4.6 — contestable markets & wra p up

4.6 — Contestable Markets & Wrap UpECON 306 · Microeconomic Analysis · Fall 2020Ryan Safner Assistant Professor of Economics [email protected] ryansafner/microF20 microF20.classes.ryansafner.com

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mailto:[email protected]

https://github.com/ryansafner/microF20

https://microf20.classes.ryansafner.com/

Game Theory: Some Generalizations


There's a lot more to game theory than aone-shot prisoners' dilemma:

one shot vs. repeated game

discrete vs. continuous strategies

perfect vs. incomplete vs. andasymmetric information

simultaneous vs. sequential game

See my game theory course for more(likely taught next in Fall 2021)

Game Theory: Some Generalizations


https://ryansafner.com/courses/econ316/

We use "solution concepts" to allow usto predict an equilibrium of a game

Nash Equilibrium is the primarly solutionconcept

Note it has many variants dependingon if games are sequential vs.simultaneous, perfect vs. imperfectinformation, etc.

Solution Concepts


Recall, Nash Equilibrium: no players wantto change their strategy given whateveryone else is playing

All players are playing a bestresponse to each other

Solution Concepts: Nash Equilibrium


Important about Nash equilibrium:

N.E. the "best" oroptimal outcome

Recall the Prisoners' Dilemma!

Game may have multiple N.E.

Game may have no N.E. (in "pure"strategies)

Solution Concepts: Nash Equilibrium

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A Coordination GameNo dominant strategies

Example: Coordination Game


Two Nash equilibria: (A,A) and (B,B)Either just as goodCoordination is most important



Two general methods to solve for Nashequilibria:

1) Cell-by-Cell Inspection: look in each cell,does either player want to deviate?

If no: a Nash equilibriumIf yes: not a Nash equilibrium




2) Best-Response Analysis: take theperspective of each player. If the otherplayer plays a particular strategy, what isyour strategy(s) that gets you the highestpayoff?

Ties are allowedAny cell where both players are playing abest response is a Nash Equilibrium



Player 1's best responses






Player 2's best responses






N.E.: each player is playing a best response






Two Nash equilibria again: (A,A) and (B,B)

But here (A,A) (B,B)!

A Change in the Game



Path Dependence: early choices mayaffect later ability to choose or switch

Lock-in: the switching cost of movingfrom one equilibrium to anotherbecomes prohibitive

Suppose we are currently in equilibrium(B,B)

Inef�cient lock-in:

Standard A is superior to BBut too costly to switch from B to A

A Change in the Game


Contestable Markets


Now that we understand Nashequilibrium...

Are outcomes of other market structuresNash equilibria?

Is Monopoly a Nash Equilibrium?


Now that we understand Nashequilibrium...

Are outcomes of other market structuresNash equilibria?

Perfect competition: no �rm wants toraise or lower price given the marketprice




Monopolist maximizes by setting :

and

This is an equilibrium, but is it the onlyequilibrium?

We've assumed just a single player in themodel

What about potential competition?


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Model the market as an entry game, withtwo players:

1. Incumbent which sets its price

2. Entrant decides to stay out or enter themarket, setting its price

Price competition between 2 �rms withsimilar products consumers buy only from �rm with lowerprice

Contestable Markets I

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Suppose �rms have costs of

If Incumbent sets , then Entrant would enter and set

(for arbitrary

Contestable Markets II


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Suppose �rms have costs of

If Incumbent sets , then Entrant would enter and set

(for arbitrary

Incumbent would forsee this, and tryto price lower than

undercutting continues until...



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Nash Equilibrium: incumbent sets , no entry

A market with a single �rm, but thecompetitive outcome!

,

competitive max Consumer Surplus, no DWL



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What if the entrant has higher costs thanthe incumbent: ?




What if the entrant has higher costs thanthe incumbent: ?

Nash equilibrium: incumbent sets

arbitrary

Entrant stays out

One �rm, but not a worst case monopoly






What if there are �xed costs, ?

With high enough , Economies of scale may prevent

marginal cost pricing from a beingpro�table Nash Equilibrium

Contestable Markets III






Nash equilibrium: Incumbent prices at earns

Entrant stays out

Again, single �rm, but not a monopoly

no pro�tsnot allocatively ef�cient,

, some DWL

Contestable Markets IV

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Markets are contestable if:

1. There are no barriers to entry or exit2. Firms have similar technologies (i.e.

similar cost structure)3. There are no sunk costs

Economies of scale need not beinconsistent with competitive markets(as is assumed) if they are contestable

Generalizes "prefect competition" modelin more realistic way, also game-theoretic

Contestable Markets: Recap


William Baumol

(1922--2017)

"This means that...an incumbent, even if he canthreaten retaliation after entry, dare not offer pro�t-making opportunities to potential entrants because anentering �rm can hit and run, gathering in the availablepro�ts and departing when the going gets rough."

Contestable Markets: Summary

Baumol, William, J, 1982, "Contestable Markets: An Uprising in the Theory of Industry Structure," American Economic Review, 72(1): 1-15


Regulation & antitrust (once) focus(ed)on number of �rms

"Count the number of �rms, if it's 1,it's a monopoly!"

Perfect competition as "gold standard",only market arrangement that is sociallyef�cient:

Allocatively ef�cient: ,

Implications for Competition

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But number of �rms is endogenous andcan evolve over time!

Function of how �rms mutuallyinteract strategically

A more dynamic situation: �rms respondover time



Perfect competition not the only sociallyef�cient market-structure

Small number of �rms (including 1)may be ef�cient if they arecontestable

Regulation and antitrust should considerwhether a market is contestable, not justthe number of �rms

Free entryNo sunk costs



Firms engaging in egregious monopolisticbehavior ,

, ,) largely persist

because of barriers to entry

Attempts to make marketuncontestable

Business activities or political dealingswith the goal to raise


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Monopoly Or Contestable Market?


"Of far greater concern toMicrosoft is the competition fromnew and emerging technologies,some of which are currently visibleand others of which certainly arenot. This array of known, emerging,and wholly unknown competitorsplaces enormous pressure onMicrosoft to price competitivelyand innovate aggressively."(Schmalensee 1999)

Contestable Markets


Contestable Markets


In perfect competition (model):

price-taking �rms set price equal tomarginal costlong run economic pro�ts are zeroallocative ef�ciency: consumer andproducer surplus maximized

This is a tendency only because of freeentry and exit

So What's the Point of the Models?


Don't judge real markets by theirsimilarity to the perfect competitionmodel

Judge them more on their level ofcontestability, ease of potential entry



"...In that Empire, the Art of Cartography attainedsuch Perfection that the map of a single Provinceoccupied the entirety of a City, and the map of theEmpire, the entirety of a Province. In time, thoseUnconscionable Maps no longer satis�ed, and theCartographers Guilds struck a Map of the Empirewhose size was that of the Empire, and whichcoincided point for point with it. The followingGenerations, who were not so fond of the Study ofCartography as their Forebears had been, saw thatthat vast Map was Useless..."

Jorge Luis Borges, 1658, On Exactitude in Science



Economics Uses, but Is Not Limited to, Math


Optimization

Agents have objectives they value

Agents face constraints

Make tradeoffs to maximize objectiveswithin constraints

Equilibrium

Agents compete with others over scarceresources

Agents adjust behaviors based on prices

Stable outcomes when adjustments stop

The Two Major Models of Economics as a “Science”


Economics Is Broader Than You Think


4.6 — contestable markets & wra p up

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