Game Theory Intro The Prisoner's Dilemma as a Model for Oligopoly Behavior - Jason Welker

[Music] in today's video lesson we're going to examine the market structure of oligopoly we're going to define oligopoly and learn how game theory can be used as a model for understanding the behavior of firms in an oligopolistic market as you can see today we're going to be looking at two firms McDonald's and Burger King and the market for their two best selling meals the Big Mac by McDonald's and the whopper by Burger King before we get into our game theory analysis let's begin with a definition of oligopoly and an identification of some of the characteristics of an oligopolistic market an oligopoly is a market structure with a few dominant firms some of the characteristics of oligopolistic markets include the existence of high barriers to entry the fact that firms have price making power the fact that firms are interdependent on each other the interdependence between firms in an oligopolistic market is particularly important for our study of game theory as a model for behavior for oligopolistic firms in addition to these characteristics and other characteristic of oligopoly is that the products being produced by firms are differentiated in this regards oligopoly is very similar to monopolistic competition the primary difference being that the firms have a much larger share of the total market demand in an oligopolistic market than they do in monopolistic competition however since there is more than one firm no single firm has total monopoly power in the market so with these characteristics in mind we're going to now begin our analysis of oligopoly behavior using a tool that economists and mathematicians refer to as game theory so today we're going to be studying the behavior of two firms McDonald's and Burger King in the market for hamburgers the firm's have a decision to make they must decide whether they're going to charge $7 for their meals or $5 for their meals both the decisions of McDonald's and Burger King will be represented in a table known as a payoff matrix in our payoff matrix we can see that McDonald's can either price its Big Mac meal at seven dollars or five dollars likewise Burger King the competitor of McDonald's can produce its whopper meal at a price of seven dollars or five dollars what the table will show us is that levels of economic profit that the two firms will enjoy based on their decision of whether to price their meals at seven dollars or five dollars so looking at the table here what we're going to do is we're going to add some values to each of the boxes in this table what the values will tell us is the level of economic profit that Burger King and McDonald's will earn based on their pricing decision for example if both Burger King and McDonald's choose to price their meals at 7 dollars then the level of economic profit expected to be earned by Burger King will be 15 million dollars and the level of economic profit that McDonald's can expect to earn will be 15 million dollars in other words the two firms will split the market for hamburger meals each firm will learn a profit of fifteen million dollars the next question would be well what if Burger King were to lower its price to five dollars how would this affect the market for hamburger meals how would it affect the level of profits enjoyed by Burger King and McDonald's let's assume that Burger King unilaterally lowers its price to five dollars while McDonald's remains at seven dollars for its Big Mac meal if the price of whopper meals Falls to five dollars we can expect that Burger King will capture a much larger share of the total market and will thereby increase its profits to thirty million dollars while McDonald's profits will fall to five million dollars the rationale behind this now Burger King has the more competitively priced hamburger meal therefore a large percentage of McDonald's customers will shift their demand to Burger King and will consume fewer Big Mac meals as a result now what if Burger King had kept its price at $7 and McDonald's had lowered its price to $5 let's look in the upper right hand corner and we'll show the payoffs that the two firms would enjoy if this were the case let's assume that the same thing happens when McDonald's lowers its price as did for Burger King when it lowered its price if McDonald's unilaterally lowers its price McDonald's can expect its total profits to increase to 30 million dollars at the expense of Burger King whose profits will fall to five million dollars finally what if both firms reduced their price to $5 how will this affect the total profits in the market well if both firms lower the price then we can assume that both firms were will earn lower economic profits then they would have if they had both kept their price at $7 in fact if both firms lower their price they will continue to split the market fifty-fifty but their level of economic profits will be lower since they have to lower their price to only $5 so if both firms lower their prices economic profits will be 10 million dollars apiece and both firms will continue to split the market neither one taking a larger market share from the other so what we have now is our payoffs we have just shown that all of the yellow payoffs represent Burger King's profits based on the pricing decisions of Burger King and the competitor McDonald's the green numbers those which I'm highlighted in green represent McDonald's possible payoffs which as we can see are dependent upon the pricing decision not just of McDonald's itself but also its competitor Burger King this is why this is called a payoff matrix it is a matrix or a table showing all the various payoffs based on the price decided by the two primary competitors in an oligopolistic market we can use this table to analyze the most likely outcome in a game in which the two firms are deciding between a high price of $7 or a low price of $5 let's let's look at the upper left-hand corner for example let's assume that both firms are currently selling their hamburger meals at $7 apiece and both firms are enjoying high economic profits of 15 million dollars the question is will Burger King wish to lower its price to $5 well let's see what happens when one firm lowers its prices and the other one keeps its price the same as we can see if Burger King lowers its price and McDonald's keeps its price high Burger King can expect to go from earning fifteen million dollars to earning 30 million dollars clearly this is a strategy that is in Burger Kings best interest the next question is what would Burger King want to do if McDonald's lowered its price if McDonald's lured its price and Burger King kept its price at $7 Burger King can expect its profits to fall from 15 million to 5 million dollars which is clearly not an optimal outcome for Burger King on the other hand if Burger King were to match the price decrease and lower its price at the same time that McDonald's does Burger King's profits would go from 15 million to 10 million dollars clearly this is better than experiencing a falling profits all the way down to 5 million dollars so we're gonna go through a couple of options here if McDonald's charges $7 what should Burger King do Burger King should charge $5 why because Burger King's profits will be 30 million dollars instead of 15 million dollars if it lowers its price to 5 so what if McDonald's charges $5 if McDonald's charges $5 Burger King should charge $5 why is this the case well as we demonstrated in our payoff matrix by lowering its price to $5 at the same time that that McDonald's lowers its price to $5 Burger King prevents its profits from falling from 15 to 5 million instead they only fall from 15 to 10 million therefore Burger King should always charge $5 we can say that $5 is a dominant strategy a dominant strategy exists if an oligopolistic firm should always do the same thing regardless of what its competitor does in the case of Burger King it should always charge $5 Burger King can be better off by charging $5 whether or not McDonald's is charging seven dollars or five dollars we have demonstrated this by showing that there is always an incentive for Burger King to charge five dollars based on its competitors behavior now since the payoffs for McDonald's are identical to that for Burger King five dollars is also a dominant strategy for McDonald's if Burger King charges seven dollars McDonald's can earn more economic profits by lowering its price to five dollars it can experience a doubling of its economic profits in fact on the other hand if Burger King charges five dollars again McDonald's can earn a greater level of economic profits by also charging five dollars so in this game of high price or low price between McDonald's and Burger King in the hamburger market both firms have a dominant strategy of charging five dollars what does this mean for the likely outcome of the game in other words what does this mean for consumers of hamburgers and the tube firms producing hamburgers the outcome will be that the price of hamburgers should always be equal to five dollars and the level of economic profits both firms enjoy will only be ten million dollars the implications of this outcome are that without the ability to collude or cooperate with one another McDonald's and Burger King will always end up charging a lower price for their products and earn a lower level of economic profit then would be achievable if they both charged a higher price but this is the nature of oligopoly markets the firm's are interdependent on each other Burger King cannot unilaterally charge $7 because there will always be an incentive for it to lower its price to $5 McDonald's also can't charge a price of $7 because if it does Burger King will lower its price and McDonald's profits will fall to only five million dollars both firms have a strong incentive to lower the price to $5 the behavior of oligopolistic firms is highly interdependent on the behavior of competitors this is what game theory shows us this is called a game because it's basically a to move game firms can either charge a high price or they can charge a low price there are other games we could play besides those with just price other games might include whether to advertise or not to advertise whether to offer discounts or not to offer discounts whether to have a spring sale or not to offer a spring sale the profits of firms depend not just on what the firm itself does but just as importantly a firm's profits an oligopoly depends on what its competitors will do

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Id: 8-PVNLH_MpE

Length: 12min 30sec (750 seconds)

Published: Fri May 13 2016