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The Economic Framework
• For our purposes two basic sets of agents:
– Consumers
– Firms
• Interact through markets
• Faced with some economic environment
or market structure, each agent makes
Market Structure
• What is a market?
-Set of firms and consumers whose
interactions establish the price of products
that are viewed as close substitutes by
consumers (firms produce different
• When are brands ‘close substitutes’?
• Cross Price Elasticity
-Measures how responsive quantity
demanded is to changes in price of other
-% change in quantity demanded of X / %
change in price of Y.
Market Power
• Ability to raise price above marginal cost
• Interested in strategies that can be used to
obtain and/or preserve market power
-pricing strategies
-product positioning strategies
-choice of quality
-advertising strategies
-R&D strategies
Market power depends on:
i) Demand Elasticity
ii) Market concentration
iii) Collusive behaviour
Market Structure
Perfect Competition vs Monopoly
Perfect Competition
• Perfectly competitive environment
-large number of small producers
-identical product
-perfect information
-free entry into and exit from market
- price takers
• Firms choose output level to maximize
Max Profits=Revenue-Costs
Max PxQ-C(Q)
What Q should the firm choose?
The one that makes MR=MC
At Ph: eco profits
At Pl : eco losses
• In the long run 2 things can happen:
-firms in industry can adjust their fixed
factors to maximize profits
-new firms can enter, old firms can leave
As a result, all firms break even in the long
• A single firm serves an entire market for a
good that has no close substitutes
• Why are some markets monopolized?
- Cost advantages over other firms
- Government created
Monopolists are price makers
• Amount of output they sell responds
continuously as a function of the price they
• In fact, they can charge a price above
MC—they have market power
• Operate where MR=MC
• What is MR?
-MR= ∆R /∆Q= ∆(PxQ)/∆Q
-So, P[1+1/E]=MC
Price is marked-up over marginal cost
What is a Game?
• A game describes any situation:
– involving the interaction of two or more
– in which the individuals can make choices that
affect the “outcome” of the interaction
How Do We Describe a Game?
• A game is described by:
– number of players/agents
– the “strategies” available to each player
– each player’s preferences over outcomes of
the game
• For any game, a strategy choice by each
one of the players results in a unique
outcome of the game
What is a Strategy?
• A strategy is an action plan for a player. It
– what action the player takes
– when the player takes the action
– the way that the action choice depends on the
information the player has when taking the
• Two action plans that specify different
actions represent two different strategies
• Dominant Strategy
-yields at least as high a payoff as any other
strategy available to agent regardless of
strategy choices of other agents
Predicting Behavior in Games
• If games are to help us understand
observables, we need a way of predicting
how agents behave in game settings; i.e.,
we need a notion of equilibrium for games
• Some equlibrium notions:
• Dominant strategy equilibrium
• Nash equilibrium
Dominant Strategy Equilibrium
Roughly speaking a Dominant strategy
equilibrium has the feature that each
player’s strategy choice is best for that
player regardless of other players’ strategy
Nash Equilibrium
Roughly speaking a Nash equilibrium has
the feature that each player’s strategy
choice is best for that player given other
players’ strategies
– each player acts in a purely self-interested
way and seeks to be as “well off” as possible
– in making a strategy choice, each player
forms beliefs about what strategies the other
players are choosing
– These beliefs are correct in equilibrium