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Lecture 24

# Lecture 24 - Announcement s iClicker Quest ions will be...

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Announcements iClicker Questions will be posted later today. Wednesday is review – Bring questions. MT is Friday 50 questions Can use a calculator More details on Weds. 1 of 38

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Oligopoly and game theory Another way to analyze the behavior of oligopolistic firms is to use something called game theory. The firms in Cournot’s model do not anticipate the moves of the competition. Yet in choosing strategies in an oligopolistic market, real-world firms can and do try to guess what the opposition will do in response. In 1944, John von Neumann and Oskar Morgenstern published a path-breaking work in which they analyzed a set of problems, or games , in which two or more people or organizations pursue their own interests and in which no one of them can dictate the outcome. 2 of 38
Game theory Game theory goes something like this: In all conflict situations, and thus all games, there are decision makers (or players), rules of the game (basically what strategies are available to the players), and payoffs (or prizes). Players choose strategies without knowing with certainty what strategy the opposition will use. 3 of 38

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Game theory Below we have what is called a “payoff matrix” for a very simple game. Each of two firms, A and B, must decide whether to mount an expensive advertising campaign. If they both do not advertise, they both earn profits of \$50,000. If one firm advertises and the other does not, the firm that does will increase its profit by 50% (to \$75,000), while driving the competition into the loss column (losing \$25k). If both firms decide to advertise, they will each earn profits of \$10,000. They may generate a bit more demand by advertising, but that demand is completely wiped out by the expense of advertising itself. 4 of 38
5 of 38 OLIGOPOLY Payoff Matrix for Advertising Game

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Advertising Game If Firms A and B could collude (and we assume they cannot), their optimal strategy would be to agree not to advertise. That solution maximizes the joint profits to both firms. If neither firm advertises, join profits are \$100,000. If both firms advertise, joint profits are only \$20,000. If only one of the firms advertises, joint profits are \$50,000. 6 of 38
7 of 38 OLIGOPOLY Payoff Matrix for Advertising Game

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Advertising Game The strategy that Firm A will actually choose depends on: 1.the information available concerning B’s likely strategy, 2.Firm A’s preferences for risk. In this case, it is possible to predict behavior. Consider A’s choice of strategy. Regardless of what B does, it pays for A to advertise. If B does not advertise, A makes \$25,000 more by advertising than by not advertising. Thus, A will advertise. If B does advertise, A must advertise to avoid a loss. The same logic holds for B. Regardless of the strategy pursued by A, it pays B to advertise.
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