Final Review Class Managerial Economics

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Final Review ClassManagerial Economics

• MBS, Term 3, 2004

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Overview

• Exam details preparation tips
• Exam tips general
• 3 must knows from each class
• Practice maths what you need to know
• Any other questions you have
• Until then
• Appendix other key information from each class

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Exam Details

• Final Exam
• 1.45 pm Monday 29 November
• 15 minutes reading time (from 1.45pm)
• 2 hours writing time (from 2pm)
• Open book you may bring in anything
  consistent with MBS policy
• 10 short answer questions (40)
• 2 longer questions (60)
• Where CUB, Coles Rio Tinto theatres
• Review Session
• Saturday 27 November, 9.00am to 11.00am
• Coles Threatre

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If we were doing the exam, wed focus on
Materials in order of importance Class
slides Problem sets Practice questions Readings
from Joshua Gans website Text book
(Brandenberger and Nalebuff)
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Exam tips general

• Really understand the question first before
  writing- eg- whats the trade-off?- is price
  negotiated or posted/TIOLI? affects price,
  how surplus is split, etc- little things
  determine whether its Bertrand, Cournot,
  collusion or- Payment or surplus split
• Focus on specifically answering the question
  dont waste your time writing stuff unless it
  helps answer the question / supports your answer
• Answer every little bit of the question asked,
  including discuss/explain

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Exam tips general

• Adequately support your answers (show
  calculations, explain why)
• Clearly state your opinion dont overly hedge
  your bets
• If get stuck, make an assumption and move on
• Be ruthless highly likely that some information
  will be irrelevant, so dont worry about not
  using it
• Make an attempt at every question a genuine
  attempt will gain some marks (even if completely
  wrong!) no attempt no marks

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3 must knows 1. Economic decision-making

• How to draw a decision/game tree- Defining
  decision-makers, decisions uncertainties
  make sure youve captured all the options, are
  options really either/or?- Getting the order
  right- Getting the pay-offs right incremental
  (what changes?), economic profit, opportunity
  costs, sunk costs, double- counting

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3 must knows 1. Economic decision-making
(continued)

• How to solve a decision/game tree- Roll-back
  straightforward if youve drawn the tree
  correctly
• How to use expected values to deal with
  uncertainties

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3 must knows 2. Value creation

• Calculation of value created by an option- Value
  created total surplus increase in size of
  pie, ie total payoffs of option total
  payoffs of BATNA- eg, in pure trade value
  created WTP WTS consumer surplus WTP-P
  producer surplus (economic profit) P-WTS-
  Calculating WTP and WTS (wont always be
  given) eg WTP gross payoff if buy
  (excluding price paid) payoff of next best
  option

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3 must knows 2. Value creation(continued)

• In maximising value created, ignore the
  division issue and self-interested behaviour
  ask what is the optimum for the group
• Be aware of all the common errors (eg, sunk
  costs, double-counting, ignoring complements) so
  you dont commit them

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3 must knows 3. Game theory bargaining

• Dont forget the option of making a commitment
• How to split surplus, including the payment
  required
• Example - if total surplus 100 and, with no
  payments, As surplus is 30 and Bs 70, then
  an equal split requires B to pay A 20

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3 must knows 4 5. Added value and changing
it

• How to calculate AV pie with you pie without
  you- be careful of common traps (eg, is MC of
  servicing customer X the production cost or the
  WTP of next customer?)
• Worthwhile reviewing Making sure we have the
  right surplus added value numbers
• Will not be a question on CORE bargaining

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3 must knows 6. Mass market pricing (posted
price)

• Recognising whether its a mass market with a
  posted price from the wording of the question
• Calculating market outcomes (P, Q, profits,
  consumer surplus) in any type of market-
  Perfect competition P MC- Monopoly or perfect
  collusion MR MC- If P a bQ, MR a 2bQ
• Maximising value vs profit vs consumer surplus

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Monopoly / collusion example

• Given P 3,060 18Q, MC 700
• MR 3,060 36Q MC 700
• Q 65.56
• P 3,060 18(65.56) 1,880
• Profit Q(P-MC) (assume no FC)
  65.56(1,880-700) 77,361
• Consumer surplus 0.5.(3,060-1,880).65.56
  38,680

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3 must knows 7. Innovative pricing

• How to develop key forms of price discrimination,
  particularly- versioning / self-selection-
  2-part tariffs
• Pricing with multiple markets MR1 MR2
• Pricing with multiple plants MC1 MC2

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Multiple markets example

• P1 1,499 7Q1 P2 4,007 10Q2
• MC 267, capacity of 500 units
• MR1 1,499 14Q1 MR2 4,007 20Q2
• Assuming spare capacityMR1MC 1,499 14Q1
  267 Q188MR2MC 4,007 20Q2 267
  Q2187
• Q 88 187 275 lt 500 capacity, so OK
• P1 1,499 7(88) 883
• P2 4,007 10(187) 2,137

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Multiple plants example

• P 2,050 6Q
• MC1 250, capacity of 75 unitsMC2 50 2Q2,
  capacity of 125 units
• MC1 MC2 250 50 2Q2 max Q2 100 (lt 125
  capacity, so OK)
• Assuming Q gt 100, MC1 is the relevant MC
• MR 2,050 12Q MC1 250Q 150Q1 150
  100 50 (lt75, so OK)
• P 2,050 6(150) 1,150

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3 must knows 8. Competitive pricing

• Be able to draw a game matrix or game tree and
  solve in particular, identify Nash equilibria
  and joint optimum
• Know how to pick the appropriate model from the
  question (eg, tough price competition, output
  decision made in advance) and then solve-
  Bertrand duopoly P MC- Cournot equilibrium
  at intersection of best response curves must
  know how to construct curves (see example
  later)
• Always be on the look-out for pre-emption /
  commitment opportunities

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3 must knows 9. Cooperative pricing

• Can collusion be sustained?- finite games no-
  infinitely repeated games maybe depends on
  trade-off need be able to calculate d and r
• Tacit ways to promote/sustain collusion
  reputation, commitment, customer contracts, etc
• How to evaluate collusion vs competition which
  is better (for you!)

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3 must knows 10. Price signals

• Dont assume that signaling is the best option
  it depends
• 3 tests of whether signaling can work (lecture
  notes p. 24)- too costly for baddies- less
  costly for goodies- more profitable for goodies
  than not signaling
• How to work out a simple signaling (or pooling)
  equilibrium revise warranty example from last
  class

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What other maths do you need to know? (it wont
get more complicated than this)

• , -, x, /
• If your answer has more than 2 decimal places, go
  back and check
• Dont need to know anything about PVs (for exam,
  that is do in real life!) any numbers will be
  given in annual equivalent terms
• Need to be able to solve the following 2 problems

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What other maths do you need to know? (cont)

• Marginal revenue- Demand curve P a
  bQ- MR curve MR a 2bQ
• Consumer surplus 0.5.(a-P).Q(assuming single
  price)
• Cournot best response function (2 player)-
  Demand curve P a bQ- Player 1s MR MR1
  a 2bQ1 bQ2- 1s best response curve set MR1
  MC, or cheat Q1 (MC-a)/2b Q2/2-
  Equilibrium where best response functions
  intersectexample

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Cournot example (2 player)

• Given P 205 0.4Q MC 25
• MR1 205 0.8Q1 0.4Q2 MC 25
• Q1 225 Q2/2 player 1s reaction function
• Q2 225 Q1/2 (by symmetry)
• Solving the 2 equationsQ1 225 (225
  Q1/2)/2Q1 150 Q2 (by symmetry)
• Q Q1 Q2 300
• P 205 0.4(300) 85

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Until then

• You have my numbers call any time (including
  nights weekend) if you have any questions

GOOD LUCK!!!
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Appendix

• Other key information from each class

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Topic 1 Economic Decision Making

• The Purpose of Economics. To understand
• How individuals (households and firms) make
  decisions (choices) about scarce resources.
• What those decisions collectively add up to (the
  equilibrium in markets market price, quantities
  produced, range of products, number of firms,
  etc.)
• The role of economic organizations. That is, the
  value proposition of organizations like firms,
  banks, unions, government, etc. (This question
  is covered in other courses.)

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Topic 1 Economic Decision Making

• Objectives
• Understand how firms make decisions about
  resources in a strategic setting that is,
  where the decisions of other sellers, as well
  as buyers, must be taken into consideration.
• Co-opetition Framework
• Players Customers, Suppliers, Competitors
  and Complementors
• Added Value Total value created with the
  player in the game less total value
  created without that player
• Rules Contractual arrangements, laws,
  conventions, etc.
• Tactics Tactics in games and pricing
  strategy
• Scope

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Topic 1 Economic Decision Making

• Decision Trees for Sequential Decision Making
• Build the decision tree by adding nodes
  (forks), branches and pay-offs. At some nodes
  decisions are made by players (square
  nodes). At other nodes random outcomes of chance
  occur.
• To solve decision trees -- look forwards and
  work backwards (always do this in strategic
  situations).
• Eliminate branches that give inferior outcomes
  from any decision node.
• Decision trees are useful
• Helps to summarize and clarify the decision
  process
• Even in simple situations it is easy to miss
  something unless you take a systematic
  approach (Indiana Jones)

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Topic 1 Economic Decision Making

• Deciding whether the firm should continue
  producing
• Consider only variable costs in the short run
  (when some costs are still fixed)
• Consider all costs in the long run
• Some fixed costs are sunk costs that cannot
  ever be reclaimed
• Firm must make positive economic profit in the
  long run or take their resources to where they
  are more productive
• Firms may continue producing even when costs
  are not covered to maintain the option to
  produce if demand moves up again
• That option is worth more
• - Demand is highly volatile
• - Cost of re-entering after scrapping
  production capacity is large

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Topic 2 Value Creation

• The Value Net Framwork of Co-Opetition
• A player is your complementor if customers
  value your product more when they have the other
  players product than when they have your product
  alone
• A player is your competitor if customers value
  your product less when they have the other
  players product than when they have your product
  alone

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Topic 2 Value Creation

• Customer Side
• A player is your complementor if customers
  value your product more when they have the other
  players product than when they have your product
  alone
• A player is your competitor if customers value
  your product less when they have the other
  players product than when they have your product
  alone
• Supplier Side
• A player is your complementor if it is more
  attractive for a supplier to provide resources to
  you when it is also supplying the other player
  than when it is supplying you alone.
• A player is your competitor if it is less
  attractive for a supplier to provide resources to
  you when it is also supplying the other player
  than when it is supplying you alone.

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Topic 2 Value Creation

• Willingness to Pay (WTP)
• WTP is the highest price that a buyer will
  agree to pay for a good or service.
• It is the price at which the buyer doesnt care
  whether he buys or walks away. The price
  at which economic profit is zero.
• Willingness to Sell
• WTP is the lowest price that a buyer will agree
  to accept for a good or service.
• It is the price at which the seller doesnt
  care whether he sells or walks away. The
  price at which economic profit is zero.

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Topic 2 Value Creation

• Buyers surplus and sellers surplus are
  determined by where the price is set
• Transaction costs eat into the total surplus.
  Brokers and dealers help to reduce transaction
  costs

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Topic 2 Value Creation

• Firms co-operate to maximize the total surplus
  that is, maximize the value added by a
  transaction.
• Production and trade
• Joint ventures shared facilities industry
  groups
• But they compete in dividing the surplus
• Setting prices and payments determines division
  of the surplus
• Take actions that maximize the surplus (if
  contracts can be written) and then bargain over
  the division of the surplus

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Topic 3 Game Theory and Bargaining

• Game Trees
• Sequential moves made by players
• Where moves are simultaneous we need to use a
  pay-off matrix rather than a decision tree
• Decision of first player restricts set of
  possible outcomes for both players
• Second player wishes to influence the decision
  of first player
• Second player may be able to shape the pay-offs
  to the first player by pre-commiting to certain
  actions
• Child and Parent example, Nuclear deterrence
  example
• Credible commitment requires a reputation a
  delegation of the decision to a decision
  maker with reputation cutting off
  communication mandated negiotiating
  agents etc.
• We see later that pre-commitment is also the
  essence to escaping the prisoners dilemma in
  simultaneous games

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Topic 3 Game Theory and Bargaining

• Because of inability to write water-tight
  contracts sequential games do not always lead
  to value maximizing outcomes
• Most B2B interactions are negotiations or
  auctions. We need to make a prediction about
  what the outcome of bargaining will be
• Otherwise how do decision makers look ahead to
  future pay-offs and work backwards (if they
  cant anticipate their pay-off)
• We looked at why bargaining often splits the
  surplus
• Note that this was bargaining with complete
  information. Otherwise there may be no
  agreement to divide surplus (examples strikes,
  disputes going to court rather than settling)

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Topic 3 Game Theory and Bargaining

• Almost all bargaining is a sequential game a
  series of offers and counter-offers
• Take it or leave it offers
• The player who can make a take it or leave it
  offer can claim most of the surplus, because
  there is no scope for a counter-offer.
• But this is constrained by the other players
  sense of fairness
• If there is a fixed number of rounds in the
  bargaining, then we can work backwards from
  the take it or leave it offer in the last
  round. Then calculate what offers will be
  accepted by the respective players in
  each previous round
• If there are many rounds of offer and counter
  offer then expect surplus to be divided
  evenly (ice cream example, hotel example)
• Players will get less of the surplus if they
  have higher delay costs and lower negotiating
  skill

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Topic 3 Game Theory and Bargaining

• BATNA -- Best alternative to a negotiated
  settlement
• For a buyer an improved BATNA reduced the WTP
• For a seller an improved BATNA increases the
  WTS
• Improved alternatives gives any party a better
  negotiating position. This is obvious
  intuitively. But our framework shows exactly
  how alternatives to the negotiation feed into
  speceific expected outcomes.
• Your BATNA determines your WTP or WTS
• Pay-off to A if agree -- Pay-off to A if dont
  agree As BATNA
• Pay-off to B if agree Pay-off to B if
  dont agree Bs BATNA

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Topic 4 Added Value

• Your value added
• (Total Value with you in the game) minus
• (Total Value without you in the game)
• Predictions about outcomes of negotiations
• Efficiency Players make decisions to
  maximize total value added
• Added value Cannot claim more than your value
  added
• Equity Equal bargaining power
• Efficiency
• Market problems can lead to decisions that do
  not maximize value added in the market.
• - Incomplete information
• - Incomplete contracts
• - Monopoly power

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Topic 4 Added Value

• Added Value
• Two player case
• - Added values are equal. Expect them to be
  evenly divided
• - If one player has an alternative use of
  resource then added value is reduced
  (their total pay-off goes up because they get
  BATNA plus half the reduced surplus)
• - Price moves in favour of the person who has
  an improved alternative
• - There is an obvious benefit to reducing the
  added value of the other player (you get one
  half of the reduction in their value added)

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Topic 4 Added Value

• Added Value (continued)
• Multi-player case more complicated
• - No individual or sub-group can get more than
  their value added
• - No individual or sub-group will accept less
  than their combined value added
• - These conditions taken together define a
  core of possible outcomes
• - An allocation is the division of the surplus
  among the players
• - BUT the core may not exist is some cases
  unstable bargaining. In that case seize the
  initiate and set the rules in your favour.

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Topic 5 Changing Added Values

• Co-operation versus competition (revisited in
  Topics 8 and 9)
• Your pay-off depends on your added value
• At the time of negotiations your added value is
  fixed
• BUT, you can take actions before hand to
• - increase your added value through increased
  demand, network effects etc. or
• - decrease the added value of other parties
  through artificial scarcity (if other party is
  a buyer), introduction of competition
  (if other party is a seller), raising rivals
  costs etc.
• Avoid sunk costs before division of added
  value.

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Topic 5 Changing Added Values

• Monopoly
• A market with single producer. A single buyer
  market is called a monopsony
• Natural supply side monopoly -- large fixed
  costs that if replicated by another producer
  would be inefficient (railways, water, gas and
  other utilities)
• Natural demand side monopoly -- product is
  more valuable to users the more users there
  are (Ebay, Windows, iTunes and other
  information products
• Creating artificial scarcity
• By reducing output monopolists reduced the
  total value added, BUT they also reduce the
  value added of the buyers.
• Monopolist gets a larger share of a smaller
  total amount of value added
• The reduction in total value is often socially
  unacceptable

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Topic 5 Changing Added Value

• Red card black card example
• This example is simple but powerful display of
  the advantage of reducing value added
  of other parties
• 26 black cards held by monopolist and 26 red
  cards held by buyers
• One black card plus one red card 10 Who
  gets what??
• What if monopolist destroys 3 black cards??
• What if monopolist finds 3 more red cards??
• Timing of bargaining
• Hold-up can occur where one party has made a
  sunk cost investment before the
  bargaining (or renogiation) is undertaken
• Problem is that it is difficult to write
  water-tight contracts that prevent hold-up
  in the future
• Reputation for not holding up others is one
  solution (Toyota)
• Another solution is to bring equipment or
  people inside the firm (part of the reason we
  have firms)

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Topic 6 Mass Market Pricing

• Strategies for setting prices in mass markets
• In mass markets sellers simply post prices.
• This amounts to a take it or leave it offer to
  buyers
• Buyers with WTP greater than the posted price
  will buy
• Firm sets the price to maximize its own profit
• Where MRFirm MCFirm
• MR Increase in total revenue from selling
  one more unit of output
• MC Increase in total cost from selling one
  more unit of output
• MR MC Increase in profit (TR TC) from
  producing one more unit of output
• Continue increasing output if MR MC gt 0
  because that increases total profit

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Topic 6

• Demand curve simply shows the highest to
  lowest WTP of buyers
• MR curve is below the D curve because MR P
  ?P.Q
• For a linear demand curve the MR curve has the
  same intercept on the price (Y) axis and twice
  the slope
• Elasticity of demand (Ep) is (1/slope) times
  (P/Q)

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Topic 6 Mass Market Pricing

• The total surplus (value added) is the sum of
  the shaded areas
• With uniform pricing the firm cannot get more
  than the blue area in surplus. The surplus
  economic profit fixed cost
• The monopolist will use more sophisticated
  pricing strategies to get at the other areas of
  surplus

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Topic 7 Innovative Pricing

• Uniform Pricing
• Charge a single price to all buyers.
• Set MR MC to get the price
• Non-linear Pricing
• Quantity discounts to make total sale price
  close to total WTP for both low volume and
  high volume buyers
• Two part pricing. Set P MC to maximize CS
  and then set connection price (entry
  price) CS
• Group pricing
• Charge prices based on willingness to pay
• Must be able to prevent low price buyers
  selling to high price
• Must be able to identify high WTP and low WTP
  buyers

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Topic 7 Innovative Pricing

• Versioning
• Create 3 (or more) versions of the product
  intended for high WTP, medium WTP, low WTP
  segments of the market (or more segments)
  
• Use the inclusion or ommission of features in
  the product to get buyers to self select in
  the product (and pricing level) intended for
  them
• Usually have 3 versions to guide extremeness
  averse buyers to the high volume middle
  version
• Bundling
• Where preferences of buyers vary sharply across
  different items in the same group (news vs
  movies vs sports in cable channels
  powerpoint vs excel vs windows in Office)
  and preferences cannot be observed
• Capture full WTP across the items for all
  buyers by selling bundle of items at the sum
  of WTP for items

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Topic 8 Competitive Pricing

• Game trees are used for analysing strategic
  decisions where the players move sequentially
• Game boxes (pay-off matrices) are used where
  the players move simultaneously
• Began with non-cooperative simultaneous games
• Write down the pay-off for each player in the
  game box

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Topic 8 Competive Pricing

• A players strategy is a description of the
  choices the players make on the basis of
  assumptions about what the other player(s) will
  do
• Which outcome do we expect to occur in this
  case where the players cannot observe each
  others moves
• An outcome (i.e., set of strategy choices for
  each player) is a Nash equilibrium, if each
  player -- holding the choices of other players
  as constant -- cannot do better by changing her
  own choice. Unilateral deviations are
  unprofitable
• Can find Nash Equilibria by studying the
  pay-off matrix
• In some cases can find the expected outcome by
  eliminating dominated strategies

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Topic 8 Competitive Pricing

• Competition in mass markets with homogenous
  products
• Compete on price Bertrand equilibrium
• Bertrand competition on price will arise where
  there is excess capacity and players do not
  co-operate
• Players undercut each other on price until P
  MC
• If capacity cannot equal demand at P MC then
  P price at all capacity is sold in the
  market
• Compete on quantity -- Cournot equilibrium
• Cournot equilibrium competition on quantity
  will arise where firms decide their
  production level simultaneously and before the
  selling period
• Each firm has a reaction curve
• The Nash equilibrium is the intersection of the
  reaction curves.

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Topic 9 Co-operation

• Co-operative equilibrium may arise between
  firms where
• The game is expected to be repeated
  indefinitely in the following periods
• If it is known that the game will end in a few
  periods time (because of regulation or the
  entry of new players, for instance) then
  co- operation cannot be sustained.
• Firms trust each other to act rationally

54
Topic 9 Cooperation

• Under what circumstances will they co-operate
• If the future expected pay-offs from
  co-operating are sufficiently high then we
  expect both firms to cooperate
• If neither firm wishes to move away from the
  cooperate strategy then cooperation is a dynamic
  Nash equilibrium
• We can calculate a discount factor at which
  cooperation can be expected
• The discount factor captures both the
  probability that the game will go on and
  the time value of money