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)

x1 x2

41 42 41 42
3

Bertrand (1883)

p1 p2

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 k2 p1 p2

41 42

and proved that capacities in a Nash equilibrium are determined by Cournots model.
4

Cournot versus Stackelberg



Cournot duopoly (simultaneous quantity competition) 41 x1 x2 42 Stackelberg duopoly (sequential quantity competition) 4 1 x1 x2 4 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:


pX ! a bX ! a bx1  x2

Profit function of firm 1: 41x1, x2 ! pX x1 c1x1 ! a bx1  x2 c1 x1

6

Cournot-Nash equilibrium
Profit functions: 41 ( x1 , x2 ), 4 2 ( x1 , x2 )  Reaction functions:


x ( x2 ) ! arg maxx1 41 ( x1 , x2 )
R x2 ( x1 ) ! arg maxx2 4 2 ( x1 , x2 )

R 1

Nash equilibrium: ( x , x ) R C C x1 ( x 2 ) ! x 1
x (x ) ! x
R 2 C 1 C 2

C 1

C 2

Computing the Cournot equilibrium (accommodation)

  

Profit function of firm 1

41 ( x1 , x2 ) ! p( X ) x1  c1 x1 ! (a  b( x1  x2 )  c1 ) x1

Reaction function of firm 1

a  c1 x2  x1 ( x2 ) ! 2b 2

a  c2 x1  analogous : x2 ( x1 ) ! 2b 2

Nash equilibrium
a  2 c1  c 2 a  2 c 2  c1 C C x1 ! , x2 ! 3b 3b ( a  c1  c 2 ) C p ! 3 ( a  2 c1  c 2 ) 2 ( a  2 c 2  c1 ) 2 C C analogous : 4 2 ! 41 ! 9b 9b
8

Depicting the Cournot equilibrium

x2
x1R ( x2 )
x
M 2

C x2

Cournot-Nash equilibrium
R x2 ( 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 c1 = 3 and c2 = 2.
S. : x1C ! 20 and 3
C x2 !

23 3

10

Common interests
 c1, c2

q Obtaining government subsidies and negotiating with labor unions.

a o, b q 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 . : 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

 

4 c1 , c2 ! 4 1  1 , c2 , x c1 , c2 , x c1 , c2 c
C 1 C 1 C 2

Direct approach (reduction of your own marginal costs):

C C x4 1 x41 x41 xx1C x41 xx2 !   xc1 xc1 xx1 xc1 xx2 xc1

  0

  !0

direct effect

    0 "   0   0 strategic effect

14

Direct approach, graphically x2

x1 ( x 2 )

equilibria: increase in production of firm 1

x 2 ( x1 )

x1
15

Exercise (direct approach)



Who has a higher incentive to reduce own costs, a monopolist or a firm in CournotDuopoly?

16

Indirect approach, analytically

 

4 c1 , c2 ! 4 1  1 , c2 , x c1 , c2 , x c1 , c2 c
C 1 C 1 C 2

Indirect approach (raising rivals cost): C C C d4 1 x4 1 x 4 1 dx 2 x 4 1 dx 1 !   "0 dc 2 xc2 x x 2 dc 2 x x1 dc 2

] ]] ]
=0
direct effect

   "0
strategic effect

<0 <0

=0

17

Indirect approach, graphically x2

equilibria: increase in production of firm 1
x1R ( x 2 )

x ( x1 )

R 2

x1
18

Reaction curve in the linear case x2

x2
a  c2 x1  x2 ( x1 ) ! 2b 2 0

if x1

a  c2 b otherwise

x2 ( x1 )
L 1

Note: x1L !

a  c2 alone leads to a price of c2. b

x1
19

Blockaded entry, graphically

x2
x1 ( x2 )

C
x2
x2 ! 0

x2 ( x1 )

firm 1 as a monopolist

M
x x1
L 1

x1
20

Blockaded entry


Entry is blockaded for each firm: c 1 u a and c 2 u a Entry is blockaded for firm 2:

c1

a and
M 1

x1 e x

i.e.
M

a  c2 a  c1 e b 2b

1 c2 u p (c1 ) ! ( a  c1 ) 2
21

Blockaded entry (overview) c2

a

firm 1 as a monopolist

no supply

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 41 ( x1 , x2 ), 4 2 ( x1 , x2 ) Followers reaction function (2nd stage)

R x 2 ( x1 ) ! arg max x2 4 2 ( x1 , x 2 )

Leaders optimal quantity (1st stage)

x ! arg max x1 41 x1 , x2 ( x1 )
S 1
S 1 R 2

Nash equilibrium: ( x , x )
24

Finding the profit-maximizing point on the followers reaction curve x2 Accommodation

x2
R x2 ( x1 )

R x2

Blockade or deterrence

x1

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:

R 2

Nash equilibrium

a  c 2 x1 4 1 ( x1 , x ( x1 )) ! a  b x1    c1 x1 2b 2

a  2 c1  c 2 S R x1 ! , x2 2b a  2 c1  3 c 2 S with x 2 ! 4b

and

a  2 c1  c 2 p ! 4
S
26

Depicting the Stackelberg outcome (both firms produce)

x2
x1R ( x 2 )
M x2

quantities in a Stackelberg equilibrium

x x

C 2 S 2

C S
x1C
R x 2 ( x1 )

x1S

x1
27

Exercise (equilibria)


Which is an equilibrium in the Stackelberg model?

x x x


S 1 S 1 C 1

R , x 2 x1S , R , x2

,x

C 2

 , ?

Are there any additional Nash equilibria ?

28

Cournot versus Stackelberg



Profit function of firm 1

4 1 ( x1 , x2 ) ! p ( X ) x1  C1 ( x1 )

First order condition for firm 1

R 2

dR1 dp dX dp dx1 dx ! p( X )  x1 ! p ( X )  x1  dx1 dX dx1 dX dx1 dx1 R ! dp dp dx 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.
R S. : x1S ! 10, x 2

C S 41 " 41 ?  Possible or not:

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!
50 .: p ! 3

31

Blockaded entry
p blockaded entry for firm 2
p ( x1 )

c2 p1 c1

x1

x1

x1
32

Reaction functions in the case of blockaded entry

x2
x1R ( x2 )
R x2 ( x1 )

L 1

M 1

x1
33

Profit function of firm 1 in the case of blockaded entry of firm 2

41
M 41

4 1 x1 ,0
R 4 1 x1 , x 2 x1

x1L

x1M

x1
34

Deterring firm 2s entry p

a

p ( x1 )
p1M c2

c1

4 1L 
x 1M

x1L

x1
35

Deterrence pays,
41
M 41

R d4 1 x1 , x2 x1 "0 dx1 L x1

4 1 x1 ,0

R 4 1 x1 , x 2 x1

x1M x1L

x1
36

Deterrence does not pay

41
M 41

R d4 1 x1 , x2 x1 dx1 L x1

4 1 x1 ,0
R 4 1 x1 , x 2 x1

x1M

x1S

x1L

x1
37

Blockaded and deterred entry I



Entry is blockaded for each firm:

c 1 u a and c2 u a
x1L e x1M A and c1 a

Blockaded entry (firm 2):

?c

u p M ( c1 ) or

c1

a  c1 c2 u 2

and

38

Blockaded and deterred entry II



Deterred entry (firm 2):

Entry is not blockaded if Deterrence pays if

c2

a  c1 ! p1M 2

R d41 x1 , x 2 x1 1 1 1 3 L ! bx1  a  c2  c1 !  a  c2  c1 0 dx1 2 2 2 2 L x1

1 2 c2 u a  c1 3 3

Deterrence if

1 2 a  c1 e c2 3 3

a  c1 2
39

Blockade and deterrence c2

a
blockade

no supply firm 1 as a monopolist

1 a 3

duopoly

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 c2=1. Should the incumbent deter entry?
S. : a) blockaded entry, b) entry is not blockaded S L c) 4 1 ! 0.5 " 12 ! 4 1 , accomodation
41

Deterrence and sunk costs I

We now introduce quasifix costs of 3: p(X)=4-0.25X eader' s cost function 3  2 x1 , x1 " 0 C1 x1 ! x1 ! 0 0 , ollower' s cost function 3  x2 , x2 " 0 C2 x2 ! 0 x2 ! 0 ,
42

Deterrence and sunk costs II



b) Entry blockaded ?
M 1 ?

4 ! 3 M 41 4,0 ! 1 " 0 ! 41 0,0 p x1 ! 4

x ! 4, p
M

4 ! 3

p x1M u c2 is not sufficient Comparison 1 R R M x2 x1 ! 6  x1 p x2 x1 ! 4 2 4 2 4,4 ! 4  0,25 4  4 4  3  1 4 ! 1 " 0

Entry not blockaded

43

Deterrence and sunk costs III



c) Should firm 1 deter?

R R R 0 ! 4 2 x1Lq , x2 x1Lq ! p X x 2 x1Lq  C2 x 2 x1Lq R R 4 4 3 R ! ?  1 x1Lq  x 2 x1Lq A x 2 x1Lq    x2 x1Lq

x1Lq ! limit quantity with quasifixed costs, x1Lq

x1L (why?)

5 6 2 6 2 ! ?  1 x1Lq A   1 x1Lq  3    1 x1Lq 2 8

4 4 3 6 2 A6 2 ! ?  1 x1Lq  6  1 x1Lq   1 x1Lq      1 x1Lq 2

3 4 Lq 1

! 15  x !6 x
3 2

 x
5 4 1 16

Lq 1

1 16

Lq 2 1

 3  6  1 x1Lq 2

Lq 1

Lq 2 1

x1Lq1 ! 12  4 3,

x1Lq :! x1Lq 2 ! 12  4 3

 12 ! x
L 1 44

Deterrence and sunk costs IV

12 41 x1Lq ,0 !   1   4 3  0   4 3  0    24  8 3 4 4 12 3
} 0,71 " 1 S R ! 4 1 x1S , x2 x1S (see exercise " entry and deterrence " ) 2 deterrence pays

45

Deterrence and sunk costs V

x2

R x2 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

41 42

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 ! 4 c  s, c  sx c  s, c
C d C d

Which subsidy s maximizes domestic welfare?

ac S. : s ! 4
* 49

Solution (Strategic trade policy) interpretation

 

Direct effect of subsidy for domestic welfare is zero. xx C Strategic effect: x4 d f

xx f
<0
R xd ,s

xf

xs
<0

"0

x xM

R d

Cournot-Nashequilibria

C S xd c  s, c ! xd c, c !!

(firm d Stackelberg leader)

xR f x
M

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

41 ( x1, x2 )  42 ( x1, x2 ) ! p( X )(x1  x2 )  C1 ( x1 )  C2 ( x2 )

Optimization conditions
! x(41  4 2 ) dp ! p( X )  ( x1  x2 )  MC1 ( x1 ) ! 0 xx1 dX ! x(41  4 2 ) dp ! p( X )  ( x1  x2 )  MC2 ( x2 ) ! 0 xx2 dX

Compare monopoly with two factories.

54

The cartel agreement



The optimization condition is given by

! d4 1 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
x1R ( x 2 )

quantities in a symmetric cartel

M x2 C x2

C S K
1 2 R x2 ( x1 )

1 M S x2 ! x2 2

x x x !x
M 1 C 1
S 1

M 1

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
X
M

monopoly (M) and cartel (K) Cournot (C) Stackelberg (S) perfect competition (PC)

PC

quantity
59

Antitrust laws and enforcement, Germany



laws

Gesetz gegen unlauteren Wettbewerb (1896) Gesetz gegen Wettbewerbsbeschrnkungen (GWB), (1957) Bundeskartellamt

enforcement

60

Ck concentration ratio
xi Setup: n firms, si ! X
k

and

s1 u s2 u - u sk u - u sn

k Definition: Ck ! si , for n identical firms : Ck ! ,k e n n i !1 n ! k !1 p k !1 monopoly: n

perfect comp.: lim k ! 0 for identical firms n

npg

Exercise: Calculate C2 for  2 firms with equal market shares,  3 firms with shares of 0.1, 0.1 and 0.8 or  3 firms with shares of 0.2, 0.6 and 0.2 ?
61

GWB, 19 (3)
One firm is called market dominating if C1>1/3.  A group of firms is called market dominating if


Ck u 1 / 2, k e 3 or Ck u 2 / 3, k e 5.
62

The Herfindahl (Hirschman) index



Definition:
n xi H ! ! si2 i !1 X i !1 n 2

monopoly : H ! 1 n identical firms : H ! perfect competitio n (n p g) : H p 0 1 n

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:


4 i ( x1 ,..., xn ) ! 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 ! p1  ! X p dX

1  si p I 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:

1  si p p I p  MCi ! X,p ! p p
n

! si I X,p

Lerner index for the industry:

p  MCi ! n si H ! si ! si p I X ,p I X ,p i !1 i !1
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 2 . j a) Calculate the inverse market demand function! b) Calculate the reaction function of firm j and the total market C C output X C ! x1C  x2  -  x n and pC in the symmetric Cournotequilibrium! Hint: Use X  j ! x1  ...  x j 1  x j 1  ..  xn c) Now the number of firms and costumers is multiplied by P. Calculate again pC and MCj! Prove that for P p g the gap between price and marginal costs converges to zero! X S. : a) p X ! 1  m
b) X C ! n m n , pC ! 1  m 1 n m 1 n
Theorie der Industriekonomik; Bester

66