Corporate Investment in Oligopolistic Market - Essay Example

First Question Introduction: Regarding the corporate investment viewpoint, the game theory has a great value for the specific industry that is specially characterized as an example of oligopoly market. So, before starting our discussion, we need have a specific idea of oligopoly competition. In terms of competitiveness, the spectrum of market structures reaches from pure competition, to monopolistic competition, to oligopoly to pure monopoly among them oligopoly market is dominated by a few large producers of a homogeneous or differentiated product. Because of their fewness, oligopolists have considerable control over their prices, but each must consider the possible reaction of rivals to its own pricing, output & advertising decision. Understanding the Game Theory: Oligopoly pricing behavior has the characteristics of certain game of strategy, such as poker, chess, & bridge. The best way to play such game depends on the way one's opponent plays. Players (& oligopolists) must pattern their actions according to the actions & expected reaction of rivals. The study of how people behave in strategic situations is called game theory. In other words, game theory analyzes the way that two or more players choose strategies that jointly affect each-other. This theory that sounds frivolous in its terminology is fought with significance & was largely developed by john Von Neumann (1903 - 1957), a Hungarian-born mathematical genius. Economists, union-management disputes, country's trade policies, international environmental agreements, reputations, & a host of other situations have used game theory. It offers insights for policies, welfare, & everyday life as well. Thus, similarly, in our motto in the market competition in the product market for business investment purpose, this theory has a major implication. To realize so, we will need to move for the further analysis. In price setting: Let's begin by analyzing the dynamics of price-cutting. Assume that there are two firms named as Starship & Uptown which are the two famous oligopolists firms in UK, producing athletic shoes. Here, the vertical rust arrows show uptown's price cuts; the horizontal rust arrows show Starship's matching each price cut. By tracing through the pattern of reaction & counter reaction, we can see that this kind of rivalry will end in mutual ruin at a 0 price. Why Because the only price compatible with both stratifies is a price of 0, 90% of 0 is 0. Finally, it dawns on the two firms- when one firm cuts its price, the other firm will match the price cut. Only if the firms are shortsighted will they think that they can undercut each-other for long. So, they will think that- What will my rival do if I cut my price or raise my price Basic Explanation: In a duopoly market, it is assumed that each firm has the same cost & demand structure, each can choose whether to charge its normal or lower price below marginal cost & try to drive its rival into bankruptcy & then capture the entire market. The novel element is the firm's profits will depend on its rival's strategy as well as on its own growth. A useful tool for representing the interaction between two firms is a two way payoff table or matrix which shows the strategic & payoffs of a game between two players. In this table, a firm can choose between the strategies listed in its rows or columns like below- In this figure, each firm decides whether to charge its high price or to start a price war by choosing a lower price. Cell A, at the upper left, shows the outcome when both firm choose the high price; D is the outcome when both choose to conduct a price war & B & C result when one firm has a high price & one a war price. The numbers insight the cells show the payoffs of the two firms, the profits earned by each firm for each of the four outcomes. The rust number in the lower left shows the payoff to the player on the left (Starship), the upper right shows the payoff of the player at the top (Uptown) as the firms are identical, the payoffs are mirror images. Alternative Strategies: The new element in a game theory is analyzing not only the individual actions but also the interaction between a firm's goals & moves & those of the competitors. But while in trying to outwit the opponent, it should be remembered that the opponent is trying to outwit the firm. The guideline philosophy in the game theory is- pick your strategy by asking what makes most sense for your assuming that your opponents are analyzing your strategy & doing what is best for them. Note that the two firms have the highest joint profits in outcome A, each firm earns 12 when both follow a normal or high price strategy. At the other extreme in the price war, each cuts its price & runs a big loss. In between are the interesting strategies where only one firm engages in the price war. In outcome C, for example, the Uptown follows a high price strategy while Starship takes most of the market but losses a great deal of money because it is selling below costs, Uptown is actually better off selling at a normal price rather than responding. So, here Starship's low price acquires 15 million while Uptown will earn only 6 million. Several strategies used in Game Theory- Dominant Strategy: - In considering possible strategies, the simplest case is that of a dominant strategy. This situation arises when one player has a single best strategy no matter what strategy the other player follows. If Uptown conducts business as usual with a high price, Starship will get 6 million of profit if it plays the high price & will lose 15 if it declares economic war. On the other hand, if Uptown starts a war, Starship will lose 6 if it follows a high price but will lose even more if it also engages in economic warfare. We can see that the same reasoning holds for Uptown. Therefore, no matter what strategy the firm follows, each firm's best strategy is to have the high price. Charging the high price is a dominant strategy for both firms in this particular price war game & here cell A is the dominant equilibrium as it arises from a situation where both firms are playing their dominant strategies. Nash equilibrium: - When we call the rivalry game, each firm considers whether to charge its high price or to raise its price toward the monopoly price & try to earn monopoly profit. The firms can raise their price in the hopes of earning monopoly profits. The other situation considering the reactions of opposition are described in cell B & C. So, Nash equilibrium is a solution in which no player can improve his or her payoff given the other player's strategy. This concept has been named after mathematician John Nash, who won a Noble prize for his discovery. It is also sometimes called as the non-cooperative equilibrium because each party chooses the strategy which is best for itself- without collusion or co-operation & without regard for the welfare of the society or any other party. Important issues of Game Theory: To collude or not to collude: - One of the important lessons regarding game theory is that the non co-operative equilibrium can be inefficient for the players. Thus the Nash equilibrium in cell D brings in less total profit for the duopolists than any of the other outcomes. The best joint situation is A, in which each duopolist are charging the higher price & earning a joint profit of 24 million. The worst is the non co-operative equilibrium with total profits of 16 million. Consider the co-operative equilibrium which occurs when the players act in union & set strategies that will maximize their joint payoffs. They may decide to form a cartel, setting a high price & dividing all profits equally between the firms. Clearly, this will help the duopolists at the expense of the consumers. But curtails & collusion in restraint of trade are illegal in most market economics, highest hurdle is self-interest. Say, that the prices have been collusively set at in cell A, then Starship secretly decides to sell a little output at a lower price, in effect moving to cell C. Starship might be able to do this undetected for a while. The same situation is applicable for Uptown also. We can also apply this reasoning in perfectly competitive equilibrium as here each firm maximizes the profit & each consumer maximizes utility, leading to a 0 profit outcome in which price equals marginal costs. So, even each person is behaving in a non co-operative manner, the economic outcome is socially efficient. Moreover the competitive equilibrium is a Nash Equilibrium in the sense that no individual would be better off by changing strategies as long as all other individuals continue with their strategies. In the perfectly competitively world, non co-operative behavior produces the socially desirable state of economic efficiency. By contrast, if some prices (such as the duopolists in the given example) were co-operate & decide to move to the monopoly price in cell A, the efficiency of the economy would suffer. This suggests why governments want to enforce antitrust laws that contain harsh penalties for those who collude to fix prices or divide up the markets. The prisoner's dilemma: - By an almost miraculous coincidence of economic life, Adam Smith's individual hand produces in perfectly competitive markets an efficient allocation of resources. But the beneficial outcome of the invisible hand does not arise in all circumstances. This is illustrated in the prisoner's dilemma. Here, it refers to prisoner's Molly & Knuckles, who are partners in crime. The district attorney interviews each separately, saying, "I have enough on both of you to send you to jail for a year. But I'll make a deal with you: if you alone confess, you will get off with a three months sentence, while your partner will serve 10years. If you both confess, you will both get five years." Suppose, Molly does not confess, & unbeknownst to her, Knuckles does confess. Molly stands to get 10 years. It is clearly better in this situation for Molly to confess & get 50 years rather than 10 years. Similarly, Knuckles is on the same dilemma. The significant result here is that when both prisoners act selfishly by confessing, they both end up with long prison terms. Only when they both act collusively or altruistically will they end up with short prison term. The pollution game: - An important example, similar to prisoner's dilemma, is the pollution game shown in the diagram. Consider an economy with externalities such as pollution. In a world of unregulated firms, each profit maximizing firm would prefer to pollute rather than install expensive pollution-control equipment. Moreover which behaves altruistically & cleans up its wastes will have higher production costs, higher prices & fewer customers. The pressure of Darwinian competition will drive all firms to starred Nash Equilibrium in cell D. Here neither firm can improve its profits by lowering pollution. When the Nash Equilibrium is insignificant, governments may step in. By setting efficient regulations, or by establishing efficient property rights, government can induce firms to move to outcome A, the "low pollute", "low pollute" world. Deadly Arms Races: - A particularly dangerous game with an inefficient non co-operative equilibrium, seen many times in history, is the arms race. Say, you are superpower. A facing hostile superpower R, or anticipating the rise of superpower C. As you are uncertain about your opponent's intentions, you play it safe by having modest weapons superiority over your opponent. Your generals tell you that this is just prudent military policy. Now put yourself in the shoes of R, which is watching you engage in a military buildup. R does not know your intentions. So, A wants 10% more bombs than R, & R wants 10% more bombs than A. This triggers an explosive arms race. Winner-take-all society: - This situation, in which the payoffs are determined primarily by relative merit rather than absolute merit. Compare such situation with factory workers, whose earning are determined by absolute marginal productivity rather than relative marginal productivity. Games as a Tradition: - The insights of game theory pervade economics, the social sciences, business, & everyday life. In economics, for example, game theory can explain trade wars as well as price wars. Game theory can also suggest why foreign competition can lead to greater price competition. While the foreign firms may refuse to play the game, they may not agree with the rules, so they may cut prices to gain market shares. Collusion may break down. A key feature in many games is the attempt of players to build credibility. You are credible if you are expected to keep your promises & carry out your threats. Credibility must be consistent with the incentives of the game. How can a business get credibility Business make credible promises by writing contracts that inflict penalties if they do not perform as promised. This area has been enormously useful in helping economists & other social scientists think about situations where small numbers of people are well informed & try to outwit each other in markets, policies & military affairs. So, after analyzing the different issues regarding game theory, we can now able to understand that this theory can be continuously used in corporate investment appraisal in the competitive product market successfully but while implementing such concept, a company should be alert about the sensitive points of this theory. Question-2 i. NPV or Net Present Value is the traditional approach for the valuation of investment projects, which involves the risk- adjustment & discount rate, which means discounting of expected CF from a given project which shows the risk of that CF, that means NPV is the sum of all cash inflows & outflows of a project. From the financial point of view, in order to calculate NPV, we need to use the following calculation- N CFt NPV = t=0 (1+k) t The NPV method is simply used regularly as by this the estimation of risk-adjusted rate of discount is easier relative to similar certain CF. Thus, to represent this equation, we will need k = interest rate & n = number of years/time which is not clearly mentioned here. So, in such cases, the future spot prices goods, that are highly volatile, future prices can be replaced. This methodology bypasses the requirement to compute a risk- adjustments discount rate. Here, the adjustment for risk has been equally made as the cash inflows of the related discount rate which is the risk-free rate of interest. In our current concern, as there is universal risk neutrality, thus, the risk free rate is zero. If time is assumed to be 1 year, then NPV of initial investment will be 100. Another equation can also be used to determine NPV of each types of investment. Like- For company-A: VA in = D11 (1 + /R) Y0 - I or 100 Here, I = investment VA = NPV VA out = D01 (1 + /R) Y0 Here, there is no investment. So, optimal strategy is- (Ain , Aout) = if I I1 Similar calculation for B: VB in = D11 (1 + /R) Y0 - I or 100 Here, I = investment VB = NPV VB out = D01 (1 + /R) Y0 Here, there is no investment. So, optimal strategy is- (Bin, Bout) = if I I1 NPV for immediate investment by both A & B = 500 NPV for delayed investment by both A & B = 600 NPV for non-collusive action- 800 for A & 200 for B. or, 800 for B & 200 for A. i. Here is graph that is showing the required condition as a format of game theory- After picturing the above conditions as a shape of game theory, we can now explain the behavior of the two players. Here, we can see a payoff table where the two duopolists companies are named as A & B. It is showing a strategic game between these two companies. Here, each firm can choose its own strategy in the rows or columns. Such as, company A can choose between the two rows. In this example, each firm can decide whether to make the investment immediately or lately. Combining those two decisions, the two companies can give four possible outcomes that have been shown in the diagram. Cell 1, existing in the upper left is showing the outcome when both firms simultaneously invest immediately & earn an inflow of 500 equally. Cell 4 is the outcome when both firms delay in investing to the project & gain an inflow of 600 each. Cell 2 & 3 result when one company invests immediately & other delays. The numbers that stay inside of the cell are showing the payoffs of the two firms. That means the amount of possible inflows that has been obtained by individual firm for each of the four outcomes. The number in the lower left shows the payoffs of the company B & right corner of the upper left shows the payoff of the company A (player of the top). As the firms are identical, the payoffs are visualized as mirror images. Applying the maximum benefits to the duopoly example we can identify several key issues. First, in outcome 1, each firm earns a combined profit of 1000 while they are ready to invest immediately. While the delay option adds value because here the PV of future cash flow will be 600 for each project. ii. This game will significantly represent 2 types of equilibrium. Such as- Dominant Equilibrium: In this game, consider the option opened to A. If B conducts the project as useful with a delayed investment, A will get the profit of 800 by investing immediately. Similarly, if B starts this investment opportunity war by investing immediately, A will lose 600 (800-200), if its investment is delayed. So, there is no attention to the other firms' strategy, rather than each one's best strategy is to invest immediately. So, immediate investment is the dominant strategy for both firms in this situation, when all players have dominant strategy, the outcome is called dominant equilibrium & here cell 1 is that equilibrium. Nash Equilibrium: We can also find out Nash equilibrium in this aspect. Here, it is the rivalry game while both firms consider whether to invest immediately or make a delay. The firms can stay at the immediate investment equilibrium or they can make a delayed investment in the hope of earning monopoly inflows. Thus, they have the highest joint amount in cell 4, while they can earn a total of 1200 when each follows a delayed investment strategy. At the other extreme, it is the competitive strategy of prompt investment inflow where each rival can obtain only 500. In cell 3, A undercuts A as it is taking most of the benefits & has high inflow than any other situation while B is losing money. In cell 2, A introduces late & B immediate investment means a loss of A. Here, the main theme is- a company should set its strategy on the assumption that the opponents will act in his / her best interest. This is the Nash Equilibrium of the game that has been just described. Here, no players can improve the own payoff that has been given to the other players strategy. That means, here each player's strategy is a best response against the others. It is also a non co-operative equilibrium as each party chooses the option that is best for itself without any collusion. In this figure, cell-4 represents a Nash Equilibrium as neither A nor B can improve its payoffs from the (immediate, immediate) equilibrium as the other does not change the strategy. Prisoner's Dilemma- From the price game, we know that competition among firms simply led to the competitive outcome with fewer prices. The invisible hand theory by Adam Smith produces in perfectly competitive markets for the efficient allocation of resources. But this incident does not arise in all situations. In that regard, prisoner's dilemma is one of the most famous terms in all games that can be applied in our project investment appraisal. Say, company A & B are in the role of 2 prisoners. Both are simultaneously deciding whether to invest immediately or to delay in an innovative project. Here, the initial investment is 100 regardless the optional condition. Their investment opportunity implies that if both invest immediately, the PV of future CF will be 500, delay investment will have a value addition of 600 for each, but breaking this condition will result in the acquisition of 800 for one & 200 for other. So, now the questions arise- what should A do Should it delay & hope to get a big amount 800 is preferable to 600 that can be earned by avoiding mutuality Say, A does not invest immediately & B does immediately. A will get only 200. It is clearly better for A to invest immediately to get 500 of inflow that is better than getting 200. B is in the equal dilemma. If it knew that A was thinking or what A thought B was thinking as a cyclic order. The optimum result is that when both firms are acting selfishly by investing immediately, they both conclude with long prison terms. Only when the two act collusively will they stop the short prison terms in this case. ii. The new game theory for the changed circumstances can be visualized by the following graph- This payoff table is showing the reformed strategic games between A & B where the companies have taken a collusive decision by signing a contract based on the agreement adopting 'wait-&-see' procedure. Here, if a firm breaks the agreement & invests early, it will be finned by other firm as there is a transfer of balance of 400 to the delayed firm. But if both firms break the agreement, there will be no fine or no transfer of account. In this example, each firm has the opportunity to have a stable investment, punishment or finned transfer or another collusive agreement to break down of the agreement at the same time. Combining all of the possible decisions, the company's probable outcomes can be shown in the figure. Here, cell A, staying at the upper left of the table, represents the position where each firm is maintaining its argument of delay investment & getting cash inflows of 600 each. Cell 4 also represents the equal outcomes while the breaking of argument by both firms will result in no punishment & remain the same inflows. In case of Dominant Equilibrium, cell 1 & 4 are both representatives of a definite amount. Considering the option disclosed to company A, we can find out that if B operates its business with a hurry-up strategy, that means if B invests early by breaking the mutual agreement, it will lose 400 from its existing inflow of 600 & as a result the deducted gain for B will be 200. The same statement can be applied for A's changed strategy also. So, cell A is the dominant equilibrium point while it is also predetermined. Here, the consideration of dominant equilibrium is quite clumsy as the entire game is the result of primary mutual agreement. Next, we can consider the Nash Equilibrium point of the companies. In such types of equilibrium point, each company can select its own strategy regardless society & other competitors. So, here, cell 4 is representing Nash Equilibrium as neither A nor B can improves its payoffs from the (finned, finned) equilibrium as long as other does not change the strategies. While a firm will go to the value addition technique by the exercise of delaying a project, it may find out the option if to collude or not to collude & a prisoner's dilemma. Such as, non co-operative equilibrium can be inefficient for a company which is a major problem in product market competition. As in cell 4, it brings an equal profit than the collusive outcomes. Here is no best joint solution which may discourage the firms. If each company would move towards a selfish interest it will lose 400 from the original amount & the rival's total inflow will be 1000 = (600 + 400). The prisoner's dilemma will also operate the firm's confusion in taking right decision. As here is no rewarding point, both the firms may not go for a punishment chance. Thus, by legal contract, no firm will be able to create additional values because of penalties & ultimate loss rather than competitors. So, a competition will take a straight shape of social welfare. Bibligraphy: Brigham, E. F., & Houseton, J. F. (2004), Fundamentals of Financial Management, 10th Edition, Thomson south-western, Singapore, ISBN: 0-324-17829-8 Pandey, I. M. (2007), Financial Management, 9th Edition, Vikas publishing house PVT LTD, New Delhi, ISBN: 81-259-1658-X Samuelson, P. A., Nordhaus, W. D. (2006), Economics, 18th Edition, Tata Mcgraw-Hill Publishing Company Limited, New Delhi, ISBN: 0-07-059855-X Mcconnel, C. R., Brue, S. L. (2005), Economics-Principles, problems & policies, 16th Edition, Mcgraw-Hill International Edition, Singapore, ISBN: 007-124914-1 Imai, J. & Watanabe, T. 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