BUSB200F
Integrated Business Foundation
Module 6: Economic Thinking for Business
Tutorial Notes 10
Revision on Oligopoly
Financial Market (Foreign Exchange Market)
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Revision on Oligopoly
2
Oligopoly
• Oligopoly
– Few sellers offering similar or identical products
– Interdependent firms
– Best off cooperating and acting like a monopolist
by producing a small quantity of output and
charging a price above marginal cost
• Duopoly
– An oligopoly with only two members. It is the
simplest type of oligopoly
Interaction in Oligopolies
• In Oligopolies, firms have to take in
consideration of other firms’ action.
– Example: If there are only 2 firms in Hong Kong
supply water, Firm A & Firm B. If Firm A maintains
a high pricing strategy, what should Firm B do? If
Firm B cuts the price, what should Firm A do?
• The mutual interdependence of firms’ behaviors is
known as strategic interactions between firms
• Game Theory: the study of how people behave in
strategic situations
Copyright© 2003 Southwestern/Thomson Learning
Bonnie’ s Decision
Confess
Confess
Bonnie gets 8 years
Clyde gets 8 years
Bonnie gets 20 years
Clyde goes free
Bonnie goes free
Clyde gets 20 years
gets 1 yearBonnie
Clyde gets 1 year
Remain Silent
Remain
Silent
Clyde’s
Decision
The Prisoners’ Dilemma
What would be the outcome?
• Suppose Clyde confesses, if you are Bonnie …
– Confess >>> 8 years in jail
– Silent >>> 20 years in jail !!
– Bonnie should confess
• Suppose Clyde remains silent, if you are Bonnie
…
– Confess >>> free
– Silent >>> 1 year in jail!!
– Bonnie should confess
• No matter Clyde chooses, Bonnie will confess!!
What would be the outcome?
• Dominant strategy
– The best strategy for a player to follow regardless of
the strategies chosen by the other players.
(In the Prisoners’ Dilemma, Confess is the dominant
strategy)
• Nash Equilibrium
– The equilibrium situation at which each player does
not have an incentive to deviate from the chosen
strategy, assuming other players follow the chosen
strategies.
(In the Prisoners’ Dilemma, both of them confess is the
Nash Equilibrium)
Implication
• Nash Equilibrium is not necessary efficient
• If both remain silent, they would be better off
(only suffer 1 year in jail compares to 8 years)
• Implication:
– Often people (firms) fail to cooperate with one
another even when cooperation would make
them better off
Why firms cooperate?
• Self-interest makes it difficult for the oligopoly
to maintain a cooperative outcome with low
production, high prices, and monopoly profits.
• Firms that care about future profits will
cooperate in repeated games rather than
cheating in a single game to achieve a one-
time gain.
Collusion and Cartels
• The oligopolists may agree on a monopoly
outcome.
– Collusion
• An agreement among firms in a market about
quantities to produce or prices to charge.
– Cartel
• A group of firms acting in unison.
• Caterl-monopoly
Shell and Exxon Oligopoly Game
EXXON’s payoff
EXXON sells 40
Gallons
EXXON sells 30
Gallons
SHELL’s payoff
SHELL sells 40
Gallons
(1600, 1600)
(SHELL, EXXON)
(2000, 1500)
(SHELL, EXXON)
SHELL sells 30
Gallons
(1500, 2000)
(SHELL, EXXON)
(1800, 1800)
(SHELL, EXXON)
Shell and Exxon Oligopoly Game
• Dominant strategy: sell 40 gallons
• Nash Equilibrium: both sell 40 gallons
• Total Output: 80 gallons
• Price per gallon: $40
• If they cooperate: both sell 30 gallons
• Total Output: 60 gallons
• Price per gallon: $60
Implication
• If Shell and Exxon cooperate, the two firms
would be benefited
• Cooperation is difficult to maintain, because
cooperation is not in the best interest of the
individual player.
• Cooperation among oligopolists is undesirable
from the standpoint of society as a whole
because it leads to production that is too low
and prices that are too high
Example
• The payoff table of two companies “Firm B”
and “Firm A” are as follow:
Firm B
Firm A
High price Low price
High price (2000,6000) (500,10000)
Low price (3000,4000) (1000,5000)
• Determine the dominant strategy of “Firm B” and
“Firm A” respectively. Find the Nash equilibrium.
Example
• First Step: Identify the payoffs
Firm B
Firm A
High price Low price
High price (2000,6000) (500,10000)
Low price (3000,4000) (1000,5000)
Example
• Consider opponent’s action first.
• If you want to know the strategy of Firm A:
– You should assume Firm B takes certain action.
(cut price or hold price)
Firm B
Firm A
High price Low price
High price (2000,6000) (500,10000)
Low price (3000,4000) (1000,5000)
Example
• Assume Firm B keeps a high price:
– If Firm A keeps high price, payoff is 2000.
– If Firm A keeps low price, payoff is 3000.
– Payoff of low price (3000) > Payoff of high price (2000)
– So Firm A should keep low price when Firm B keeps a high price
Firm B
Firm A
High price Low price
High price (2000,6000) (500,10000)
Low price (3000,4000) (1000,5000)
Example
• Assume Firm B keeps a low price:
– If Firm A keeps high price, payoff is 500.
– If Firm A keeps low price, payoff is 1000.
– Payoff of low price (1000) > Payoff of high price (5000)
– So Firm A should keep low price when Firm B keeps a low price
Firm B
Firm A
High price Low price
High price (2000,6000) (500,10000)
Low price (3000,4000) (1000,5000)
Example
– Firm A should keep low price when Firm B keeps a high price
– Firm A should keep low price when Firm B keeps a low price
• Conclusion: Firm A will set low price regardless of Firm B’s
strategy, so Firm A’s dominant strategy is to set low price.
Firm B
Firm A
High price Low price
High price (2000,6000) (500,10000)
Low price (3000,4000) (1000,5000)
Example
• Same procedure for Firm B …
• First assume the opponent Firm A takes an action …
• If Firm A keeps a high price …
• Firm B should …
Firm B
Firm A
High price Low price
High price (2000,6000) (500,10000)
Low price (3000,4000) (1000,5000)
Example
• If Firm A keeps a low price …
• Firm B should …
• So conclusion: Firm B should …
Firm B
Firm A
High price Low price
High price (2000,6000) (500,10000)
Low price (3000,4000) (1000,5000)
Sequential Game
Sequential Game
• There is a first mover in the market, the other
competitors have to designed whether or not
to enter the market.
• Rules:
– First assume the first mover to take one action
– Identify the corresponding competitor’s action
– Compare the payoff and determine first mover’s
action
Example
• Firm C and Firm D are deciding to launch one of the new flavour potato
chips: Sweet or Spicy. Suppose Firm C can launch the product first and
their payoff can be represented by the following tree diagram:
Firm C
Firm D
Firm D
(5, 5)
(15, 10)
(10, 15)
(5, 5)
Sweet
Sweet
Sweet
Spicy
Spicy
Spicy
C D
Example
• Step 1: compare the payoff of the second mover under different scenarios:
Firm C
Firm D
Firm D
(5, 5)
(15, 10)
(10, 15)
(5, 5)
Sweet
Sweet
Sweet
Spicy
Spicy
Spicy
C D
Firm D should choose Spicy
if Firm C chooses Sweet
Firm D should choose Sweet
if Firm C chooses Spicy
Example
• Step 2: base on second mover’s choices, find the payoff to first mover
under different scenarios.
Firm C
Firm D
Firm D
(5, 5)
(15, 10)
(10, 15)
(5, 5)
Sweet
Sweet
Sweet
Spicy
Spicy
Spicy
C D
Firm C gets 15 if
it chooses Sweet
Firm C gets 10 if
it chooses Spicy
Example
• Step 3: State the outcome.
Firm C
Firm D
Firm D
(5, 5)
(15, 10)
(10, 15)
(5, 5)
Sweet
Sweet
Sweet
Spicy
Spicy
Spicy
C D
As the payoff of Sweet (15) to Firm C is higher than
Spicy (10), Firm C will choose Sweet and Firm D will
choose Spicy. The payoff to Firm C and D are 15 and
10 respectively
Foreign Exchange Market,
Nominal Exchange Rate &
Real Exchange Rate
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Foreign Exchange Market
• Nominal exchange rate: value of one country’s
currency in terms of another country’s currency
• Two ways to express exchange rate:
(Assume USD as local currency)
• Example:
– Unit of foreign currency per local currency
• Example: 1USD = 111.134 JPY
– Unit of local currency per foreign currency
• Example: 1 JPY = 0.009 USD
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Foreign Exchange Market
• Demand curve of currency is downward
sloping and Supply curve is upward sloping
(Unit of foreign currency/one unit of local currency)
• Currency appreciation
– Increases in market value of local currency to
foreign currency
• Currency depreciation
– Decreases in market value of local currency to
foreign currency
Exchange rate
USD / Euro
(1 USD to _ Euro)
0 Quantity
0.880
Equilibrium
quantity
Supply
Demand
Example of Foreign Exchange Market
(The market to determine the value of local currency: USD)
Excess Supply
Excess Demand
0.860
0.900
Foreign Exchange Market
• The demand curve for local currency is downward
sloping. When local currency appreciates:
– The price of local produced good increases relative to
other countries, the demand for locally produced
good decreases, hence the quantity demanded for
local currency decreases (Foreigners need local
currency to purchase locally produced good)
– The cost to invest in local asset increases, the demand
for local assets decreases, hence the quantity
demanded for local currency decreases
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Foreign Exchange Market
• The supply curve for local currency is upward
sloping. When local currency appreciates:
– The price of foreign produced good decreases relative
to local good, the demand for foreign produced goods
increases, hence the quantity supplied for local
currency increases (in order to exchange foreign
currency to purchase foreign goods).
– The cost to invest in foreign asset decreases, the
demand for foreign assets increases, hence the
quantity supplied for local currency increases.
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Factors affect the demand and supply
• Factors that shifts the demand curve of local
currency (cause by factors other than changes
in nominal exchange rate):
– Demand for local produced goods and services
– Desire to invest in local country
– Expectation on future value of local currency
– Interest rate in local country
Factors affect the demand and supply
• Factors that shifts the supply curve of local
currency (cause by factors other than changes
in nominal exchange rate):
– Demand for foreign produced good and services
– Desire to invest in foreign countries
– Expectation on future value of foreign currencies
– Interest rate in foreign countries
The Real Exchange Rate
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• Real exchange rate: price of domestic goods in
terms of foreign goods
Real Exchange Rate =
P = domestic price
P* = foreign price (in foreign currency)
e = nominal exchange rate
(unit of foreign currency/one unit domestic currency)
e x P
P*
The Real Exchange Rate
• Example:
– a Japanese burger’s price is 200 Yen
– a US burger’s price is $1 USD
– the nominal exchange rate is 1USD to 100 Yen
• If US is the local economy, then the real exchange
rate is:
ℎ =
100 × 1
200
= 0.5
• Implication: 1 US burger is equal to 0.5 Japanese
Burger in terms of price. US burger is cheaper
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The Real Exchange Rate
• Real exchange rate reflects the relative price
of a product (or general price level) between
two economies.
– When real exchange rate > 1, local product is
more expensive
– When real exchange rate < 1, local product is
cheaper
– When real exchange rate = 1, local product price is
the same as foreign
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