LECTURE 5 Oligopoly

Mid-trimester Exam: Monday Students Only
Mid-trimester Examination
Date: Week 6, Monday 17th August 2015
Venue: CR 101 + CR 102
Time: 4:30pm- 6:40pm (including 10mins
Reading Time)
Coverage: Lectures 1 5.
Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Mid-trimester Exam: Thursday Students

Mid-trimester Examination
Date: Week 6, Wednesday 19th August
2015
Venue: CR 101 + CR 102
Time: 4:30pm- 6:40pm (including 10mins
Reading Time)
Coverage: Lectures 1 5.
OLIGOPOLY
&
GAME THEORY
Oligopoly and barriers to entry

Oligopoly: A market structure in which a small number of
interdependent firms compete.
It is difficult to know what an oligopolists demand and
marginal revenue curves look like.
It is not known what quantity an oligopolist will sell at a
particular price, as the price charged depends on the
prices and actions of competitors.
Oligopoly and barriers to entry

Barrier to entry: Anything that keeps new firms from
entering an industry.
Examples are economies of scale, ownership of
a key input, and government-imposed barriers.
Economies of scale: Economies of scale exist when a
firms long-run average costs fall as it increases scale of
production and the quantity of output it produces.
Using game theory to analyse oligopoly

As the demand and marginal revenue curves of an
oligopolist may be unknown, the profit-maximising level
of output and price cannot be calculated in the same way
as for competitive markets.
Game theory: The study of how people make decisions
in situations where attaining their goals depends on their
interactions with others; in economics, the study of the
decisions of firms in industries where the profits of each
firm depend on its interactions with other firms.
Game Theory: Key Characteristics

Players
The actors/participant/opponents
Rules
Describe how the game works
Actions
Available choices to each player
Strategies
A contingent plan of action taken by a player to achieve a
goal, such as a firm maximising profit
Payoffs
Rewards or results of the interaction between the players
strategies.
Dominant strategy: A player has a dominant

strategy when it has one strategy that works best
(that is optimal) no matter what an opponent does.
Payoff matrix: A table that shows the payoffs that

each firm earns from every combination of strategies
adopted by the firms.
A duopoly game is price competition between two

firms.

Firm behaviour and the prisoners dilemma
Cooperative equilibrium: An equilibrium in a game in
which players cooperate to increase their mutual payoff.
Non-cooperative equilibrium: An equilibrium in a game

in which players do not cooperate but pursue their own selfinterest.
Strategic Interaction: Payoff Matrix

and Dominant Strategy
The Payoff Matrix describes the payoffs to both
player for every possible outcome (see next slide)
A dominant strategy
A player has a dominant strategy when it has one strategy that

works best (that is optimal) no matter what an opponent does.
Example: A firm (e.g. Woolworths) has a dominant

strategy when it has one strategy that WORKS BEST
(that maximises its payoff) NO MATTER what its rival
(e.g. Coles) does.
10
Firm B
Advertise
Firm A
Advertise
Dont
advertise
Dont advertise
10, 5
15, 0
6, 8
10, 2
In
this game there are 2 players (Firm A and Firm B)

Each firm can take 2 different actions Advertise or Dont
advertise
Each firm has 4 different payoffs
The payoff matrix shows how the payoff achieved by each firm
depends on its own actions and the actions of its rival
11
Firm B
Firm A
Advertise
Dont advertise
Advertise
10, 5
15, 0
Dont
advertise
6, 8
10, 2
Firm
A considers its payoffs to formulate its strategy:

1) if B advertises (column 1)
2) if B doesnt advertise (column 3)
NB Firm A looks up and down the payoff matrix to to formulate its strategy
Firm B considers its payoffs to formulate its strategy:
1) if A advertises (row 1)
2) if B doesnt advertise (row 2)
NB Firm B looks across the payoff matrix to to formulate its strategy
12
Dominant Strategy (Firm A)

Firm B
Advertise
Firm A
Dont advertise
Advertise
10, 5
15, 0
Dont
advertise
6, 8
10, 2
Firm A has a dominant strategy in this game
If B advertises, A should advertise (10>6)
If B doesnt advertise, A should advertise (15>10).
As Dominant Strategy is to Advertise.
Because 10>6 & 15>10, A will always choose Advertise.

13
Dominant Strategy (Firm B)

Firm B
Advertise
Firm A
Firm
Dont advertise
Advertise
10, 5
15, 0
Dont
advertise
6, 8
10, 2
B also has a dominant strategy in this game
If A advertises, B should advertise (5>0)

If A doesnt advertise, B should advertise (8>2).
Bs Dominant Strategy is to Advertise.
Because 5>0 & 8>2, B should always choose Advertise.
14
Dominant Strategy (A & B)
Does A have a dominant strategy?

YES Regardless of what B does, As best strategy is still TO
ADVERTISE.
Does B have a dominant strategy?
YES Regardless of what A does, Bs best strategy is still TO
ADVERTISE.
When both firms have dominant strategies, there STABILITY.

We call the outcome a DOMINANT STRATEGY EQUILIBRIUM.
BUT Sometimes a firm does not have a dominant

strategy
15
Example of a situation where a firm does NOT

have a Dominant Strategy
Firm B
Advertise
Firm A
Dont Advertise
Advertise
10, 5
15, 0
Dont
6, 8
20, 2
Advertise
If B Advertise, A should Advertise (10>6)

However, if B Dont Advertise, A should play Dont Advertise
(20>15).
A does not have a dominant strategy.
Thus, it is more difficult to PREDICT As actions in these
circumstances
16
Nash Equilibrium (NE)
A situation where each firm chooses the best strategy,

given the strategies chosen by other firms.
Occurs where NEITHER PLAYER HAS INCENTIVE

TO DEVIATE UNILATERALLY from its chosen
strategy
Implies stability EQUILIBRIUM
17
Firm A does not have a Dominant

Strategy. What is the Nash Equilibrium?
Firm B
Advertise
Firm A
Dont advertise
Advertise
10, 5
15, 0
Dont
advertise
6, 8
20, 2
(B:
Advertise, A: Dont advertise) Not NE, because A has

incentive to unilaterally deviate and play Advertise (10>6)
(B:
Dont advertise, A: Dont advertise) Not NE, because B has

incentive to unilaterally deviate and play Advertise (8>2).
>>>>>next slide
18
Firm A does not have a Dominant

Strategy. What is the Nash Equilibrium?
Firm B
Advertise
Firm A
Dont advertise
Advertise
10, 5
15, 0
Dont
advertise
6, 8
20, 2
(B:
Dont advertise, A: Advertise) Not NE, because B has

incentive to unilaterally deviate and play Advertise (5>0).
(B:
Advertise, A: Advertise) Is NE, because A has no incentive

to unilaterally deviate and play Dont advertise (6<8). Also, B has
no incentive to unilaterally deviate and play Dont advertise (0<5).
19
The prisoners dilemma

Prisoners dilemma: A game where pursuing dominant
strategies results in non-cooperation that leaves everyone
worse off.
OR
A game in which each player has a dominant strategy,

and when each plays their dominant strategy the
resulting payoffs are smaller than if each had played a
dominated strategy.
20
The Prisoners Dilemma

The setting
Two bank robbers (Alf and Bob) have been captured by

the police
Without a confession, the police have insufficient

evidence to convict them of a robbery
They can prosecute for possession of unlicensed weapons
The police have a cunning plan

21
Rules of the game
Prisoners are put in separate rooms and cannot

communicate with each other.
They are told
If one of the prisoners confesses, he can go free
The partner will then be convicted and face a heavy

sentence for uncooperative behaviour
If both prisoners confess, they will be convicted and

face a moderate sentence
22

Possible actions
Confess
Deny
Strategies (contingent plan of action)
Confess
Deny
23

Payoffs
4 outcomes are possible:

Both confess.
Both deny.
Alf confesses and Bob denies.
Bob confesses and Art denies.
24

Payoffs
If both confess, they will get 5 years.
If one confesses and the other does not, the confessor

will be set free while the other gets 10.
If neither confesses, they each get 1 year for the minor

crime
The Payoff Matrix describes the payoffs to both player for

every possible outcome
25
Payoff Matrix
Alfs strategies
Confess
Deny
5 years
10 years
Confess
5 years
Bobs
0 (Free)
strategies
0 (Free)
1 year
Deny
10 years
1 year
26

Alf
Confess
Confessing is a dominant
strategy for Alf and Bob
If Alf denies
Bob goes free if he
5 yrs
If Alf confesses
confesses and 10 years if
he denies
27
10 yrs
Confess
confesses and gets 1 year

Bob
if he denies
Bob gets 5 years if he
Deny
5 yrs
(0) Free
(0) Free
1 yr
Deny
10 yrs
1 yr

Alf
Confess
Bob is better off
confessing no matter what

Alf does
Deny
5 yrs
10 yrs
Confess
Confessing is a dominant
strategy for Bob
5 yrs
Bob
(0) Free
The same reasoning
suggests that confessing is

a dominant strategy for Alf
28
(0) Free
1 yr
Deny
10 yrs
1 yr
Advertising Dilemma
Coles
Advertise
Advertise
Woolworths
Dont
advertise
Dont advertise
10, 10
17, 8
8, 17
15, 15
If
Coles Advertise, Woolworths should Advertise (10>8).
If
Coles Dont advertise, Woolworths should Advertise (17>15).
Woolworths
By
Dominant Strategy is Advertise.
the same logic, Coles Dominant Strategy is Advertise.
Therefore,
both firms play a dominant strategy equilibrium,

(Advertise, Advertise), whose pay offs are less than (Dont advertise,
29
Dont advertise).

Can firms escape the prisoners dilemma?
The prisoners dilemma is not always applicable as it
assumes the game will only be played once.
Most of the time, managers are playing a repeated

game.
Losses for not cooperating are greater in a repeated
game.
30

Retaliation strategies can be used against those who
dont cooperate.
A tit-for-tat strategy: is one in which one player
cooperates this period if the other player cooperated in
the previous period but cheats in the current period if
the other player cheated in the previous period.
31
A trigger strategy is one in which a player cooperates

if the other player cooperates but plays the Nash
equilibrium strategy forever thereafter if the other
player cheats.

Can firms escape the prisoners dilemma?, cont.
These are more likely to see cooperative behaviour in

repeated games.
Price leadership: A form of implicit collusion in which

one firm in an oligopoly announces a price change and
the other firms in the industry match the change.
32

LECTURE 5 Oligopoly

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LECTURE 5 Oligopoly

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Mid-trimester Exam: Monday Students Only

Mid-trimester Exam: Thursday Students

Oligopoly and barriers to entry

Oligopoly and barriers to entry

Using game theory to analyse oligopoly

Game Theory: Key Characteristics

Using game theory to analyse oligopoly

Dominant strategy: A player has a dominant

Payoff matrix: A table that shows the payoffs that

A duopoly game is price competition between two

Using game theory to analyse oligopoly

Non-cooperative equilibrium: An equilibrium in a game

Strategic Interaction: Payoff Matrix

A player has a dominant strategy when it has one strategy that

Example: A firm (e.g. Woolworths) has a dominant

this game there are 2 players (Firm A and Firm B)

A considers its payoffs to formulate its strategy:

Dominant Strategy (Firm A)

Firm A has a dominant strategy in this game

If B advertises, A should advertise (10>6)

If B doesnt advertise, A should advertise (15>10).

As Dominant Strategy is to Advertise.

Because 10>6 & 15>10, A will always choose Advertise.

Dominant Strategy (Firm B)

B also has a dominant strategy in this game

If A advertises, B should advertise (5>0)

Dominant Strategy (A & B)

Does A have a dominant strategy?

When both firms have dominant strategies, there STABILITY.

BUT Sometimes a firm does not have a dominant

Example of a situation where a firm does NOT

If B Advertise, A should Advertise (10>6)

Nash Equilibrium (NE)

A situation where each firm chooses the best strategy,

Occurs where NEITHER PLAYER HAS INCENTIVE

Implies stability EQUILIBRIUM

Firm A does not have a Dominant

Advertise, A: Dont advertise) Not NE, because A has

Dont advertise, A: Dont advertise) Not NE, because B has

Firm A does not have a Dominant

Dont advertise, A: Advertise) Not NE, because B has

Advertise, A: Advertise) Is NE, because A has no incentive

The prisoners dilemma

A game in which each player has a dominant strategy,

The Prisoners Dilemma

Two bank robbers (Alf and Bob) have been captured by

Without a confession, the police have insufficient

They can prosecute for possession of unlicensed weapons

The police have a cunning plan

The Prisoners Dilemma

Rules of the game

Prisoners are put in separate rooms and cannot

They are told

If one of the prisoners confesses, he can go free

The partner will then be convicted and face a heavy

If both prisoners confess, they will be convicted and

The Prisoners Dilemma

Strategies (contingent plan of action)

The Prisoners Dilemma

4 outcomes are possible:

The Prisoners Dilemma

If both confess, they will get 5 years.

If one confesses and the other does not, the confessor

If neither confesses, they each get 1 year for the minor