Course outline I

Introduction
Game theory
Price setting
monopoly
oligopoly

Quantity setting
monopoly
oligopoly

Homogeneous
goods

Process innovation
1

Quantity and cost competition

Bertrand versus Cournot
Simultaneous quantity competition (Cournot)
Sequential quantity competition (Stackelberg)
Quantity Cartel
Concentration and competition

Price or quantity competition?

Cournot (1838)

Bertrand (1883)

x1
x2

p1
p2

2
3

Capacity + Bertrand = Cournot

Bertrand (1883) criticized Cournots model (1838) on the

grounds that firms compete by setting prices and not by
setting quantities.
Kreps and Scheinkman (1983) defended Cournots model.
They developed a two-stage game with capacities
k1

p1

1
2

p2 in a Nash equilibrium are

k2 capacities
and proved that
determined by Cournots model.
4

Cournot versus Stackelberg

Cournot duopoly (simultaneous quantity

competition)
1
x1
2
x2

Stackelberg duopoly (sequential quantity

competition)
1
x1
x2
2
5

Homogeneous duopoly
(linear case)
Two firms (i=1,2) produce a homogenous
good.
Outputs: x1 and x2, X= x1+x2

Marginal costs: c1 and c2

Inverse demand function:

Profit function of firm 1:

1 x1 , x2 p X x1 c1 x1 a b x1 x2 c1 x1

p X a bX a b x1 x2

Cournot-Nash equilibrium
Profit functions: 1 ( x1 , x2 ), 2 ( x1 , x2 )
Reaction functions:

x ( x2 ) arg max x1 1 ( x1 , x2 )
R
1

x2R ( x1 ) arg max x2 2 ( x1 , x2 )

C
1

C
2

Nash equilibrium: ( x , x )
x1R ( x2C ) x1C
x2R ( x1C ) x2C
7

Computing the Cournot equilibrium

(accommodation)

Profit function of firm 1

1 ( x1 , x2 ) p ( X ) x1 c1 x1 (a b( x1 x2 ) c1 ) x1

Reaction function of firm 1

a c1 x2
x ( x2 )

2b
2
R
1

Nash equilibrium

a c2 x1
analogous : x ( x1 )

2b
2
R
2

a 2c1 c2 C
a 2c2 c1
, x2

3b
3b

(a c1 c2 )
C
p
3
( a 2c1 c2 ) 2
( a 2c2 c1 ) 2
C
C
1
analogous : 2
9b
9b

C
x1

Depicting the Cournot equilibrium

x2
x1R ( x2 )
x

M
2

C
2

Cournot-Nash
equilibrium

x2R ( x1 )
x1C

x1M

x1
9

Exercise (Cournot)
Find the equilibrium in a Cournot competition.
Suppose that the demand function is given by
p(X) = 24 - X and the costs per unit by c 1 = 3
and c2 = 2.
20
S. : x
and
3
C
1

23
x
3
C
2

10

Common interests

c 1, c 2
Obtaining government subsidies and
negotiating with labor unions.

a , b
Advertising by the agricultural industry
(e.g. CMA).
11

Exercise (taxes in a duopoly)

Two firms in a duopoly offer petrol. The
demand function is given by p(X)=5-0.5X.
Unit costs are c1=0.2 and c2=0.5.
a) Find the Cournot equilibrium and calculate
the price.
b) Now suppose that the government imposes a
quantity tax t (eco tax). Who ends up paying it?
dp 2
S. : a) p 1.9 b)

dt 3

12

Two approaches to cost leadership

Direct approach (reduction of own

marginal costs)
- change of ratio between fixed and variable
costs
- investments in research and development
(R&D)

Indirect approach (raising rivals costs)

- sabotage
- minimum wages, enviromental legislation
13

Direct approach, analytically

Direct approach (reduction of your own marginal costs):

1C 1 1 x1C 1 x2C

0
c1
c1
x1 c1 x 2 c1

direct
effect

0 0

0
strategic
effect

14

Direct approach, graphically

x2

t
1
s
o
m
c
r
l
i
f
a of
n
i
rg ion
a
m uct
red
equilibria: increase in
production of firm 1

x1R ( x2 )

x2R ( x1 )

x1
15

Exercise (direct approach)

Who has a higher incentive to reduce own costs, a

monopolist or a firm in Cournot-Duopoly?

16

Indirect approach, analytically

c1 , c2 1 c1 , c2 , x c1 , c2 , x c1 , c2
C
1

C
1

C
2

Indirect approach (raising rivals cost):

d1C 1
1 dx2C 1 dx1C

0
dc2
c2
x2 dc2
x1 dc2

=0

<0
<0

direct
effect

strategic
effect

=0

17

Indirect approach, graphically

equilibria: increase
in production of firm 1
x1R ( x2 )

inc
co r ea s
sts e o
of f m
fir
m argi
na
2
l

x2

x2R ( x1 )

x1
18

Reaction curve in the linear case

x2
a c2 x1

x2R ( x1 ) 2b
2
0

x2M

a c2
if x1
b
otherwise

x2R ( x1 )
x1L

a c2
Note: x
alone leads to a price of c2 .
b
L
1

x1
19

Blockaded entry, graphically

x2
x1R ( x2 )

firm 1
as a monopolist

C
x2M
x2 0

x2R ( x1 )

M
L
1

x x

M
1

x1
20

Blockaded entry

Entry is blockaded for each firm:

c1 a and c2 a

Entry is blockaded for firm 2:

c1 a and
x x
L
1

M
1

i.e.

a c2 a c1

b
2b

1
c2 p (c1 ) (a c1 )
2
M

21

Blockaded entry (overview)

c2
a

no
supply

firm 1 as a
monopolist

1
a
2

duopoly
1
a
2

firm 2 as a
monopolist
a

c1
22

Cournot Executive summary

A duopoly will occur only, if entry is
blockaded for other firms.
Firms have common and competing interests
with respect to demand and cost functions.
There are two approaches to cost leadership.
The direct approach is to lower your own
marginal cost. The indirect approach is
known as raising rivals costs.

23

Stackelberg equilibrium

Profit functions 1 ( x1 , x2 ), 2 ( x1 , x2 )

Followers reaction function (2nd stage)

x 2R ( x1 ) arg max x2 2 ( x1 , x 2 )

Leaders optimal quantity (1st stage)

x1S arg max x1 1 x1 , x2R ( x1 )

Nash equilibrium: ( x1S , x2R )

24

Finding the profit-maximizing point

on the followers reaction curve
x2
Accommodation
x2M

x2R ( x1 )

x1

Blockade or
deterrence

R
2

a c2
x
b
L
1

x1
25

Computing the Stackelberg

equilibrium (accommodation)

Reaction function of firm 2:

a c2 x1
x ( x1 )

2b
2
R
2

Profit function of firm 1:

a c2 x1
1 ( x1 , x ( x1 )) a b x1
c1 x1
2b
2

Nash equilibrium
R
2

a 2c1 c2 R
, x2
x
2b

with
and
a
2c1 3c2
S
x2
4b

S
1

a 2c1 c2
p
4
S

26

Depicting the Stackelberg

outcome (both firms produce)

x2

x1R ( x2 )
x2M

x
x

C
2
S
2

quantities in a
Stackelberg equilibrium

C
S
x1C

S
1

x2R ( x1 )

x1
27

Exercise (equilibria)

Which is an equilibrium in the Stackelberg

model?

x
x
x

S
1
S
1
C
1

,
?

, x2R x1S ,
,x

R
2

,x

C
2

Are there any additional Nash equilibria ?

28

Cournot versus Stackelberg

Profit function of firm 1

First order
condition
1
1
2 for firm 1

( x , x ) p( X ) x1 C1 ( x1 )

dR1
dp dX
dp
p( X ) x1
p ( X ) x1
dx1
dX dx1
dX

dx1 dx 2R

dx1 dx1

R !
dx
dp
dp 2
p ( X ) x1
x1
MC1 ( x1 )
dX
dX dx1

direct effect

follower or strategic effect,

Cournot: 0, Stackelberg: >0
29

Exercise (Stackelberg)

Find the equilibrium in a Stackelberg

competition. Suppose that the demand
function is given by p(X) = 24 - X and the
costs per unit by c1 = 3, c2 = 2.
S. : x1S 10, x2R

Possible or not: ?
C
1

S
1

30

Exercise (three firms)

Three firms compete in a homogenous good market
with X(p)=100-p. The costs are zero. At stage 1, firm
1 sets its quantity; at stage 2, firms 2 and 3
simultaneously decide on their quantities.
Calculate the price on the market!
S. : p

50
3

31

Blockaded entry
p
a

blockaded entry
for firm 2
p ( x1 )

c2
p1M

c1

x1L

x1M

x1

x1
32

Reaction functions in the case of

blockaded entry
x2

x1R ( x2 )
x2R ( x1 )

L
1

M
1

x1
33

Profit function of firm 1 in the

case of blockaded entry of firm 2
1
1M

1 x1 ,0
1 x1 , x 2R x1

x1L

x1M

x1
34

Deterring firm 2s entry

p
a

p1M
c2

c1

p ( x1 )

1L
x1M

x1L

x1
35

Deterrence pays,

d1 x1 , x2R x1
0
dx1
x1L

1
1M

1 x1 ,0

1 x1 , x 2R x1
x1M x1L

x1
36

Deterrence does not pay

d 1 x1 , x2R x1
0
dx1
x1L

1
1M

1 x1 ,0
1 x1 , x2R x1
x1M

x1S

x1L

x1
37

Blockaded and deterred entry I

Entry is blockaded for each firm:

c1 a and c2 a

Blockaded entry (firm 2):

p M ( c1 ) or

a c1
c2
2

x1L x1M and

and

c1 a

c1 a

38

Blockaded and deterred entry II

Deterred entry (firm 2):

Entry is not blockaded if

Deterrence pays if

a c1
c2
p1M
2

d 1 x1 , x2R x1
1
1
1
3
L
0
bx1 a c2 c1 a c2 c1
dx1
2
2
2
2
x1L
1
2
c2 a c1
3
3

Deterrence if

1
2
a c1
a c1 c2
3
3
2
39

Blockade and deterrence

c2
a

1
a
2
1
a
3

no supply
blockade

firm 1 as a
monopolist
d et

nc
e
r
r

duopoly
1
a
2

firm 2 as a
monopolist
a

c1

40

Exercise (entry and deterrence)

Suppose a monopolist faces a demand of the
form p(X)=4-0.25X. The firms unit costs are 2.
a) Find the profit-maximizing quantity and price.
Is entry blockaded for a potential entrant
(firm 2) with unit costs of 3.5?
b) How about unit costs of c2=1?
c) Find firm 1s limit output level for c 2=1.
Should the incumbent deter entry?
S. : a) blockaded entry, b) entry is not blockaded
c) 1S 0.5 12 1L , accomodation

41

Deterrence and sunk costs I

We now introduce quasifix costs of 3:
p(X)=4-0.25X

Leader' s cost function

3 2 x1 , x1 0

C1 x1
x1 0
0,
Follower' s cost function
3 x2 , x2 0

C2 x2
x2 0
0,
42

Deterrence and sunk costs II

b) Entry blockaded ?

Comparison

is not sufficient

4 3
M
1 4,0 1 0 1 0,0 x1 4
x 4,
M
1

4 3

p x c2
1
R
R
M
x2 x1 6 x1 x2 x1 4
2
2 4,4 4 0,25 4 4 4 3 1 4 1 0
M
1

Entry not blockaded

43

Deterrence and sunk costs III

c) Should firm 1 deter?

x1Lq limit quantity with quasifixed costs, x1Lq x1L (why?)

0 2 x1Lq , x2R x1Lq p X x2R x1Lq C2 x2R x1Lq

4 14 x1Lq x2R x1Lq x2R x1Lq 3 x2R x1Lq

4 14 x1Lq 6 12 x1Lq 6 12 x1Lq 3 6 12 x1Lq

25 18 x1Lq 6 12 x1Lq 3 6 12 x1Lq
15 x

Lq
1

3
4

6 x
3
2

Lq
1

Lq
1

5
4

1
16

1
16

Lq 2
1

3 6 12 x1Lq

Lq 2
1

x1Lq1 12 4 3,

x1Lq : x1Lq 2 12 4 3

12 x
L
1

44

Deterrence and sunk costs IV

1 x1Lq ,0 4 14 12 4 3 0 12 4 3 0 3 24 8 3
1
0,71 1S x1S , x2R x1S (see exercise " entry and deterrence " )
2
deterrence pays

45

Deterrence and sunk costs V

x2

6
x 2R x1

x1S

x1M x1Lq

12

x1
46

Deterrence and sunk costs VI

x1S
7,2

x1M 4
x1S 2

0,5 1,44
Accommodation

3
Deterrence

4
Accommodation

CF
Blockade

47

Strategic trade policy

s

xd
xf

1
2

Two firms, one domestic (d), the other foreign (f),

compete on a market in a third country.
The domestic government subsidizes its firms
exports using a unit subsidy s.
The subsidy grants the domestic firm an advantage
that is higher than the subsidy itself (Brander /
Spencer (1981, 1983)).
48

Exercise (Strategic trade policy)

In the setting just described, assume c : c1 c2
and p(X)=a-bX.
Since the two firms sell to a third country, the
rent of the consumers is without relevance and
domestic welfare given by

W s Cd c s, c sxdC c s, c

Which subsidy s maximizes domestic welfare?

ac
S. : s
4
*

49

Solution (Strategic trade policy) interpretation

xf

Direct effect of subsidy for domestic welfare is zero.

C

x
Strategic effect: d f 0
x
x

R
d

R ,s
d

x f

<0

<0

Cournot-Nashequilibria

xdC c s, c xdS c, c !!

xM

(firm d Stackelberg
leader)

x Rf
x

xd
50

Strategic trade policy - problems

The recommendation depends on whether
there is price or quantity competition.
One can always do better than free trade, but
the optimal tariffs or subsidies seem to be
small, the potential gains tiny, and there is
plenty of room for policy errors that may lead
to eventual losses rather than gains.

Trade Policy and Market Structure; Helpman/Krugman, S. 186

51

Stackelberg Executive Summary

Time leadership is worthwhile: in a Stackelberg

equilibrium the leader realizes a profit that is
higher

than the followers and

his own in a Cournot equilibrium.

Costs of entry (even in the form of identical

quasifix costs) make the followers deterrence
easier.
Strategic trade policy may conceivably pay.

52

Example: The OPEC Cartel

The best known cartel is the OPEC, which was

formed in 1960 by Saudi Arabia, Venezuela,
Kuwait, Iraq and Iran. Each member nation must
agree to an individual output quota, except for
Saudi Arabia, which adjusts its production as
necessary to maintained high prices.
In 1982, OPEC set an overall output limit of 18
million barrels per day (before 31 million).
Production quota at 28 million barrels per day
effective July 1, 2005.
53

The quantity cartel

The firms seek to maximize joint profits

1 ( x1 , x2 ) 2 ( x1 , x2 )
p( X )( x1 x2 ) C1 ( x1 ) C2 ( x2 )

Optimization conditions
!
( 1 2 )
dp
p( X ) ( x1 x2 )
MC1 ( x1 ) 0
x1
dX

!
( 1 2 )
dp
p( X ) ( x1 x2 )
MC2 ( x2 ) 0
x2
Compare
monopoly withdX
two factories.

54

The cartel agreement

The optimization condition is given by

!
d1
dp
dp
p( X ) x1
MC1 ( x1 ) x2
0
dx1
dX
dX

Each firm will be tempted to increase its

profits by unilaterally expanding its output.
In order to maintain a cartel, the firms need a
way to detect and punish cheating, otherwise
the temptation to cheat may break the cartel.

55

Cartel quantities
x2

quantities in a
symmetric cartel

x1R ( x2 )
x2M

x2C

1 M
x2 x2S
2

S
K
1
2

M
1

C
1

x x x x
S
1

M
1

x2R ( x1 )

x1
56

Exercise (cartel quantities)

Consider a cartel in which each firm has

identical and constant marginal costs. If the
cartel maximizes total industry profits, what
does this imply about the division of output
between the firms?

Intermediate Microeconomics; Hal R. Varian

57

Cartel Executive Summary

If all firms keep the cartel agreement, they
can increase their profits compared to
Cournot competition.
Nevertheless cartels are unstable from a
static point of view.
However, cartel agreements may be stable
from the point of view of repeated games.

58

The outcomes of our models

price
a

pM
pC
pS
p PC = c

monopoly (M) and cartel (K)

Cournot (C)
Stackelberg (S)
perfect competition (PC)

X M X C X S X PC

quantity
59

Antitrust laws and enforcement,

Germany

laws

Gesetz gegen unlauteren Wettbewerb (1896)

Gesetz gegen Wettbewerbsbeschrnkungen
(GWB), (1957)

enforcement

Bundeskartellamt

60

Ck concentration ratio
xi
Setup: n firms, si
X

and

s1 s2 sk sn

k
C

s
,
for
n
identical
firms
:
C

,k n
Definition: k i
k
n
i 1
n k 1 kn 1
monopoly:

perfect comp.: lim kn 0 for identical firms

n

Exercise: Calculate C2 for

2 firms with equal market shares,

3 firms with shares of 0.1, 0.1 and 0.8 or

61

GWB, 19 (3)

One firm is called market dominating if

C1>1/3.

A group of firms is called market

dominating if
Ck 1 / 2, k 3
or
Ck 2 / 3, k 5.
62

The Herfindahl (Hirschman) index

Definition:
xi
H

i 1 X
n

monopoly : H 1
2

s
i 1

2
i

n identical firms : H

1
n

perfect competition
(n ) : H 0

Exercise: Calculate H for

2 firms with equal market shares,

3 firms with shares of 0.8, 0.1 and 0.1 or

3 firms with shares of 0.6, 0.2 and 0.2 ?

63

n firms in Cournot competition

Total industry output: X x1 x2 ... xn
Firm is profit function:

i ( x1 ,..., x n ) p( x1 ... xn ) xi Ci xi

Firm is marginal revenue:

dp
dp d x1 xn
dp
MR ( xi ) p xi
p xi
p xi
1
dxi
dX
dxi
dX

xi X dp
si

p 1
p 1
X p dX
X ,p

64

Lerner index of market power

First order condition:

dp dX !
MR( xi ) p ( X ) xi
MC ( xi )
dX dxi
Lerner index for one firm:

p MCi !

p p

si
1
X , p
p

si

X ,p

Lerner index for the industry:

p MCi ! n
si
H
si
si

p
X ,p X ,p
i 1
i 1
n

65

Exercise (Replication)
In a homogenous good market there are m identical costumers and n
identical firms. Every costumer demands the quantity 1-p at price p.
The cost function of firm j is given by
C j x j 0,5 x 2j .
a) Calculate the inverse market demand function!
b) Calculate the reaction function of firm j and the total market output
and pC in the symmetric CournotC
C
C
C
X x1 x 2 x n
equilibrium! Hint:
Use
X j x1 ... x j 1 x j 1 .. xn
c) Now the number of firms and costumers is multiplied by Calculate
.
again pC and MCj! Prove that for
the gap between
price and marginal costs converges to zero!
S. : a) p X 1 mX
m
n
b) X C n
, pC 1
m 1 n
m 1 n

Theorie der Industriekonomik; Bester

66