Applied Economics For Managers Recitation 3 Monday June 21st 2004 Outline 1 Monopolistic competition 2 Game Theory and Strategic Interaction MONOPOLISTIC COMPETITION Our goal now is to begin to investigate the middle ground between perfect competition and monopoly In such markets things are more complicated and it is less easy to make general statements as we can for the two extreme cases much depends on the details of the industry For that reason we will look at various different models that will be appropriate under different circumstances One industry structure which captures a flavor of both is MONOPOLISTIC COMPETITION These are industries in which although firms compete they sell DIFFERENTIATED PRODUCTS so that the competition is not directly head to head Firms have some scope to raise prices without losing all their customers as their products have some unique selling point that appeals to particular consumers Examples the newspaper market that we discussed in Lecture We can analyze the pricing decision of each firm as if they are a monopolist since they have some pricing power v What is the competitive aspect It is that there is nothing to stop other firms entering with their own varieties How can we model this As the market becomes more crowded the demand which can be capture by each individual firm shrinks It will keep shrinking until profits are zero This is similar to the story we told about a perfectly competitive industry but note that here things are more complicated In particular the long run equilibrium is NOT EFFICIENT FIRMS HAVE EXCESS CAPACITY in the sense that AVERAGE COSTS ARE NOT MINIMIZED EVEN IN THE LONG RUN The key to this result is that even though firms have pricing power so can raise prices above marginal costs they also have fixed costs The monopoly profits are offset by the fixed costs and as entry occurs profits are bid down until they are completely absorbed by the fixed cost but even so the price distortion at the margin keeps quantity below that at which AC is minimized GAME THEORY I I fR IvtL i idc use the tools of In general when we think about firms with a small GAME THEORY We analyze the STRATEGIC INTERACTIONS AMONG THE FIRMS A game has a specific meaning in economics In particular we define a game as i ii iii iv rules strategies payoffs outcome The idea is that all players know the structure of the environment they are acting in the rules In particular they know what the relevant decision variables for themselves and the other players are the strategies and they know what the consequences of these decisions are both for themselves and the other player the payoffs The goal in game theory is to analyze the economic environment above and make a prediction about the outcome i e WHAT IS THE EQUILIBRIUM In analyzing games we will use a lot 2 tools i ii the payoff matrix Nash equilibrium The payoff matrix summarizes all the information relevant to points I iii above it is a complete description of the economic environment who can do what and what the consequences are Nash equilibrium is the basic tool we use to predict the outcome Let s look at an example of a payoff matrix and then understand how to use the idea of Nash Equilibrium A famous game in economics is the PRISONER S DILEMMA It s important as it captures the basic conflict between competition and cooperation in industries with a small number of firms We ll use this game to illustrate the concepts above mapping the environment into rules strategies payoffs and showing how to solve using NASH EQUILIBRIUM Set up of the PD is a parable Two prisoners have been caught and are being interrogated about a crime They are in separate rooms and don t know what their accomplice is saying Each prisoner can separately choose whether or not to confess If neither confesses they get convicted of a lesser crime for 3 years If one confesses and the other not the confessor gets a light sentence of 1 year and the other gets 10 If they both confess they get 5 years The first thing to do is set up the payoff matrix Confess CLYDE Confess Deny 5 5 10 l BONNIE I Deny 1 10 3 3 In this example there are 2 strategies for each player they just have to decide whether to confess or deny The payoffs here are simply the years in jail Each cell of the matrix describes the payoff for Clyde Bonnie as a function of the strategy chosen by each of them NOTE there is interdependence the other player s choice affects me this is the essence of a game What is the NASH EQUILIBRIUM OF THIS GAME DEFINITION THE NASH EQUILIBRUIM IS A STRATEGY CHOICE FOR EACH PLAYER SUCH THAT EACH CHOOSES OPTIMALLY TAKING AS GIVEN THE CHOICE OF THE OTHER PLAYER Compare with competitive equilibrium there players took the market price as given and formed responses Here we think of players taking the strategic choice of the other player as given and forming a best response Just as in competitive eqm the outcome was the price that made firms and consumers choices consistent with each other here NE is the outcome which makes each player s assumptions about what other players are doing and the actions they choose consistent with each other To find the NE players don t necessarily know what the other player will do they form a conjecture and they choose the best response to every possible choice of the other player In equilibrium the conjecture they make must be right this is because the other player is also making the same calculations and the equilibrium is the pair of choices that make each players assumptions correct This is similar to the demand and supply curves firms don t know what the price will be but they think through a supply schedule for every possible price The equilibrium then selects the actual price and firms choices are then consistent with the price that occurs in equilibrium In this example consider what happens from Clyde s perspective i ii if Bonnie confesses Clyde gets 10 if he denies and 5 if he confesses he chooses confess If Bonnie denies Clyde gets 3 if he denies 1 if he confesses he again confesses Likewise for Bonnie Thus Confess Confess is a NE since it is optimal given the choice of the other There is no other NE if Bonnie expects deny she confesses If Clyde expects Bonnie to confess he would also confess so Bonnie would not expect Clyde to deny and this can t be part of an eqm Thus we have found the outcome of the game if both players are rational and understand the structure of the game we would expect both of them to confess