Chapter 13:
STRATEGIC DECISION MAKING IN OLIGOPOLY MARKETS
Essential Concepts
▪ Interdependence of firms’ profits, which is the distinguishing feature of oligopoly markets, arises
when the number of firms in a market is small enough that every firm’s price and output decisions
affect the demand and marginal revenue conditions of every other firm in the market.
This chapter is divided into four sections: Section 13.1 examines simultaneous decisions, Section 13.2
examines sequential decisions, Section 13.3 examines repeated decisions, and Section 13.4 examines
strategic entry deterrence. The Essential Concepts for this chapter are organized accordingly.
Simultaneous Decisions:
1. Simultaneous decision games occur when managers must make their individual decisions without
knowing the decisions of their rivals.
2. A dominant strategy is a strategy or action that always provides the best outcome no matter what
3. A dominant strategy equilibrium exists when all decision makers have dominant strategies.
4. A prisoners’ dilemma arises when all rivals possess dominant strategies, and in dominant strategy
5. When a firm does not have a dominant strategy, but at least one of its rivals does have a dominant
6. Dominated strategies are strategies or decisions that are never the best strategy for any of the
decisions that rivals might make. Therefore, a dominated strategy would never be chosen and should
7. Strategically astute managers will search first for dominant strategies, and, if no dominant strategies
can be discovered, they next look for dominated strategies. When neither form of strategic dominance
exists, decision makers must employ a different concept for making simultaneous decisions.
8. In order for all firms in an oligopoly market to be predicting correctly each others’ decisions—
managers cannot make best decisions without making correct decisions—all firms must be choosing
9. A Nash equilibrium is a set of actions or decisions for which all managers are choosing their best
actions given the actions they expect their rivals to choose.
10. In Nash equilibrium, no single firm can unilaterally (by itself) make a different decision and do better.
11. When managers face a simultaneous decision-making situation possessing a unique Nash equilibrium
12. All dominant strategy equilibria are also Nash equilibria, but Nash equilibria can occur without either
dominant or dominated strategies.
13. Economists have developed a tool, called best-response curves, to analyze and explain simultaneous
decisions when decision choices are continuous rather than discrete. A firm’s best-response curve
Sequential Decisions:
1. In contrast to simultaneous decisions, the natural process of some decisions requires one firm to make
a decision, and then a rival firm, knowing the action taken by the first firm, makes its decision. Such
2. The easiest way to analyze sequential decisions is to use a game tree. A game tree is a diagram
3. When firms make sequential decisions, managers make best decisions for themselves by working
backwards through the game tree using the roll-back method. The roll-back method (also known as
backward induction) results in a unique path that is also a Nash decision path: Each firm does the best
for itself given the best decisions made by its rivals.
4. If letting your rivals know what you are doing by going first in a sequential decision game increases
5. To determine whether the order of decision making can confer an advantage when firms make
6. Managers can make strategic moves to achieve better outcomes for themselves, usually to the
detriment of their rivals. Only credible strategic moves matter; rivals ignore any commitments,
threats, or promises that will not be carried out should the opportunity to do so arise. There are three
types of strategic moves: commitments, threats, and promises.
Repeated Decisions:
2. Making noncooperative decisions is called “cheating” by game theorists, even though “cheating” does
not imply that the firms have made any kind of agreement to cooperate.
3. Cooperation is possible in every prisoners’ dilemma decision, but cooperation is not strategically
4. When decisions are repeated over and over again by the same firms, managers get a chance to punish
cheaters. When cheating can be punished by making credible threats of punishment in later rounds of
decision making, strategically astute managers can sometimes, but not always, achieve cooperation in
prisoners’ dilemmas.
5. Cooperation increases a firm’s value when the present value of the costs of cheating exceeds the
6. A widely studied category of punishment strategies is known in game theory as trigger strategies.
Managers implement trigger strategies by initially choosing the cooperative action and continuing to
7. The two most commonly studied trigger strategies are tit-for-tat and grim strategies.
a. In a tit-for-tat strategy, cheating triggers punishment in the next decision period, and the
8. Since cooperation usually increases profits, managers frequently adopt legal tactics, known as
facilitating practices, designed to make cooperation more likely. Four such tactics are price matching,
sale-price guarantees, public pricing, and price leadership:
a. Price matching: A firm commits to a price-matching strategy by publicly announcing, usually in
an advertisement, that it will match any lower prices offered by its rivals. This largely eliminates
Chapter 13: Strategic Decision Making in Oligopoly Markets
9. Cartels are the most extreme form of cooperative oligopoly. Essentially a cartel is an explicit
collusive agreement among firms to drive up prices by restricting total market output. Cartels are
illegal in the United States, Canada, Mexico, Germany, and the European Union.
10. Cartels find it extremely difficult to maintain cooperatively set cartel prices because cartel pricing
schemes are usually strategically unstable. The lack of strategic stability of cartels stems from the
11. A far less extreme form of cooperation among oligopoly firms is tacit collusion, which occurs when
oligopoly firms cooperate without an explicit agreement or any other facilitating practices.
Strategic Entry Deterrence
1. Strategic entry deterrence occurs when an established firm (or firms) makes strategic moves designed
to discourage or even prevent the entry of a new firm or firms into a market. Two types of strategic
moves designed to manipulate the beliefs of potential entrants about the profitability of entering are
limit pricing and capacity expansion.
2. Limit Pricing Under certain circumstances, an oligopolist, or possibly a monopolist, may be able to
3. Capacity Expansion Sometimes an established firm can make its threat of a price cut in the event of
entry credible by irreversibly increasing its plant capacity. When increasing production capacity
Answers to Applied Problems
1. McDonald’s major rivals responded with price cuts of their own. The WSJ reported that Burger King
responded by selling its “flagship” Whopper, with no strings attached, for 99 cents, $1 off regular
3. While all of these firms compete in the same market, personal-computers, Dell’s profits are more
interdependent with profits of HP and Gateway than with the profit of Apple because consumers can
4. The retailers were in a prisoner’s dilemma. They all wanted to close on Sunday to save money with
little loss of sales. But if one or a few closed, they would lose a great deal of sales to the firms that
were open. The government would enforce cooperation with Sunday closing laws.
5. By binding oneself to take an action that would otherwise not be in your best interest, you can alter
6. Although the evidence is not conclusive as to which type of market is most conducive to innovation,
more research and development (R&D) may occur in oligopoly markets due to mutual
7. If Gore can make a better decision for himself by knowing who Bush will choose to be his running
mate, then Gore experiences a second-mover advantage.
8. Crandall’s brass-knuckle style could be of strategic value if it gives Crandall a reputation for being a
“tough guy” who will seldom, if ever, back down on his threats or promises. Crandall’s tough-guy
9. Apparently Mr. Rodriquez believes OPEC members are more willing to lower prices together than to
raise prices together. The theory of cartels suggests he may be right. Suppose the price of crude oil is
10. If you believe there is no tomorrow, you may feel that there can be no future penalty for actions you
11. Mercedes USA, by asking all of its dealers to charge the same prices, appears to be dangerously close
to engaging in illegal price fixing. Perhaps the New Jersey dealer refused to follow the no-haggling
pricing policy because he thought it would reduce his profits to charge the same price as his rivals.
Chapter 13: Strategic Decision Making in Oligopoly Markets
12. Price matching makes cooperation to set high prices easier to achieve, which is bad news for
consumers.
13. a. Initially, when the program goes into effect, some buyers who were postponing a planned
purchase will buy in the current period, seeming to increase demand. After these buyers have
made their purchases, demand should return to approximately the same level as before the plan
14. a. By delaying the implementation, Advanta may be trying to protect itself should its rival credit-
card companies choose not to follow its initiative to raise fees. Furthermore, by just announcing
its “intentions” (i.e., signaling its desire to raise fees), Advanta does not actually raise its fees on
any customers, thereby avoiding a potentially unilateral price hike that could cost it substantial
15. a. For cell B (C), any pair of values with America’s payoff less (greater) than 1,000 and Britain’s
payoff greater (less) than 1,000 will work. For example: in cell B, $600, $1500 and in cell C,
$1500, $600 will create a prisoners’ dilemma.
16. a. If PV = $200, then Golden Inn faces the following demand-related functions:
Chapter 13: Strategic Decision Making in Oligopoly Markets
b. To find Nash equilibrium, you must find the intersection of the two best-response curves:
125 0.2[125 0.3125 ]
125 25 0.0625
N N
G G
N
G
P P
P
= + +
= + +
c. For prices PG = $165 and PV = $180, profits are:
p
G
o=(165–50)[5,000 –25(165)+10(180)]
=$307,625
17. a. If Whirlpool enters the market, Samsung’s best–response is to price at $1,000. Samsung’s threat
is not credible, so Whirlpool ignores it and enters the market. At a price of $1,000, Whirlpool
Chapter 13: Strategic Decision Making in Oligopoly Markets
b. If Samsung invests in extra production capacity, its best-response to entry by Whirlpool is to
price at $500, which discourages Whirlpool from entering since Whirlpool would lose $6
million by entering when price is $500. In order for the threat to be credible, investment in
c. The diagram below shows the Nash equilibrium path that leads to Samsung earning $24 million
and Whirlpool earning $0 because it does not enter the market.
Answers to Mathematical Exercises
1. Set P = c and solve for Qc to get Qc = (c – a)/b.
Set MR = c to get Qm
Chapter 13: Strategic Decision Making in Oligopoly Markets
b.
1 1
: ( ) 3000 2
J S J J J
BR q BR q q
– –
= = –
S
q
3000
3. a.
( ) 13.5 0.188
A A B B
P BR P P= = +
( ) 31.5 0.125
B B A A
P BR P P= = +
Chapter 13: Strategic Decision Making in Oligopoly Markets
b. See figure below. Note that the inverse of
( )
B A
BR P
,
1( ) 252 8
B B B
BR P P
–= – +
, is shown in the
figure below:
A
P
1( ) 252 8
B B B
BR P P
–= – +