Monopoly

1. Monopoly Please read the article at the web site http://sports.espn.go.com/espn/columns/story?columnist=munson_lester&id=4336261 In this article the author is suggesting something similar to what our authors say about the Detroit Lions. The point is the Lions are a monopoly if the definition of the market is narrow. Market definition is a key feature of monopoly.

2. Natural Monopoly A natural monopoly is said to occur when a large firm operates more efficiently than a small firm. If the most efficient size is so large relative to the number of customers in the market, then maybe only firm can effectively serve the market and thus the firm is a natural monopoly. This can happen if the firm has large start up costs and low marginal costs. Page 122 of the book has an elaborate graphical example. Some folks say if a natural monopoly exists we should regulate it by having a group watch the firm and have to approve price changes recommended by the firm.

3. Limit Pricing Limit Pricing is a situation where a firm with monopoly power does not charge the monopoly price because it is concerned the resulting profits will attract other firms So, the firm only raises price above MC a little. This is seen as a barrier to other firms entering the industry and thus preserving the monopoly.

4. Antitrust Laws The Sherman Act of 1890 is the primary anti-monopoly law in the US. The 1st 2 sections of the law are listed in the book. Section 1 means firms that ought to be competing can not form a cartel or trust. Section 2 attacks existing monopolies, however they were formed. In US history the court system has moved back and forth in interpreting the law between what is called a “per se” view and a “rule of reason” view. Under the “per se” view if monopoly power has been established to exist then the existing parties are guilty of violating the law. Under the “rule of reason” view it has been argued that society can tolerate the monopoly if monopoly power was not exercised or if considerable benefits have also been achieved. Collusion is when teams cooperate and act like one big monopoly. When it comes to baseball many say the courts have made some very peculiar rulings!

5. Game Theory As we consider some terminology, we will see the simultaneous move, one shot game.

6. Have you every played the game rock, scissors, paper with someone else? Basically you and the other player reveal at the same time each of your choices of the three mentioned alternatives. If both have the same it is a tie. Rock beats scissors, scissors beats paper and paper beats rock. Now, when you reveal your choice, your outcome not only depends on what you do, but also on what the other does. Sometimes the environment of an industry will be like this. The point is that firms in this type of environment have to worry about how their rivals might act. We say the firms are connected by strategic interaction. So, we see the interdependency of firms. We will start off with a story called game theory as a way to model strategic interaction.

7. Examples of Oligopolies: Beer industry, electric light bulbs, and tires There are other industries. Note: in any one industry each firm is very aware that there are other firms in their market. Plus each firm makes its decisions while recognizing the others are watching and responding. Example: When Coke decides how much to advertise it is aware that Pepsi will have a response, and vice versa.

8. Simultaneous Move, One Shot Games We will assume there are only two decision makers. For now we assume both have to make their decisions at the same time. This is a simultaneous move game. Games could be sequential, where one player follows the other (like in tic-tac-toe). Some games have only one decision by each player involved. Other games involve repeated rounds of play. Here we focus on the one shot games.

9. Normal Form In the normal form of a game, information about the options of each player is presented in a matrix. The “row” player’s options are described in each row and the payoff is the first number in each cell. The “column” player’s options are described in each column and the payoff is the second number in each cell. Since we have a simultaneous move game each player will choose its options without knowing what the other player will choose. But the choice of the other player may be anticipated. Let’s check out an example on the next few screens.

10. Column player left right Row up a, A c, C Player down b, B d, D Let’s make sure we understand this table. Here we have two players: the Row Player and the Column Player (Miller and Bud, if you want). This is a generic game for now and all the Row Player can do is choose up or down (in rock, scissors, paper you can choose one of the three, but for the Row Player here the choice is up or down.) The Column Player can only choose leftor right. Now, let’s say the row player picks up and the column player picks left.

11. Column player left right Row up a, A c, C Player down b, B d, D Now, let’s say the row player picks up and the column player picks left just as an example to see what each would get. If the game ended at up, left, the row player would get “a” and the column player would get “A.” Note all these letters usually are dollar amounts for us and can be negative amounts. But, sometimes the letters represent other concepts besides dollars. As an example the numbers could represent jail time.

12. Column player left right Row up a, A c, C Player down b, B d, D If the game ended at down, right, the row player would get “d” and the column player would get “D.” Caution: If as ROW Player you pick down thinking you get “b” remember that what you get is also influenced by Column Player. So, you could actually get “d” if the Column Player picks right. Next we want to think about how each player should decide what strategy to pick.

13. Row player should think this way: (As the row player) I do not know what the column player will do. But, I can look at each option of the column player, one strategy at a time. If the column player picks left my choices are up a down b As the row player I would pick the option that has the highest value: pick up if a > b, or pick down if a < b. If the column player picks right my choices are up c down d As the row player I would pick the option that has the highest value: pick up if c > d, or pick down if c < d.

14. For the row player the choice of strategy is up or down. A strategy is called a dominant strategy for a player if it has a higher payoff no matter what the other player chooses. So, up would be a dominant strategy for the row player if both a > b and c > d. Down would be a dominant strategy for the row player if both a < b and c < d.

15. Example column player left right Row up 10, 20 15, 8 Player down -10, 7 10, 10 The row player will think in the following way(look at each column). If column man picks left I can have 10 if I go up and –10 if I go down. So I will go up. If column man goes right I can have 15 if I go up and 10 if go down. So I will go up. In this example the row player sees it is best to go up no matter what the column player is doing. In this sense we say “up” is a dominant strategy for the row player.

16. Example column player left right Row up 10, 20 15, 8 Player down -10, 7 10, 10 This is the same slide as before, but I show in each column what the ROW player will look at. If the highest value in each column is in the same row – the person has a dominant strategy. Again, up is a dominant strategy here for the row player.

17. Column player should think this way: (As the column player) I do not know what the row player will do. But, I can look at each option of the row player, one strategy at a time. If the row player picks up my choices are left right A C As the column player I would pick the option that has the highest value: pick left if A > C, or pick right if A < C. If the row player picks down my choices are left right B D As the column player I would pick the option that has the highest value: pick left if B > D, or pick right if B < D.

18. For the column player the choice of strategy is left or right. A strategy is called a dominant strategy for a player if it has a higher payoff no matter what the other player chooses. So, left would be a dominant strategy for the column player if both A > C and B > D. Right would be a dominant strategy for the column player if both A < C and B < D.

19. Example column player left right Row up 10, 20 15, 8 Player down -10, 7 10, 10 The column player will think in the following way(look at each row). If row man picks up I can have 20 if I go left and 8 if I go right. So I will go left. If row man goes down I can have 7 if I go left and 10 if go right. So I will go right. In this example the column player does not have a dominant strategy. What to do? If the other player has a dominant strategy, assume he will play it and then do the best you can. Column player should go left.

20. Example column player left right Row up 10, 20 15, 8 Player down -10, 7 10, 10 This is the same slide as before, but the column player looks at his possibilities in each row. Players look for a dominant strategy before the game is played and players play dominant strategies. Next we look at outcomes after the game is played and see if both players are satisfied with the outcome.

21. Nash Equilibrium A set of choices by the players would be considered a Nash equilibrium if each player would NOT want to change their choice given the choice of the other player. The choices up and left represents a Nash equilibrium because neither would choose to change given the choice of the other. The row player says – if the column player will be at left, then it is best for me to stay at up. The column player says - if the row player will be at up, then it is best for me to stay at left.

22. Let’s pick a different cell than up, left to see why another cell might not be a Nash equilibrium. Let’s look at up, right. The row player says - if the column player is at right then I want to stay at up (Nash Equilibrium may still be in the running). The column player says – if the row player is up, then I want to change from right to left. Because the column player wants to change, the cell considered is not a Nash Equilibrium. Note: You look for dominant strategies before the game is played and you see if you have a Nash equilibrium after the game is played.

23. Applications Here we look at several applications. We will see a classic example of a dilemma that can arise in such games.

24. Pricing Example column player low price high price Row low price 0, 0 50, -10 Player high price -10, 50 10, 10 The numbers in the matrix represent profit. The row player has a dominant strategy of a low price (0 is better than -10 and 50 is better than 10) and the column player has a dominant strategy of a low price as well (similar numbers). And, low low is a Nash equilibrium. A dilemma that arises here is that both could be better off if they both went with a high price.

25. Prisoner Dilemma Games The game we just saw has the characteristic that has come to be known as the prisoners’ dilemma. When the players act separately (competitively) the outcome is worse than if they cooperated.

26. Don’t be taken advantage of In the pricing example each might be tempted to get together and both charge the high price and both do better than the low price strategy. The problem of the high, high solution is that it is not a Nash equilibrium and thus each would have the incentive to change to the low price strategy. Your stockholders would not want you to be taken advantage of by a double crosser. Don’t collude here, for it is not likely to pay off. Let’s see why. Say you are the row player and you agree (illegally) to set prices high with the column player. After you finish the meeting you will note 1) if you as the row player see the column stay at a high price then it is better for you to have a low price (this is part of why high, high is not a Nash equilibrium), and 2) perhaps more importantly you will note the column player also has the incentive to switch to low (this is the other part of high, high not being a Nash equilibrium). So, if you stay at high you will look bad!

27. Advertising Example column player ad no ad Row ad 4, 4 20, 1 Player no ad 1, 20 10, 10 Profits are in the matrix. Each player has a dominant strategy of advertise. This outcome is a Nash equilibrium. A similar dilemma arises here as before. No ads would be better but each does not want to get taken advantage of in this situation. If you don’t have ads when the other does you won’t be on the minds of the consumers and thus you will not make enough.

28. NCAA Football dilemma The NCAA had a dilemma in televising games. It wanted to limit the number of games seen so it could charge a high price and thus have high profit for a few games. Some members sued because they wanted a lot of their games on TV. By winning the option of having a lot of games on means that any one game is less valuable and thus the outcome is inferior to having limits.