Chapter 2

DEMAND ANALYSIS,
ESTIMATION AND
FORECASTING

Presenter: Vo Hoang Kim An

Foreign Trade University – Ho Chi Minh City – Vietnam
1.
Demand Analysis
By using elasticity of demand

2
 Price Elasticity of Demand (E)

◎ Measures responsiveness or sensitivity of

consumers to changes in the price of a good

◎ P & Q are inversely related by the law of demand

so E is always negative
○ The larger the absolute value of E, the more
sensitive buyers are to a change in price

6-3
RELATIVELY ELASTIC
As price changes, there is a
LARGE change in quantity
demanded for a good or
service
5
 UNIT ELASTICITY
As price changes, quantity
demand for a good or service
will change by the same
amount
RELATIVELY INELASTIC
As price changes, there is a
SMALL change in quantity
demanded for a good or
service
 Price Elasticity of Demand (E)

Elasticity Responsiveness ⏐E⏐

Elastic
Unitary Elastic
Inelastic

6-8
 Calculating Price Elasticity of Demand
◎ Price elasticity can be calculated by multiplying
the slope of demand (ΔQ/ΔP) times the ratio of
price to quantity (P/Q)

◎ Given Q = a + bP where b = ΔQ/ΔP

6-9
 Group discussion

◎ What is the relationship between

elasticity of demand and total revenue?
Please give examples.

6-10
 MR, TR, & Price Elasticity

Marginal Price elasticity of

Total revenue
revenue demand

TR increases Elastic Elastic

(⏐E⏐> 1)
MR > 0 as Q increases
(⏐E⏐> 1)
(P decreases)

Unit Unit
elastic (⏐E⏐= 1)
elastic
MR = 0 TR is maximized
(⏐E⏐= 1)
TR decreases as Inelastic (⏐E⏐< 1)
Inelastic
MR < 0 Q increases (⏐E⏐< 1)
(P decreases) 6-11
 Price Elasticity & Total Revenue

Elastic Unitary elastic Inelastic

Quantity-effect No dominant effect Price-effect dominates
dominates

Price rises No change in TR TR rises

TR falls

Price falls TR rises No change in TR TR falls

6-12
 Price Elasticity & Total Revenue
The manager at Borderline Video Emporium faces the demand
curve for Blu-ray DVD discs shown in Figure 6.1. Predict and
calculate the change in total revenue in below instances:
1. At the current price of $18 per DVD Borderline can sell 600
DVDs each week. The manager can lower price to $16 per DVD
and increase sales to 800 DVDs per week. Over the interval a to
b on demand curve D the price elasticity is equal to -2.43.
2. Now suppose the manager at Borderline is charging just $9 per
compact disc and sells 1,500 DVDs per week (see Panel B). The
manager can lower price to $7 per disc and increase sales to
1,700 DVDs per week. Over the interval c to d on demand curve
D, the elasticity of demand equals -0.50.
○ From those results, what do you infer?
6-13
Price Elasticity & Total Revenue

6-14
 Marginal Revenue

◎ Marginal revenue (MR) is the change in total

revenue per unit change in output
◎ Since MR measures the rate of change in total
revenue as quantity changes, MR is the slope of
the total revenue (TR) curve

6-15
2.
Demand Estimation
and Forecasting
By using regression and
statistical knowledge
16
Example: Estimating the Demand for a Pizza Firm

6-17
 Marginal Revenue & Price Elasticity

◎ For all demand & marginal revenue curves, the

relation between marginal revenue, price, &
elasticity can be expressed as

6-18
 Example: Estimating the Demand for a Pizza Firm

◎ Test the significance of estimated slope

parameters?
◎ Is the model as the whole significant?
◎ Calculate the estimated demand elasticity at
values of P, M, PAl, and PBmac where P = 9.05, M
= 26,614, PAl = 10.12, and PBMac = 1.15.
◎ Explain the result?
6-19
 Empirical Demand Functions
◎ Demand equations derived from actual market
data
◎ Useful in making pricing & production decisions
◎ In linear form, an empirical demand function can
be specified as

7-20
Example: Estimating the Demand for a Pizza Firm

Specify price-setting firm’s demand function

Q = a + bP + cM + dPAl + ePBMac
Where:
◎ Q = sales of pizza at Checkers Pizza

◎ P = price of a pizza at Checkers Pizza

◎ M = average annual household income in Westbury

◎ PAl = price of a pizza at Al’s Pizza Oven

◎ P = price of a Big Mac at McDonald’s 6-21

 Linear Trend Forecasting

○ If b > 0, sales are increasing over time

○ If b < 0, sales are decreasing over time
○ If b = 0, sales are constant over time

7-22
Forecasting Sales for Terminator Pest Control

7-23
 Direct Methods of Demand Estimation
◎ Consumer interviews
○ Range from stopping shoppers to speak with them to
administering detailed questionnaires
○ Potential problems
◉ Selection of a representative sample, which is a sample (usually
random) having characteristics that accurately reflect the
population as a whole
◉ Response bias, which is the difference between responses given
by an individual to a hypothetical question and the action the
individual takes when the situation actually occurs
◉ Inability of the respondent to answer accurately
7-24
 Direct Methods of Demand Estimation

◎ Market studies & experiments

○ Market studies attempt to hold everything
constant during the study except the price of
the good
○ Lab experiments use volunteers to simulate
actual buying conditions
○ Field experiments observe actual behavior of
consumers

7-25
Thank you for
your listening!
Any
questions?

You can find me at:

[email protected]
26
Chapter 3
Production and cost analysis;
The organization of a firm

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
 Time-Series Forecasts

◎ A time-series model shows how a time-ordered

sequence of observations on a variable is
generated
◎ Simplest form is linear trend forecasting
○ Sales in each time period (Qt ) are assumed to be
linearly related to time (t)

7-28
 Basic Concepts of Production Theory

◎ Inputs are considered variable or fixed depending on

how readily their usage can be changed
◎ Variable input
○ An input for which the level of usage may be changed quite
readily
◎ Fixed input
○ An input for which the level of usage cannot readily be changed
and which must be paid even if no output is produced
◎ Quasi-fixed input
○ An input employed in a fixed amount for any positive level of
8-29
output that need not be paid if output is zero
 “
Part 1.
Production and cost analysis

30
 Basic Concepts of Production Theory

◎ Short run
○ At least one input is fixed
○ All changes in output achieved by changing
usage of variable inputs
◎ Long run
○ All inputs are variable
○ Output changed by varying usage of all inputs

8-31
1.
Production and Cost
in the Short Run

32
 Short Run Production
◎ In the short run, capital is fixed
○ Only changes in the variable labor input can
change the level of output
◎ Short run production function

8-33
 Average & Marginal Products

◎ Average product of labor

○ AP = Q/L
◎ Marginal product of labor
○ MP = ΔQ/ΔL
◎ When AP reaches it maximum:
○ AP = MP
◎ Law of diminishing marginal product
○ As usage of a variable input increases, a point is
reached beyond which its marginal product
decreases
8-34
Total, Average & Marginal Product
Curves
o Increasing marginal
returns: Range of input
usage over which marginal
product increases
o Decreasing (diminishing)
marginal returns: Range of
input usage over which
marginal product declines.
o Negative marginal returns:
Range of input usage over
which marginal product is
negative.
(OMG, cái quỷ này có trong
trắc nghiệm final nè) 8-35
 Phases of
Marginal Returns
As the usage of an input increases, marginal
product initially increases (increasing marginal
returns), then begins to decline (decreasing
marginal returns), and eventually becomes
negative (negative marginal returns).

36
The Role of the Manager in the
Production Process

8-37
 Profit-Maximizing
Input Usage
To maximize profits, a manager should use inputs at levels
at which the marginal benefit equals the marginal cost.
More specifically, when the cost of each additional unit of
labor is w, the manager should continue to employ labor
up to the point where VMPL = w in the range of
diminishing marginal product

38
 Short Run Production Costs

◎ Total variable cost (TVC)

○ Total amount paid for variable inputs
○ Increases as output increases
◎ Total fixed cost (TFC)
○ Total amount paid for fixed inputs
○ Does not vary with output
◎ Total cost (TC)
○ TC = TVC + TFC
8-39
 Short-Run Total Cost Schedules

Output (Q) Total fixed cost Total variable Total Cost

(TFC) cost (TVC) (TC=TFC+TVC)
0 $6,000 $ 0 $ 6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000

8-40
Total Cost Curves

8-41
 Average Costs
•

8-42
 Short Run Marginal Cost

◎ Short run marginal cost (SMC) measures

rate of change in total cost (TC) as
output varies

8-43
 Average & Marginal Cost Schedules

Output Average Average Average total Short-run

(Q) fixed cost variable cost cost marginal cost
(AFC=TFC/Q (AVC=TVC/Q) (ATC=TC/Q= (SMC=ΔTC/ΔQ)
) AFC+AVC)
0 -- -- -- --
$100
100 $60 $40 $40
200 30 30 60 20
300 20 30 50 30
400 15 35 50 50
500 12 44 56 80
600 10 56.7 66.7 120

8-44
Average & Marginal Cost Curves

8-45
Short Run Average & Marginal
Cost Curves

8-46
 Short Run Cost Curve Relations

◎ AFC decreases continuously as output

increases
○ Equal to vertical distance between ATC & AVC
◎ AVC is U-shaped
○ Equals SMC at AVC’s minimum
◎ ATC is U-shaped
○ Equals SMC at ATC’s minimum

8-47
 Short Run Cost Curve Relations

◎ SMC is U-shaped
○ Intersects AVC & ATC at their minimum points
○ Lies below AVC & ATC when AVC & ATC are
falling
○ Lies above AVC & ATC when AVC & ATC are
rising

8-48
Relations Between Short-Run Costs & Production

8-49
Relations Between Short-Run Costs & Production

◎ In the case of a single variable input, short-run

costs are related to the production function by
two relations

8-50
Short-Run Production & Cost Relations

8-51
 Relations Between Short-Run Costs
& Production
◎ When marginal product (average product) is increasing,
marginal cost (average cost) is decreasing
◎ When marginal product (average product) is decreasing,
marginal cost (average variable cost) is increasing
◎ When marginal product = average product at maximum
AP, marginal cost = average variable cost at minimum
AVC

8-52
 Summary of Short-Run Empirical
Production Functions
Short-run cubic
production equations
Total product

Average product of labor

Marginal product of labor

Diminishing marginal
returns
Restrictions on
parameters
10-5
 Summary of Short-Run Empirical
Cost Functions
Short-run cubic
cost equations
Total variable cost

Average variable cost

Marginal cost
Average variable cost
reaches minimum at
Restrictions on
parameters
10-5
 Sunk cost
A cost that is forever lost
after it has been paid.

55
Exercise 1

8-56
Exercise 1

a. What are the estimated total, average, and marginal product

functions?
b. Are the parameters of the correct sign, and are they significant
at the 1 percent level?
c. At what level of labor usage is average product at its maximum?
Assume that the wage rate for labor (w) is $200.
d. What is output when average product is at its maximum?

8-57
Exercise 2

8-58
Exercise 2

a. Do the parameter estimates have the correct signs? Are they

statistically significant at the 5 percent level of significance?

b. b. At what level of output do you estimate average variable cost

reaches its minimum value?

c. What is the estimated marginal cost curve?

d. What is the estimated marginal cost when output is 700 units?

e. What is the estimated average variable cost curve?

f. What is the estimated average variable cost when output is 700 8-59
Typical Isoquants

9-60
2.
Production and Cost
in the Long Run

61
 Marginal Rate of Technical Substitution

◎ The MRTS is the slope of an isoquant & measures

the rate at which the two inputs can be substituted
for one another while maintaining a constant level
of output

9-62
 Marginal Rate of Technical Substitution

◎ The MRTS can also be expressed as the ratio of

two marginal products:

9-63
 Isocost Curves

•
○ Represents amount of capital that may be purchased if zero
labor is purchased 9-64
Isocost Curves

9-65
Optimal Input Combination to Minimize
Cost for Given Output

9-66
 Optimal Combination of Inputs

◎ Minimize total cost of producing Q by choosing the

input combination on the isoquant for which Q is just
tangent to isocost curve
◎ Two slopes are equal in equilibrium
◎ Implies marginal product per dollar spent on last unit
of each input is the same

9-67
 DEMONSTRATION PROBLEM
Terry’s Lawn Service rents five small push mowers and two
large riding mowers to cut the lawns of neighborhood
households. The marginal product of a small push mower
is 3 lawns per day, and the marginal product of a large
riding mower is 6 lawns per day. The rental price of a small
push mower is $10 per day, whereas the rental price of a
large riding mower is $25 per day. Is Terry’s Lawn Service
utilizing small push mowers and large riding mowers in a
cost-minimizing manner?

8-68
 Long-Run Costs

◎ Long-run total cost (LTC) for a given

level of output is given by:
LTC = wL* + rK*
◎ Where w & r are prices of labor & capital, respectively

9-69
 Long-Run Costs
◎ Long-run average cost (LAC) measures the cost per
unit of output when production can be adjusted so
that the optimal amount of each input is employed
○ LAC is U-shaped
○ Falling LAC indicates economies of scale
○ Rising LAC indicates diseconomies of scale

9-70
 Long-Run Costs
◎ Long-run marginal cost (LMC) measures the rate of
change in long-run total cost as output changes along
expansion path
○ LMC is U-shaped
○ LMC lies below LAC when LAC is falling
○ LMC lies above LAC when LAC is rising
○ LMC = LAC at the minimum value of LAC

9-71
Long-Run Average & Marginal Cost

9-72
 INSIDE BUSINESS
In industries with economies of scale, firms that produce greater levels of output produce at
lower average costs and thus gain a potential competitive advantage over rivals. Recently,
two international businesses pursued such strategies to enhance their bottom line.
Japan’s Matsushita Plasma Display Panel Company, Ltd., invested $835 million to build the
world’s largest plant for producing plasma display panels. The factory—a joint venture
between Panasonic and Toray Industries—had the capacity to produce 250,000 panels per
month by the late 2000s. This strategy was implemented in response to rising global demand
for plasma display panels, and a desire on the part of the company to gain a competitive
advantage over rivals in this increasingly competitive industry.
An automaker in India—Maruti Udyog Ltd.—produced tangible evidence that economies of
scale are important in business decisions. It enjoyed a 271 percent increase in net profits in
the mid-2000s, thanks to its ability to exploit these economies. The increase was spawned by
a 30 percent increase in sales volume that permitted the firm to spread its sizable fixed costs
over greater output. Importantly, the company’s reduction in average costs due to economies
of scale was more than enough to offset the higher costs stemming from increases in the
price of steel.
SOURCES: “Matsushita Plans Big Expansion of PDP Manufacturing,” IDG News Service, May 19, 2004; “MUL Gains from Cost-Saving Measures,”
Sify India, May 18, 2004. 73
 “
Part 2.
The organization of a firm

74
75
 OVERVIEW
I. Methods of Procuring Inputs
○ Spot Exchange
○ Contracts
○ Vertical Integration
II. Optimal Procurement Input
III. Principal-Agent Problem
○ Owners-Managers
○ Managers-Workers

76
 Learning objectives
1. Discuss the economic trade-offs associated with obtaining inputs
through spot exchange, contract, or vertical integration.
2. Identify four types of specialized investments, and explain how each
can lead to costly bargaining, underinvestment, and/or a “hold-up
problem.”
3. Explain the optimal manner of procuring different types of inputs.

4. Describe the principal–agent problem as it relates to owners and

managers.
5. Discuss three forces that owners can use to discipline managers.
77
1.
METHODS OF
PROCURING INPUTS
1. Spot exchange
2. Contract
3. Vertical integration
78
 METHODS OF PROCURING INPUTS

Consider the manager of a car rental company. One

input needed to produce output (rental cars) is
automobile servicing (tune-ups, oil changes, lube jobs,
and the like). The manager has three options:
1. Simply take the cars to a firm that services
automobiles and pay the market price for the
services
2. Sign a contract with a firm that services automobiles
3. Create within the firm a division that services
automobiles 79
 METHODS OF PROCURING INPUTS

◎ Spot exchange: An informal relationship between a

buyer and seller in which neither party is obligated to
adhere to specific terms for exchange.
◎ Contract: A formal relationship between a buyer and
seller that obligates the buyer and seller to exchange
at terms specified in a legal document.
◎ Vertical integration: A situation where a firm
produces the inputs required to make its final product.

80
 SPOT EXCHANGE (AT ARM’S LENGTH )
◎ Definition: An informal relationship between a
buyer and seller in which neither party is obligated
to adhere to specific terms for exchange.
○ Occurs when autonomous parties exchange goods or
services with no explicit or implicit agreement that the
relationship will continue into the future.
◎ Examples: Purchasing at Coop Mart, staying at New
World hotel for a night.
◎ Advantage: the firm gets to specialize in doing what it
does best

81
 CONTRACTS

◎ Definition: A contract is a legal agreement which defines the

conditions of an exchange or series of exchanges.
○ A formal relationship between a buyer and seller that obligates the
buyer and seller to exchange at terms specified in a legal document
◎ Examples: Bank loan, futures contract, marriage, etc.
◎ Advantage: purchase “nonstandard” inputs
◎ Disadvantage: costly to write; it takes time, and often legal
fee, extremely difficult to cover all the contingencies that could
occur in the future

82
 VERTICAL INTEGRATION (VI)
Definition: it is the situation where a firm shuns other
suppliers and chooses to produce an input internally.
◎ It alters control structures. Hidden information and hidden action
problems are reduced.
◎ Repeated interactions improve trust and coordination
◎ The integrated firm has a common set of goals.
◎ But remember the problems with making
Advantage: no longer has to rely on other firms
Disadvantage: loses the gains in specialization, has to
manage the production of inputs and final product
→bureaucratic costs associated with a larger 83
 PRACTICE
Determine whether the following transactions involve
spot exchange, a contract, or vertical integration:
1. Clone 1 PC is legally obligated to purchase 300 computer chips
each year for the next three years from AMI. The price paid in
the first year is $200 per chip, and the price rises during the
second and third years by the same percentage by which the
wholesale price index rises during those years.
2. Clone 2 PC purchased 300 computer chips from a firm that ran
an advertisement in the back of a computer magazine.
3. Clone 3 PC manufactures its own motherboards and computer
chips for its personal computers.
84
 TRANSACTION COSTS

◎ Definition: Transactions costs are costs associated

with acquiring an input that are in excess of the
amount paid to the input supplier (Coase, 1937).
◎ Obvious examples: Insurance, freight, damage, own
time.
◎ Other important examples: cost of searching for a
supplier willing to sell a specific input, negotiations
costs incl. opportunity cost of time, legal costs, costs of
maintaining assets required to engage in the
transactions.
85
 TRANSACTION COSTS

◎ Many transaction costs are obvious.

○ Ex: input supplier charges a price of $10 per unit
but requires you to furnish your own trucks and
drivers to pick up the input → transaction costs :
the cost of the trucks and the personnel needed to
“deliver” the input to your plant.
◎ Some important transaction costs are less obvious →
distinguish b/w transaction costs : specific to a
particular trading or general in nature → specialized
investment.

86
 SPECIALIZED INVESTMENT

◎ Definition: A specialized investment (SI) is an expenditure that

is made to allow two parties to make exchanges, but has less
value in alternative uses.
→ Examples: to ascertain the quality of chips, Apple spend $100 on a machine that
tests the chips’ quality:
○ If the machine is useful only for testing chips from TSM → SI.
○ If the machine can be resold at its purchase price or used to test the quality
of bolts produced by Intel Corp→ not a SI
→ Examples: Insuring assets (life or crops) when taking out a loan, building trust with
a supplier/customer, quality control investments required to access international
markets (food, toys, etc.).

◎ Definition: A relationship-specific exchange is one that occurs

when both parties to the exchange have made specialized
87
investments. These investments are called relationship-specific
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

1. Site specificity
2. Physical asset specificity
3. Human asset
4. Dedication

88
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

◎ Site specificity: Here, assets are situated

side-by-side.
○ Examples: Coal mines and power plants, grain elevators
and rail-spurs, processes in steel or wine production

◎ Physical asset specificity: Here, the physical/

engineering/chemical properties of the asset are
tailored to a given set of transactions.
○ Examples: Dyes and molds, some genetically modified
organisms, software products

89
 FORMS OF SPECIALIZED INVESTMENTS (SIs)

◎ Human asset specificity: Here, the SI is human in

nature.
○ Examples: Skill acquisitions, building trust
◎ Dedicated asset: is one that would be a complete
write-off if the transactions in question were
cancelled.

There are other types of specificities, and some

investments may express multiple forms

90
 USEFULNESS OF SIs

◎ SIs generally promote economic efficiency (increase

the welfare of society) in that they identify
collaborations between firms that reduce the cost of
producing the same amount of goods or increase the
amount of goods produced by the same level of
resources or do a bit of both (supply/demand graphs).
◎ They are probably good for the firms in question
because the firms would likely not make the
investment otherwise.
◎ Problems may arise because SIs create vulnerability.
91
 IMPLICATION OF SI

◎ Specialized investments increase transaction costs

because they lead to
(1) costly bargaining: no other supplier capable of providing
the desired input at a moment’s notice → no “market price” for
the input → bargaining process costly
(2) underinvestment: the level of the specialized investment
often is lower than the optimal level.
(3) opportunism: When a SI existed, buyer/seller attempt to
capitalize on the “sunk” nature of the investment by engaging in
opportunism

92
 IMPLICATION OF SI

(3) opportunism:
→ The “hold-up problem”: Once a firm makes a
specialized investment, the other party may attempt to
“rob” it of its investment by taking advantage of the
investment’s sunk nature.
→ This behavior make firms reluctant to engage in
relationship-specific investments in the first place
unless they can structure contracts to mitigate the
hold-up problem.

93
1.
OPTIMAL INPUT
PROCUREMENT
When to use each form of input
procurement?

94
 OPTIMAL INPUT PROCUREMENT

Spot exchange
Jiffyburger, a fast-food outlet, sells approximately 8,000
quarter-pound hamburgers in a given week. To meet that demand,
Jiffyburger needs 2,000 pounds of ground beef delivered to its
premises every Monday morning by 8:00 AM sharp.
1. As the manager of a Jiffyburger franchise, what problems would
you anticipate if you acquired ground beef using spot
exchange?
2. As the manager of a firm that sells ground beef, what problems
would you anticipate if you were to supply meat to Jiffyburger
through spot exchange?
95
 SPOT EXCHANGE

◎ Used if there are no transaction costs and there are

many buyers and sellers in the input market
◎ Price is determined by the market price (intersection
of the supply and demand curves)
◎ Easily to change to suppliers that offer lower prices
◎ Disadvantages: result in high transaction costs due
to opportunism, bargaining costs, and
underinvestment when input requires substantial
specialized investments

96
 CONTRACTS

◎ Overcome hold-up problem and the need to bargain

over price each time the input is to be purchased
◎ Can specify prices of the input before the parties
make specialized investments
◎ Reduces the incentive for either the buyer or the
seller to skimp on the specialized investments
required for the exchange
◎ How long should the contract last?

97
 CONTRACT LENGTH

◎ “Optimal” contract length: trade-off between the

marginal costs and marginal benefits of extending the
length of a contract.
◎ MC increases as contracts become longer
○ Contracts of long duration are more difficult to write because
it is harder to specify all contingencies, e.g., oil price rise,
new technology, etc; the less flexibility the firm has in
choosing an input supplier
◎ MB (avoided transaction costs of opportunism and
bargaining) vary with the length of the contract
○ For simplicity we can draw a flat MB curve
98
OPTIMAL CONTRACT LENGTH

99
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

100
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

101
SPECIALIZED INVESTMENTS AND CONTRACT LENGTH

102
 VERTICAL INTEGRATION

◎ Produce the input internally. Utilized when:

○ SIs generate transaction costs (due to opportunism, bargaining
costs, or underinvestment)
○ Product is extremely complex
○ The economic environment is plagued by uncertainty
◎ Advantage: mitigate transaction costs
◎ Disadvantages:
○ Managers must replace the discipline of the market with an internal
regulatory mechanism
○ The firm must bear the cost of setting up production facilities →firm
no longer specializes in doing what it does best
◎ VI should be undertaken only when spot exchange or 103
 OPTIMAL INPUT PROCUREMENT
Depend on the extent to which there is
relationship-specific exchange.

104
 EXAMPLE: GENERAL MOTOR AND FISHER BODY

◎ Early 20th century: specialized

investments were relatively unimportant
→ GM bought the bodies for its cars
using spot exchange
◎ Closed metal bodies for car
manufacturing → high degree of
physical-asset specificity → GM and
Fisher Body signed a 10-year contract
◎ Parties to engage in opportunism → GM
vertically integrated by purchasing Fisher
Body

105
 METHODS OF PROCURING INPUTS

◎ Spot Exchange
○ When the buyer and seller of an input meet,
exchange, and then go their separate ways.
◎ Contracts
○ A legal document that creates an extended
relationship between a buyer and a seller
◎ Vertical Integration
○ When a firm shuns other suppliers and chooses to
produce an input internally

106
 KEY FEATURES

◎ Spot Exchange
○ Specialization, avoids contracting costs, avoids costs of
vertical integration.
○ Possible “hold-up problem.”
◎ Contracts
○ Specialization, reduces opportunism, avoids skimping on
specialized investments
○ Costly in complex environments
◎ Vertical Integration
○ Reduces opportunism, avoids contracting costs
○ Lost specialization and may increase organizational costs
107
 THE PRINCIPAL-AGENT PROBLEM

◎ Occurs when the principal cannot observe the effort of the

agent.
○ Example: Shareholders (principal) cannot observe the effort of the
manager (agent).
◎ The Problem: Principal cannot determine whether a bad
outcome was the result of the agent’s low effort or due to bad
luck
◎ Manager’s must recognize the existence of the principal-agent
problem and devise plans to align the interests of workers with
that of the firm
◎ Shareholders must create plans to align the interest of the
manager with those of the shareholders.
108
109
Manager receive 10 percent of profits

110
 SOLVING THE PROBLEM BETWEEN OWNERS AND
MANAGERS

◎ Internal incentives
○ Incentive contracts
○ Stock options, year-end bonuses
◎ External incentives
○ Personal reputation.
○ Potential for takeover.

111
 SOLVING THE PROBLEM BETWEEN WORKERS AND
MANAGERS

◎ Profit sharing: Mechanism used to enhance workers’ efforts

that involves tying compensation to the underlying profitability of
the firm.
◎ Revenue sharing: Mechanism used to enhance workers’
efforts that involves linking compensation to the underlying
revenues of the firm.
◎ Piece rates: depend on the output produced
◎ Time clocks and spot checks

112
 CONCLUSION

◎ The optimal method for acquiring inputs

depends on the nature of the transactions
costs and specialized nature of the inputs
being procured.
◎ To overcome the principal-agent problem,
principals must devise plans to align the
agents’ interests with the principals.

113
Google Buys Motorola Mobility to Vertically Integrate In a bold
move, Google purchased Motorola Mobility—the recently
spun-off cellular arm of Motorola—for $12.5 billion. This move
marks an attempt by Google to vertically integrate into the
smartphone hardware market. Industry experts note that the
purchase will allow Google to build prototypes and advanced
hardware devices that will help to point its software business
partners in the direction Google wants to go. Google is banking
on the increased coordination between its software and
Motorola’s hardware and the reduction in risks associated with
vertical integration outweighing the costs.
If you were a decision maker at Google, would you have
recommended vertical integration?

114
Thank you for
your listening!
Any
questions?

You can find me at:

[email protected]
115
Chapter 5
Pricing, Advertising and
Investment policies in business

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
1.
Pricing policies

117
HEADLINE: Mickey Mouse Lets You Ride “for Free” at Disney
World
Walt Disney World Theme Parks offer
visitors a wide variety of ticket choices.
The one thing these ticket options have
in common is that they entail a fixed
entrance fee and allow customers to
take as many rides as they want at no
additional charge. For instance, by
purchasing a 1-Day ticket for about
$105, a customer gains unlimited
access to the park of her choice for one
day.
Wouldn’t Disney earn higher profits if it
charged visitors, say, $10.50, each
time they went on a ride?
118
 OVERVIEW
1. Basic pricing strategies
○ Perfect competition
○ Monopoly & Monopolistic Competition
○ Cournot Oligopoly
2. Strategic pricing for greater profits
○ Price Discrimination o Two-part pricing
○ Block Pricing o Commodity Bundling
3. Pricing strategies for special structure of cost and
demand structures
○ Peak-Load Pricing => hai cái này không có tính toán
○ Cross -Subsidies 119
 “
BASIC PRICING
STRATEGIES

120
 PERFECT COMPETITION
S
Price (dollars)

Price (dollars)
P0
P0 D = MR

0 Q0 0 Quantity
Quantity Panel B – Demand curve
Panel A – facing a 122
 PERFECT COMPETITION

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
•
123
PERFECT COMPETITION

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

Total cost = $19 x 600

= $11,400

124
 PERFECT COMPETITION

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

Total revenue = $10.50 x 300

= $3,150

125
Step 1: Find the profit-maximizing quantity

In a perfectly competitive market, a firm maximizes profit where Ma

(MC) = Price (P):

MC(Q)=PMC(Q) = PMC(Q)=P 2Q=202Q = 202Q=20 Q=10Q = 10Q

So, the profit-maximizing quantity is 10 units.

Step 2: Calculate Total Revenue (TR)

TR=P×QTR = P \times QTR=P×Q TR=20×10=200TR = 20 \times 1
200TR=20×10=200

Step 3: Calculate Total Cost (TC)

TC=C(10)=5+(10)2TC = C(10) = 5 + (10)^2TC=C(10)=5+(10)2 TC=
5 + 100 = 105TC=5+100=105

Step 4: Calculate Profit

Profit=TR−TCProfit = TR - TCProfit=TR−TC Profit=200−105=95Pro
95Profit=200−105=95
126
LONG-RUN PROFIT-MAXIMIZING EQUILIBRIUM

Profit = ($17 - $12) x

240 = $1,200

127
Short-Run Profit Maximization for Monopoly

128
129
Maximizing Profit at Aztec Electronics: An Example

◎ Aztec possesses market power via patents

◎ Sells advanced wireless stereo headphones
◎ Using time-series data over the ten-year time
period 1994-2004, estimated demand function:
Q = 41.000 - 500P + 0,6M - 22,5Pr
○ Q: Output; P: Price of advanced wireless stereo
headphones; M: Consumer Income; Pr: Price of
signal tuning tool

130
Maximizing Profit at Aztec Electronics: An Example

◎ From a consulting firm, Aztec predicted consumer

income and price of signal tuning tool in 2002 are
$45.000 and $800, respectively.
◎ Aztec estimated their average variable cost function:
AVC = 28 - 0,005Q + 0,000001Q2
Requests:
◎ What is Aztec’s optimal decision in 2005, knowing that
their estimated fixed cost is $270.000?
◎ What is Aztec’s decision when the demand function
changes as a result of reduced consumer income?
P = 80 – 0,002Q 131
 Profit Maximization at Aztec
Electronics

132
 A SIMPLE MARKUP RULE

133
 AN EXAMPLE

134
135
 MARKUP RULE FOR COURNOT OLIGOPOLY

136
 AN EXAMPLE
◎ Homogeneous product Cournot industry, 3 firms.
◎ MC = $10.
◎ Elasticity of market demand = - 1/2.
◎ Determine the profit-maximizing price?

14-1
 BASIC PRICING
◎

138
 “
STRATEGIC PRICING
FOR GREATER PROFITS

139
 STRATEGIC PRICING FOR GREATER PROFITS
◎ Most models examined to this point involve a
“single” equilibrium price
◎ In reality, there are many different prices being
charged in the market
1. Price discrimination
2. Two-part pricing
3. Block pricing
4. Commodity bundling
140
 PRICE DISCRIMINATION
Price discrimination: The practice of
charging different prices to consumers for
the same good or service.
3 basic forms:
1. First-degree price discrimination
2. Second-degree price discrimination
3. Third-degree price discrimination
141
FIRST-DEGREE (PERFECT) PRICE DISCRIMINATION
◎ Every unit is sold for the
maximum price each
consumer is willing to pay
○ Allows the firm to capture entire
consumer surplus
◎ Difficulties
○ Requires precise knowledge
about every buyer’s demand for
the good
○ Seller must negotiate a different
14-1
price for every unit sold to every
 SECOND-DEGREE PRICE DISCRIMINATION

◎ Lower prices are offered for larger

quantities and buyers can self-select
the price by choosing how much to
buy
◎ Given the posted schedule of prices,
consumers sort themselves
according to their willingness to pay
for alternative quantities of the good.
◎ The firm charges different prices to
different consumers, but does not
need to know specific characteristics
of individual consumers. 14-1
AN EXAMPLE

You are a pricing analyst for QuantCrunch Corporation, a company that

recently spent $15,000 to develop a statistical software package. To
date, you only have one client. A recent internal study revealed that this
client’s demand for your software is Qd = 300 – 0.2P and that it would
cost you $1,000 per unit to install and maintain software at this client’s
site. The CEO of your company recently asked you to construct a report
that compares (1) the profit that results from charging this client a single
per-unit price with (2) the profit that results from charging $1,450 for the
first 10 units and $1,225 for each additional unit of software purchased.
Construct this report, including in it a recommendation that would result
in even higher profits.

14-1
 THIRD-DEGREE PRICE DISCRIMINATION

◎ If a firm sells in two markets, 1 & 2

(consumer in different demographic
groups)
○ Allocate output (sales) so MR1 = MR2
○ Optimal total output is that for which MRT = MC
◎ For profit-maximization, allocate sales of
total output so that
MRT = MC = MR1 = MR2

14-1
 THIRD-DEGREE PRICE DISCRIMINATION

14-1
 AN EXAMPLE
◎

14-1
 THIRD-DEGREE PRICE DISCRIMINATION

Conditions for the pricing strategy to be effective

◎ Differences must exist in the elasticity of demand
of various consumers.
◎ The firm must have some means of identifying the
elasticity of demand by different groups of
consumers
◎ Consumers purchasing at lower prices cannot
resell their purchases to others.
14-1
6-14
6-15
ALLOCATING SALES BETWEEN MARKETS

14-1
CONSTRUCTING THE MARGINAL REVENUE CURVE

14-1
PROFIT-MAXIMIZATION UNDER THIRD-DEGREE
PRICE DISCRIMINATION

14-1
 TWO-PART PRICING
◎ Two-part pricing: Pricing strategy in which
consumers are charged a fixed fee for the right to
purchase a product, plus a per-unit charge for each
unit purchased.
○ Example: Athletic club memberships.

14-
 “
Two-Part Pricing:
A firm can enhance profits by engaging in
two-part pricing: charge a per-unit price that
equals marginal cost, plus a fixed fee equal
to the consumer surplus each consumer
receives at this per-unit price.

155
 A NUMERICAL EXAMPLE
Assume that an individual’s inverse demand curve is
given by: P = 20 – 2Q, and the cost function is C(Q) =
2Q. The firm seeks to find the optimal, profit-maximizing
two-part pricing. Find the optimal price and initiation fee
for this product.

14-
6-15
 BLOCK PRICING
◎ Block pricing: Pricing
strategy in which
identical products are
packaged together in
order to enhance
profits by forcing
customers to make an
all-or-none decision to
purchase.
E.g. Paper, Six-packs of soda,
Different sized of cans of green
beans. 14-
 AN ALGEBRAIC EXAMPLE
◎ Typical consumer’s ◎ Optimal Quantity To
demand is P = 10 - Package: 4 Units
2Q
◎ C(Q) = 2Q
◎ Optimal number of
units in a package?
◎ Optimal package
price?

14-
 AN ALGEBRAIC EXAMPLE
◎ Optimal Price for the ◎ Costs and Profits with
Package: $24 Block Pricing

14-
 “
Block Pricing: By packaging units of a
product and selling them as one package,
the firm earns more than by posting a
simple per-unit price. The profit-maximizing
price on a package is the total value the
consumer receives for the package.

161
 COMMODITY BUNDLING
◎ Commodity Bundling: The practice of bundling
several different products together and selling them
at a single “bundle price.”
○ E.g. Vacation packages, Computers and software, Film and
developing.

14-
6-16
DEMONSTRATION PROBLEM

14-1
6-16
 PRICING STRATEGIES FOR SPECIAL COST
AND DEMAND STRUCTURES

1. Peak-Load Pricing
2. Cross-subsidization

166
 PEAK-LOAD PRICING
◎ Peak-load Pricing:
Pricing strategy in
which higher prices
are charged during
peak hours than
during off-peak
hours.

14-
 “
Peak-Load Pricing: When demand is
higher at some times of the day than at
other times, a firm may enhance profits by
peak-load pricing: charging a higher price
during peak times than is charged during
off-peak times.

168
“

169
 CROSS-SUBSIDIES PRICING
◎ Principle: Whenever the demands for two
products produced by a firm are interrelated
through costs or demand, the firm may enhance
profits by cross-subsidization: selling one product
at or below cost and the other product above cost.
○ E.g.: Browser and server software, Drinks and meals at
restaurants.

14-
EXAMPLE
◎ The demand for electricity is Q =5-P in peak periods and Q
=4-2P in off-peak periods. Both periods take up half of each
day. Variable cost is 0.25 per unit of output per period and
capital cost capacity are 0.75 per unit of capacity per day.
Capacity costs are sunk and cannot be adjusted between
periods
◎ Find the optimal capacity, peak price and off-peak price

14-1
 CONCLUSION
◎ First degree price discrimination, block pricing,
and two part pricing permit a firm to extract all
consumer surplus.
◎ Commodity bundling, second-degree and third
degree price discrimination permit a firm to
extract some (but not all) consumer surplus.
◎ Simple markup rules are the easiest to
implement, but leave consumers with the most
surplus and may result in
double-marginalization.
◎ Different strategies require different 14-
 ANSWERING THE headLINE
Why does Disney World charge a cover fee for entering
the park and then let everyone who enters ride for free?
The answer lies in the ability to extract consumer
surplus by engaging in two-part pricing. In particular,
the marginal cost of an individual ride at an amusement
park is close to zero, as in Figure. If the average
consumer has a demand curve like the one in Figure,
setting the monopoly price would result in a price of
$10.50 per ride. Since each customer would go on five
rides, the amusement park would earn $52.50 per
customer. (This ignores fixed costs, which must be paid
regardless of the pricing strategy.) But this would leave
the average consumer with $26.25 in consumer
surplus. By charging an entry fee of $105 but pricing
each ride at $0, each consumer rides an average of 10
rides and the park extracts all consumer surplus and
earns higher profits
14-1
2.
Advertising policies
in business
1. Advertisement and its roles
2. Economic analysis of advertising in
business

174
 ADVERTISEMENT
◎ Definition: expenditure undertaken by a firm to
promote the sales of its products or services.
○ E.g.: paid-for space in print, radio or television
media; promotional activity
◎ Advertising is intended to influence consumer
choice in favor of the advertiser’s product or
service.

14-
Graphical Analysis of Advertising

14-1
 OPTIMAL ADVERTISING DECISIONS
◎ To maximize these profits, managers should
advertise up to the point where the incremental
revenue from advertising equals the incremental
cost
○ Incremental cost of advertising: the dollar cost of the
resources needed to increase the level of advertising
(e.g.: fees paid for additional advertising space)
○ Incremental revenue: the extra revenue the firm gets as
a result of the advertising campaign.

14-
 OPTIMAL ADVERTISING DECISIONS
◎

14-
 DEMONSTRATION PROBLEM

Corpus Industries produces a product at constant

marginal cost that it sells in a monopolistically
competitive market. In an attempt to bolster profits, the
manager hired an economist to estimate the demand
for its product. She found that the demand for the
firm’s product is log-linear, with an own price elasticity
of demand of –10 and an advertising elasticity of
demand of 0.2. To maximize profits, what fraction of
revenues should the firm spend on advertising?

14-1
3.
Investment policy
in business
Investment appraisal in business
1. Investment with risk and uncertainty

180
 BASIC STEPS IN INVESTMENT APPRAISAL
1. Defining the objectives: decide the type of investment
projects.
○ Replacement investment: old equipment has to be
replaced
○ Expansionary investment: firm expands its capacity to
meet growing demand
○ Other investments: health and safety or environmental
reasons.
2. Identifying options: consider the various ways in
which the objective might be met.
3. Identifying the costs, benefits, timing and
uncertainties of each option. 14-
 BASIC STEPS IN INVESTMENT APPRAISAL
4. Choosing the method of appraisal: discounted
cash flow techniques, internal rate of return,
payback or the accounting rate of return
5. Choosing the cost of capital: to choose a value
to represent the opportunity cost of the
resources
6. Test of viability: whether projects are
individually worth while and ranked in order of
merit.
7. Presenting the results: The present value of
each of the projects should be presented to 14-1
 AN INVESTMENT EXAMPLE
◎ Step 1: An electricity supplier has decided to
build a new power station
◎ Step 2: The alternative technologies available
should be considered
◎ Step 3: Costs of undertaking each alternative
plan, variable costs of producing electricity,
expected revenues, anticipated life of the
project (25 years for a power station), costs
in closing the power station
○ Estimating the cash flows of a project: capital costs,
○ operating costs, revenues and decommissioning costs 14-1
 AN INVESTMENT EXAMPLE
◎ Step 4: Choosing the method of
appraisal:
○ Discounted cash flow techniques (NPV)
○ Internal Rate of Return (IRR)
○ Payback
○ Accounting rate of return

14-1
 “
Rules to choose project
Discounted cash flow techniques (NPV):
1. Projects have positive NPV should all be
undertaken
2. Projects having a negative NPV should be
rejected
185
14-1
14-1
 INTERNAL RATE OF RETURN (IRR)

◎ The rate of discount that makes the NPV

of the cash flow of a project equal to
zero.
◎ Projects with higher IRR are preferred.

14-1
 DEMONSTRATION PROBLEM

◎ According to the IRR method, which project if

preferred?

14-1
 PAYBACK METHOD

◎ Calculates the time in years or months

that projects have to run before they
cover their original capital outlay
◎ Criticisms:
○ It does not discount the cash flows.
○ It ignores all returns after the payback period

14-1
 THE ACCOUNTING RATE OF RETURN

14-1
NON-DISCOUNTING METHODS OF INVESTMENT APPRAISAL
◎ Payback method
◎ Accounting rate of return.

14-1
 SUMMARY

◎ 4 methods of investment appraisal:

○ Discounting methods:
◉ Net present value (NPV)
◉ Internal rate of return (IRR)
○ Non-discounting methods:
◉ Payback method
◉ The accounting rate of return

14-1
 PROJECTS RANKING AND CAPITAL RATIONING

14-1
DEMONSTRATION PROBLEM

14-1
 SUMMARY

1. Pricing strategies:
a) Basic pricing strategies
◉ Monopoly & Monopolistic Competition
◉ Cournot Oligopoly
b) Strategic pricing for greater profits
◉ Price Discrimination o Two-part pricing
◉ Block Pricing o Commodity Bundling
c) Pricing strategies for special structure of cost
and demand structures
◉ Peak-Load Pricing o Transfer Pricing
◉ Cross Subsidies
14-1
 SUMMARY

14-1
 SUMMARY

3. Methods of investment appraisal:

a) Discounting methods
◉ Net present value (NPV)
◉ Internal rate of return (IRR)
b) Non-discounting methods
◉ Payback method
◉ The accounting rate of return

14-1
 PRACTICE
Using the following data for project A and B:

◎ Calculate the net present value for each project, assuming a cost of capital
of 15%.

◎ Calculate the internal rate of return for each project.

◎ Which project should the firm choose based on using net present value
and the internal rate of return?

◎ If the cost of capital were to increase to 20%, would project A or B be

preferred?

14-1
Thank you for
your listening!
Any
questions?

You can find me at:

[email protected]
200
Chapter 6
Strategic Decisions

Presenter: Vo Hoang Kim An

Foreign Trade University – Hochiminh City – Vietnam
 “
OLIGOPOLY
Strategic decisions

202
 OLIGOPOLY
Objectives: by the end of this section you should be able to:
◎ Collusion, cooperation and the prisoners’ dilemma:
○ Use game theory and/or one detailed example to explain why
economists predict that collusion between oligopolists is likely to be
fragile unless particular conditions are satisfied e.g. some
possibility of repetition in the longer term, and/or the specific
characteristics of the market are conducive to cooperation.
○ Use the concept of the prisoners’ dilemma to make predictions
about trade wars
◎ Entry barriers and entry deterrence:
○ Use one detailed example and/or sequential game theory to
explain what is meant by the idea of a credible threat e.g. the
threat to fight the entry of a new firm into an industry or the threat to
strike/lock-out. 203
 OLIGOPOLY
Oligopoly and collusion: Sustaining profitability
◎ Key to determination of profits of firms in an oligopoly
and how they can continue to improve profits
○ Porter’s 5 forces (1980) – profitability depends on:
1. Extent of rivalry among existing firms
(competition)
2. Number of potential entrants (and barriers to
entry)
3. Number of substitutes (and complements)
4. The bargaining power of customers
5. The bargaining power of suppliers
○ Question: when is a firm more profitable in terms of
the 5 forces? 204
 OLIGOPOLY
Entry deterrence and entry barriers - Porter’s Five Forces:
◎ A firm is more profitable:
◉ The less intense the rivalry among existing firms
(monopoly or if oligopoly -collusion vs. strategic
competition)
◉ The less the danger of potential entrants and the
higher barriers to entry
◉ The fewer substitutes for the firm’s products (the
more firms that sell complements)
◉ The weaker the bargaining power of customers
◉ The weaker the bargaining power of suppliers

205
 CLASS ACTIVITY

◎ If everyone chooses collude, all students get 1

bonus points in the mid-term exam.
◎ If everyone chooses collude, but one
student defects, that person gets 5 bonus
points in the mid-term exam, and no other student
gets any points.
◎ If more than 1 person chooses to defect, no
student receives any bonus points.
◎ And these are REAL bonus points, not pretend.
https://www.poll-maker.com/#qp=3773962xeECc17f2-116

206
 CLASS ACTIVITY

What would you like to choose?

a) Collude
b) Defect

207
Game theory
Prisoner Dilemma & Collusion

208
 GAME THEORY
Some important definitions:
◎ A game includes:
○ Players: individuals who make decisions
○ Strategies: The planned decisions of the players
○ The payoffs to the players: the profits or losses that result from the
strategies

◎ The order in which players make decisions:

○ Simultaneous-move game: Game in which each player makes decisions
without knowledge of the other players’ decisions.
○ Sequential-move game: Game in which one player makes a move after
observing the other player’s move.

◎ One-shot games vs. repeated games:

○ One-shot game: Game in which the underlying game is played only once. 209
 GAME THEORY
Strategic competition among the few
◎ Oligopolists are likely to participate in non-price competition:
competition among the few - strategic competition
○ But what is strategic competition and does it (1) weaken the
sustainability of oligopoly collusion and (2) sustain profits by
deterring entry?
◎ Strategic competition is analyzed using game theory
◎ Interdependency between oligopolists implies strategic
decision making
○ They make secret moves, try to outguess each other and
respond to each others actions
◉ Moves in secret are analysed as if moving simultaneously and
to predict the outcome solve for the Nash equilibrium
● And if there is one, a dominant strategy equilibrium (since all 210
 GAME THEORY
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

211
 GAME THEORY
Prisoners’ Dilemma
◎ All rivals have dominant strategies
◎ In dominant strategy equilibrium, all are worse off
than if they had cooperated in making their
decisions Bill
Don’t confess Confess
A B B
Don’t
confess 2 years, 2 years 12 years, 1 year
Jane
C J D JB
Confess 1 year, 12 years 6 years, 6 years
212
213
 GAME THEORY
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

214
 GAME THEORY
Successive Elimination of Dominated Strategies
Palace’s price
High ($10) Medium ($8) Low ($6)
A B C C CP
High
$1,000, $1,000 $900, $1,100 $500, $1,200
($10)

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

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

Payoffs in dollars of profit per 215

 GAME THEORY
Reduced Payoff Table
Palace’s price Unique
Solution
Medium ($8) Low ($6)
B C C CP
High $900, $1,100 $500, $1,200
($10)
Castle’
s price H I P
Low $500, $350 $400, $400
($6)

216
217
218
 GAME THEORY

The prisoners’ dilemma and cooperation/collusion

between 2-firms in an Oligopoly (Duopoly)
Alpha and Beta are two oil producers who share the
market.
Each firm has two possible strategies:
1. High output –Lower price
2. Low output – higher price
◎ Each chooses its strategy without knowing what
strategy the other has chosen (equivalent to
simultaneous or hidden moves)
219
 GAME THEORY
Prisoners’ dilemma and oligopoly
Four possible outcomes:
1. Both produce a high output
○ OK profits (1 billion)
2. Both produce a low output – collusive agreement.
○ E.g. by forming a cartel: Arrangements entered into voluntarily
which restrict firms’ future actions (Alpha and Beta each agree to
restrict output to keep prices high).
○ High profits (2 billion)
3. Beta produces low output but Alpha produces high output.
○ Beta has very low profits (0), Alpha very high profits (3)
4. Alpha produces low output but Beta produces high output. 220
 GAME THEORY
The Prisoners’ Dilemma and oligopoly collusion
Beta’s
Strategy
Compete on price: high Don’t compete on price:
output low output

Compete on price:
high output
1 1 3 0
Alpha’s
Strategy Don’t compete on
price: low 0 3 2 2
Output

Both firms would improve profits if they colluded to form a cartel in which each agreed to limit
price competition and restrict output. But what is the likely outcome (the Nash Equilibrium) of
this strategic game?
221
 GAME THEORY
The Prisoners’ Dilemma and oligopoly collusion
Beta’s
Strategy
Compete on price: high Don’t compete on price:
output low output

Compete on price:
high output 1 1 3 0
Alpha’s
Don’t compete on
Strategy price: low
0 3 2 2
Output

Although both firms would have higher profits if they colluded to restrict output there is an
incentive for each to cheat because each firm could increase its profits by increasing its output as
long as the other firm keeps to the agreement and keeps its own output low. The likely outcome is
that they both produce high output. 222
 GAME THEORY
Implications
◎ Collusion between oligopolists is undesirable but it
is also unlikely to be stable
◎ Firms are likely to be involved in a ‘prisoners’
dilemma’ – especially given that collusion is illegal
and subject to punishment
○ they can agree to collude BUT this still leaves
problem of enforcement.
◎ So regulators don’t have to worry?
○ Depends

223
 GAME THEORY

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

224
PRINCIPLE:
Put Yourself in Your
Rival’s Shoes
If you do not have a
dominant strategy, look at the
game from your rival’s
perspective. If your rival has
a dominant strategy,
anticipate that he/she will
play it. 225
 Super Bowl Advertising: A Unique
Nash Equilibrium
Pepsi’s budget
Low Medium High

A C B P C
Low $60, $45 $57.5, $50 $45, $35

Coke’ D P E C F
s Medium $50, $35 $65, $30 $30, $25
budge
t
G H I C P
High $45, $10 $60, $20 $50, $40

Payoffs in millions of dollars of semiannual

profit.
13-2
 GAME THEORY
What is a Nash equilibrium?
◎ A pair of strategy choices that are at least ‘best’
responses to each other (if not all the possible
choices of the other player)
◉ No incentive for either player to deviate
◉ Strategic stability: No single firm can unilaterally
make a different decision & do better
◎ In a Nash equilibrium of a game played between X
and Y:
◉ Y will be satisfied with her choice given whatever X is
doing and X will be satisfied with his choice given
whatever you have decided to do 227
 GAME THEORY
Summary
◎ When agent’s payoffs depend on what other
agents do, we need to look at all possible choices
and outcomes
◎ The predicted strategies are ones that are:
○ best responses to each other
○ i.e. they constitute a Nash equilibrium
◉ if we are lucky they will also constitute a dominant strategy
equilibrium

228
 GAME THEORY
Example: The Copy Cat Coffee Shop
◎ Participants = 2 coffee shop chains (the players):
○ Your own coffee chain called YOU-Star and a
competitor, X-Cup.
◉ Your company wants to be different from X-Cup in order to
gain market share because of uniqueness.
◉ X-Cup is a smaller firm and for security wants to do what
ever you do – a copy cat strategy
◎ Both of you have two choices which you make
simultaneously in secret:
◉ Launch a new product
◉ Make a special offer 229
 GAME THEORY

The possible outcomes:

1. YOU-star (You) and X-Cup both launch a new
product
2. You launch a new product and X-Cup makes the
offer
3. You make the offer and X-Cup launches a new
product
4. You and X-Cup both make the offer

230
 GAME THEORY
YOU-star’s payoffs
◎ The profit level that results from your choice is your
payoff
○ You really want to choose a different strategy from firm X
– your coffee shop chain really wants to differentiate itself
from firm X
◉ Whatever strategy you chose, if firm X chooses the same
strategy as you, your profits will be lower
◎ But launching a new product is less costly and
potentially more profitable than making the offer - you
have already done the R&D and the market research -
launching the new product gives you your highest
profits ……………as long as X-Cup doesn’t launch its 231
 GAME THEORY

YOU-star’s payoffs
◎ Highest payoff = 10 (e.g. $10 million): You launch
the new product and X-Cup makes the offer
◎ Second best payoff = 1: You make the offer and
X-Cup launches a new product
◎ Third best payoff = -5 : You and X-Cup both launch
new products
◎ Lowest payoff = -10: You and X-Cup both make the
offer

232
 GAME THEORY
Your payoffs in a matrix
X-Cup X-Cup makes
launches new offer
product
New -5 10
Your product
decision Make 1 -10
offer
•Your payoffs depend on what firm X does
•You don’t have an automatically best choice
•Your decision depends on what you think firm X will do 233
 GAME THEORY

X-Cup’s payoffs
◎ Like you X-Cup would really prefer to launch the
new product
○ Making an offer is extremely costly for X-Cup
◎ But firm X is small and also would prefer to follow
your firm’s strategy rather than go it alone

234
 GAME THEORY

X-Cup’s payoffs
◎ Highest payoff = 20: You both launch a new
product
◎ Second best payoff = 5: X-Cup has the new
product and you make the offer
◎ Third best payoff = 1: You and X-Cup both make
the offer
◎ Lowest payoff = -100: X-Cup makes the offer and
you launch a new product

235
 GAME THEORY
X-Cup’s payoffs in a matrix
X-Cup’s choice
New product Make offer

You launch a new 20 -100

product

You make the offer 5 1

•X-Cup’s payoffs depend on what you do but X-Cup always prefers to

launch a new product – whatever you do
•The new product is X’s dominant strategy – a best choice whatever
you do
236
 GAME THEORY

Predicting the outcome

◎ As you don’t have a dominant strategy there can’t
be a dominant strategy equilibrium(DSE); in a DSE
both players choose their dominant strategies
◎ We need to find the next best thing to a DSE - a
Nash equilibrium
○ A pair of strategy choices that are at least ‘best’
responses to each other (even if not best responses to all
the possible choices of the other player)
○ In a Nash equilibrium of the game there is no incentive
for either of you to deviate as:
◉ You will be satisfied with your choice given whatever X is
doing and X-Cup will be satisfied with their choice given
whatever you have decided to do 237
 GAME THEORY
Identifying the Nash equilibrium

X-Cup
New product Make offer
New You:-5, X:20 You:10, X: -100
You product
Make You:1, X: 5 You:-10, X:1
offer

238
 GAME THEORY
Identifying the Nash equilibrium
X-Cup
New product Make offer

New You:-5, X:20 You:10, X: -100

You product
Make offer You:1, X: 5 You:-10, X:1

The Nash equilibrium is {You: make the offer, X: new product}

This is the only strategy combination in which neither of you will want to
deviate (if the other doesn’t deviate)
239
 GAME THEORY
Practise
◎ In a payoff matrix write payoffs for a version of the
game in which your payoffs are unchanged but although
X-Cup still wants to copy you, X-cup now strongly
prefers to make the offer instead of launch the new
product
○ X-cup’s best outcome is to make the offer with you
○ X-cup’s worst case scenario is to launch the new product while
you make the offer
○ But X-cup would rather make the offer without you than go for
the new product with you
◎ What will this game look like and what will be the Nash
equilibrium? 240
 GAME THEORY
Revised game
◎ Fill in X-Cup’s payoffs and find the Nash
equilibrium
○ Use the following numbers to represent X-Cup’s
payoffs: -100, 20, 1, 5. X-Cup
New product Make offer
New You:-5 X:? You:10 X:?
You product
Make You:1 X:? You:-10 X:?
offer
241
242
 GAME THEORY
Investment game:
Two oligopolists choose between investing in new technology or not.
Interpret the game (describe the scenario) and use the underlying
method so see if there is a Nash equilibrium and if there is whether
this is also a dominant strategy equilibrium?
Oligopolist 2
Invest Don’t Invest

Invest 200, 150 350, -10

Oligopolist
1 Don’t Invest -5, 500 0, 0
243
 GAME THEORY
Investment game:The Nash equilibrium is a dominant strategy
equilibrium and therefore the predicted outcome is more
convincing? What do you think?
Oligopolist 2
Invest Don’t Invest

Invest 200, 150 350, -10

Oligopolist
1
Don’t Invest -5, 500 0, 0

244
 GAME THEORY
Battle of the sexes; coordination?
These two managers of two different firms want to meet up for
various reasons. There are two possible locations where they
might meet. Each has a preference. Interpret the scenario and
predict the outcome.
Jane
Golf club Tennis club

Gold club 200, 150 10, 10

John
Tennis club -10, -10 150, 200
245
 GAME THEORY
Battle of the sexes; coordination?
Interpret the scenario and predict the outcome. How could the
managers coordinate?
Jane
Golf club Tennis club

Golf club 200, 150 10, 10

John
Tennis club -10, -10 150, 200

246
 GAME THEORY
Summary
◎ In the strategic competition between oligopolists
predications need to take account of the
interdependence between the firms.
◎ Game theory can do this
○ e.g. discrete decisions between strategies in
simultaneous move games
◉ And also continuous strategies about output and price (e.g.
Cournot, Stackelberg, Bertrand) where the predicted out is
also a Nash equilibrium

247
Sequential
games
Entry barriers and entry
deterrence

248
 SEQUENTIAL GAMES
Entry barriers and entry deterrence: Objectives
◎ Explain what is meant by the idea of a credible
threat e.g. the threat to fight the entry of a new
firm into an industry.
◎ Use game theory to show how an incumbent
monopolist (or oligopolistic cartel) might be able
to deter entry even though fighting entry is
costly.

249
 ENTRY BARRIERS AND ENTRY DETERRENCE
Porter’s Five Forces again…
◎ A firm is more profitable:
○ The less intense the rivalry among existing firms
(monopoly or if oligopoly -collusion vs. competition) ✓
○ The less the danger of potential entrants and the
higher barriers to entry
○ The fewer substitutes for the firm’s products (the more firms
that sell complements)
○ The weaker the bargaining power of customers (e.g. in sports)
○ The weaker the bargaining power of suppliers

250
 SEQUENTIAL GAMES
Implications of the analysis so far i.e. in relation to
oligopoly collusion
◎ Oligopoly collusion (restrained rivalry) can be
sustained in some circumstances
○ But new entrants to the sector also have to
be kept out – HOW?

251
 SEQUENTIAL GAMES
Entry barriers and entry deterrence
◎ If firms in an industry are profitable, there are likely
to be potential entrants
○ Successful entry will lower profits for existing/incumbent
firms
○ Therefore existing firms will want to impede (deter) entry
◎ Question: what kinds of entry barrier exist? Hint:
some are ‘tangible or semi tangible’ and some are
based on beliefs (psychological)
○ See e.g. Kreps chapter 20 or Frank chapter 12 pp. 413-7

252
 SEQUENTIAL GAMES
Types of entry barriers (1)
◎ Tangible and semi tangible
○ Put entrants at a disadvantage in the competition that takes
place after entry e.g.:
◉ Cost
● Economies of scale: large firms more able to withstand cost
cutting (price war)
● Economies of scope : large diversified firms have cost
advantages
◉ Knowledge based advantages (technology gives cost
advantages)
◉ Access to resources e.g. financial or access to natural
resources or distribution channels
◉ Customer loyalty – goodwill and reputation (brands, niche 253
 SEQUENTIAL GAMES
Types of entry barriers (2)
◎ Psychological barriers (beliefs)
○ Reputation for aggressive response to entry –
fighting is a credible threat even if costly for the
incumbent (e.g. price war)
◉ Key is credibility

254
 SEQUENTIAL GAMES
Analyzing the idea of credibility in relation to entry
barriers and entry deterrence
◎ Sequential moves mean that players move in turns
– so one player moves first and the other follows
e.g.:
○ Firm A erects an entry barrier
◉ Pre-emptive investment strategies – tangible entry
barrier
◉ Threatens to fight a price war if there is entry -
Psychological entry barrier
○ Firm B decides whether to enter or not
255
 SEQUENTIAL GAMES
Credible threats
◎ A key idea in the analysis of sequential move
games is that of credibility
○ The credibility of a threat or promise depends on whether
the action would actually be carried out if it was tested;
the potential gain needs to outweigh any cost
◉ A threat to enter a market whatever the cost
◉ A threat to fight entry (e.g. by fighting a price war) - a
psychological entry barrier
● In either case can pre-emptive action be taken by those
threatened (to neutralise the threat) or those doing the
threatening (to make the threat credible)
○ e.g. by introducing a new product or expand a product
256
line = a tangible entry barrier
 SEQUENTIAL GAMES
Example 1: pre-emptive investment decisions and
credible threats in the aircraft industry
◎ The aircraft companies Boeing and Airbus are
involved in a strategic game, in this example
Airbus moves first
○ Airbus has to decide whether to invest in new
plane or not i.e. a new product line/market
○ Boeing is also deciding whether to invest in a new
plane but because of lags its production process it
has to make its decision after Airbus has made its
decision
257
 SEQUENTIAL GAMES
The firms’ payoffs
◎ The firms’ payoffs reflect the following:
○ Despite high development costs there is a market for the
new plane which could be supplied profitably
○ But the market for aircraft is limited and there is only
room for one company to supply a new plane profitably
◉ If both companies supply a new plane they would be in
direct competition with each other and both would make
lower profits due to undercutting
● And large economies of scale means that high levels of
output are needed to make profits
→SO THE MARKET IS NOT COMPETITIVE

258
 SEQUENTIAL GAMES
A decision tree for a game between Boeing and Airbus
Airbus +£10m
Boeing (1)
Boeing +£10m
no e
decides n
B pla
new
plan

e
1 e Airbus +£1m (2)

an
pl
Boeing +£50m
no
Airbus
decides A ne
w Airbus +£50m
e (3)
pla p lan Boeing +£1m
New
ne no
market
B
new Enters same new
market
2 pla
Boeing ne
decides Airbus –£10m
Boeing –£10m
(4)
 SEQUENTIAL GAMES
Boeing’ threat
◎ Boeing threatens to also enter the new market - by
supplying the new plane - if Airbus supplies the new
plane
◎ By making this threat Boeing hopes to deter Airbus
from supplying the new plane so it can make the
new plane itself
◎ Is this a credible threat?
○ Would this threat deter Airbus from building the new
plane?
○ Can Airbus take pre-emptive action?
260
 SEQUENTIAL GAMES
Game theoretic analysis: Is Boeing’ threat credible?
◎ Boeing’ threat is only credible if Boeing would
actually carry it out if Airbus built the new plane
○ We need to think about what Boeing would
actually do if Airbus built the new plane or did
not
◉ Whether the threat is credible or not depends on
Boeing’s payoff if the threat is carried out and its
payoff if it isn’t

261
 SEQUENTIAL GAMES
Analysing the game tree: what will Boeing actually
do at B1 and B2?
Airbus +£10m
Boeing (1)
no e Boeing +£10m
decides n
B pla
new
plan

e
1 e Airbus +£1m (2)

an
pl
Boeing +£50m
no
Airbus
decides A ne
w Airbus +£50m
e (3)
pla p lan Boeing +£1m
ne no
B
new
2 pla
Boeing ne
decides Airbus –£10m
Boeing –£10m
(4)
263
 SEQUENTIAL GAMES
Boeing’s decisions
Airbus +£10m
Boeing (1)
Boeing +£10m
no e
decides n
B pla
new
plan
e

e
1 Airbus +£1m (2)

an
pl
Boeing +£50m
no
Airbus
decides A ne
w Airbus +£50m
e (3)
pla p lan Boeing +£1m
ne no
B
new
2 pla
Boeing ne
decides Airbus –£10m
Boeing –£10m
(4)
 SEQUENTIAL GAMES
Boeing’ choices
Boeing will supply the new plane if Airbus does
not
◎ Boeing will not supply the plane if Airbus does
○ Therefore the threat to do so is not credible
○ So what will Airbus do?

265
 SEQUENTIAL GAMES
Analysing the game tree: what will Airbus do at A?
Airbus +£10m
Boeing (1)
Boeing +£10m
no e
decides n
B pla
new
plan
e

e
1 Airbus +£1m (2)

an
pl
Boeing +£50m
no
Airbus
decides A ne
w Airbus +£50m
e (3)
pla p lan Boeing +£1m
ne no
B
new
2 pla
Boeing ne
decides Airbus –£10m
Boeing –£10m
(4)
 SEQUENTIAL GAMES

Analysing the game tree: what will Airbus do at A?

Airbus +£10m
Boeing (1)
Boeing +£10m
no e
decides n
B pla
new
plan
e

e
1 Airbus +£1m (2)

an
pl
Boeing +£50m
no
Airbus
decides A ne
w Airbus +£50m
e (3)
pla p lan Boeing +£1m
ne no
B
new
2 pla
Boeing ne
decides Airbus –£10m
Boeing –£10m
(4)
 SEQUENTIAL GAMES
The game theoretic prediction
◎ Backward induction implies that Airbus will
supply the new plane and Boeing will not
○ Boeing’ threat to also supply the new plane if Airbus
supplies the plane is not a credible threat and
therefore it does not deter Airbus
◎ Airbus will make higher profits
○ it has a first mover advantage and take the
pre-emptive investment choice

268
 SEQUENTIAL GAMES
Exercise
◎ The aircraft industry is considered to be strategically important
by both the USA and the EU and therefore worth protecting by
subsidizing or using tariffs (see Allen Chapter 16)
◎ There are ongoing disputes between the USA and the EU
regarding ‘unfair’ subsidization of Boeing and Airbus in
developing aircraft
◎ Construct a game tree and use backward induction to predict
the outcome of the game if Boeing receives a subsidy of the
equivalent of £12m from the US government if and only if it
builds the plane
○ In the new version of the game is Boeing’s threat to build the
new plane credible? 269
 Analysing the new game tree: what will happen?

Airbus +£10m
Boeing (1)
Boeing +£10m
no e
decides n
B pla
new
plan
e

e
1 Airbus +£1m

an
(2)

pl
Boeing +£(50+12)m
no
Airbus
decides A ne
w Airbus +£50m
e (3)
pla p lan Boeing +£1m
ne no
B
new
2 pla
Boeing ne
decides Airbus –£10m (4)
Boeing –£10m + £12m = £2m
 Analysing the new game tree

Airbus +£10m
Boeing (1)
Boeing +£10m
no e
decides n
B pla
new
plan
e

e
1 Airbus +£1m (2)

an
pl
Boeing +£(50+12)m
no
Airbus
decides A ne
w Airbus +£50m
e (3)
pla p lan Boeing +£1m
ne no
B
new
2 pla
Boeing ne
decides Airbus –£10m (4)
Boeing –£10m + £12m = £2m
 SEQUENTIAL GAMES
The game theoretic prediction
◎ Government intervention changes the outcome of
the strategic game by making Boeing’s threat
credible
○ Implication: government intervention can change the
outcome of transnational strategic games played by
oligopolists
◎ But what about the long-term?
○ What do you think the EU will do?
◉ And what will be the outcome of the EU’s decision?

272
 SEQUENTIAL GAMES
Example 2: Entry deterrence and reputation
E = Potential market entrant - first mover
M = Incumbent monopolist (or oligopoly cartel – effectively a
monopoly) making monopoly profits

E M Is the
1 4
Concede incumbent’s
M1
threat to
Enter -1 1 fight
Fight credible?
E What
outcome do
Stay Out M2 0 8 you predict in
Do nothing this game?
 SEQUENTIAL GAMES
Entry deterrence and reputation
Threat to fight is not credible – there will be entry followed by
concession, unless the monopolist (or cartel) can make the threat to fight
credible by pre-committing to fight

E M
Concede 1 4

M1
Enter
Fight -1 1
E

Stay Out M2 0 8
Do nothing
 SEQUENTIAL GAMES
Making the threat to fight credible
◎ Firms can take costly pre-emptive actions to make
a psychological barrier credible e.g.:
○ Excess capacity for increasing output (lowers prices)
○ Holding patents or products as backup if there is entry
○ Choosing high fixed cost (economies of large scale)
technologies – so needs to protect market share
○ Investing in ability to retaliate in other markets
◉ i.e. some makes some unrecoverable ‘sunk’ cost that
makes fighting optimal
● There is a commitment cost (c) but a reward (d) if there is
entry and the monopolist fights
275
 SEQUENTIAL GAMES
Making the threat to fight credible
E M The monopolist (or
1 4-c cartel) invests in
Concede some
M1 unrecoverable
Enter Fight ‘sunk’ cost that
-1 1+d makes fighting
E optimal:
Commitment cost = c
Stay Out M2
0 8-c Generates reward if
Do nothing fights entry =d.

Under what conditions will entry be fought?

 SEQUENTIAL GAMES
Making the threat to fight credible
◎ The threat to fight is credible only if:
(payoff from fighting) 1 + d > 4 – c (payoff from concession)
or -c < 1+ d - 4 (divide through by -1)
or c > 3-d (1)
◎ But the commitment will only be made if payoff in game
without commitment (4) is greater than 8-c:
8–c>4
or c < 4 (2)
◎ Combining (1) and (2): The cartel will invest in the
commitment and entry will be deterred if:
4 > c > 3 –d (3)
277
 SEQUENTIAL GAMES
Making the threat to fight credible
◎ The threat to fight is credible only if:
1+d>4–c or c > 3-d (1)
◎ But the commitment will be made if:
8–c>4 or c < 4 (2)

◎ Combining (1) and (2):

4 > c > 3 –d (3)
Example:
If d = 2 and c = 3 both conditions are satisfied
(1) 1+d = 3, 4-c = 1 so 1=d >4-c
and (2) 8-c = 5 > 4
Which must mean that 4 > c (= 3) > 3-d (= 1)
1. Think of two other values for d and c that would satisfy the
278
conditions
 SEQUENTIAL GAMES
Implication
◎ Firms can make tangible and costly investments
(commitments) that make psychological entry
barriers credible – but costs (c) can’t be too high
and gains (d) need to be sufficiently large so that:
○ Payoff from deterring entry with the investment cost (8-c)
is greater than the payoff without incurring the
commitment (4)
○ Increase in payoff from fighting with commitment (d)
needs to large enough so that fighting is optimal

279
 SEQUENTIAL GAMES
Uncertainty and reputation
◎ The costly commitment to fight might not even need
to be made if there is:
○ Uncertainty e.g. about whether the commitment has been
made or not e.g. if the probability of fighting is high
enough
○ And/or the scenario is repeated (indefinitely or infinitely)
and the cartel has or can gain a reputation for fighting
entry – its worth a costly fight initially in order to create a
reputation for fighting
◉ Previous aggressive behaviour – reputation: E.g.
Procter & Gamble deterred Union Carbide from entry
into the disposable diaper industry by making it look
like it was up for a fight with a series of price cutting
280
strategies (see e.g. Kreps chapter 23 – page 586)
 SEQUENTIAL GAMES
Implication
◎ Analysis of repeated prisoners’ dilemma suggests
that oligopolists may be able to sustain collusion in
order to extract monopoly profits
◎ And sequential game theory shows that they may
be able to protect their collusive agreements
through psychological entry barriers e.g.
threatening to fight entry - as long as this is
credible
○ But the creation of entry barriers and entry deterring
strategies are often illegal……….

281
The same kind of analysis might be applicable to a
situation of industrial conflict – see e.g. Washington Post
cases - what’s your prediction?

Union –£100m
Employer fight Employer –£150m

E1 Con
e ced

e
rik
st Union +300m
Employer -£500m
UNION (but union is uncertain
U Do about employer’s
n’
ts payoff)
tri
ke
E Union +£50m
Employer +
2
Employer introduces £200m
labour reforms
The same kind of analysis might be applicable to a
situation of industrial conflict – see e.g. Washington Post
cases - what’s your prediction?

Union –£100m
Employer ight Employer –£150m
f

E1 Co
nce
e d

e
rik
st Union +300m
Employer -£500m
UNION (but union is uncertain
U Do
n’ about employer’s
ts
tri payoff)
ke?
E Union +£50m
Employer +
2
Employer introduces £200m
labour reforms
This game theoretic model could also be used to analysed some
international relations scenarios: Is the USA’s threat to invade credible
– this depends on what will the small country does if the USA invades
– what will it do?
Small country
decides USA –£100m
h fig Small country
t –£150m
S1 Giv
e

e
in

ad
USA +300m
v
In
Small Country +
The £50m
USA U Do
in n’t
va
de
S USA +£50m
Small Country +
2
Small £200m
country
does nothing
Since the small country will give in if the USA
invades - the USA will invade – its threat is
credible
Small USA –£100m
country gh Small country
i
decide f t –£150m
s
B
Giv
1
e
in

d
va
In USA +300m
US
e
Small
A
A Do Country
in n’t
va
de +£50m
B USA +£50m
Small Country +
2
Small £200m
country
does nothing
 A very different example: Robbing a bank: Is Bert’s
threat to blow himself and Angela up credible?

B A
Detonate -∞, -∞
B1
N
S Not -100, 100
B A Deton
ate
Demands
S
money B2 1000, -10
Not Detonate and
take the money

B = Bert the bank robber

A = Angela the bank cashier; S =surrender; NS = not surrender
-∞ implies infinite pain and suffering and/or death
Robbing a bank: Is Bert’s threat to blow himself
and Angela up credible?

B A
D etonate -∞, -∞
B1
N
S Not -100, 100
B A Deton
ate
Demands
S
money B2 1000, -10
Not
Detonate

B = Bert the bank robber

A = Angela the bank cashier; S =surrender; NS = not
surrender
-∞ implies infinite pain and suffering and/or death
 SEQUENTIAL GAMES
Test your understanding
Entry barriers and entry deterrence
1. Explain what is meant by the idea of a credible
threat e.g. the threat to fight the entry of a new firm
into an industry.
2. Use game theory to show how an incumbent
monopolist (or oligopolistic cartel) might be able to
deter entry even though fighting entry is costly.

288
Thank you for
your listening!
Any
questions?

You can find me at:

[email protected]
289