Game Theory and Industrial Economics

Outline

• What is Industrial Economics? Game Theory and • Market Power Industrial Economics • Main questions in Industrial Economics

• Introduction to Game Theory

A Taxonomy of Market Structures What is Industrial Economics? Perfect Competition • Many firms • Free entry • Homogeneous product • No strategic interaction • The study of the operation and performance of imperfectly competitive markets and the behaviour of Monopolistic firms in these markets Oligopoly Competition • Few firms • Many firms • Restricted entry • Free entry • Homogeneous or differentiated • Differentiated product product • What happens when perfect competition does not hold • No strategic interaction • Strategic interaction

Monopoly • 1 firm • No free entry • Homogeneous product • No strategic interaction

Examples of Market Structures Perfect Competition • Particular types of grains Main Questions of Industrial Economics • Particular types of milk

1) Is there Market Power? Monopolistic Oligopoly Competition • Crude Oil (OPEC) 2) How is Market Power acquired & maintained? • Restaurants • Cars • Breakfast Cereal • Novels 3) What are the implications of Market Power? • Cheese • Sports shoes • Wine • Computer Operating Systems 4) Is there a role for public policy regarding Market Power? Monopoly

• Water supply • Cable TV (per area)

1 Game Theory

Strategic Behaviour: Consider 2 firms, A and B. • Game theory:

How to make decisions when there is strategic A’s optimal strategy is affected by B’s optimal strategy, interaction and A takes this into account.

B’s optimal strategy is affected by A’s optimal strategy, and B takes this into account.

Game Theory Game Theory

Strategic Behavior: Consider 2 firms, A and B.

A’s optimal strategy is affected by B’s optimal strategy, and A takes this into Definition 1: A Game account. B’s optimal strategy is affected by A’s optimal strategy, and B takes this into A game consists of: account. 1) A set of players (assumed finite and countable). Furthermore: A’s optimal strategy takes into account the fact that B’s optimal strategy takes 2) A set of strategies for each player. into account A’s optimal strategy. B’s optimal strategy takes into account the fact that A’s optimal strategy takes 3) A pay-off function for each player. into account B’s optimal strategy.

And so on successively… Definition 2: Nash Equilibrium

This creates an infinite loop. How do we break out of this problem? A set of strategies, one for each player, such that GIVEN the John Nash’s insight… strategies of rivals no player can raise its payoff by deviating to another strategy.

Simultaneous Choice Games Types of games A Cooperative Game

Possible Payoffs: P2 Simultaneous Choice Games Confess Quiet • Jail: -1 Confess (-1,-1) (-2,+1) • Free: 0 • Jail+Fine: -2 Sequential Move Games P1 • Free+Compensation: +1 Quiet (+1,-2) (0,0)

Strategies: Repeated Games • Confess Payoffs: (P1, P2) • Keep quiet

Dynamic Games Nash-Equilibrium: Players: (Quiet, Quiet) Cooperative Outcome: P1, P2 (Quiet, Quiet)

2 Simultaneous Choice Games Example: Duopoly Sequential Move Games (Same Structure as the Prisoner’s Dilemma)

Firm 2 P1 Competitive Monopoly Price Price enter not enter Competitive (0, 0) (+4,-1) Price Firm 1 Π =0 Monopoly P2 1 (-1,+4) (2, 2) Price Π2=50 fight accept

Payoffs: (Firm 1, Firm 2) Π1=-10 Π1=10 Π =20 Nash-Equilibrium: Π2=-10 2 (Competitive Price, Competitive Price) Incentives to defect Nash-Equilibria: (Fight, Not Enter), (Accept, Enter) Cooperative Outcome: (Monopoly Price, Monopoly Price) Subgame Perfect Nash-Equilibrium:

Build normal form

Sequential Move Games Sequential Move Games The importance of the sequence of moves Stage Games

fight accept Stage 1: Stage 2: Players choose Players choose long-run variable short-run variable P1 P1

enter not enter enter not enter

Π1=-10 Π1=0 Π1=10 Π1=0 Π2=-10 Π2=50 Π2=20 Π2=50

Build normal form

Repeated Prisoner’s Dilemma Repeated Games

Firm 2 Competitive Monopoly Price Price Competitive (0, 0) (+4,-1) Price Firm 1 Monopoly (-1,+4) (2, 2) Price

Payoffs: (Firm 1, Firm 2)

Nash-Equilibrium: (Competitive Price, Competitive Price)

Cooperative Outcome: (Monopoly Price, Monopoly Price)

3 Repeated Games: Game Theory Exercise Sustaining Collusion/Cooperation The Centipede Game

Trigger Strategies: Play the cooperative strategy, as long as all other players play 100 cooperatively (cooperative phase). Otherwise, play the competitive strategy for P1 P2 P1 … P2 P1 P2 the following T periods (punishment phase). 100

Folk Theorem: If players are sufficiently patient (i.e., their discount rate is 2 1 4 sufficiently low), any combination of payoffs can be sustained as an 95 98 97 equilibrium*, so long as players use trigger strategies. 0 3 2 97 96 101

Π1 * The equilibrium referred to here is a ‘Subgame Perfect Nash Equilibrium’ Π2

Suggested Reading • Cabral (2000). Introduction to Industrial Organization, MIT Press. Ch 1, 3, 4.

• Tirole (1988). The Theory of Industrial Organization, MIT Press. Introduction and Appendix (Game Theory)

• Gibbons. A Primer in Game Theory.

• Reviews of I.O. – Schmalensee, R. Industrial organization. In New Palgrave Dictionary of Economics – Schmalensee, R. Industrial organization: An overview. Economic Journal 98, 643-681