Managerial Economics Thomas

Assoc. Prof. Dr. Do Anh Tai

eighth edition Maurice
TNU

Part 4

Decisions Marking

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 2 Managerial Economics

Managerial Decisions in
Competitive Markets

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 3 Managerial Economics

Perfect Competition
• Firms are price-takers
• Each produces only a very small portion of
total market or industry output
• All firms produce a homogeneous
product
• Entry into & exit from the market is
unrestricted

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 4 Managerial Economics
Demand for a Competitive
Price-Taker
• Demand curve is horizontal at price
determined by intersection of market
demand & supply
• Perfectly elastic
• Marginal revenue equals price
• Demand curve is also marginal revenue curve
(D = MR)
• Can sell all they want at the market price
• Each additional unit of sales adds to total
revenue an amount equal to price

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 5 Managerial Economics
Demand for a Competitive
Price-Taking Firm (Figure 11.2)

P0 P0
D=
MR

) sr all od( eci r P

) sr all od( eci r P

0 Q0 0

Quantity Quantity

Panel A – Panel B – Demand curve

Market facing a
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 6 Managerial Economics
Profit-Maximization in the
Short Run
• In the short run, managers must make
two decisions:
1. Produce or shut down?
 If shut down, produce no output and hires no
variable inputs
 If shut down, firm loses amount equal to TFC
1. If produce, what is the optimal output
level?
 If firm does produce, then how much?
 Produce amount that maximizes economic profit

Profit = π = TR − TC
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 7 Managerial Economics

Profit Margin (or Average Profit)

π ( P − ATC )Q
Average profit = =
Q Q
= P − ATC = Profit margin

• Level of output that maximizes total

profit occurs at a higher level than the
output that maximizes profit margin (&
average profit)
• Managers should ignore profit margin
(average profit) when making optimal
decisions
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 8 Managerial Economics

Short-Run Output Decision

• Firm’s manager will produce output
where P = MC as long as:
• TR ≥ TVC
• or, equivalently, P ≥ AVC
• If price is less than average variable cost
(P < AVC), manager will shut down
• Produce zero output
• Lose only total fixed costs
• Shutdown price is minimum AVC

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 9 Managerial Economics
Profit Maximization: P = $36
(Figure 11.3)

Total revenue
Profit =$36 x 600
= $21,600 -
$11,400= $21,600
= $10,200

Total cost = $19 x

600 = $11,400

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10 Managerial Economics
Profit Maximization: P = $36
(Figure 11.4)

Panel A: Total
revenue & total cost

Panel B: Profit curve

when P = $36

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11 Managerial Economics
Short-Run Loss Minimization:
P = $10.50 (Figure 11.5)

Profitcost
Total = $3,150
= $17 x- 300
$5,100 = $5,100 =
-$1,950

Total revenue = $10.50 x

300 = $3,150

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12 Managerial Economics

Irrelevance of Fixed Costs

• Fixed costs are irrelevant in the
production decision
• Level of fixed cost has no effect on
marginal cost or minimum average
variable cost
• Thus no effect on optimal level of
output

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13 Managerial Economics
Summary of Short-Run Output
Decision
• AVC tells whether to produce
• Shut down if price falls below minimum
AVC
• SMC tells how much to produce
• If P ≥ minimum AVC, produce output at
which P = SMC
• ATC tells how much profit/loss if
produce
• π = ( P − ATC )Q
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14 Managerial Economics

Short-Run Supply Curves

• For an individual price-taking firm
• Portion of firms’ marginal cost curve
above minimum AVC
• For prices below minimum AVC,
quantity supplied is zero
• For a competitive industry
• Horizontal sum of supply curves of all
individual firms
• Always upward sloping
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15 Managerial Economics
Derivation of Short-Run Supply
Curves (Figure 11.6)

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16 Managerial Economics
Long-Run Profit-Maximizing
Equilibrium (Figure 11.7)

Profit = ($17 - $12) x

240 = $1,200

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17 Managerial Economics

Long-Run Competitive Equilibrium

• All firms are in profit-maximizing
equilibrium (P = LMC)
• Occurs because of entry/exit of
firms in/out of industry
• Market adjusts so P = LMC = LAC

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18 Managerial Economics
Long-Run Competitive
Equilibrium (Figure 11.8)

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19 Managerial Economics

Long-Run Industry Supply

• Long-run industry supply curve
can be flat (perfectly elastic) or
upward sloping
• Depends on whether constant cost
industry or increasing cost industry
• Economic profit is zero for all
points on the long-run industry
supply curve for both types of
industries
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20 Managerial Economics

Long-Run Industry Supply

• Constant cost industry
• As industry output expands, input prices
remain constant, & minimum LAC is
unchanged
• P = minimum LAC, so curve is horizontal
(perfectly elastic)
• Increasing cost industry
• As industry output expands, input prices
rise, & minimum LAC rises
• Long-run supply price rises & curve is
upward sloping

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21 Managerial Economics
Long-Run Industry Supply for a
Constant Cost Industry (Figure 11.9)

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22 Managerial Economics
Long-Run Industry Supply for an
Increasing Cost Industry (Figure 11.10)

Firm’s
output

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23 Managerial Economics

Economic Rent
• Payment to the owner of a scarce,
superior resource in excess of the
resource’s opportunity cost
• In long-run competitive equilibrium
firms that employ such resources
earn only normal profit
• Economic profit is zero
• Potential economic profit is paid to
the resource as rent
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24 Managerial Economics
Economic Rent in Long-Run
Competitive Equilibrium (Figure 11.11)

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25 Managerial Economics

Profit-Maximizing Input Usage

• Profit-maximizing level of input
usage produces exactly that level
of output that maximizes profit

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26 Managerial Economics

Profit-Maximizing Input Usage

• Marginal revenue product (MRP)
• MRP of an additional unit of a variable input is
the additional revenue from hiring one more unit
of the input
∆TR
MRP = = P × MP
∆L
• If choose to produce:
• If the MRP of an additional unit of input is
greater than the price of input, that unit should
be hired
• Employ amount of input where MRP = input price
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27 Managerial Economics

Profit-Maximizing Input Usage

• Average revenue product (ARP)
• Average revenue per worker

TR
ARP = = P × AP
L

• Shut down in short run if ARP < MRP

• When ARP < MRP, TR < TVC

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28 Managerial Economics
Profit-Maximizing Labor Usage
(Figure 11.12)

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29 Managerial Economics
Implementing the Profit-
Maximizing Output Decision
• Step 1: Forecast product price
• Use statistical techniques from
Chapter 7
• Step 2: Estimate AVC & SMC
• AVC = a + bQ + cQ
2

• SMC = a + 2bQ + 3cQ 2

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30 Managerial Economics
Implementing the Profit-
Maximizing Output Decision
• Step 3: Check shutdown rule
• If P ≥ AVCmin, produce
• If P < AVCmin, shut down
• To find AVCmin, substitute Qmin into AVC
equation
b
Qmin =−
2c
AVC min = a + bQmin + cQmin
2

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31 Managerial Economics
Implementing the Profit-
Maximizing Output Decision
• Step 4: If P ≥ AVCmin, find output
where P = SMC
• Set forecasted price equal to
estimated marginal cost & solve for Q*

P = a + 2bQ + 3cQ
* *2

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32 Managerial Economics
Implementing the Profit-
Maximizing Output Decision
• Step 5: Compute profit or loss
• Profit = TR - TC
= P × Q* − AVC × Q* − TFC
= ( P − AVC )Q* − TFC

• If P < AVCmin , firm shuts down &

profit is -TFC

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33 Managerial Economics
Profit & Loss at Beau Apparel
(Figure 11.13)

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34 Managerial Economics
Profit & Loss at Beau Apparel
(Figure 11.13)

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35 Managerial Economics

Managerial Decisions for

Firms with Market Power

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36 Managerial Economics

Market Power
• Ability of a firm to raise price
without losing all its sales
• Any firm that faces downward sloping
demand has market power
• Gives firm ability to raise price
above average cost & earn
economic profit (if demand & cost
conditions permit)

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37 Managerial Economics

Monopoly
• Single firm
• Produces & sells a particular good
or service for which there are no
good substitutes
• New firms are prevented from
entering market

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38 Managerial Economics

Measurement of Market Power

• Degree of market power inversely
related to price elasticity of demand
• The less elastic the firm’s demand, the
greater its degree of market power
• The fewer close substitutes for a firm’s
product, the smaller the elasticity of demand
(in absolute value) & the greater the firm’s
market power
• When demand is perfectly elastic (demand is
horizontal), the firm has no market power

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39 Managerial Economics

Measurement of Market Power

• Lerner index measures proportionate
amount by which price exceeds marginal
cost:

P − MC
Lerner index =
P

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40 Managerial Economics

Measurement of Market Power

• Lerner index
• Equals zero under perfect competition
• Increases as market power increases
• Also equals –1/E, which shows that the
index (& market power), vary inversely
with elasticity
• The lower the elasticity of demand
(absolute value), the greater the index
& the degree of market power
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41 Managerial Economics

Measurement of Market Power

• If consumers view two goods as
substitutes, cross-price elasticity
of demand (EXY) is positive
• The higher the positive cross-price
elasticity, the greater the
substitutability between two goods, &
the smaller the degree of market
power for the two firms

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42 Managerial Economics

Determinants of Market Power

• Entry of new firms into a market
erodes market power of existing
firms by increasing the number of
substitutes
• A firm can possess a high degree of
market power only when strong
barriers to entry exist
• Conditions that make it difficult for
new firms to enter a market in which
economic profits are being earned
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43 Managerial Economics

Common Entry Barriers

• Economies of scale
• When long-run average cost declines over
a wide range of output relative to
demand for the product, there may not
be room for another large producer to
enter market
• Barriers created by government
• Licenses, exclusive franchises

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44 Managerial Economics

Common Entry Barriers

• Input barriers
• One firm controls a crucial input in the
production process
• Brand loyalties
• Strong customer allegiance to existing
firms may keep new firms from finding
enough buyers to make entry worthwhile

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45 Managerial Economics

Common Entry Barriers

• Consumer lock-in
• Potential entrants can be deterred if
they believe high switching costs will
keep them from inducing many consumers
to change brands
• Network externalities
• Occur when value of a product increases
as more consumers buy & use it
• Make it difficult for new firms to enter
markets where firms have established a
large network of buyers
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46 Managerial Economics
Demand & Marginal Revenue for a
Monopolist
• Market demand curve is the firm’s demand
curve
• Monopolist must lower price to sell
additional units of output
• Marginal revenue is less than price for all but the
first unit sold
• When MR is positive (negative), demand is
elastic (inelastic)
• For linear demand, MR is also linear, has the
same vertical intercept as demand, & is
twice as steep

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47 Managerial Economics
Demand & Marginal Revenue for a
Monopolist (Figure 12.1)

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48 Managerial Economics
Short-Run Profit Maximization for
Monopoly
• Monopolist will produce a positive
output if some price on the demand
curve exceeds average variable cost
• Profit maximization or loss
minimization occurs by producing
quantity for which MR = MC

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49 Managerial Economics
Short-Run Profit Maximization for
Monopoly
• If P > ATC, firm makes economic
profit
• If ATC > P > AVC, firm incurs loss, but
continues to produce in short run
• If demand falls below AVC at every
level of output, firm shuts down &
loses only fixed costs

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50 Managerial Economics
Short-Run Profit Maximization for
Monopoly (Figure 12.3)

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51 Managerial Economics
Short-Run Loss Minimization for
Monopoly (Figure 12.4)

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52 Managerial Economics
Long-Run Profit Maximization for
Monopoly
• Monopolist maximizes profit by
choosing to produce output where
MR = LMC, as long as P ≥ LAC
• Will exit industry if P < LAC
• Monopolist will adjust plant size to
the optimal level
• Optimal plant is where the short-run
average cost curve is tangent to the long-
run average cost at the profit-
maximizing output level

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53 Managerial Economics
Long-Run Profit Maximization for
Monopoly (Figure 12.5)

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54 Managerial Economics

Profit-Maximizing Input Usage

• Profit-maximizing level of input
usage produces exactly that level
of output that maximizes profit

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55 Managerial Economics

Profit-Maximizing Input Usage

• Marginal revenue product (MRP)
• MRP is the additional revenue attributable to
hiring one more unit of the input
∆TR
MRP = = MR × MP
∆L
• When producing with a single variable input:
• Employ amount of input for which MRP = input
price
• Relevant range of MRP curve is downward sloping,
positive portion, for which ARP > MRP
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56 Managerial Economics
Monopoly Firm’s Demand for
Labor (Figure 12.6)

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57 Managerial Economics

Profit-Maximizing Input Usage

• For a firm with market power,
profit-maximizing conditions MRP
= w and MR = MC are equivalent
• Whether Q or L is chosen to maximize
profit, resulting levels of input usage,
output, price, & profit are the same

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58 Managerial Economics

Monopolistic Competition
• Large number of firms sell a
differentiated product
• Products are close (not perfect)
substitutes
• Market is monopolistic
• Product differentiation creates a
degree of market power
• Market is competitive
• Large number of firms, easy entry
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59 Managerial Economics

Monopolistic Competition
• Short-run equilibrium is identical to
monopoly
• Unrestricted entry/exit leads to
long-run equilibrium
• Attained when demand curve for each
producer is tangent to LAC
• At equilibrium output, P = LAC and
MR = LMC

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60 Managerial Economics
Short-Run Profit Maximization for
Monopolistic Competition (Figure 12.7)

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61 Managerial Economics
Long-Run Profit Maximization for
Monopolistic Competition (Figure 12.8)

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62 Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 1: Estimate demand equation
• Use statistical techniques from
Chapter 7
• Substitute forecasts of demand-
shifting variables into estimated
demand equation to get

Q = a' + bP
ˆ + dPˆ
Where a' = a + cM R
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63 Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 2: Find inverse demand
equation
• Solve for P

−a' 1
P= + Q = A + BQ
b b
ˆ ˆ 1
Where a' = a + cM + dPR , A = − a' b , and B =
b

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64 Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 3: Solve for marginal revenue
• When demand is expressed as
P = A + BQ, marginal revenue is

−a' 2
MR = A + 2 BQ = + Q
b b

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65 Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 4: Estimate AVC & SMC
• Use statistical techniques from
Chapter 10

AVC = a + bQ + cQ 2

SMC = a + 2bQ + 3cQ 2

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66 Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 5: Find output where MR = SMC
• Set equations equal & solve for Q*
• The larger of the two solutions is the profit-
maximizing output level
• Step 6: Find profit-maximizing price
• Substitute Q* into inverse demand
P* = A + BQ*

Q* & P* are only optimal if P ≥ AVC

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67 Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 7: Check shutdown rule
• Substitute Q* into estimated AVC
function

AVC = a + bQ + cQ
* * *2

• If P* ≥ AVC*, produce Q* units of

output & sell each unit for P*
• If P* < AVC*, shut down in short run
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68 Managerial Economics
Implementing the Profit-Maximizing
Output & Pricing Decision
• Step 8: Compute profit or loss
• Profit = TR - TC
= P × Q* − AVC × Q* − TFC
= ( P − AVC )Q* − TFC

• If P < AVC, firm shuts down & profit

is -TFC

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69 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Aztec possesses market power via
patents
• Sells advanced wireless stereo
headphones

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70 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Estimation of demand & marginal
revenue

Q = 41, 000 − 500 P + 0.6M − 22.5PR

= 41, 000 − 500 P + 0.6(45, 000) − 22.5(800)
= 50, 000 − 500P

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71 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example

Q − 50, 000 = −500 P

Q − 50, 000 −500 P
=
−500 −500
Q −50, 000
+ =P
−500 −500
1
P = 100 − Q
500
= 100 − 0.002Q
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72 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Determine marginal revenue
function

P = 100 − 0.002Q

MR = 100 − 0.004Q

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73 Managerial Economics
Demand & Marginal Revenue for
Aztec Electronics (Figure 12.9)

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74 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Estimation of average variable cost and marginal cost
Given the estimated AVC equation:
•

AVC = 28 − 0.005Q + 0.000001Q 2

• So,

SMC = 28 − (2 × 0.005)Q + (3 × 0.000001)Q 2

= 28 − 0.01Q + 0.000003Q 2

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75 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example

100 − 0.004Q = 28 − 0.01Q + 0.000003Q 2

0 = (28 − 100) + (−0.01 + 0.004)Q + 0.000003Q 2

= −72 − 0.006Q + 0.000003Q 2

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76 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Output decision
Solve for Q* using the quadratic formula
•

−(−0.006) + (−0.006) 2 − 4(−72)(0.000003)

Q* =
2(0.000003)

0.036
= = 6, 000
0.000006

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77 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
Pricing decision
•
Substitute Q* into inverse demand
•

P* = 100 − 0.002(6, 000)

= $88

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78 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Shutdown decision
Compute AVC at 6,000 units:
•

AVC* = 28 − 0.005(6, 000) + 0.000001(6, 000) 2

= $34

Because P = $88 > $34 = AVC, Aztec should

produce rather than shut down

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79 Managerial Economics
Maximizing Profit at Aztec
Electronics: An Example
• Computation of total profit

π = TR − TVC − TFC
= ( P * ×Q*) − ( AVC * ×Q*) − TFC
= ($88 × 6, 000) − ($34 × 6, 000) − $270, 000

= $528, 000 − $204, 000 − $270, 000

= $54, 000

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80 Managerial Economics
Profit Maximization at Aztec
Electronics (Figure 12.10)

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81 Managerial Economics

Strategic Decision Making in

Oligopoly Markets

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82 Managerial Economics

Oligopoly Markets
• Interdependence of firms’ profits
• Distinguishing feature of oligopoly
• Arises when number of firms in
market is small enough that every
firms’ price & output decisions affect
demand & marginal revenue conditions
of every other firm in market

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83 Managerial Economics

Strategic Decisions
• Strategic behavior
• Actions taken by firms to plan for &
react to competition from rival firms
• Game theory
• Useful guidelines on behavior for
strategic situations involving
interdependence

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84 Managerial Economics

Simultaneous Decisions
• Occur when managers must make
individual decisions without
knowing their rivals’ decisions

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85 Managerial Economics

Dominant Strategies
• Always provide best outcome no matter
what decisions rivals make
• When one exists, the rational decision
maker always follows its dominant
strategy
• Predict rivals will follow their dominant
strategies, if they exist
• Dominant strategy equilibrium
• Exists when when all decision makers have
dominant strategies

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86 Managerial Economics

Prisoners’ Dilemma
• All rivals have dominant strategies
• In dominant strategy equilibrium,
all are worse off than if they had
cooperated in making their
decisions

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87 Managerial Economics

Prisoners’ Dilemma (Table 13.1)

Bill
Don’t confess Confess
Jane Don’t A B B
confes 2 years, 2 12 years, 1
s years year
Confes C J D JB
s 1 year, 12 6 years, 6
years years

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88 Managerial Economics

Dominated Strategies
• Never the best strategy, so never would
be chosen & should be eliminated
• Successive elimination of dominated
strategies should continue until none
remain
• Search for dominant strategies first,
then dominated strategies
• When neither form of strategic dominance
exists, employ a different concept for
making simultaneous decisions
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89 Managerial Economics
Successive Elimination of
Dominated Strategies (Table
13.3)
Palace’s price
High ($10) Medium ($8) Low ($6)

Castle’ High A B C C CP
s price ($10) $1,000, $900, $1,100 $500,
$1,000 $1,200

Medium D E P F
($8) $1,100, $400 $800, $800 $450, $500

Low G C H I P
($6) $1,200, $300 $500, $350 $400, $400

Payoffs in dollars of profit per

week.
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90 Managerial Economics
Successive Elimination of
Dominated Strategies (Table
13.3)
Unique
Reduced Payoff
Table Palace’sSolution
price
Medium ($8) Low ($6)
Castle’s High B C C CP
price ($10) $900, $1,100 $500, $1,200

Low H I P
($6) $500, $350 $400, $400

Payoffs in dollars of profit per week.

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91 Managerial Economics

Making Mutually Best Decisions

• For all firms in an oligopoly to be
predicting correctly each others’
decisions:
• All firms must be choosing individually
best actions given the predicted
actions of their rivals, which they can
then believe are correctly predicted
• Strategically astute managers look for
mutually best decisions
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92 Managerial Economics

Nash Equilibrium
• Set of actions or decisions for
which all managers are choosing
their best actions given the actions
they expect their rivals to choose
• Strategic stability
• No single firm can unilaterally make a
different decision & do better

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93 Managerial Economics
Super Bowl Advertising: A Unique
Nash Equilibrium (Table 13.4)
Pepsi’s budget
Low Medium High

Coke’s Low A C B P C
budget $60, $45 $57.5, $50 $45, $35

Medium D P E C F
$50, $35 $65, $30 $30, $25

High G H I C P
$45, $10 $60, $20 $50, $40

Payoffs in millions of dollars of semiannual

profit.
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94 Managerial Economics

Nash Equilibrium
• When a unique Nash equilibrium set of
decisions exists
• Rivals can be expected to make the decisions
leading to the Nash equilibrium
• With multiple Nash equilibria, no way to predict
the likely outcome
• All dominant strategy equilibria are also
Nash equilibria
• Nash equilibria can occur without dominant or
dominated strategies

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95 Managerial Economics

Best-Response Curves
• Analyze & explain simultaneous
decisions when choices are continuous
(not discrete)
• Indicate the best decision based on the
decision the firm expects its rival will
make
• Usually the profit-maximizing decision
• Nash equilibrium occurs where firms’
best-response curves intersect

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96 Managerial Economics
Deriving Best-Response Curve
for Arrow Airlines (Figure 13.1)

and marginal revenue

Arrow Airline’s price

Panel A –
Arrow believes PB =
Bravo Airway’s quantity
$100
Arrow Airline’s
price

Panel B – Two points

on Arrow’s best-
Bravo Airway’s price
response curve
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97 Managerial Economics
Best-Response Curves & Nash
Equilibrium (Figure 13.2)

Arrow Airline’s
price

Bravo Airway’s
price
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98 Managerial Economics

Sequential Decisions
• One firm makes its decision first,
then a rival firm, knowing the
action of the first firm, makes its
decision
• The best decision a manager makes
today depends on how rivals respond
tomorrow

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99 Managerial Economics

Game Tree
• Shows firms decisions as nodes with
branches extending from the nodes
• One branch for each action that can be taken
at the node
• Sequence of decisions proceeds from left to
right until final payoffs are reached
• Roll-back method (or backward induction)
• Method of finding Nash solution by looking
ahead to future decisions to reason back to
the current best decision

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 100 Managerial Economics
Sequential Pizza Pricing
(Figure 13.3)

Panel
Panel B –ARoll-back
– Game
tree
solution

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 101 Managerial Economics
First-Mover & Second-Mover
Advantages
• First-mover advantage
• If letting rivals know what you are
doing by going first in a sequential
decision increases your payoff
• Second-mover advantage
• If reacting to a decision already made
by a rival increases your payoff

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 102 Managerial Economics
First-Mover & Second-Mover
Advantages
• Determine whether the order of
decision making can be confer an
advantage
• Apply roll-back method to game trees
for each possible sequence of
decisions

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 103 Managerial Economics
First-Mover Advantage in
Technology Choice (Figure 13.4)
Motorola’s technology
Analog Digital
Sony’s Analo A SM B
technolog g $10, $13.75 $8, $9
y

Digital C D SM
$9.50, $11 $11.875,
$11.25

Panel A – Simultaneous technology

103 decision
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 104 Managerial Economics
First-Mover Advantage in
Technology Choice (Figure 13.4)

Panel B – Motorola secures a first-

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McGraw-Hill/Irwin
 105 Managerial Economics

Strategic Moves
• Actions used to put rivals at a
disadvantage
• Three types
• Commitments
• Threats
• Promises
• Only credible strategic moves
matter
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 106 Managerial Economics

Commitments
• Managers announce or
demonstrate to rivals that they will
bind themselves to take a
particular action or make a specific
decision
• No matter what action or decision is
taken by rivals

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 107 Managerial Economics

Threats & Promises

• Conditional statements
• Threats
• Explicit or tacit
• “If you take action A, I will take
action B, which is undesirable or costly
to you.”
• Promises
• “If you take action A, I will take
action B, which is desirable or
rewarding to you.”
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 108 Managerial Economics
Cooperation in Repeated
Strategic Decisions
• Cooperation occurs when
oligopoly firms make individual
decisions that make every firm
better off than they would be in a
(noncooperative) Nash equilibrium

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 109 Managerial Economics

Cheating
• Making noncooperative decisions
• Does not imply that firms have made
any agreement to cooperate
• One-time prisoners’ dilemmas
• Cooperation is not strategically stable
• No future consequences from
cheating, so both firms expect the
other to cheat
• Cheating is best response for each
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 110 Managerial Economics
Pricing Dilemma for AMD & Intel
(Table 13.5)

AMD’s price
High Low
Intel’ High A: Cooperatio B: AMD
s n $5, $2.5 $2, $3
cheats
price
A
Low C: Intel D: Noncooperati
cheats
$6, $0.5 on $3, $1

I IA
Payoffs in millions of dollars of profit per
week.
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 111 Managerial Economics

Punishment for Cheating

• With repeated decisions, cheaters
can be punished
• When credible threats of
punishment in later rounds of
decision making exist
• Strategically astute managers can
sometimes achieve cooperation in
prisoners’ dilemmas

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 112 Managerial Economics

Deciding to Cooperate
• Cooperate
• When present value of costs of cheating
exceeds present value of benefits of
cheating
• Achieved in an oligopoly market when all
firms decide not to cheat
• Cheat
• When present value of benefits of
cheating exceeds present value of costs
of cheating
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 113 Managerial Economics

Deciding to Cooperate

B1 B2 BN
PVBenefits of cheating = + + ... +
(1 + r ) (1 + r )
1 2
( 1 + r )N

Where Bi = π Cheat − π Cooperate for i = 1 , ..., N

C1 C2 CP
PVCosts of cheating = N +1
+ N +2
+ ... +
(1 + r ) (1 + r ) ( 1 + r )N + P
Where C j = π Cooperate − π Nash for j = 1 , ..., P

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 114 Managerial Economics
A Firm’s Benefits & Costs of
Cheating (Figure 13.5)

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 115 Managerial Economics

Trigger Strategies
• A rival’s cheating “triggers”
punishment phase
• Tit-for-tat strategy
• Punishes after an episode of cheating
& returns to cooperation if cheating
ends
• Grim strategy
• Punishment continues forever, even if
cheaters return to cooperation
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 116 Managerial Economics

Facilitating Practices
• Legal tactics designed to make
cooperation more likely
• Four tactics
• Price matching
• Sale-price guarantees
• Public pricing
• Price leadership

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 117 Managerial Economics

Price Matching
• Firm publicly announces that it will
match any lower prices by rivals
• Usually in advertisements
• Discourages noncooperative price-
cutting
• Eliminates benefit to other firms from
cutting prices

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 118 Managerial Economics

Sale-Price Guarantees
• Firm promises customers who buy
an item today that they are entitled
to receive any sale price the firm
might offer in some stipulated
future period
• Primary purpose is to make it costly
for firms to cut prices

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 119 Managerial Economics

Public Pricing
• Public prices facilitate quick
detection of noncooperative price
cuts
• Timely & authentic
• Early detection
• Reduces PV of benefits of cheating
• Increases PV of costs of cheating
• Reduces likelihood of noncooperative
price cuts

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 120 Managerial Economics

Price Leadership
• Price leader sets its price at a level
it believes will maximize total
industry profit
• Rest of firms cooperate by setting
same price
• Does not require explicit
agreement
• Generally lawful means of facilitating
cooperative pricing
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 121 Managerial Economics

Cartels
• Most extreme form of cooperative
oligopoly
• Explicit collusive agreement to
drive up prices by restricting total
market output
• Illegal in U.S., Canada, Mexico,
Germany, & European Union

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 122 Managerial Economics

Cartels
• Pricing schemes usually strategically
unstable & difficult to maintain
• Strong incentive to cheat by lowering price
• When undetected, price cuts occur
along very elastic single-firm demand
curve
• Lure of much greater revenues for any one
firm that cuts price
• Cartel members secretly cut prices causing
price to fall sharply along a much steeper
demand curve
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 123 Managerial Economics
Intel’s Incentive to Cheat
(Figure 13.6)

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 124 Managerial Economics

Tacit Collusion
• Far less extreme form of
cooperation among oligopoly firms
• Cooperation occurs without any
explicit agreement or any other
facilitating practices

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