Feb 27 2009

## The “delicate balance of terror”: How game theory can be used to predict firm behavior (oh, and save the human race from utter annihilation)

This week in AP Microeconomics students get to play online games, watch movies, and compete with their classmates in strategic competitions in which there are proud winners and sad losers. That’s right, we’re studying oligopoly!

What makes oligopolistic markets, which characterized by a few large firms, so different from the other market structures we study in Microeconomics? The answer is that unlike in more competitive markets in which firms are of much smaller size and one firm’s behavior has little or no effect on its competitors, an oligopolist that decides to lower its prices, change its output, expand into a new market, offer new services, or adverstise, will have powerful and consequential effects on the profitability of its competitors. For this reason, firms in oligopolistic markets are always considering the behavior of their competitors when making their own economic decisions.

To understand the behavior of non-collusive oligopolists, economists have employed a mathematical tool called Game Theory. The assumption is that large firms in competition will behave similarly to individual players in a game such as poker. Firms, which are the “players” will make “moves” (referring to economic decisions such as whether or not to advertise, whether to offer discounts or certain services, make particular changes to their products, charge a high or low price, or any other of a number of economic actions) based on the predicted behavior of their competitors.

If a large firm competing with other large firms understands the various “payoffs” (referring to the profits or losses that will result from a particular economic decision made by itself and its competitors) then it will be better able to make a rational, profit-maximizing (or loss minimizing) decision based on the likely actions of its competitors. The outcome of such a situation, or game, can be predicted using payoff matrixes. Below is an illustration of a game between two coffee shops competing in a small town.

As illustrated above, the tools of Game Theory, including the “payoff matrix”, can prove helpful in helping firms decide how to respond to particular actions by their competitors in oligopolistic markets. Of course, in the real world there are often more than two firms in competition in a particular market, and the decisions that they must make include more than simply to advertise or not. Much more complicated, multi-player games with several possible “moves” have also been developed and used to help make tough economic decisions a little easier in the world of competition.

While Game Theory can be useful in predicting firm behavior in oligopolistic markets, believe it or not that is not its most useful application developed. In fact, would you believe me if I told you that Game Theory may be precisely what saved the world from nuclear holocaust during the 20th Century? It’s true. The US government employed Game Theory to avert annihilation by nuclear attack from the Soviet Union during much of the 20th Century. This video tells the story!

Feb 25 2009

## Starbucks instant coffee: a sign of the times?

Chicago, Seattle first markets to get instant Starbucks — chicagotribune.com

I consider myself a Seattleite. I discovered the joy of drinking coffee in the home of Starbucks, Tully’s, Seattle’s Best, and countless local coffee shops that inhabit every corner of the rainy city. To me, the experience of drinking a latte, machiato, cappuccino, or simply a “coffee of the week” encapsulates the smells, soft decor and friendly greetings from the barista at my favorite coffee shop. Living overseas, I have turned to Starbucks over and over for a taste of Seattle and a feeling of home.

There is no denying that the Starbucks experience is one that does not come cheap. Here in Switzerland, a grande latte, my drink of choice, sets the consumer back nearly \$7. In an economic downturn such as that the US and the rest of the world are experiencing right now, such expenses are often the first to be reduced by cash strapped consumers. In fact, I recently began bringing a thermos of homemade coffee to work every day, rather than stopping at the Starbucks at the train station as I had done for several months not long ago.

Starbucks, which recently announced the closure of hundreds of its locations around the world, is actually expanding its product line while simultaneously closing down shops. It may not be in the way you expect, though. Soon, I’ll be able to get my \$7 cup of coffee for as little as \$1, it will just come in a different form:

Starbucks Corp. will launch its new instant coffee product next month in Chicago and its home turf of Seattle, with a full-scale, national offensive set for the fall.

Starbucks on Tuesday formally unveiled the new product, called Via Ready Brew. It will be available in Starbucks retail outlets in the Chicago and Seattle areas on March 3, Howard Schultz, the company’s chief executive, said in an interview with the Tribune.

Instant coffee from the king of gourmet blends? Sounds suspicious. Well, it’s all about economics, you see. Starbucks coffee is a normal good, one for which demand falls as incomes fall, as evidenced by falling sales at its coffee shops around the world. In order to maintain its customer base even as incomes fall, a company like Starbucks must expand its product line to include inferior products, or those for which demand increases even as incomes fall. Clearly, instant coffee is viewed as an inferior product, due to its significantly lower price and reputation of poor quality.

Furthermore, Starbucks’ new product is in response to increased competition from lower-end fast food chains that traditionally did not compete in the coffee market, but recently have begun offering various blends and varieties of coffee to the price-sensitive coffee consumers, further harming business at Starbucks’ higher end coffee outlets.

Via marks Starbucks second announcement this month of a cheaper menu alternative, as the famous coffee chain struggles in a weak economy. Starbucks is also now selling pairings of coffee and breakfast offerings for \$3.95.

Starbucks’ troubles have occurred at the same time value-oriented fast-food chains, particularly Oak Brook-based McDonald’s Corp., have thrived. McDonald’s owes part of its success to improving the quality of its basic coffee, and expanding into new drinks like iced coffee, and, more recently, flavored specialty coffees such as lattes and cappuccinos.

Still, Schultz said McDonald’s coffee offensive hasn’t really affected Starbucks: “We have a lot of respect for McDonald’s as a company. But we have not seen any significant issues with McDonald’s share of the coffee business affecting Starbucks.”

McDonald’s offers “a different product, a different value proposition,” he said. In fact, Schultz said McDonald’s should expand the overall coffee market, thus leading some customers to “trade up” to Starbucks.

Despite the CEO’s claims that Starbucks and McDonald’s coffees are “different” products, it is clear by his firm’s decision to expand into the instant coffee market that Starbucks is concerned about the loss of customers to lower-end coffee retailers.

The theory of firm behavior as studied in AP and IB Economics teaches us that firms in oligopolistic or monopolistically competitive markets, such as that for coffee shops in the US, tend to compete using non-price methods such as product differentiation and advertising. Rather than slashing the prices of all of its coffee in the face of a recession and falling consumer incomes, Starbucks has instead diversified its product line to include lower end options for consumers whose sensitivity to price and demand for gourmet coffee have been adversely affected by the weak economy.

Jan 28 2009

## Product differentiation in imperfectly competitive markets – the MacBook Wheel

In  IB Economics, we are currently learning about how firms in imperfectly competitive markets differentiate their products in order to increase their market power and their price-making power.

In a market with a few large firms such as the laptop computer market, companies must do what they can to increase demand for their own products over those of their competitors. Apple Computer is an example of a company that has successfully differentiated its line of laptop computers in recent years, regularly improving the features of its line of MacBooks to attract consumers away from its competitors and into the world of Macs.

Last year Apple launched the MacBook Air, the lightest and thinnest laptop on the market, creating a huge buzz in the technology world and converting millions to Apple’s line of laptops. This year, Apple has launched yet another innovation in laptop computing, in the hope of once again increasing demand for its products, and making consumers think they cannot live without the sleek, shiny Apple computers. This year’s innovation? The “MacBook Wheel”… watch:

Apple Introduces Revolutionary New Laptop With No Keyboard

The goal of an imperfectly competitive firm like Apple is to increase its market power by increasing demand for its particular product through product differentiation, advertising, developing brand loyalty, and “hype”: all forms of non-price competition. If Apple were to simply charge a lower price than its competitors for its products, it would also succeed in increasing the amount of computers it sells to consumers, but may also end up accepting lower profits due to the lower prices it must sell for.

Through differentiation, which means making its products unique and attractive to consumers, Apple attempts to increase market demand for its computers, while simultaneously making demand less elastic. With higher, more inelastic demand, Apple gains price-making power over the laptop computer market, as can be seen in the graphs below, which show that after the successful launch of a new product like the MacBook wheel Apple is able to charge a higher price, produce a similar quantity, and earn greater economic profits.

In the video, one customer says that he’d buy “buy almost anything if it’s shiny and its made by Apple”. Such statements reflect that among loyal customers, demand for Apple’s products is highly inelastic. While the firm is certainly not a monopolist in the market for laptop computers, Apple has surely succeeded to increase its market power and thus its power over prices through product differentiation, brand loyalty, and the “hype” surrounding the launch of new products like the MacBook Wheel.

Discussion questions:

1. In the graphs above, the slopes of the demand curve increases after successful product differentiation by Apple. Why does this happen?
2. Assuming the market for laptop computers is monopolistically competitive, what will likely happen to Apples economic profits over time? What must Apple do if it wishes to maintain its profits in the long-run?
3. What are some real ways companies like Apple and its competitors have attempted to differentiate their products over the years? Would YOU buys a MacBook Wheel if it were real?

Dec 05 2007

## Is Nokia in denial?

As we know, oligopolistic markets are characterized by a few large firms which act interdependently based on the actions of one another. Examples of such interdependence may include pricing and output behavior, advertising behavior, sales and promotions, non-price competition, services offered to consumers, and so on. The “game” of oligopoly is played with one very important goal in mind: maintaining market share in the face of competition from rivals.

In a previous post I discussed some of the strategies Apple has used to break into the oligopolistic market for cellular phones, which it recently did by introducing the thus far wildly successful iPhone. A chart in that post showed that as of earlier this year, the dominant firm in the mobile phone market was Nokia, with a market share of 35.1%. Apple was not even a competitor in this market until July of this year, which saw the successful launch of the iPhone, causing some of the incumbent mobile phone makers to pay close attention to the newcomer’s behavior.

Nokia executives, however, appear to be in denial of the potential threat posed by the iPhone to its dominance in the cell phone industry:

Nokia managers would never admit to being influenced by the Apple iPhone, which mobile phone industry insiders regard as clever but technologically unimpressive. “We don’t determine strategy based on the competition,” insists Anssi Vanjoki, Nokia executive vice-president and general manager for multimedia. “The consumer is our compass.”

Nov 17 2007

## Does Apple stand a chance?

China Mobile negotiating with Apple to carry iPhone

Try try as he might, Steve Jobs and Apple can barely launch their hottest new product, the iPhone, before the Chinese have copied it and put a knockoff on the market as quickly as you can say “can you hear me now?” But what is Apple doing making a cell phone anyway? Isn’t the mobile phone market pretty much dominated by a few big name companies already? How will apple ever survive in a market with such well established firms as Nokia, Samsung, and Motorola?

The answer is through product differentiation. The iPhone is truly an innovative little gadget. More than an MP3 player, more than a cell phone, the iPhone has features that differentiate it from most products available from the established firms in the mobile phone market. Like any firm, Apple advertises its iPod through commercials and other media in order to inform consumers about what makes its product special. What message does the following advertisement send about the iPhone?

The table below shows the market shares of the larges mobile phone makers as of late last year (before the release of the iPhone). A simple calculation finds that the four firm concentration ratio in the mobile market was 75.6%, clearly putting the market in the realm of an oligopoly (a market in which the four firm concentration ration is 40%).

With 75% of the market being controlled by Nokia, Motorola, Samsung and Sony Ericsson, the question arises whether Apple will be able to overcome the barriers to entry in the mobile market and establish itself as one of the big boys. Apple’s strategy for profits and market penetration certainly leverages the power of product differentiation and non-price competition, both firm behaviors common among firms in oligopolistic markets.

To make matters worse for Apple, only months after the iPhones release, and in the midst of negotiations between Apple and China Mobile to officially launch the product in China, a cheap, 4 GB knock-off of the fancy device comes along to entice Chinese consumers away from the 5,000 RMB (nearly \$700) real deal. Check this thing out… would you be able to tell the difference?

Discussion Questions:

1. What barriers to entry exist in the market for mobile phones?
2. Why do you think so few firms produce mobile phones?
3. Do you think Apple will be able to successfully penetrate the mobile market?
4. What threat do cheaper “knock-offs” of the Apple iPhone pose to Apples attempts to compete in China’s mobile market?

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