Contents

Oligopoly ........................................................................................................................................ 3

Kinked demand curve in Oligopoly ................................................................................................ 3

Pricing strategy ............................................................................................................................... 3

COORDINATION TASKS OF ANY ECONOMY ....................................................................... 3

comparative advantage.................................................................................................................... 5

The marginal rate of substitution .................................................................................................... 7

BUDGET LINE OF THE CONSUMER ........................................................................................ 7

Total effect ...................................................................................................................................... 8

substitution effect ............................................................................................................................ 8

income effect ................................................................................................................................... 8

Pareto Optimality .......................................................................................................................... 10

Compensation principle ................................................................................................................ 11

INCOME ELASTICITY OF DEMAND ...................................................................................... 11

Different Types of Income Elasticity of Demand ......................................................................... 12

Significance of Income Elasticity of Demand .............................................................................. 12

CROSS PRICE ELASTICITY OF DEMAND ............................................................................. 13

Different Types of Cross Price Elasticity of Demand .................................................................. 13

Significance of Cross Price Elasticity of Demand ........................................................................ 14

ELASTICITY OF SUPPLY ......................................................................................................... 14

Factors Influencing Elasticity of Supply....................................................................................... 14

Different Types of Elasticity of Supply ........................................................................................ 15

Sticky price ................................................................................................................................... 16

MONOPSONY ............................................................................................................................. 19
MONOPOLISTIC MARKET ....................................................................................................... 19

Productive Efficiency.................................................................................................................... 20

Allocative Efficiency .................................................................................................................... 21

Analysis of different markets ........................................................................................................ 22

INEFFICIENCY(market failure) .................................................................................................. 24

MAJOR AREAS OF MARKET FAILURE ................................................................................. 24

EXTERNALITIES ........................................................................................................................ 24

Coase theorem ............................................................................................................................... 25

Government Intervention .............................................................................................................. 26

The Tools of Government Intervention ........................................................................................ 26

Cost of intervention and failure .................................................................................................... 26

Game Theory ................................................................................................................................ 27

Application of Game Theory ........................................................................................................ 27

BASIC CONCEPTS ..................................................................................................................... 28

Strategies ....................................................................................................................................... 28

Games without Dominant Strategies ............................................................................................ 29

Threats and Credibility ................................................................................................................. 30

Entry and Entry-Blocking Strategy ............................................................................................... 31

Oligopoly
An oligopoly is a market dominated by a few sellers, at least several of which are large enough
relative to the total market to be able to influence the market price.

Ignoring dependence: behave as if their actions will not elicit reactions from their rivals.

Strategic Interaction: follows others decision of price

Cartels: A cartel is a group of sellers of a product who have joined together to control its
production, sales, and price in the hope of obtaining the advantages of monopoly.

Kinked demand curve in Oligopoly

A kinked demand curve is a demand curve that changes its slope abruptly at some level of output

Pricing strategy
In price leadership, one firm sets the price for the industry and the others follow

In a price war, each competing firm is determined to sell at a price that is lower than the prices of
its rivals, often regardless of whether that price covers the pertinent cost. Typically, in such a price
war, Firm A cuts its price below Firm B’s price; B retaliates by undercutting A; and so on and on
until some of the competitor firms surrender and let themselves be undersold

COORDINATION TASKS OF ANY ECONOMY

• Allocation of resources

It refers to society’s decisions on how to divide up its scarce input resources among the different
outputs produced in the economy and among the different firms or other organizations that produce
those outputs.

➢ how to utilize its resources efficiently

 ➢ which of the possible combinations of goods to produce

➢ how much of the total output of each good to distribute to each person

TASK 1

• Division of labor by Adam Smith

• Division of labor means breaking up a task into a number of smaller, more specialized tasks
so that each worker can become more adept at a particular job.

• An economy will be most efficient if people specialize in doing what they do best and then
trade with one another,

Smith observed that by dividing the work to be done in this way, each worker became quite skilled
in a particular specialty, and the productivity of the group of workers as a whole was greatly
enhanced.

PRODUCTIVITY

COST MINIMISATION
comparative advantage
One country is said to have a comparative advantage over another in the production of a particular
good relative to other goods if it produces that good less inefficiently than it produces other goods,
as compared with the other country.

TASK 2

MARKET EXCHANGE AND DECIDING HOW MUCH OF EACH GOOD TO PRODUCE

>the productivity due to comparative advantage and the division of labor would do society little
good
> each producer in an efficient arrangement would be left with only the commodities in whose
production its comparative efficiency was greatest and would have no other goods to consume.
With it, standards of living have risen enormously.

TASK 3

HOW TO DISTRIBUTE THE ECONOMY’S OUTPUTS AMONG CONSUMERS

A market system is a form of economic organization in which resource allocation decisions are
left to individual producers and consumers acting in their own best interests without central
direction

The marginal rate of substitution

• The marginal rate of substitution of X for Y (MRSxy) refers to the amount of Y that a
consumer is willing to give up in order to gain one additional unit of X (and still remain on
the same indifference curve). As the individual moves down an indifference curve, the
MRSxy diminishes.
• The slope of an indifference curve, referred to as the marginal rate of substitution
(MRS) between the commodities, represents the maximum amount of one commodity that
the consumer is willing to give up in exchange for one more unit of another commodity.

• MRSxy = Slope of the indifference curve = Δy / Δx

• The marginal rate of substitution is diminishing

BUDGET LINE OF THE CONSUMER

 • The budget line represents the various combinations of the amounts of the goods, which
the consumer can purchase given his money income and the price of the goods.

• M = Px Qx + Py Qy

Total effect
• The total effect of a price change is the total change in quantity demanded as the consumer
moves from one equilibrium.

• The total effect of a price change can be decomposed into two effects. The substitution and
the income effect

substitution effect
• Substitution effect is the change in the quantity demanded resulting from a change in
relative price after compensating the consumer for the change in real income. In other
way, the substitution effect is the change in quantity demanded resulting from a
movement along the original indifference curve , thus holding real income constant.

• The substitution effect of an increase in the price of any good is the resulting switch of
customers to a substitute product whose price has not risen. An increase in the price of
fish, for example, can lead consumers to buy more meat. The same is true of wages and the
demand for leisure. For instance, if you decide not to work overtime this weekend, the price
you pay for that increase in leisure (the opportunity cost) is the amount of wage you have
to give up as a result. An increase in wages makes leisure more expensive. So a wage
increase can induce workers to buy less leisure time (and more of other things). Thus: The
substitution effect of higher wages leads most workers to want to work more

• The substitution effect increases the quantity demanded of a good whose price has fallen
and reduces the quantity demanded of a good whose price has risen.

income effect
• Income effect of a change in the price of one commodity is the change in quantity
demanded resulting exclusively from a change in real income, all other prices and
money income held constant.

• An increase in the price of any good, other things equal, clearly increases the real incomes
of sellers of the good. That rise in income affects the amount of the good (as well as the
amounts of other items) that the individual demands. This indirect effect of a price change
on demand, called the income effect of the price change, is especially important in the case
of wages. Higher wages make consumers richer. We expect this increased wealth to raise
the demand for most goods, including leisure. So: The income effect of higher wages leads
most workers to want to work less (that is, demand more leisure), whereas the income effect
of lower wages makes them want to work more.
Pareto Optimality
➢ An important principle of economics- the gains that result from trade.

➢ Consumers always will make each other better off by trading.

➢ When a trade makes at least one participant better off and no participant is worse off, then
it is said to be Pareto superior.

➢ Pareto optimal allocation. A Pareto optimal allocation exists when any possible move
reduces the welfare of at least one person. Sometimes, a Pareto optimal solution is referred
to as a Pareto efficient allocation.
 ➢ a Pareto superior move sometimes is referred to as a Pareto efficient trade.

➢ Focus- to move from superior condition to optimal condition

➢ contract curve segment and contract line.

➢ On the contract curve: A shorthand way of describing a Pareto optimum solution; its
meaning derives from the edgeworth box. A contract line is formed by the locus of
equilibrium points , the exact equilibrium point can be determined only if demand is
known.

CONSIDERING NATURE OF IC CURVE-THEY DO NOT INTERSECT WITH EACH OTHER

NOT NECESARRILY PARALLEL TO EACH OTHER

HIGHER IC -HIGHER UTILITY

Compensation principle
• A change in utility brought about by either a change in price or other interference to the
market can be translated into a monetary value by searching for the increment in income
that restores the original level of utility.

INCOME ELASTICITY OF DEMAND

Income elasticity of demand is a measure of the responsiveness of the quantity demanded of a
good to a change in the income of the consumer, ceteris paribus.

Ey = Percentage change in quantity demanded of a good/Percentage change in income

Q/ I * I/Q (Can also use Y in pace of I to represent income)

Different Types of Income Elasticity of Demand

• Income Elasticity of Demand Is High: EY > 1

When the consumer’s income increases, the quantity demanded of the good increases more than
proportionately. Example: Luxuries

• Income Elasticity of Demand Is Equal to One or Unitary Income Elasticity: EY = 1

When the consumer’s income increases, the quantity demanded of the good increases
proportionately. Example: Comforts

• Income Elasticity of Demand Is Low: 0 < EY < 1

When the consumer’s income increases, the quantity demanded of the good increases less than
proportionately. Thus, here income elasticity is positive but < 1. Example: Necessities.

• Income Elasticity of Demand Is Zero: EY = 0

In such a situation, there does not occur any change in the quantity demanded when there is a
change in the income. It is very difficult to specify the type of good, which will have zero income
elasticity.

• Income Elasticity of Demand Is < 0 or Negative Income Elasticity: EY < 0

In such a situation, an increase in the income leads to a decrease in the quantity demanded of the
good. Example: Inferior goods.(canned or frozen food, instant noodles)

Significance of Income Elasticity of Demand

 (i) Income elasticity of demand helps classify goods into luxuries, comforts, necessities and
inferior goods. This is of great use to a firm when it is making its decision as to which
goods to produce.

(ii) Income elasticity of demand is very useful when forecasts of demand for the different goods
are to be made. Thus, it helps the fi rm in planning its production strategies.

CROSS PRICE ELASTICITY OF DEMAND

• Cross price elasticity of demand is a measure of the responsiveness of the quantity
demanded of a particular good to a change in the price of another good, ceteris paribus.

Exy= Percentage change in quantity demanded of good x/ Percentage change in price of good
Y

Qx/ Py * Py/Qx

*Positive/negative signs matter here

Positive-substitute goods

Negative- complementary goods

Different Types of Cross Price Elasticity of

Demand
• Cross Elasticity of Demand Is > 0, Exy > 0

In such a situation, the two goods x and y are substitutes, for example, tea and coffee. An increase
in the price of good y leads to an increase in the quantity demanded of good x.(more elastic)

• Cross Elasticity of Demand Is Equal to Zero, Exy = 0

In such a situation, the two goods x and y are independent goods or goods which are not related to
each other, for example, car and mobile phones. An increase in the price of good y does not lead
to any change in the quantity demanded of good x. (inelastic)

• Cross Elasticity of Demand Is < 0, Exy < 0

In such a situation, the two goods x and y are complements, for example, coffee and sugar. An
increase in the price of good y leads to a decrease in the quantity demanded of good x.(elastic)

Significance of Cross Price Elasticity of Demand

Most often firms are interested in analysing the cross elasticity of demand for their goods with
respect to other goods, especially the complementary and substitute goods. Th is is important so
that the effect of any changes in the prices can be evaluated and taken into consideration when the
firm is planning on its production and pricing strategies.

ELASTICITY OF SUPPLY
Elasticity of supply is a measure of the responsiveness of the quantity supplied of a good to a
change in the price of the good

Es= Percentage change in the quantity supplied of a good Percentage change in the price of the
good

Factors Influencing Elasticity of Supply

 • Time Available: If the time is very short, then in that case the supply of the good is inelastic
as the factors of production are fixed. However, if the period is long enough, then the
supply of a good is elastic as the factors of production are variable.

• Availability of the Factors of Production: if the factors of production are available easily
and at low prices, then the supply of the good will be elastic.

• Expectations Relating to the Future Prices: If, in the future, firms expect an increase in the
prices, they will shift their supplies from the present to the future.

Different Types of Elasticity of Supply

Supply Is Perfectly Inelastic, ES = 0

In such a situation, the ratio of percentage change in the quantity supplied to the percentage change
in the price of the good is zero. Th is implies that whatever is the price of the good the quantity
supplied remains the same.

Supply Is Relatively Inelastic, 0 < ES < 1

In such a situation, the ratio of percentage change in the quantity supplied to the percentage change
in the price of the good is < 1. This implies that the percentage change in the quantity supplied is
less than the percentage change in the price of the good.

• Supply Has a Unitary Elasticity, ES = 1

In such a situation, the ratio of percentage change in the quantity supplied equals the percentage
change in the price of the good.

• Supply Is Elastic, ES > 1

In such a situation, the ratio of percentage change in the quantity supplied to the percentage change
in the price of the good is >1.

Supply Is Perfectly Elastic, ES = ∞

In such a situation, any price change, which may be very small, leads to an infinite change in the
quantity supplied of the good
Sticky price

• Another oligopoly analysis model was designed to explain the alleged “stickiness” in
oligopolistic pricing, meaning that prices in oligopolistic markets change far less frequently
than do competitive market prices. The prices of corn, soybeans, pork bellies, and silver—
all commodities that trade in markets with large numbers of buyers and sellers—change
second by second. But products supplied by oligopolists, such as cars, televisions, and
refrigerators, usually change prices only every few months or even more rarely. These
products seem to resist frequent price changes, even in inflationary periods.
• One reason for such “sticky” prices may be that when an oligopolist cuts its product’s
price, it can never predict how rival companies will react. One extreme possibility is
that Firm Y will ignore Firm X’s price cut; that is, Firm Y’s price will not change.
Alternatively, Firm Y may reduce its price, precisely matching that of Firm X.
• Accordingly to elaborate on the model of oligopolistic behavior we use two different
demand curves. One curve represents the quantities a given oligopolistic firm can sell at
different prices if competitors match its price moves, and the other demand curve
represents what will happen if competitors stubbornly stick to their initial price levels.
• Point A in Figure 4 represents our firm’s initial price and output: 1,000 units at $8 each.
Two demand curves, DD and dd, pass through point A. DD represents company’s demand
 if competitors keep their prices fixed, and dd indicates what happens when competitors
match our firm’s price changes.
• Of the two, the DD curve is the more elastic (flatter with demand, more responsive to
price changes). This can be explained as follows:
If firm cuts its price from its initial level of $8 to, say, $7, and if competitors do not match
this cut, we would expect our firm to get a large number of new customers—perhaps its
quantity demanded will jump to 1,400 units. However, if its competitors respond by also
reducing their prices, its quantity demanded will rise by less—perhaps only to 1,100 units
(more inelastic demand curve dd).
Similarly, when it raises its price, our firm may expect a larger customer flight to its rivals
if those rivals fail to match its price increase, and this is indicated by the relative flatness
(elasticity) of the curve DD in Figure 4, as compared to dd, the firm’s demand curve when
rivals do match our firm’s price changes.

The economists who designed this model hypothesized that a typical oligopolistic firm has
good reason to fear the worst. If Firm X lowers its prices its rivals will be forced to do the
same, because otherwise X’s price cut will steal away many of its competitors’ customers.

• The inelastic demand curve, dd (that applies when competitors copy X’s price
cut), will therefore be the relevant curve if Firm X decides on a price reduction
(points below and to the right of point A). If, on the contrary, Firm X chooses to
increase its price, management fears that its rivals will respond quite differently than
they would to a price cut. The price-raising Firm X will fear that its rivals will continue
to sit at their old price levels, calmly collecting customers as they flee from X’s higher
prices. Thus, this time, for price increases, the relevant demand curve (above A)
will be DD, not dd.
• In sum, our firm will figure that it will face a segment of the elastic demand curve DD
if it raises its price and a segment of the inelastic demand curve dd if it decreases its
price. Its true demand curve will then be given by the line highlighted with pen.-
DAd. it is called a kinked demand curve.
• The kinked demand curve represents a “heads you lose, tails you lose” proposition in
terms of any potential price changes. If a firm raises its price, it will lose many
 customers (because in that case rivals will [may] not follow, so X’s demand is elastic);
if it lowers its price, the sales increase will be comparatively small (because then rivals
can be expected to have to match the cut, so X’s demand is inelastic). In these
circumstances, neither a price cut nor a price rise seems beneficial, and management
will vary its price only under extreme provocation—that is, only if its costs change
enormously.

A price is called sticky if it does

not change often, even when
there is a moderate change in
cost.

• The two demand curves, DD and dd, are carried over precisely from Figure 4. The dashed
line labeled MR is the marginal revenue curve associated with DD, whereas the solid line
labeled mr is the marginal revenue curve associated with dd. The marginal revenue curve
relevant to the firm’s decision making is MR for any output level below 1,000 units,
but mr for any output level above 1,000 units.
• Therefore, the composite marginal revenue curve facing the firm is shown by the
gold-highlighted line DBCmr with two slopes. The marginal cost curve drawn in the
diagram cuts this composite marginal revenue curve at point E, which indicates the profit-
maximizing combination of output and price for this oligopolist. Specifically, the quantity
supplied at point E is 1,000 units, and the price is $8, which we read from the pen
highlighted demand curve DAd.
 • The unique aspect of this diagram is that the kinked demand curve leads to a marginal
revenue curve that takes a sharp plunge between points B and C. Consequently, even
if the MC curve shifts moderately upward or downward, it will still intersect the marginal
revenue curve somewhere between B and C and thus will not lead the firm to change its
output decision. Therefore, the firm’s price will remain unchanged.
• Oligopoly prices are “sticky,” then, in the sense that they do not respond to minor cost
changes. Only cost changes large enough to push the MC curve out of the BC range will
lead to price changes.

MONOPSONY
A monopsony is a market situation in which there is only one buyer.

A monopsony is when a firm is the sole purchaser of a good or service.

the classic example of a monopsony is a company coal town, where the coal company acts the
sole employer and therefore the sole purchaser of labor in the town

MONOPOLISTIC MARKET
Monopolistic competition refers to a market in which products are heterogeneous but which is
otherwise the same as a market that is perfectly competitive.

A market is said to operate under conditions of monopolistic competition if it satisfies four

requirements, three of which are the same as those for perfect competition:

• Numerous participants—that is, many buyers and sellers, all of whom are small

• Freedom of exit and entry

• Perfect information
• Heterogeneous products—as far as the buyer is concerned, each seller’s product differs at least
somewhat from every other seller’s product

For example, differences in packaging or in associated services can and do distinguish otherwise
identical products. eg;pepsi and cola

Productive Efficiency
Productive efficiency for the firm requires the firm to be producing its output at the lowest possible
cost.

Productive efficiency for the industry requires that the marginal cost of production be the same
for each firm.

If firms and industries are productively efficient, the economy will be on, rather than inside, the
production possibilities boundary.

any profit· maximizing firm will seek co be productively efficient no matter the marker structure
within which it operates-perfect competition, monopoly, oligopoly, or monopolistic competition.
Allocative Efficiency
• The economy is allocatively efficient when, for each good produced, its marginal cost of
production is equal to its price.

• Allocative efficiency requires that all goods be produced to the point where the marginal
cost to producers equals the marginal value to consumers. MC=MV

• When the combination of goods produced is allocatively efficient, economists say that the
economy is Pareto efficient,
Analysis of different markets
INEFFICIENCY(market failure)
perfect competition, imperfect information, externalities, and public goods all represent cases in
which the market does not produce economic efficiency.

• Market failure

• “fails” not by ceasing to exist but by failing to produce efficient outcomes.

MAJOR AREAS OF MARKET FAILURE

• business fluctuations, unemployment, and inflation

• Inequal income distribution

• Inequal distribution of resources

• Side effects

• Lack of provision for public good

• Poor job allocation

• Expensive services

EXTERNALITIES
• Many economic activities provide incidental benefits to others for whom they are not
specifically intended.
 • An activity is said to generate a beneficial or detrimental externality if that activity causes
incidental benefits or damages to others not directly involved in the activity and no
corresponding compensation is provided to or paid by those who generate the externality.

• Positive and negative

• The marginal social cost (MSC) of an activity is the sum of its marginal private cost
(MPC) plus its incidental costs (positive or negative) that are borne by others who receive
no compensation for the resulting damage to their well-being.

• The marginal private cost (MPC) is the share of an activity’s marginal cost that is paid
for by the persons who carry out the activity.

• The marginal social benefit (MSB) of an activity is the sum of its marginal private benefit
(MPB) plus its incidental benefits (positive or negative) that are received by others, and for
which those others do not pay.

• The marginal private benefit (MPB) is the share of an activity’s marginal benefit that is
received by the persons who carry out the activity.

• Where a firm’s activity causes detrimental externalities, the marginal benefits of the output
will be less than marginal social costs in a free market. Smaller outputs will be socially
desirable.

• Where the firm’s activity generates beneficial externalities, free markets will produce too
little output. Society would be better off with larger output levels.

Coase theorem
• In a famous paper, Ronald Coase shows that the market delivers the socially optimal
amount of some externality without benefit of intervention under two conditions:
transactions costs are zero, and property rights are well defined.
Government Intervention
• depends both on-benefits and cost associated

• Cost benefit analysis -desirability of a given policy, based on comparing total costs with
total benefits.

• Issues- 1) difficult to predict

• 2) long term effect

• 3) inclusion of other costs

The Tools of Government Intervention

1. Public Provision like National defence, the criminal justice system, public schools, universities,
the highway system, and national parks etc.

2. . Redistribution Programs Taxes and government spending are often used to provide a
distribution of income.

3. Regulation: Government regulations are public rules that apply to private behaviour.

Cost of intervention and failure

 • Direct Costs- payment of wage and technical applications

• Indirect Costs - Changes in Costs of Production, Costs of Compliance

• Government Failure- Decision Makers' Objectives(economic theory)

public choice theory.

Game Theory
Once decisions reach the stage of thinking about what your opponent is thinking, and how you
would then react……This is the analysis of situations involving two or more interacting decision
makers who have conflicting objectives.

Few findings…

➢ As the number of noncooperative oligopolists becomes large, the industry price and
quantity tend toward the perfectly competitive outcome.

➢ If fi rms succeed in colluding, the market price and quantity will be close to those generated
by a monopoly.

➢ as the number of firms increases frequency of cheating and noncooperative behaviour

increases.

➢ In many situations, there is no stable equilibrium for an oligopolistic market. Strategic

interplay may lead to unstable outcomes.

Application of Game Theory

• Game theory analyses the ways in which two or more players choose strategies that jointly
affect each other.

• largely developed by John von Neumann (1903–1957), a Hungarian born mathematical

genius.
 • It is used by economists to study the interaction of oligopolists, union-management
disputes, countries’ trade policies, international environmental agreements, reputations,
and a host of other topics.

BASIC CONCEPTS
• duopoly price game

each firm has the same cost and demand structure. Further, each firm can choose whether to charge
its normal price or lower its price below marginal costs and try to drive its rival into bankruptcy
and then capture the entire market

Strategies
• A payoff matrix shows how much each of two competitors (players) can expect to earn,
depending on the strategic choices each of them makes.

• A dominant strategy for one of the competitors in a game is a strategy that will yield a
higher payoff than any of the other strategies that are possible, no matter what choice of
strategy is made by competitors.

• A Nash equilibrium results when each player adopts the strategy that gives the highest
possible payoff if the rival sticks to the strategy it has chosen.

• A zero-sum game is one in which exactly the amount one competitor gains must be lost
by other competitors.

• A repeated game is one that is played a number of times.

Repeated games give all of the players the opportunity to learn something about each
other’s behaviour patterns and, perhaps, to arrive at mutually beneficial arrangements. By
adopting a fairly clear pricing behaviour pattern, each firm can attain a reputation that
elicits desired responses from competitors.
Games without Dominant Strategies
• One firm pay off matrix with dominant strategy

Consider Firm A’s decision. Either company can select either the high-tech or the low-tech
strategy. Whichever choice depending on which strategy it selects. For example, if B
selects low-tech, A will either earn $10 million or $12 million, depending on its strategy
choice (see the left-hand column of Table 1). So the high-tech strategy, with its $12 million
payoff, is clearly A’s better decision if B selects low-tech. But what if B turns out to pick
high-tech, instead? In that case, we see from the right-hand column of the matrix that if A
offers the low-tech product, it will lose $2 million, whereas with that same choice by firm
B, A could earn $3 million in profit by choosing high-tech (the lower right-hand entry). So
high-tech is again the better choice for A. Clearly, the high-tech option is a dominant
strategy for firm A, because it will give A a higher profit than the low-tech choice no
matter which option firm B selects.

• Two firm pay off matrix with dominant strategy

• The maximin criteria

With these new numbers, neither a low-tech nor a high-tech choice is a dominant strat egy
for A. Suppose A chooses to go with the low-tech product. Then, if B also happens to select
low-tech, A will find itself better off (at a $10 million payoff) than if it had chosen a high-
tech product (profit 5 $3 million). But if B goes the other way and offers the high tech
product, A’s payoff will be worse ($7 million) with a low-tech prod uct than with one that
is high-tech ($8 million payoff). Which of the two options is better for A depends on B’s
unforeseeable strategy choice. Neither choice by A offers it foolproof protection, so neither
of A’s possible strategies is dominant.

The decision for A in Table 3 is now much harder than it was before. How can it go about
selecting a strategy? One solution proposed in game theory is called the maximin criterion.
In this strategy, we may envision the management of Firm A reasoning as follows: “If I
choose a low-tech strategy, the worst that can happen to me is that my competitor will
 select the high-tech counterstrategy, which will make my return $7 million (the brick-
colored number in the first row of the payoff matrix). Similarly, if I select a high-tech
strategy, the worst possible outcome for me is a $3 million profit” (the brick-colored
minimum payoff in the second row of the matrix).

How can the managers of Firm A best protect their company from trouble in these
circumstances? Game theory suggests that it may be rational to select a strategy based on
comparison of the two minimum payoffs offered by the two different strategies. If the
firm’s managers want to cut down the risk, they should pick what can be interpreted as an
insurance-policy approach. They should select the strategy that will guarantee them the
highest of these undesirable minimum payoffs. In other words, expecting the worst
outcome for any strategy choice it makes, Firm A should pick the strategy that promises
the best of those bad outcomes. In this case, the maximin strategy for Firm A is to offer the
low-tech product, whose worst possible outcome is $7 million, whereas the worst outcome
if it selects the high-tech product is a profit of only $3 million.

It requires a player to select the strategy that yields the maximum payoff on the assumption that
the opponent will do as much damage as it can.

Q. In the payoff matrix in the first number in each of the four cells refers to the payoff (profit) for
firm A, while the second is the payoff (profit) for firm B, if each firm advertises or does not
advertise. If firm B does advertise (i.e., moving down the left column of the table), we see that
firm A will earn a profit of 4 if it also advertises and 2 if it doesn’t. Thus, firm A should advertise
if firm B advertises. If firm B doesn’t advertise, (i.e., moving down the right column in the table),
firm A would earn a profit of 5 if it advertises and 3 if it doesn’t. Thus, firm A should advertise
whether firm B advertises or not. Advertising is then the dominant strategy for firm A. Moving
across each row of the table shows that advertising is also the dominant strategy for firm B.

Threats and Credibility

 • A credible threat is a threat that does not harm the threatener if it is carried out.

• For example: if Firm A signed an irrevocable contract committing it to double its output if
Firm B copied A’s product, then the threat would become credi ble, and B would be
forced to believe it. But A can make other commitments that make its threat credible. For
example, it can build a large plant with plenty of excess capacity. The factory may be very
expensive to build, but once built, that cost is irrevocable. If there is only a small additional
cost of raw material and labor needed to turn out the product, once the cost of the plant has
already been paid, then it may not harm A to expand its output of the product, even at a
competitor’s very low price (if that price exceeds the marginal [vari able] cost of the
item). So, having built the large factory, the threat to expand output in re sponse to entry
becomes credible.

Entry and Entry-Blocking Strategy

• “Wasting” money on excess capacity may not be wasteful to the oligopolist firm if it
protects the firm’s long-term interest

• Some hypothetical numbers and a typical game theory graph will make the story clear.

The old firm faces two options: to build a small factory or a big one. Potential entrant firms
also face two options: open for business (that is, enter the industry) or do not enter. Figure
6 shows the four resulting possible decision combinations and the corresponding profits or
losses that the two firms may expect in each case.
The graph shows that the best outcome for the old firm occurs when it builds a small factory
and the new firm decides not to enter.

In that case, the old firm will earn $6 million, whereas the new firm will earn nothing,
because it never starts up. However, if the old firm does decide to build a small factory, it
can be fairly sure that the new firm will open up for business, because the new firm can
then earn $2 million (rather than zero), as shown by the dashed lines. In the process, the
old firm’s profit will be reduced, also to $2 million

.If the old firm builds a big factory, its increased output will depress prices and profits. The
old firm will now earn only $4 million if the new firm stays out, as shown by the asterisk
line, whereas each firm will lose $2 million if the new firm enters. Obviously, if the old
firm builds a big factory, the new firm will be better off staying out of the business rather
than subjecting itself to a $2 million loss.

What size factory, then, should the old firm build? When we consider the firms’
interactions, to protect itself the old firm must clearly build the large factory with its excess
capacity—because this decision will keep the new firm out of the industry, leaving the old
firm with a $4 million profit.

The moral of the story: “Wasting” money on excess capacity may not be wasteful to the
oligopolist firm if it protects the firm’s long-term interest.