Business economics

1. Chapter 6
Strategic Decisions
Presenter: Vo Hoang Kim An
Foreign Trade University – Hochiminh City – Vietnam

2. “
OLIGOPOLY
Strategic decisions
2

3. 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.
○ Use sequential game theory to show how an incumbent monopolist
(or oligopolistic cartel) might be able to deter entry even though
fighting entry is costly . 3

4. 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?
Note: Suggested reading: Kreps, D. M. 2004. Microeconomics for Managers. Norton.
4

5. 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
5

6. CLASS ACTIVITY
What would you like to choose?
a) Collude
b) Defect
7

7. Game theory
Prisoner Dilemma & Collusion
8

8. 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.
○ Repeated game: Game in which the underlying game is played more than once.
9

9. 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
dominant strategy equilibria are also Nash equilibria)
10

10. 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
11

11. 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
12
Bill
Don’t confess Confess
Jane
Don’t
confess
A
2 years, 2 years
B
12 years, 1 year
Confess
C
1 year, 12 years
D
6 years, 6 years
J J
B
B

12. 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
13

13. GAME THEORY
Successive Elimination of Dominated Strategies
14
Palace’s price
High ($10) Medium ($8) Low ($6)
Castle’
s price
High
($10)
A
$1,000, $1,000
B
$900, $1,100
C
$500, $1,200
Medium
($8)
D
$1,100, $400
E
$800, $800
F
$450, $500
Low
($6)
G
$1,200, $300
H
$500, $350
I
$400, $400
C
C C P
P
P
Payoffs in dollars of profit per week.

14. GAME THEORY
Reduced Payoff Table
15
Palace’s price
Medium ($8) Low ($6)
Castle’s
price
High
($10)
B
$900, $1,100
C
$500, $1,200
Low
($6)
H
$500, $350
I
$400, $400
C C P
P
Unique
Solution

15. 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)
16
GAME THEORY

16. 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.
○ Beta has very high profits (3), Alpha very low profits (0)
17
GAME THEORY

17. GAME THEORY
The Prisoners’ Dilemma and oligopoly collusion
18
Compete on price: high
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?
Don’t compete on price:
low output
Beta’s
Strategy
Alpha’s
Strategy
Compete on
price: high output
Don’t compete on
price: low
Output
1 1 3 0
0 3 2 2

18. GAME THEORY
The Prisoners’ Dilemma and oligopoly collusion
19
Compete on price: high
output
Don’t compete on price:
low output
Beta’s
Strategy
Alpha’s
Strategy
Compete on
price: high output
Don’t compete on
price: low
Output
0
0 2 2
1 1 3
3
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.

19. 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
20

20. 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
21

21. 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.
22

22. 13-23
Super Bowl Advertising: A Unique
Nash Equilibrium
Pepsi’s budget
Low Medium High
Coke’s
budget
Low
A
$60, $45
B
$57.5, $50
C
$45, $35
Medium
D
$50, $35
E
$65, $30
F
$30, $25
High
G
$45, $10
H
$60, $20
I
$50, $40
C
P
Payoffs in millions of dollars of semiannual profit.
C
C
P
P

23. 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
24

24. 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
25

25. 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
26

26. 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
27

27. 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 new product as well – in which
case you prefer to make the offer 28

28. 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
29

29. GAME THEORY
Your payoffs in a matrix
30
X-Cup
launches new
product
X-Cup makes
offer
Your
decision
New
product
-5 10
Make
offer
1 -10
•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

30. 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
31

31. 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
32

32. GAME THEORY
X-Cup’s payoffs in a matrix
33
X-Cup’s choice
New product Make offer
You launch a new
product
20 -100
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

33. 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 34

34. 35
X-Cup
New product Make offer
You
New
product
You:-5, X:20 You:10, X: -100
Make
offer
You:1, X: 5 You:-10, X:1
GAME THEORY
Identifying the Nash equilibrium

35. 36
GAME THEORY
Identifying the Nash equilibrium
X-Cup
New product Make offer
You
New
product
You:-5, X:20 You:10, X: -100
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)

36. 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?
37

37. 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.
38
X-Cup
New product Make offer
You
New
product
You:-5 X:? You:10 X:?
Make
offer
You:1 X:? You:-10 X:?

38. 39

39. 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?
40
Oligopolist 2
Invest Don’t Invest
Oligopolist
1
Invest 200, 150 350, -10
Don’t Invest -5, 500 0, 0

40. GAME THEORY
Investment game:The Nash equilibrium is a dominant strategy
equilibrium and therefore the predicted outcome is more convincing?
What do you think?
41
Oligopolist 2
Invest Don’t Invest
Oligopolist
1
Invest 200, 150 350, -10
Don’t Invest -5, 500 0, 0

41. 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.
42
Jane
Golf club Tennis club
John
Gold club 200, 150 10, 10
Tennis club -10, -10 150, 200

42. GAME THEORY
Battle of the sexes; coordination?
Interpret the scenario and predict the outcome. How could the
managers coordinate?
43
Jane
Golf club Tennis club
John
Golf club 200, 150 10, 10
Tennis club -10, -10 150, 200

43. 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
44

44. Sequential
games
Entry barriers and entry deterrence
45

45. 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.
46

46. 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
47

47. 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?
48

48. 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
49

49. 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
markets), lock-in (e.g. due to compatibility)
◉ Legal factors e.g. certification, subsidies, trade barriers and patents
◉ Strategic entry barriers e.g. output and pricing decisions (product
development, bundling products, loss leaders, limit pricing)
50

50. 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
51

51. 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
52

52. 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 line
= a tangible entry barrier
53

53. 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
54

54. 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
55

55. A decision tree for a game between Boeing and Airbus
Airbus +£10m
Boeing +£10m
(1)
Airbus +£1m
Boeing +£50m
(2)
Airbus +£50m
Boeing +£1m
(3)
Airbus –£10m
Boeing –£10m
(4)
Boeing
decides
B2
Airbus
decides A
Boeing
decides
B1
New
market
Enters same new
market
SEQUENTIAL GAMES

56. 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?
57

57. 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
58

58. Analysing the game tree: what will Boeing actually
do at B1 and B2?
Airbus +£10m
Boeing +£10m
(1)
Airbus +£1m
Boeing +£50m
(2)
Airbus +£50m
Boeing +£1m
(3)
Airbus –£10m
Boeing –£10m
(4)
Boeing
decides
B2
Airbus
decides A
Boeing
decides
B1
SEQUENTIAL GAMES

59. Boeing’s decisions
Airbus +£10m
Boeing +£10m
(1)
Airbus +£1m
Boeing +£50m
(2)
Airbus +£50m
Boeing +£1m
(3)
Airbus –£10m
Boeing –£10m
(4)
Boeing
decides
B2
Airbus
decides A
Boeing
decides
B1
SEQUENTIAL GAMES

60. 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?
61

61. Analysing the game tree: what will Airbus do at A?
Airbus +£10m
Boeing +£10m
(1)
Airbus +£1m
Boeing +£50m
(2)
Airbus +£50m
Boeing +£1m
(3)
Airbus –£10m
Boeing –£10m
(4)
Boeing
decides
B2
Airbus
decides A
Boeing
decides
B1
SEQUENTIAL GAMES

62. Analysing the game tree: what will Airbus do at A?
Airbus +£10m
Boeing +£10m
(1)
Airbus +£1m
Boeing +£50m
(2)
Airbus +£50m
Boeing +£1m
(3)
Airbus –£10m
Boeing –£10m
(4)
Boeing
decides
B2
Airbus
decides A
Boeing
decides
B1
SEQUENTIAL GAMES

63. 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
64

64. 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?
65

65. Analysing the new game tree: what will happen?
Airbus +£10m
Boeing +£10m
(1)
Airbus +£1m
Boeing +£(50+12)m
(2)
Airbus +£50m
Boeing +£1m
(3)
Airbus –£10m
Boeing –£10m + £12m = £2m
(4)
Boeing
decides
B2
Airbus
decides A
Boeing
decides
B1

66. Analysing the new game tree
Airbus +£10m
Boeing +£10m
(1)
Airbus +£1m
Boeing +£(50+12)m
(2)
Airbus +£50m
Boeing +£1m
(3)
Airbus –£10m
Boeing –£10m + £12m = £2m
(4)
Boeing
decides
B2
Airbus
decides A
Boeing
decides
B1

67. 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?
68

68. SEQUENTIAL GAMES
E M
1 4
-1 1
E
M1
M2
Enter
Concede
Stay Out
Do nothing
Fight
0 8
Example 2: Entry deterrence and reputation
E = Potential market entrant - first mover
M = Incumbent monopolist (or oligopoly cartel – effectively a
monopoly) making monopoly profits
Is the
incumbent’s
threat to
fight
credible?
What
outcome do
you predict in
this game?

69. SEQUENTIAL GAMES
E M
1 4
-1 1
E
M1
M2
Enter
Concede
Stay Out
Do nothing
Fight
0 8
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

70. 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
71

71. Making the threat to fight credible
E M
1 4-c
-1 1+d
E
M1
M2
Enter
Concede
Stay Out
Do nothing
Fight
0 8-c
The monopolist (or
cartel) invests in
some
unrecoverable
‘sunk’ cost that
makes fighting
optimal:
Commitment cost = c
Generates reward if
fights entry =d.
Under what conditions will entry be fought?
SEQUENTIAL GAMES

72. 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)
73

73. 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 conditions
2. Can you provide any interpretation of what these conditions mean (in
terms of the cost and rewards of commitment - the relative payoffs)? 74

74. 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
75

75. 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 strategies (see
e.g. Kreps chapter 23 – page 586)
76

76. 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……….
77

77. 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 –£150m
Union +300m
Employer -£500m
(but union is uncertain
about employer’s payoff)
Union +£50m
Employer +£200m
Employer introduces
labour reforms
E2
UNION
U
Employer
E1

78. 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 –£150m
Union +300m
Employer -£500m
(but union is uncertain
about employer’s payoff)
Union +£50m
Employer +£200m
Employer introduces
labour reforms
E2
UNION
U
Employer
E1

79. 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?
USA –£100m
Small country –£150m
USA +300m
Small Country +£50m
USA +£50m
Small Country +£200m
Small country
does nothing
S2
The
USA U
Small country
decides
S1

80. Since the small country will give in if the USA invades
- the USA will invade – its threat is credible
USA –£100m
Small country –£150m
USA +300m
Small Country
+£50m
USA +£50m
Small Country +£200m
Small country
does nothing
B2
USA
A
Small
country
decides
B1

81. A very different example: Robbing a bank: Is Bert’s threat to
blow himself and Angela up credible?
A
B1
B2
B A
-, -
-100, 100
1000, -10
Demands
money
NS
Not Detonate and
take the money
B
S
B = Bert the bank robber
A = Angela the bank cashier; S =surrender; NS = not surrender
- implies infinite pain and suffering and/or death

82. Robbing a bank: Is Bert’s threat to blow himself and
Angela up credible?
A
B1
B2
B A
-, -
-100, 100
1000, -10
Demands
money
NS
Not
Detonate
B
S
B = Bert the bank robber
A = Angela the bank cashier; S =surrender; NS = not surrender
- implies infinite pain and suffering and/or death

83. 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.
84

84. Thank you for
your listening!
Any questions?
85
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an.vohoangkim16@gmail.com