game theory and business decisions unit 6 study guides

Key Concepts

• Oligopoly market structure characterized by a small number of firms (usually 2-8) that dominate the market and have significant market power
• Interdependence firms' actions and decisions affect each other, leading to strategic interactions and the need for game theory analysis
• Barriers to entry high start-up costs, economies of scale, or legal barriers (patents, licenses) prevent new firms from easily entering the market
• Product differentiation firms often differentiate their products to gain market share and customer loyalty (branding, quality, features)
• Price and output decisions firms must consider their rivals' potential reactions when setting prices or production levels
  • Kinked demand curve model suggests that firms face a kinked demand curve due to the expectation of rival price matching
• Collusion firms may engage in explicit or tacit collusion to reduce competition and increase profits (price fixing, market allocation)
• Nash equilibrium a key concept in game theory where each firm's strategy is the best response to the strategies of its competitors

Types of Oligopoly Models

• Cournot model firms simultaneously choose their output levels, taking their competitors' output as given
  • Equilibrium occurs when each firm's output maximizes its profit given the output of its rivals
• Bertrand model firms simultaneously choose their prices, assuming their competitors' prices remain constant
  • Equilibrium occurs when each firm's price maximizes its profit given the prices of its rivals
• Stackelberg model a sequential model where one firm (the leader) moves first, and the other firm (the follower) responds
  • The leader anticipates the follower's reaction and incorporates this into its decision-making
• Price leadership model one firm acts as a price leader, setting the price for the market, while other firms follow suit
• Capacity-constrained models consider the impact of production capacity limitations on firms' strategic decisions
• Repeated games oligopoly markets often involve repeated interactions, allowing for the possibility of collusion and punishment strategies
• Product differentiation models account for the impact of product differentiation on competition and market outcomes

Game Theory Basics

• Players the decision-makers in a game (firms in an oligopoly market)
• Strategies the available actions or plans of action for each player (price, output, investment decisions)
• Payoffs the outcomes or rewards associated with each combination of strategies (profits, market share)
• Normal-form representation a matrix showing the players, strategies, and payoffs in a game
• Dominant strategy a strategy that yields the highest payoff for a player regardless of the strategies chosen by other players
• Nash equilibrium a set of strategies where no player can improve their payoff by unilaterally changing their strategy
  • Pure strategy Nash equilibrium each player adopts a single, deterministic strategy
  • Mixed strategy Nash equilibrium players adopt a probability distribution over their available strategies
• Repeated games games played over multiple rounds, allowing for the possibility of cooperation, punishment, and reputation effects

Strategic Decision-Making

• Best response a player's optimal strategy given the strategies of the other players
• Reaction functions mathematical expressions or curves that show a firm's best response to its competitors' actions (output or price)
• First-mover advantage the potential benefit gained by being the first to make a strategic decision or enter a market
• Commitment the ability to credibly bind oneself to a particular course of action, influencing rivals' behavior
• Signaling conveying information about one's own characteristics, intentions, or actions to influence others' beliefs and decisions
• Strategic entry deterrence actions taken by incumbent firms to discourage potential entrants (capacity expansion, limit pricing)
• Predatory pricing setting prices below cost to drive out competitors, with the intention of raising prices after they exit

Market Outcomes and Efficiency

• Equilibrium prices and quantities the prices and quantities that result from the strategic interactions among firms in an oligopoly
• Producer surplus the difference between the market price and the minimum price a firm is willing to accept for a good
• Consumer surplus the difference between the maximum price a consumer is willing to pay and the market price
• Deadweight loss the reduction in total economic surplus (producer + consumer surplus) due to market imperfections or distortions
• Allocative efficiency achieved when resources are allocated to their most valued uses, maximizing total economic surplus
• Productive efficiency achieved when goods are produced at the lowest possible cost, given available technology
• Dynamic efficiency the ability of a market to encourage innovation, technological progress, and long-run growth
• Pareto efficiency a situation where no one can be made better off without making someone else worse off

Real-World Applications

• Airline industry characterized by a small number of dominant carriers, strategic interactions, and price discrimination
• Telecommunications industry features high fixed costs, network effects, and rapid technological change
• Pharmaceutical industry marked by high R&D costs, patent protection, and product differentiation
• Automotive industry exhibits economies of scale, global competition, and environmental regulations
• Energy markets (oil, gas, electricity) often involve a few large producers, geopolitical factors, and government intervention
• Technology markets (smartphones, software) feature strong network effects, compatibility issues, and rapid innovation
• Retail markets (supermarkets, department stores) characterized by strategic location decisions, loyalty programs, and price competition

Limitations and Criticisms

• Rationality assumption game theory assumes that players are fully rational and seek to maximize their payoffs, which may not always hold in reality
• Information assumptions models often assume perfect or complete information, while real-world decision-making involves uncertainty and asymmetric information
• Static vs. dynamic games many models focus on one-shot interactions, while real-world oligopolies involve repeated, dynamic interactions
• Quantifying payoffs assigning numerical values to payoffs can be challenging, especially for non-monetary factors (reputation, customer loyalty)
• Multiple equilibria some games may have multiple Nash equilibria, making it difficult to predict outcomes
• Behavioral factors models may not fully capture the impact of bounded rationality, emotions, or social norms on decision-making
• Empirical validation difficulties in obtaining data and controlling for confounding factors can make it challenging to test and validate oligopoly models

Advanced Topics

• Subgame perfect equilibrium a refinement of Nash equilibrium for dynamic games, ensuring that strategies are optimal at every decision point
• Bayesian games games with incomplete information, where players have beliefs about each other's characteristics or payoffs
• Bargaining theory analyzes the strategic interactions and outcomes in bargaining situations, such as negotiations between firms
• Cooperative game theory studies the formation and stability of coalitions among players, such as cartels or industry associations
• Evolutionary game theory applies game-theoretic concepts to model the evolution of strategies or behaviors in a population over time
• Experimental economics uses controlled experiments to test game-theoretic predictions and study human decision-making in strategic settings
• Behavioral game theory incorporates insights from psychology and behavioral economics to enrich traditional game-theoretic models
• Agent-based modeling simulates the interactions and outcomes of multiple agents (firms, consumers) based on specified rules and parameters