Techniques. Recall that there is an entire spectrum of market structures. Market Structures. Perfect Competition Many firms, each with zero market share P = MC Profits = 0 (Firm’s earn a reasonable rate of return on invested capital)

jael
Download Presentation

Economics of the Firm

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Economics of the Firm Strategic Pricing Techniques

  2. Recall that there is an entire spectrum of market structures Market Structures • Perfect Competition • Many firms, each with zero market share • P = MC • Profits = 0 (Firm’s earn a reasonable rate of return on invested capital) • NO STRATEGIC INTERACTION! • Monopoly • One firm, with 100% market share • P > MC • Profits > 0 (Firm’s earn excessive rates of return on invested capital) • NO STRATEGIC INTERACTION!

  3. Most industries, however, don’t fit the assumptions of either perfect competition or monopoly. We call these industries oligopolies • Oligopoly • Relatively few firms, each with significant market share • STRATEGIES MATTER!!! Wireless (2002) Verizon: 30% Cingular: 22% AT&T: 20% Sprint PCS: 14% Nextel: 10% Voicestream: 6% US Beer (2001) Anheuser-Busch: 49% Miller: 20% Coors: 11% Pabst: 4% Heineken: 3% Music Recording (2001) Universal/Polygram: 23% Sony: 15% EMI: 13% Warner: 12% BMG: 8%

  4. Market shares are not constant over time in these industries! Airlines (1992) Airlines (2002) American American United United Delta Delta Northwest Northwest Continental Continental US Air SWest While the absolute ordering didn’t change, all the airlines lost market share to Southwest.

  5. Another trend is consolidation Retail Gasoline (1992) Retail Gasoline (2001) Shell Exxon/Mobil Chevron Shell Texaco BP/Amoco/Arco Exxon Amoco Chev/Texaco Mobil Total/Fina/Elf BP Conoco/Phillips Citgo Marathon Sun Phillips

  6. The key difference in oligopoly markets is that price/sales decisions can’t be made independently of your competitor’s decisions Your Price (-) Monopoly Oligopoly Your N Competitors Prices (+) Oligopoly markets rely crucially on the interactions between firms which is why we need game theory to analyze them! Strategy Matters!!!!!

  7. Prisoner’s Dilemma…A Classic! Two prisoners (Jake & Clyde) have been arrested. The DA has enough evidence to convict them both for 1 year, but would like to convict them of a more serious crime. Jake Clyde • The DA puts Jake & Clyde in separate rooms and makes each the following offer: • Keep your mouth shut and you both get one year in jail • If you rat on your partner, you get off free while your partner does 8 years • If you both rat, you each get 4 years.

  8. Jake is choosing rows Clyde is choosing columns Clyde Jake

  9. Suppose that Jake believes that Clyde will confess. What is Jake’s best response? If Clyde confesses, then Jake’s best strategy is also to confess Clyde Jake

  10. Suppose that Jake believes that Clyde will not confess. What is Jake’s best response? If Clyde doesn’t confesses, then Jake’s best strategy is still to confess Clyde Jake

  11. Dominant Strategies Jake’s optimal strategy REGARDLESS OF CLYDE’S DECISION is to confess. Therefore, confess is a dominant strategy for Jake Clyde Jake Note that Clyde’s dominant strategy is also to confess

  12. Nash Equilibrium The Nash equilibrium is the outcome (or set of outcomes) where each player is following his/her best response to their opponent’s moves Clyde Jake Here, the Nash equilibrium is both Jake and Clyde confessing

  13. “Winston tastes good like a cigarette should!” “Us Tareyton smokers would rather fight than switch!”

  14. How about this game? Acme and Allied are introducing a new product to the market and need to set a price. Below are the payoffs for each price combination. Acme Allied What is the Nash Equilibrium?

  15. Iterative Dominance Note that Allied would never charge $1 regardless of what Acme charges ($1 is a dominated strategy). Therefore, we can eliminate it from consideration. Acme With the $1 Allied Strategy eliminated, Acme’s strategies of both $.95 and $1.30 become dominated. Allied With Acme’s strategies reduced to $1.95, Allied will respond with $1.35

  16. Repeated Games Jake Clyde The previous example was a “one shot” game. Would it matter if the game were played over and over? Suppose that Jake and Clyde were habitual (and very lousy) thieves. After their stay in prison, they immediately commit the same crime and get arrested. Is it possible for them to learn to cooperate? 0 1 2 3 4 5 Time Play PD Game Play PD Game Play PD Game Play PD Game Play PD Game Play PD Game

  17. Repeated Games Jake Clyde We can use backward induction to solve this. 0 1 2 3 4 5 Time Play PD Game Play PD Game Play PD Game Play PD Game Play PD Game Play PD Game Confess Confess Confess Confess Confess Confess Confess Confess Confess Confess Confess Confess Similar arguments take us back to period 0 However, once the equilibrium for period 5 is known, there is no advantage to cooperating in period 4 At time 5 (the last period), this is a one shot game (there is no future). Therefore, we know the equilibrium is for both to confess.

  18. Infinitely Repeated Games Jake Clyde 0 1 2 Play PD Game Play PD Game Play PD Game …………… Suppose that Jake knows Clyde is planning on NOT CONFESSING at time 0. Option #1: Don’t confess, get 1 year in jail (rather than 0 if he confesses), but establish trust for the next time Option #2: Confess, get 0 years in jail (rather than 1 if he doesn’t confess), but ruins trust for the next time You need to value the future for this option to be viable

  19. Suppose that McDonald’s is currently the only restaurant in town, but Burger King is considering opening a location. Should McDonald's fight for it’s territory? 0 Fight 0 IN 2 Cooperate 2 5 Out 1

  20. Now, suppose that this game is played repeatedly. That is, suppose that McDonald's faces possible entry by burger King is 20 different locations. Can entry deterrence be a credible strategy? Enter Don’t Fight Enter Don’t Fight Enter Don’t Fight 2 2 2 Total =2*20 = 40 OR Enter Fight Don’t Enter Don’t Enter Don’t Enter Don’t Enter 0 5 5 5 5 Total =19*5 = 95

  21. Now, suppose that this game is played repeatedly. That is, suppose that McDonald's faces possible entry by burger King is 20 different locations. Can entry deterrence be a credible strategy? Enter Don’t Enter Fight Don’t Fight Enter Don’t Enter Fight Don’t Fight Enter Don’t Enter Fight Don’t Fight End of Time Does McDonald’s have an incentive to fight here? What will Burger King do here? If there is an “end date” then McDonald's threat loses its credibility!!

  22. Ever Cheat on your taxes? In this game you get to decide whether or not to cheat on your taxes while the IRS decides whether or not to audit you What is the equilibrium to this game?

  23. If the IRS never audited, your best strategy is to cheat (this would only make sense for the IRS if you never cheated) If the IRS always audited, your best strategy is to never cheat (this would only make sense for the IRS if you always cheated) The Equilibrium for this game will involve mixed strategies!

  24. A quick detour: Expected Value Suppose that I offer you a lottery ticket: This ticket has a 2/3 chance of winning $100 and a 1/3 chance of losing $100. How much is this ticket worth to you? Suppose you played this ticket 6 times: Total Winnings: $200 Attempts: 6 Average Winnings: $200/6 = $33.33

  25. A quick detour: Expected Value Given a set of probabilities, Expected Value measures the average outcome Expected Value = A weighted average of the possible outcomes where the weights are the probabilities assigned to each outcome Suppose that I offer you a lottery ticket: This ticket has a 2/3 chance of winning $100 and a 1/3 chance of losing $100. How much is this ticket worth to you?

  26. Cheating on your taxes! Suppose that the IRS Audits 25% of all returns. What should you do? Cheat: Don’t Cheat: If the IRS audits 25% of all returns, you are better off not cheating. But if you never cheat, they will never audit, …

  27. The only way this game can work is for you to cheat sometime, but not all the time. That can only happen if you are indifferent between the two! Suppose the government audits with probability Doesn’t audit with probability Cheat: Don’t Cheat: If you are indifferent… (83%) (17%)

  28. We also need for the government to audit sometime, but not all the time. For this to be the case, they have to be indifferent! Suppose you cheat with probability Don’t cheat with probability Audit: Don’t Audit: If they are indifferent… (91%) (9%)

  29. Now we have an equilibrium for this game that is sustainable! The government audits with probability Doesn’t audit with probability Suppose you cheat with probability Don’t cheat with probability (7.5%) (1.5%) We can find the odds of any particular event happening…. (75%) (15%) You Cheat and get audited: (1.5%)

  30. The Airline Price Wars Suppose that American and Delta face the given demand for flights to NYC and that the unit cost for the trip is $200. If they charge the same fare, they split the market $500 $220 American 60 180 What will the equilibrium be? Delta

  31. The Airline Price Wars If American follows a strategy of charging $500 all the time, Delta’s best response is to also charge $500 all the time If American follows a strategy of charging $220 all the time, Delta’s best response is to also charge $220 all the time American This game has multiple equilibria and the result depends critically on each company’s beliefs about the other company’s strategy Delta

  32. The Airline Price Wars: Mixed Strategy Equilibria Suppose American charges $500 with probability Charges $220 with probability Charge $500: American Charge $220: Delta (6%) (19%) (19%) (56%) (75%) (25%)

  33. Suppose that we make the game sequential. That is, one side makes its decision (and that decision is public) before the other Don’t Cheat Cheat Don’t Audit Audit Don’t Audit Audit (-25, 5) (5, -5) (-1, -1) (0, 0) Your reward is on the left

  34. If the IRS observes you cheating, their best choice is to Audit Don’t Cheat Cheat Don’t Audit Audit Don’t Audit Audit (-25, 5) (5, -5) (-1, -1) (0, 0) Your reward is on the left vs

  35. If the IRS observes you not cheating, their best choice is to not audit Don’t Cheat Cheat Don’t Audit Audit Don’t Audit Audit (-25, 5) (5, -5) (-1, -1) (0, 0) Your reward is on the left vs

  36. Knowing how the IRS will respond, you never cheat and they never audit!! (0%) (0%) Don’t Cheat Cheat (100%) (0%) Don’t Audit Audit Don’t Audit Audit (-25, 5) (5, -5) (-1, -1) (0, 0) Your reward is on the left vs

  37. Now, lets switch positions…suppose the IRS chooses first (0%) (0%) Don’t Audit Audit (0%) (100%) Don’t Cheat Cheat Don’t Cheat Cheat (-25, 5) (-1, -1) (5, -5) (0, 0) Your reward is on the left

  38. Again, we could play this game sequentially (100%) (0%) $500 $220 (0%) (0%) $500 $220 $220 $500 (9,000, 9,000) (3,600,0) (0, 3,600) (1,800, 1,800) Delta’s reward is on the left

  39. Note: Even if the moves are made sequentially, if one party is not aware of the other’s move, we are back to the simultaneous move game i.e., Al Capone might have cheated all the time, but if the IRS is unaware, they might not audit all the time! Don’t Cheat Cheat Don’t Audit Audit Don’t Audit Audit (-25, 5) (5, -5) (-1, -1) (0, 0)

  40. In the Movie Air Force One, Terrorists hijack Air Force One and take the president hostage. Can we write this as a game? (Terrorists payouts on left) Terrorists Take Hostages Don’t Take Hostages President (0, 1) Don’t Negotiate Negotiate In the third stage, the best response is to kill the hostages (1, -.5) Terrorists Given the terrorist response, it is optimal for the president to negotiate in stage 2 Kill Don’t Kill Given Stage two, it is optimal for the terrorists to take hostages (-.5, -1) (-1, 1)

  41. Terrorists The equilibrium is always (Take Hostages/Negotiate). How could we change this outcome? Take Hostages Don’t Take Hostages President (0, 1) Suppose that a constitutional amendment is passed ruling out hostage negotiation (a commitment device) Don’t Negotiate Negotiate (1, -.5) Terrorists Without the possibility of negotiation, the new equilibrium becomes (No Hostages) Kill Don’t Kill (-.5, -1) (-1, 1)

  42. Player A A bargaining example…How do you divide $20? Offer Player B Day 1 Accept Reject Player B Two players have $20 to divide up between them. On day one, Player A makes an offer, on day two player B makes a counteroffer, and on day three player A gets to make a final offer. If no agreement has been made after three days, both players get $0. Offer Player A Day 2 Accept Reject Player A Offer Player B Day 3 Accept Reject (0,0)

  43. Player A Offer Player A knows what happens in day 2 and wants to avoid that! Player B Day 1 Player A: $19.99 Player B: $.01 Accept Reject Player B Offer Player B knows what happens in day 3 and wants to avoid that! Player A: $19.99 Player B: $.01 Player A Day 2 Accept Reject Player A Offer If day 3 arrives, player B should accept any offer – a rejection pays out $0! Player B Day 3 Player A: $19.99 Player B: $.01 Accept Reject (0,0)

  44. Player A Lets consider a couple variations… Offer Player B Day 1 • Variation #1: Negotiations take a lot of time and each player has an opportunity cost of waiting: • Player A has an investment opportunity that pays 20% per year. • Player B has an investment strategy that pays 10% per year Accept Reject Player B Offer Player A Day 2 Accept Reject Player A Offer Player B Day 3 Accept Reject (0,0)

  45. Player A If player B rejects, she gets $3.35 in one year. That’s worth $3.35/1.10 today Offer Player A: $16.95 Player B: $3.05 Player B Year 1 Accept Reject Player B Offer If player A rejects, she gets $19.99 in one year. That’s worth $19.99/1.20 today Player A: $16.65 Player B: $3.35 Player A Year 2 Accept Reject Player A Offer If year 3 arrives, player B should accept any offer – a rejection pays out $0! Player B Year 3 Player A: $19.99 Player B: $.01 Accept Reject (0,0)

  46. Continuous Choice Games • Consider the following example. We have two competing firms in the marketplace. • These two firms are selling identical products. • Each firm has constant marginal costs of production. What are these firms using as their strategic choice variable? Price or quantity? Are these firms making their decisions simultaneously or is there a sequence to the decisions?

  47. Cournot Competition: Quantity is the strategic choice variable There are two firms in an industry – both facing an aggregate (inverse) demand curve given by D Total Industry Production Both firms have constant marginal costs equal to $20

  48. From firm one’s perspective, the demand curve is given by Treated as a constant by Firm One Solving Firm One’s Profit Maximization…

  49. In Game Theory Lingo, this is Firm One’s Best Response Function To Firm 2 If firm 2 drops out, firm one is a monopolist! 0

  50. What could firm 2 do to make firm 1 drop out?

More Related