5 minute read
Testing commitment
9. Substitute qB = 140 in the equation from Step 5 to determine qA.
Advertisement
10. Solve for Q, the quantity the cartel produces.
11. Solve for P, the price the cartel establishes for the good.
The cartel establishes a price of $18.60 for the good. Firm A produces 130 units and firm B produces 140 units.
Cartel participants jointly determine quantity and price based upon marginal revenue, derived from the market demand curve, equaling each participant’s marginal cost.
Profiting from the Long Run
Economies of scale serve as a barrier to entry in oligopolistic markets. Economies of scale mean that existing firms produce a large quantity of the good at very low average total cost per unit. The existing firms tend to have substantial fixed costs, so producing a larger quantity of output reduces their fixed cost per unit and thus their average total cost per unit. On the other hand, a new firm entering the market isn’t likely to have many customers at first. Therefore, the new firm produces a much smaller quantity of output and can’t spread its fixed costs as far. The result is much higher average total cost per unit for a new firm.
Because their cost per unit is lower than the new firm’s cost per unit, the existing firms charge lower prices than the new firm. Yet, even with the lower price, the existing firms earn positive economic profit because their cost per unit is so low. If the new firm tries to match this low price, it loses money because it has a much higher cost per unit. Thus, even with the attraction of positive profit, new firms can’t effectively compete with existing firms who take advantage of economies of scale.
Positive economic profit means the firm earns more than a normal rate of return. When economic profit is positive, you’re receiving more income — or a return that’s higher than normal — as compared to your next best alternative.
Chapter 12 Game Theory: Fun Only if You Win
In This Chapter
▶ Playing to win ▶ Taking turns ▶ Playing forever ▶ Losing by winning with prisoner’s dilemma ▶ Winning by losing through preemptive strategies ▶ Committing with credibility
Finally, some fun. You get to play games, and you’ve probably heard the saying, “It’s not whether you win or lose; it’s how you play the game.” A critical point for business that this quote misses is how you play the game determines whether you win or lose. And in business, whether you win — make profit — or lose — incur losses — means everything.
Strategic decision-making occurs when the game’s outcomes depend on the choices made by different players. Because the outcomes are interdependent, players must consider how rivals respond to their decisions. Competition in these situations leads to mutual interdependence with conflict. The complexity of the resulting environment requires decision-making rules. Game theory provides a framework for making the decisions. Game theory’s goal is to provide rules that enable you to correctly anticipate a rival’s decision.
A great example of game theory is the board game Monopoly. Monopoly involves multiple decision-makers or players. The decisions each player makes influence the game’s outcome. If I build a hotel on St. James Place and you land on it, you owe me $950. On the other hand, if you land on St. James Place when it has no house or hotel, your rent is only $14.
This chapter examines how decisions are made in game theory. I start by describing a game’s possible structure. I then examine how decisions are made given the game’s structure. A player chooses an action based on the competitor’s decision and information the player possesses. I note that players never choose a dominated action because a better choice is always available through either a pure or mixed strategy. Next, I examine games that
result in a lose-lose outcome because of the prisoner’s dilemma. I examine games involving sequences of decisions to determine whether moving first is always desirable. The chapter concludes with some special situations applying game theory, including collusion and preemptive strategies. By understanding how to play a variety of games, game theory helps improve your ability to influence the strategic environment in a number of situations ranging from oligopolistic markets to auctions. Wherever outcomes are interdependent — that is, the outcome is jointly determined by the decisions made by two or more players — you should consider using game theory.
Winning Is Everything
A game is a competitive situation where two or more players pursue their own goals — such as profit maximization or cost minimization — with no single player able to dictate the game’s outcome. Being competitive simply means that you play to win, and in business decision-making, winning means you make profit, and lots of it.
The mutual interdependence among firms in an oligopolistic market (see Chapter 11) resembles a game, and, thus, decision-makers are likely to find game theory useful in understanding these markets.
Players are the decision-makers. Players generally start with a given amount of resources. For example, in the board game of Monopoly, players start with two $500 bills, two $100 bills, two $50 bills, six $20 bills, five $10 bills, five $5 bills, and five $1 bills. In the business world, players may start with as little as their own labor and entrepreneurial abilities. Players must then decide how to use those resources.
Structuring the Game
A game is composed of rules, actions, and payoffs. The game’s structure plays a crucial role in determining the ultimate outcome.
Making rules for the game
Rules of the game describe how the game is played. Rules of the game include whose turn it is, how resources can be employed, technological constraints, what government regulations permit, and so on. Like in Monopoly, the rule book can be quite lengthy and can include things like how to mortgage property and when to pay taxes.
