Strategic Interaction and

Oligopoly (Ch17)

Slides Courtesy of Siu Kam-Wing

 Oligopoly
 Oligopoly: a market structure in which only
a few sellers offer similar or identical
products.
 Strategic behavior: A firm’s decisions (for
example, on P or Q) depend on other firms’
decision
 Game theory: the study of how people
behave in strategic situations.
 Strategic Interaction
 Suppose two fancy restaurants are located
across the street from one another?
The owner of each restaurant will be concerned
about the “pricing strategy” of the other,… …
And also the other’s business strategy in general
In fact, each owner will base her own business
strategy on her beliefs about the strategy of the
other (what the others are doing???!!!)
 Eventually, they are competing the market
(buyers). This is an example of “strategic
interaction”
 Strategic Interaction
 In a perfectly competitive market
You will not care what the others are doing –
because you are just one of the many
What you care: Equilibrium market price (price
takers), and based on the market price, you
decide how many to sell (Price = MC)
 You DON’T or no need to “interact
strategically” with competitors
 Same as for Monopoly, no strategic
interaction: You are the only seller
 Strategic Interaction
 Strategic interaction turns to be very
important when there are two or small
number of people or firms engage in
bargaining, conflict or competition
Duopoly (two competing firms)
Oligopoly (several competing firms)
 To study strategic interaction, we need a tool:
“Game Theory”
 Game Theory
 Game Theory: A set of mathematical oriented
tools used to analyze strategic interaction
Often applied in economics, political science,
and military science
 In a game theory:
Players (decision makers)
Strategies (Players’ complete plans of action)
Payoffs (rewards or punishments – outcome)
 At least two players in a game, but games
with any number of players can be analyzed
 More on “Strategies”
 Strategy: A plan of action that describes
what a player will do “in every
circumstance” that he/she can observe
Simple Strategy: involve only one choice
E.g. John asks/not asks Ann to be his gf
(More) complex strategies: involve many
contingencies
If xxx, then aaa, if yyy, then bbb, if zzz, then ccc, …
Battle of the Sexes – Cooperation?
 The Battle of the Sexes is a game-theory model of
coordination in business
 To keep the game simple, only two players are
modeled:
 Tony wants to go to a football game (F) and Janet
wants to go to a Opera (R)
 If they both do F, then Tony gets utility 2 and Janet
gets 1; If they both do R, then Janet gets utility 2
and Tony gets 1
 If they do different things, both get 0
 Both must choose their strategies simultaneously
without knowing what the other chooses
 Battle of the Sexes
 Both must choose their strategies
simultaneously, without knowing what the
other has done
 Payoff-matrix:
 Janet and Tony are “players” Tony
 F, and R are “strategies” for Tony and F R
Janet Janet F 1, 2 0, 0
 2,1,0 are “payoffs”
R 0, 0 2, 1
 Each box corresponds to a “strategy
profile” (strategy chosen by Tony +
strategy chosen by Janet): <R,F > (Janet
chooses R and Tony F)
 0 for Janet and 0 for Tony are the
corresponding payoffs of a strategy
 Battle of the Sexes
 This game is modeled as a “normal-
form game”
 Each row represents a strategy for
one player (Janet)
 Each column represents a strategy Tony
for the other (Tony) F R
 Where Janet and Tony will go? Or, Janet F 1, 2 0, 0
what is the “equilibrium”?
 However, what is “equilibrium”? R 0, 0 2, 1

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 Applying Game Theory
 The most used solution concept is the “Nash
Equilibrium”, named after John Nash (Nobel
Prize Winner of 1994)
Movie: The Beautiful Mind
 Nash Equilibrium
 A Nash Equilibrium is a strategy profile in
which each player has chosen the strategy
that is her “best response” to the strategies
of the other players
 Equivalently, in a Nash Equilibrium, when all
players found out what the others were going
to do, no player would want to “deviate” from
her chosen strategy
 Nash Equilibrium – Battle of the Sexes
 Suppose both Tony and Janet decide to go to football match:
 Is it an equilibrium?
 Let first look at Janet:
 If Tony chooses F, will Janet deviate from
F? Tony
 No. F is best response (higher payoff
F R
value) given Tony chooses F
 Then look at Tony: Janet F 1, 2 0, 0
 If Janet choose F, will Tony deviate from F? R 0, 0 2, 1
 Result: <F,F> is a Nash Equilibrium
 Any others?
 Yes, <R,R> is an Equilibrium. Why?

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 Nash Equilibrium – Battle of the Sexes
 Suppose Janet goes R and Tony goes F
 Is <R,F> an equilibrium?
 Let first look at Janet:
 If Tony chooses F, will Janet deviate Tony
from R?
F R
 Yes. R is not best response (higher
payoff value) given Tony chooses F Janet F 1, 2 0, 0
 Then look at Tony: R 0, 0 2, 1
 If Janet chooses R, will Tony deviate
from F?
 Result: <R,F> IS NOT an
Equilibrium (and <F,R> is not as
well) 14
 Nash Equilibrium – Battle of the Sexes
 In the “Battle of the Sexes” game, “coordination
failure” is not a Nash Equilibrium!
Players want to change their choice (deviate)!
 Both two equilibria are called “pure-strategy”
Nash Equilibria
 We only consider pure strategy equilibrium in this
course.

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A quick way to solve for (pure-strategy) Nash
equilibrium (equilibria) from a payoff matrix
 Fix Tony’s strategy as F, compare the
payoff to Janet if she chooses F or R
 1st column, 1st coordinate
 F gives a higher payoff to Jane, circle
the payoff
 Fix Tony’s strategy as R…
 Fix Janet’s strategy as F…
 Fix Janet’s strategy as R…
 The cell(s) where the payoffs to both
players are circled represent a pure-
strategy Nash Equilibrium.
 Esp. useful when each player has more
than 2 strategies
 Prisoners’ Dilemma
 Michael and Albert have been caught by the
police
Police have evidence to put them behind bars for
5 years each
But with a confession from Michael or Albert, the
police could get 20-year sentences for them
 So the police offer them the following:
If you confess but other not, you will get only 2
years, but the other gets 20 years
If both confess, each gets 15 years

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 Prisoners’ Dilemma
 Brother, what should I do?
Silence (S): Good brother! wow
Confession (C): It is business! Don’t blame me
 Each has to make his choice without knowing
what the other will do
Of course, police will separate them in different
room to prevent potential communication
 Suppose, both Michael and Albert decide not
to confess (S), the best interest for both
Is that an equilibrium?

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 Nash Equilibrium – Prisoners’ Dilemma
 First, draw the game in normal-
form
 Given Michael chooses S, what
happen if Albert deviates from S?
 Albert will -2 instead of -5! Michael
 Albert will deviate to C S C
 <S,S> IS NOT an equilibrium
Albert S -5, -5 -20, -2
 Is <C,S> an equilibrium?
C -2, -20 -15, -15
 Michael chooses S, should Albert
deviates from C? No!
 However, if Albert chooses C,
Michael wants to deviate to C!!!
 <C,S> IS NOT an equilibrium
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 Nash Equilibrium – Prisoners’ Dilemma
 Is <C,C> an equilibrium?
 Michael chooses C, should Albert
deviates from C?
 No. -20 instead of -15
Michael
 Only <C,C> is an equilibrium,
S C
even though both would be
better off if they could commit Albert S -5, -5 -20, -2
to S C -2, -20 -15, -15
 For each player, C is a
dominant strategy – i.e. it is
better to play C, no matter
what the other may do
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Using the method introduced before:

Dominant strategy:
A strategy that is (weakly) best for a
player in a game regardless of the
strategies chosen by the other
players.

• In the Prisoner’s Dilemma,

“Confess” is the dominant strategy
for both Michael and Albert.

• In the battle of the sexes, there is

no dominant strategy for either
Tony or Janet.
 Cooperation and the Prisoners’ Dilemma
 The Prisoners’ Dilemma illustrates how
difficult it is for competing firms to cooperate
with each other
 Whatever they have agreed to, each player
can do better by cheating (following self-
interest)

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 Oligopoly
 Oligopoly: A market with a small number of
firms, linked by strategic interaction
Decision on “P” or “Q” can affect other firms and
cause them to react
The firm will consider others’ reactions when making
its own decision
 Here, we use game theory to model
“Cournot Duopoly”, with only two firms:
Cournot Duopoly: Firms compete by choosing
output quantities
Bertrand Duopoly (not discussed): Firms compete by choosing
prices
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 Example: Mobile Phone Duopoly
P Q  Smalltown has 140 residents
$0 140  The “good”: Mobile phone services
5 130
 Smalltown’s demand schedule
10 120
15 110  Q=140-2P (P=70-0.5Q)
20 100  MR=70-Q
25 90  Two firms: T-Mobile, Verizon
30 80 (duopoly: an oligopoly with two
35 70 firms)
40 60
 Each firm’s costs: FC = $0, MC =
45 50
$10
 Example: Mobile Phone Duopoly
P Q Revenue Cost Profit Competitive
$0 140 $0 $1,400 –1,400 outcome:
P = MC = $10
5 130 650 1,300 –650
Q = 120
10 120 1,200 1,200 0
Profit = $0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000 Monopoly
25 90 2,250 900 1,350 outcome:
30 80 2,400 800 1,600 MR=MC = $10
35 70 2,450 700 1,750 Q = 60
40 60 2,400 600 1,800 P =70-0.5Q= $40
Profit = $1,800
45 50 2,250 500 1,750
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 Example: Mobile Phone Duopoly
 One possible duopoly outcome: Collusion
 Collusion: An agreement among firms in a
market about quantities to produce or prices
to charge
 T-Mobile and Verizon could agree to each
produce half of the monopoly output:
For each firm: Q = 30, P = $40, profits = $900
“Bake the biggest cake”, then divide it !!!

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 Collusion vs. Self-Interest
P Q  Duopoly outcome with collusion:
$0 140 Each firm agrees to produce Q = 30,
5 130 earns profit = $900
10 120  If T-Mobile reneges on the agreement
15 110 and produces Q = 40, what happens to
20 100 the market price? T-Mobile’s profits?
25 90  Is it in T-Mobile’s interest to renege on
30 80 the agreement?
35 70
 If both firms renege and produce Q = 40,
40 60
determine each firm’s profits
45 50
 Collusion vs. Self-Interest
P Q  If both firms stick to agreement, each firm’s profit
= $900
$0 140
5 130  If T-Mobile reneges on agreement and produces
Q = 40:
10 120
Market quantity = 30+40=70, P = 70-0.5Q=$35
15 110
T-Mobile’s profit = 40 x ($35 – $10) = $1000
20 100
T-Mobile’s profits are higher if it reneges
25 90
 Verizon will conclude the same, so
30 80
both firms renege, each produces Q = 40:
35 70 Market quantity = 40+40=80, P =70-0.5Q= $30
40 60 Each firm’s profit = 40 x ($30 – $10) = $800
45 50
 Collusion vs. Self-Interest
 Both firms would be better off if both stick to
the collusion (cooperation) agreement
 But each firm has incentive to renege on the
agreement (cheat)
 Lesson: It is difficult for oligopoly firms to
form a collusion and honor their agreements
 However, is Q=40 for each firm, a Nash
Equilibrium?
 In other words, will firms further increase their
output level?
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Equilibrium of another kind: Cell Phone Duopoly

P Q  If each firm produces Q = 40,

$0 140 market quantity = 80
5 130 P = $30
10 120
each firm’s profit = $800
15 110  Is it in T-Mobile’s interest to increase its
20 100 output further, to Q = 50?
25 90  Is it in Verizon’s interest to increase its
30 80 output to Q = 50?
35 70
40 60
45 50
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Equilibrium of another kind: Cell Phone Duopoly

P Q  If each firm produces Q = 40,

$0 140 then each firm’s profit = $800
5 130  If T-Mobile increases output to Q = 50:
10 120
Market quantity = 40+50=90,
15 110
P = 70-0.5Q= $25
20 100
25 90 T-Mobile’s profit = 50 x ($25 – $10) = $750
30 80 T-Mobile’s profits are higher at Q = 40
35 70 than at Q = 50
40 60 The same is true for Verizon
45 50
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 The Equilibrium for an Oligopoly
 Nash Equilibrium: Our duopoly example has
a Nash Equilibrium, in which each firm
produces Q = 40
Given that Verizon produces Q = 40, T-Mobile’s
best response is to produce Q = 40
Given that T-Mobile produces Q = 40, Verizon’s
best response is to produce Q = 40

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A Comparison of Market Outcomes
In duopoly (or oligopoly), individual firm
chooses production to maximize profit and
compete:
 Oligopoly Q is greater than monopoly Q
but smaller than competitive Q
 Oligopoly P is greater than competitive P
but less than monopoly P

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 A Cournot Duopoly - In equation
 How do we know “each firm produces Q =
40” is a Nash Equilibrium?
 Need to find the response functions…
 See supplement slides, will be discussed in
tutorial

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 Efficiency with many Cournot Competitors
 If the market demand curve is a downward-sloping straight
line, and MC is constant, then
N Cournot competitors would produce a total of N/(N+1) of the efficient
level of output

A monopoly would produce ½ of the efficient (competitive) level of

output
2 Cournot competitors would produce a total of 2/3 of the efficient level
of output
3 Cournot competitors would produce a total of 3/4 of the efficient level
of output
99 Cournot competitors would produce a total of 99/100 of the efficient
level of output
 Conclusion: A very large number of Cournot competitors
behave like perfect competitors and are almost efficient

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Oligopolies as a Prisoners’ Dilemma
 When oligopolies form a cartel in hopes of
reaching the monopoly outcome, they
become players in a prisoners’ dilemma
 T-Mobile and Verizon Example:
T-Mobile and Verizon are duopolists in Smalltown
The cartel outcome maximizes profits: Each firm
agrees to serve Q = 30 customers
Game and payoff matrix

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 T-Mobile & Verizon in the Prisoners’ Dilemma
Each firm’s dominant strategy: renege on agreement,
produce Q = 40.
T-Mobile
Q = 30 Q = 40
T-Mobile’s T-Mobile’s
profit = $900 profit = $1000
Q = 30
Verizon’s Verizon’s
profit = $900 profit = $750
Verizon
T-Mobile’s T-Mobile’s
profit = $750 profit = $800
Q = 40
Verizon’s profit Verizon’s
= $1000 profit = $800
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 Prisoners’ Dilemma and Society’s Welfare
The non-cooperative oligopoly equilibrium:
Nash Equilibrium
Bad for oligopoly firms: Prevents them from achieving
monopoly profits
Good for society: Q is closer to the socially efficient
output; P is closer to MC

The cooperative Cartel equilibrium:

– Not a Nash Equilibrium
– Good for oligopoly firms: achieves monopoly profits
– Bad for society: Q is monopoly quantity

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 Prisoners’ Dilemma and Society’s Welfare

Q=30 Q=35 Q=40 Q=45 Q=… …

Q=30 900,900 1000,750
Q=35
Q=40 750,1000 800,800
Q=45
Q=… …
 Other Examples of Prisoners’ Dilemma
 Ad Wars: Two firms spend millions on TV ads to steal
business from each other. Each firm’s ad cancels out
the effects of the other, and both firms’ profits fall by the
cost of the ads.
Coca Cola’s Decision

Advertise Not advertise

Pepsi’s Advertise $1,600 profit for Pepsi $2,400 profit for Pepsi
Decision $1,600 profit for Coca Cola $800 profit for Coca Cola

Not advertise $800 profit for Pepsi $2,000 profit for Pepsi
$2,400 profit for Coca Cola $2,000 profit for Coca Cola

 Nash Equilibrium: both advertise

 Other Examples of Prisoners’ Dilemma
 Organization of Petroleum Exporting Countries
Member countries (OPEC): try to act like a cartel,
agree to limit oil production to boost prices and profits.
But agreements sometimes break down when individual
countries renege.

 Nash Equilibrium: both choose high production.

 Other Examples of Prisoners’ Dilemma
 Arms race between military superpowers:
Each country would be better off if both disarm, but each
has a dominant strategy of arming.

 Nash Equilibrium: both superpowers arm.

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 Other Examples of Prisoners’ Dilemma
 Common resources: All would be better off if everyone
conserved common resources, but each person’s
dominant strategy is overusing the resources.

 Nash equilibrium: both drill 2 wells.

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 Prisoners’ Dilemma & Social Welfare
 The non-cooperative oligopoly equilibrium
Bad for oligopoly firms: prevents them from
achieving monopoly profits
Good for society: Q is closer to the socially
efficient output , and P is closer to MC
 In other prisoners’ dilemmas, the inability to
cooperate may reduce social welfare.
e.g., arms race, overuse of common resources

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Why People sometimes cooperate
 In a prisoner dilemma game, players always
have the incentive to cheat
 “Non-cooperative” equilibrium is the result,
which is not the “most beneficial” outcome
 However, in the real world, we can observe
“cooperation” is possible, at least under some
occasions, for example:
 Repeated Game: A game repeated itself
many times - Long time relationship is
valuable
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Why People sometimes cooperate
 If you cheat in a period, you (may) gain
As in mobile service example, your profit
increases from $900 to $1000, given the other
player does not cheat
 However, if you cheat this period, very likely
the other player will “revenge” by “cheating”,
which means a loss due to “non-cooperative”
equilibrium
Cooperative equilibrium, profit = $900; VS
Non-cooperative equilibrium, profit = $800

46
 Why People sometimes cooperate
 You compare the gain and loss
If gain by cheating is less than the lose in future
You will decide not to cheat in the 1st period
 In fact, a strategy “Tit-for-tat”
Play “cooperate” strategy first
Once other parties cheat (cooperate), you will
cheat (cooperate) next round
 Tit-for-tat strategy encourages the reaching
of cooperative equilibrium by playing
cooperative (at first), AND “a tooth for a tooth”
– Punishment !!!
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 Public Policy Toward Oligopolies, Part 1
 Governments
– Can sometimes improve market outcomes
 Policymakers
– Try to induce firms in an oligopoly to compete
rather than cooperate
– Move the allocation of resources closer to the
social optimum
 Antitrust laws
– Used to prevent mergers
– Used to prevent oligopolists from colluding

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 Public Policy Toward Oligopolies, Part 3
 Controversies over antitrust policies
– Used to condemn some business practices whose
effects are not obvious
o Resale price maintenance
o Predatory pricing
o Tying

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 Public Policy Toward Oligopolies, Part 4
 Resale price maintenance (fair trade)
– Require retailers to charge customers a given
price
– Might seem anticompetitive
o Prevents the retailers from competing on price
– Defenders of resale price maintenance:
o Not aimed at reducing competition
– Wholesaler could just increase the wholesale price
– Wholesaler worse off if retailers form a cartel
o Legitimate goal: some retailers offer service
– Prevent customers from knowing about the product at a
store and buy somewhere else at a cheaper price
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 Public Policy Toward Oligopolies, Part 5
 Predatory pricing
– Charge prices that are too low
o Anticompetitive
o Price cuts may be intended to drive other firms out of
the market
– Skeptics: is predatory pricing a profitable strategy
at all?
o Price war — to drive out a rival, prices of predator are
driven below cost
o Prey can respond…

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 Public Policy Toward Oligopolies, Part 6
 Tying
– Offer two goods together (as a bundle) at a single
price
o Expand market power
– Skeptics: does tying expand market power at all?
o Cannot increase market power by binding two goods
together
o Tying is a form of price discrimination, may increase
profit and total surplus

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