Microeconomic Theory

ECON2101/ECON2210 Bei Qin

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Oligopoly, game theory

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Oligopoly
Denition

Oligopoly - an oligopoly is an industry consisting of a few rms. Duopoly is the simplest case of oligopoly. A duopoly is an
industry consisting of two rms. Study of the oligopoly:

Entry by new rms is impeded. Particularly, each rm's own price of output decisions aect its competitors' prots.

the interaction of a small number of rms. consider the duopolistic case of two rms supplying the same product.

When a market is in equilibrium, rms are doing the best they can and have no reason to change their price or output. Nash equilibrium: each rm is doing the best it can given
what its competitors are doing.
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Oligopoly
Classication of theories ( to analyze the interaction) Non-collusive
Simultaneous moves
quantity setting - Cournot price setting - Bertrand

Sequential moves: leader and follower

quantity setting - Stackelberg price setting - price leader

Collusive
Cartels

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Oligopoly: simultaneous moves & quantity competition

homogeneous good, each rm treats the output of its competitors as xed, and all rms decide simultaneously how much to produce. Duopoly, rm 1 &2, each rm must decide mow much to produce (yi ) and the two rms make their decisions at the same time. When making its production decision, each rm takes its competitor into account. Each rm knows that its competitor is also deciding how much to produce, and the market price will depend on the total output of both rms (y1 + y2 ).
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Cournot model: Oligopoly model in which rms produce a

Oligopoly: simultaneous moves & quantity competition

Firm 1 takes rm 2's output level y2 as given:
max 1 (y1 ; y2 ) = p (y1 + y2 )y1 c1 (y1 )
y1 y1 satises F .O .C . 1 (y1 ;y2 ) y1

= 0 = y1 = y1 (y2 )

Firm 2 takes rm 1's output level y1 as given:

max 2 (y2 ; y1 ) = p (y1 + y2 )y2 c2 (y2 )
y2 y2 satises F .O .C y1 (y2 ) , y2 (y1 ) 2 (y2 ;y1 ) y2

, reaction curve : relationship between a rm's prot maximizing output and the amount it thinks its competitor will produce.
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= 0 = y2 = y2 (y1 )

Oligopoly: simultaneous moves & quantity competition

An equilibrium is when each rm's output level is a best response to the other rm's output level, for then neither wants to deviate from its output level.. A pair of output levels (y1 , y2 ) is a Cournot-Nash equilibrium if y1 = R1 ( y 2 ) and y2 = R2 (y1 )
Example The market inverse demand function is p (yT ) = 60 yT , where 2 and yT = y1 + y2 . The rms' total cost functions are c1 (y1 ) = y1

Firm 1:

2. c2 (y2 ) = 15y2 + y2

2 maxy1 1 (y1 ; y2 ) = (60 y1 y2 )y1 y1

F .O .C .

1 = 60 2y1 y2 2y1 = 0 y1
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i.e. rm 1's best response to y2 is y1 = R1 (y2 ) = 15 1 4 y2

Oligopoly: simultaneous moves & quantity competition Quantity Q y Competition; p ; An Example p

y2 60 Firm 1s reaction curve

1 y1 R1 ( y2 ) 15 y2 . 4

15

y1

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Oligopoly: simultaneous moves & quantity competition

Example 2 Firm 2: maxy2 2 (y2 ; y1 ) = (60 y1 y2 )y2 15y2 y2
2 F .O .C . = 60 y1 2y2 15 2y2 = 0 y2
45y1 4

Quantity Q y Competition; p ; An Example p

y2 Firm 2 2s s reaction reaction curve curve 45 y1 y2 R 2 ( y1 ) . 4 45/4 45 y1

i.e. rm 2's best response to y1 is y2 = R2 (y1 ) =

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Oligopoly: simultaneous moves & quantity competition Quantity Q y Competition; p ; An Example p In equilibrium, y = R (y ) = 15 y , and y = R (y ) =
1

1 4 2

45y1 4

y2 60

Firm 1s reaction curve

1 y1 R1 ( y2 ) 15 y2 . 4

Firm 2s reaction curve 45 y1 y2 R 2 ( y1 ) . 4 45/4 15 45 y1

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Oligopoly: simultaneous moves & quantity competition

Jointly solving the equations:
1 45 y 1 y1 = 15 ( ) y1 = 13 4 4 45 13 =8 y2 = 4 , y ) = (13, 8) So the Cournot-Nash equilibrium is (y1 2 Firm 1s reaction curve y2

Quantity Q y Competition; p ; An Example p

60

1 y1 R1 ( y2 ) 15 y2 . 4

Firm 2s reaction curve 45 y1 y2 R 2 ( y1 ) . 4

Cournot-Nash equilibrium
8 13 48 y1

* y* , y 1 2 13,8 .
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Oligopoly: simultaneous moves & price competition

What if rms compete using only price-setting strategies, instead of using only quantity-setting strategies? Bertrand model: Oligopoly model in which rms produce a homogeneous good, each rm treats the price of its competitors as xed, and all rms decide simultaneously what price to charge. Duopoly, each rm's marginal production cost is constant at c, all rms set their prices simultaneously. Nash equilibrium: All rms set their prices equal to the marginal cost c. - the competitive outcome

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Oligopoly: sequential moves & quantity competition

Stackelberg model: Oligopoly model in which one rm gets its
output before other rms do. Duopoly, rm 1 is a leader and it chooses its output level rst. Firm 2 is a follower and responds to rm1's choice. The competition is a sequential game in which the output levels are the strategic variables. The Stackelberg model of duopoly is dierent from the Cournot model, in which neither rm has any opportunity to react

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Oligopoly: sequential moves & quantity competition

Solving: For rm 2, given y1 , it will choose y2 = R2 (y1 ) in order to S (y ) = p (y + y )y c (y ) maximize its prot 2 2 1 2 2 2 2 Firm 1 knows this and so perfectly anticipates rm 2's reaction to any y1 chosen by rm 1. So, for rm 1,
S (y1 ) = p (y1 + R2 (y1 ))y1 c1 (y1 ) max 1 y1 S satises F .O .C y1

Note: the leader can make a prot at least as large as the Cournot-Nash equilibrium prot, but it doesn't need to
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Oligopoly: sequential moves & quantity competition

Example Cont. with the setting as before. 2 Firm 2: maxy2 2 (y2 ; y1 ) = (60 y1 y2 )y2 15y2 y2 y1 i.e. rm 2's best response to y1 is y2 = R2 (y1 ) = 45 4 The leader, rm 1's prot function is therefore
S 2 (y1 ) = (60 y1 R2 (y1 ))y1 y1 max 1 y1

substituting the reaction function of rm 2, we get

7 2 195 y1 y1 max 1 (y1 ) = y1 4 4
S

195 7 S F .O .C . = y1 = y1 = 13.9 4 2 S Get back to rm 2; y2 = 45413.9 = 7.8

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Oligopoly: sequential moves & quantity competition

The C-N output levels are (y1 , y2 ) = (13, 8) so the leader produces more than its C-N output. This is true generally.

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Oligopoly: sequential moves & price competition

Price - leadership game: a sequential game in pricing strategies,

with one rm decides its price ahead of the others. Think of one large rm (the leader) and one small rm (the follower). The price leader sets its price ahead of the other rm. The small rms are price-taker and so its supply reaction to a market price p is S (p ) = y2 (p )

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Oligopoly: sequential moves & price competition

The market demand function; D (p ) The leader knows that if it sets a price p the quantity demanded from it will be the residual demand
L(p ) = D (p ) S (p )

Hence the leader's prot maximizing problem ismaxp L (p ) = p (D (p ) S (p )) cL (D (p ) S (p ))

Example Same setting as before, now suppose rm 1 is price leader and rm 2 is price follower. 15 2 F .O .C = Firm 2; max y2 py2 15y2 y2 y2 = p 2 The residual demand: y1 = 60 p y2 = 67.5 1.5p Firm 1 solves the problem: maxp p (67.5 1.5p ) (67.5 1.5p )2
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Oligopoly: Collusion
Cartels: an industry where rms get together and attempt to set
prices and outputs so as to maximize total industry prots. Ex. OPEC Let's consider two rms. The prot-maximization problem facing the two rms is to choose their outputs y1 and y2 so as to maximize total industry prots
max y1 ,y2 p (y1 + y2 )[y1 + y2 ] c1 (y1 ) c2 (y2 )
F .O .C .
p ( y1 + y2 )+ p ( y1 + y2 )+ p Y p Y (y1 + y2 ) = MC1 (y1 ) (y1 + y2 ) = MC2 (y2 )

Familiar?

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Oligopoly: Collusion
Cartels: an industry where rms get together and attempt to set
prices and outputs so as to maximize total industry prots. Ex. OPEC Let's consider two rms. The prot-maximization problem facing the two rms is to choose their outputs y1 and y2 so as to maximize total industry prots
max y1 ,y2 p (y1 + y2 )[y1 + y2 ] c1 (y1 ) c2 (y2 )
F .O .C .
p ( y1 + y2 )+ p ( y1 + y2 )+ p Y p Y (y1 + y2 ) = MC1 (y1 ) (y1 + y2 ) = MC2 (y2 )

Familiar? Multi-plant rms. Please calculate the equilibrium y1 , y2 , p , Revenue1 , Revenue2 , prot1 , prot2 using the example setting.
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Oligopoly: Collusion
The rms cannot do worse by colluding since they can cooperatively choose their Cournot-Nash equilibrium output levels and so earn their Cournot-Nash equilibrium prots. So collusion must provide prots at least as large as their Cournot-Nash equilibrium prots. Such a cartel is not stable. Why? Firm i can benet from increasing its output to the level higher than the one decided by Cartel. How? For rm 1, it can instead make the decision according to
max 1 = p (y1 + y2 )y1 c1 (y1 ) y1

p d 1 = p (y1 + y2 ) + y1 MC1 (y1 )=0 F .O .C dy1 Y

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Oligopoly: Collusion
The optimality condition for the cartel solution is
p (y1 + y2 )+

p ( y1 + y2 ) = MC1 (y1 ) Y

Rearranging the equation gives us

p p p ( y1 + y2 ) + y1 MC1 (y1 ) = y2 > 0 Y Y

So, we have

Thus, if rm 1 believes that rm 2 will keep its output xed, then it will believe that it can increase prots by increasing the own production.
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d 1 dy1

>0

Game theory: Some concepts

Game theory helps to model strategic behavior by agents who understand that their actions aect the actions of other agents. A game consists of
a set of players a set of strategies for each player the payos to each player for every possible choice of strategies by the players.

Game: Situation in which players (participants) make

strategic decisions that take into account each other's actions and responses Payo: Value associated with a possible outcome Strategy: Rule or plan of action for playing a game Optimal strategy: strategy that maximizes a player's expected payo
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Game theory: Some concepts

Two persons, two strategies. The table showing the payos to both players for each the four possible action combinations An Example p ofof a Two-Player y Game is the game's payo matrix:
Pl Player B

L
Player A

R
This is the games g payoff matrix.

U D

(3,9) (1,8) (0,0) (2,1)

Player As payoff is shown first. Pl Player B Bs payoff ff i is shown h second. d

Cooperative game: game in which participants can negotiate

binding contracts that allow them to plan joint strategies. ex.bargaining Noncooperative game: game in which negotiation and enforcement of binding contracts are not possible

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13.2 Dominant Strategies

Game theory: dominant strategy

TABLE 13.1 Firm A Advertise Dont advertise

dominant strategy opponent does.

Strategy that is optimal no matter what an

PAYOFF MATRIX FOR ADVERTISING GAME Firm B Advertise 10, 5 6, 8 Dont advertise 15, 0 10, 2

Equilibrium? Advertising is a dominant strategy for Firm A. The same is true for
Firm B: No matter what firm A does, Firm B does best by advertising. The outcome for this game is that both firms will advertise. equilibrium q in dominant strategies g Outcome of a g game in which each firm is doing the best it can regardless of what its competitors are doing.

Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.

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13.2 Dominant Strategies

Game theory: dominant strategy

TABLE 13.1 Firm A Advertise Dont advertise

dominant strategy opponent does.

Strategy that is optimal no matter what an

PAYOFF MATRIX FOR ADVERTISING GAME Firm B Advertise 10, 5 6, 8 Dont advertise 15, 0 10, 2

Equilibrium? Advertising is a dominant strategy for Firm A. The same is true for Firm B : No matter what firm A does, Firmthat B does best by advertising. Dominant strategy: strategy is optimal no matterThe what outcome for this game is that both firms will advertise. an opponent does equilibrium q Equilibrium in dominant strategies g Outcome of a g game which in dominant strategies: outcome of a in game ineach firm is doing the best can regardless of what its are doing. which eachit rm is doing the best itcompetitors can regardless of what is competitors are doing. Advertising is a dominant strategy for Firm A. The same is true for rm B. No matter what rm A does, rm B does best by advertising. The outcome for this game is that both rms Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e. 5 of 47 will advertise.
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Game theory: Nash equilibrium An Example p of a Two-Player y Game

How about this one?
Pl Player B

L
Player A

U D

(3,9) (1,8) (0,0) (2,1)

plays areeach we likely to see this reply game? A play of theWhat game where strategy is for a best to the other is a Nash equilibrium. The example has two Nash-equilibria; (U , L) and (D , R ). A Nash equilibrium can be interpreted as a pair of expectations about each person's choice such that, when the other person's choice is revealed, neither individual wants to change his behavior.

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Game theory: Nash equilibrium

Nash equilibrium is a generalization of the Cournot equilibrium described before. Notice: Pure Strategies 1. a game may have more than one Nash g equilibrium.
2. there are games that have no Nash equilibrium.
Player B

L U
Player A

R (0,4) (3,2)

(1,2) (0,5)

mixed

So the game has no Nash equilibria in pure strategies. Even so, , the game g does have a Nash equilibrium, q , but strategies in mixed strategies.
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Game theory: The Prisoners' Dilemma

Another problem with the Nash equilibrium of a game is that THE PRISONERS DILEMMA it does not necessarily lead to Pareto ecient outcomes.
TABLE 13.5 PRISONERS DILEMMA Prisoner B Confess Prisoner A Confess Dont confess 5, 5 10, 1 Dont confess 1, 10 2, 2

the ideal outcome is one in which neither prisoner confesses so that both get two years in prison. confesses, prison Confessing, Confessing however, however is a dominant strategy for each prisonerit yields a higher payoff regardless of the strategy of the other prisoner. Dominant strategies are also maximin strategies. The outcome in which both prisoners confess is both a Nash equilibrium and a maximin solution. Thus, in a very strong sense, it is rational for each prisoner to confess.

Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.

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Game theory: The Prisoners' Dilemma

Another problem with the Nash equilibrium of a game is that THE PRISONERS DILEMMA it does not necessarily lead to Pareto ecient outcomes.
TABLE 13.5 PRISONERS DILEMMA Prisoner B Confess Prisoner A Confess Dont confess 5, 5 10, 1 Dont confess 1, 10 2, 2

the ideal outcome is one in which neither prisoner The strategy (Don't confess, Don't confess) is a Pareto confesses so that both get two years in prison. confesses, prison Confessing, Confessing however, however is a dominant strategy forno eachother prisonerit yields a higher payoff regardless of the both ecient there is strategy choice that makes strategy of the other prisoner. players better o - while the strategy (confess, confess) is Dominant strategies are also maximin strategies. The outcome in which both Pareto inecient. prisoners confess is both a Nash equilibrium and a maximin solution. Thus, in a very strong sense, it is rational for each prisoner to confess. The unique Nash equilibrium for this game is for both players to confess. In fact, both players confessing is not only a Nash equilibrium, it is a dominant strategy equilibrium, since each player has the same optimal choice independent of the other player.
Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e. 10 of 47

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