1 Game Theory & IO – Oligopoly

1.1 Elements of Game Theory

Game theory is the study of strategic interaction. A game consists of several key
elements:

• Players: The individuals (consumers or firms etc.) involved.

• Actions: What the players can do.
• Payoffs: The possible utilities or profits that each player could receive, which
depend on the choices of all of the players.
• Timing: Do the players act simultaneously or sequentially?
Is the game played once, or repeatedly?
If repeatedly, how often? (Finite, or infinite?)
If the game is spread over a number of periods, is the ‘stage game’ the same each
period?
• Information structure: What do the players know?
• Strategies: A pure strategy is a plan of action.
A mixed strategy specifies a probability with which each pure strategy is to be
chosen.

To which we should add:

• What is each player’s objective?

∼∼∼

A best response to s¬k is a strategy sk for player k that maximises her payoff, given
those strategies of the other players.

A dominant strategy s̄k is a best response to every strategy s¬k of the other players –
it gives a higher payoff to player k than any other strategy sk .

A Nash equilibrium is a collection of strategies "s∗1 , s∗2 , . . . , s∗K # such that s∗k is a
best response to s∗¬k for each player k = 1, 2, . . . , K.

Note: Don’t confuse an equilibrium with an equilibrium outcome. The latter is what
actually happens (actions, expected payoffs) when the players adopt their equilibrium
strategies.
In a sequential game where Player 1 first chooses U or D and Player 2 then chooses L
or R, an equilibrium might be the pair of strategies "U; if U then L, if D then R#, and
then the outcome would be the pair of actions "U; then L# with the associated payoffs.

1
Examples

‘One-shot’, simultaneous move, full-information games.

(1) Both the Row and Column players have dominant strategies (“Prisoner’s Dilemma”):

Left Right
3 5
Top
3 −2
−2 −1
Bottom
5 −1

(2) Only the Row player has a dominant strategy:

Left Right
3 −1
Top
3 −2
−2 5
Bottom
5 −1

(3) Neither player has a dominant strategy (“Coordination Game”):

Left Right
3 −1
Top
5 −1
−2 5
Bottom
−2 3

(4) Neither player has a dominant strategy (“Anti-coordination Game”):

Left Right
1 −1
Top
−1 1
−1 1
Bottom
1 −1

2
1.2 Oligopoly

Illustrated with a duopoly.

Cost functions: Ck (qk ) = Fk + ck qk

Inverse demand functions: pk = αk − βk qk − γq¬k

γ > 0 ⇒ goods are substitutes.

For homogeneous goods, we have α1 = α2 = α, β1 = β2 = γ, and

p(q) = α − γq

where q = q1 + q2 . We also then assume symmetry: c1 = c2 = c and F1 = F2 = 0.

Profit functions: πk (qk , q¬k ) = p(q)qk − cqk

1.2.1 Cournot

Duopoly, homogeneous goods, each firm chooses a quantity; one-shot, simultaneous

move game.

Best response function (or reaction curve): Firm k chooses qk to maximise πk , taking
q¬k as given.

Take FOCs: ∂πk /∂qk (qk , q¬k ) = 0.

Solve separately to obtain best response qk = (α − c − γq¬k )/2γ,

and solve together to obtain qkC = (α − c)/3γ.
This is where the reaction curves intersect, and is the Nash equilibrium of this non-
cooperative game.

1.2.2 Stackelberg

As above, except sequential moves: take firm 1 as the leader, firm 2 as the follower.

Firm 1 knows that firm 2 will produce q2 (q1 ) = (α − c − γq1 )/2γ, i.e. the best response
in the Cournot game above.

Firm 1 chooses q1 to maximise π1 (q1 , q2 (q1 )) = p(q1 + q2 (q1 ))q1 − cq1

Solution: q1S = (α − c)/2γ and q2S = (α − c)/4γ.

3
 q2 "
#
#
#
#
# Strategic
# BR1
# Substitutes
#
#
#
M2 $ #
$$ #
$
$$# C
$#!
$
# $$!
# $ S
# $$
# $$
# $ BR2
$$
# $
## $$
$ !
M1 q1

C – Nash equilibrium of the Cournot game

S – Nash equilibrium of the Stackelberg game (with Firm 1 as leader)
M1 M2 – Monopoly/collusion line

Note: If each firm’s action set is restricted to {Cournot qty., 12 Monopoly qty.}, then the
game is strategically equivalent to a Prisoner’s Dilemma.

Comparisons

Industry structure Equilibrium quantities Equilibrium price

α−c
Perfect competition γ
c

1 α−c 1 α−c 3 α−c

Stackelberg duopoly 2 γ
+ 4 γ
= 4 γ
c + 14 (α − c)

1 α−c 1 α−c 2 α−c

Cournot duopoly 3 γ
+ 3 γ
= 3 γ
c + 13 (α − c)

1 α−c
Monopoly/Collusion 2 γ
c + 12 (α − c)

4
1.2.3 Bertrand

Duopoly, homogeneous goods, each firm chooses a price; one-shot, simultaneous move
game.

Assumption: Each firm can supply the entire market if it set p = c.

Best response (of firm 2):

• if p1 > pM , then p2 = pM
• if pM ≥ p1 > c, then p2 = p1 − ε
• if c ≥ p1 , then p2 = c

p2 "

pM %
% %
%
%%
%
%
BR1 %%
%% BR2
%%
%
%
%
% Strategic
c
Complements

!
c p M
p1

The reaction curves intersect at p1 = p2 = c, which is the Nash equilibrium of this

non-cooperative game.

Note: We get the competitive outcome in a homogeneous market with only two firms.

Drop the ‘one-shot’ aspect?

Add an assumption about capacity constraints?

5
1.3 Duopoly with Differentiated Goods

Cournot & Stackelberg – negligible differences

1.3.1 Bertrand

Demand functions: qk = ak − bk pk + dp¬k

d > 0 ⇒ goods are substitutes. (d < 0 ⇒ goods are complements.)

Assumption: 0 < d < bk .

p2 "
&
&
&
BR1 &
&
& '
''
& ''''
'
''' &
BR2
'' &
''
'' &
&
&
&
&
&
&
& !
p1

The reaction curves intersect at prices which are greater than marginal cost, but lower
than the prices which prevail at the Cournot equilibrium . . .

1.4 Competing in quantities vs. prices

• Homogeneous case: quantities less competitive than prices

• Differentiated case: qualitatively the same as the homogeneous case

– quantity setters retain more monopoly power than do price setters

6
2 Game Theory & IO – Collusion & Repeated Games

2.1 Subgame perfection

Example: Incumbent threatens a price war if new firm enters the market:

Accommodate Fight
1 −1
Enter
1 −1
2 2
Don’t enter
0 0

Two Nash equilibria: "Enter, Accommodate#, "Don’t enter, Fight#.

Is the threat credible?

Extensive form, two stage game, potential entrant moves first:

•
(($$$
Enter (( $$Don’t enter
( ( $
( $$
(( $
(•$ •
( $$
Accommodate (( $
Fight (0, 2)
( $
(( $$
"(
( $"
$
(1, 1) (−1, −1)
A subgame perfect equilibrium (SPE) is a NE which induces a NE in each subgame.
"Don’t enter; if Enter then Fight# is not a SPE – the threat is not credible.

2.2 Finite Games

2.2.1 Complete & perfect information

Example: Repeated quantity setting duopoly model.

Strategies: Each produce 12 Monopoly qty. as long as opponent does likewise, else punish
by producing a ‘large’ quantity.

These might constitute a NE, but certainly not a SPE – the firms will play the NE of
the one-shot Cournot game in the last period.
Knowing this, the firms cannot sustain collusion in the next to last period, and will
play the NE of the one-shot Cournot game in the next to last period too.
Knowing this, . . . the firms play the NE of the one-shot Cournot game in every period.

All simple finite games with complete & perfect information can be solved using back-
ward induction, and repeated one-shot games unwind like this.
So, if NE is unique, we have this NE at each stage.

7
2.2.2 Incomplete/imperfect information

Example: Kreps & Wilson (1982), JET.

N potential entrants, one per period. Incumbent is ‘weak’ with probability close to 1,
else ‘tough’:
(•$
( $$
Enter (( $ Don’t enter
( $$
(( $
•(( $$
•
(($$
Accommodate (( $$ Fight (0, 2)
( $
(( $$
"(
( $"
$
(1, −1) (−1, 1)
Even if the incumbent is weak, the threat to fight (act tough) is credible in early periods,
hence building a false reputation.
Since the threat is credible, entry does not occur early on.

2.3 Infinite Games

Discount factor δ = (1 + r)−1 . In fact, defining δ = η (1 + r)−1 , where η is the hazard

rate, namely the probability that the game will continue for another period, given that
it has not ended so far, allows us to use the results for infinite games when we are
considering finite games with an uncertain number of periods.

Consider trigger strategies – play X as long as opponent doesn’t play Y , in which case
play Z.

2.3.1 Collusion with Cournot punishments – “Grim”

Repeated quantity setting duopoly model. Define the following profits in the stage game:

• π ∗ from colluding

• π d from deviating

• π C from playing Cournot quantity

Strategies: Collude as long as opponent does likewise; if either firm deviates this period,
punish by both firms reverting to Cournot forever, starting next period.

When could these constitute a SPE?

Collusion gives π ∗ each period, so π ∗ /(1 − δ).

Deviation gives π d for one period then π C each period thereafter, so π d + π C δ/(1 − δ).
Collusion is sustainable if
π∗ δ πd − π∗
> πd + π C or equivalently δ > d
1−δ 1−δ π − πC

8
Alternatively . . .
gain from deviating: π d − π ∗ today;
loss from deviating: π ∗ − π C from tomorrow on;
deviation is not profitable if
δ ! ∗ "
πd − π∗ < π − πC
1−δ

2.3.2 The Folk Theorem (minmax punishments)

A minmax punishment is the worst that one player can do to the other, given that
the player being punished is responding optimally to its punishment. Firm 1 minmaxes
firm 2 at the quantities "q̃1 , q̃2 # if those quantities solve
# $
min
q
max
q
{π2 (q1 , q2 )}
1 2

A strategy is individually rational if it guarantees the player a payoff at least as good

as its minmax payoff.

A payoff pair is feasible if there is a pair of strategies, one for each player, that generates
it.

The Folk Theorem states that any feasible payoff pair (weakly) better than that guar-
anteed by individually rational strategies can be supported by trigger strategies incor-
porating minmax punishments, for suitable values of δ.

Points to note:
• Cournot punishments are credible but not severe
• minmax punishments are severe but not credible

9
2.3.3 “Carrot and Stick” (relenting punishments)

Remember, collusion is sustainable if

d δ C π∗
π + π <
1−δ 1−δ
Abreu (1986), JET: any credible punishment will do that gives the deviator a punishment
payoff of
π∗
Πp < − πd
1−δ
e.g. a price war for one or more periods, followed by a return to co-operation.

Note that Πp is the sum of the deviator’s profits during the punishment phase plus those
after the punisher has relented.

BUT the punisher must be willing to carry out the punishment . . .

AND the deviator must be willing to accept the punishment . . .
so we need to specify a second-level course of action that would arise if, during the
punishment phase, the deviator deviates . . .

2.3.4 Collusion with imperfect information

Example: Green & Porter (1984), Econometrica.

Market demand is given by P̂t = P (Qt )θt , where θt is a multiplicative shock with mean
1 and known distribution F (θ).
Firms cannot observe rivals’ output, but try to infer it from the observed market price
P̂t .
If the price is low, is it because demand is low or because some firm is over-producing?

Trigger strategies: Firms each produce q ∗ until market price falls below p̃, at which point
they punish (by producing Cournot quantity q C ) for T periods.
Find strategies (q ∗ , p̃, T ) that sustain collusion as SPE.

In equilibrium, no-one cheats, but price occasionally falls below p̃, so punishment is
triggered which hurts everyone.
So why don’t they scrap the trigger?
Because then everyone would cheat all the time.

10
3 Game Theory & IO – Entry

Two-period entry & competition games.

3.1 Non-credible threats

3.1.1 Competing in Quantities

Revisit Stackelberg . . .
(See also Bain, Sylos, Modigliani (1950s, 60s); refs. in Tirole Ch.8.)
The leader firm says that it will produce a particular quantity, q1S .
If the follower firm believes this, then it may enter (depending on the fixed costs of entry)
and produce its best-response quantity, q2S .
If the leader firm can now change its choice, it would do so: q1S is not its best response
to q2S .
If the follower firm believed this in the first place, then (if it entered) it would produce
the best-response quantity of the Cournot game, as would the leader.

3.1.2 Threatening a Price war

We saw in Section 2.1 that a threat by an incumbent firm to fight after a potential rival
entered the market was not credible (in a finite horizon game of complete & perfect
information).

3.2 Credible behaviour

3.2.1 Sunk costs

Based on: Spence (1977), Bell Journal; Dixit (1980), EJ.

Period 1: Firm I (incumbent) chooses capacity k at a cost of r per unit

– this pushes its reaction curve out from BR#I to BR##I as long as qI < k;
– for qI > k its reaction curve is still BR#I ;
– at qI = k its reaction curve is vertical.

Having observed k, firm E (potential entrant) decides whether or not it will enter the
market in period 2 – entry will entail a fixed cost F .

Period 2: Firm I produces up to k with unit cost w, beyond k with unit cost r + w.
If firm E does not enter, it incurs no costs.
If firm E enters, the two firms engage in quantity competition, but firm E incurs the
fixed cost F and has a unit cost of r + w.

Find SPE by working backward from the end.

11
Stage 2: Quantity competition
Firm E’s best response function is bE (qI | r, w).
Firm I’s best response function is bI (qE | r, w; k).

Firm E will enter the market if its expected post-entry profit covers the fixed cost.

Stage 1: Capacity choice

Entry could be blockaded, entry could be inevitable, or entry deterrence could be possible
but not inevitable.

• Entry is blockaded • Entry is strategically accommodated

(Stackelberg)

qE " qE "
) )
) ## ) ##
) BRI ) BRI
* ) * )
* ) * )
* ) * )
* ) * )
* ) * )
* ) * )
* ) * )
$$ * $$ *
$ ) $ )
$$* $$*
*# *#
) )

C * $#$ )
$ ) $ )
$ $
!
$
Z
C * $$ S )
* $$ ) * $$ )

)# $ )# $ Z
* $) N * $) N
$$ $$
#
* *
# * ) $$ BRE # * ) $ BR
BRI BRI $$ E
* *
* !$
) $ )
) $$ ! * ) $$ !

qI qI

• Entry might not be deterred . . . but if it is, output and welfare increase

qE " qE "
) )
) ## ) ##
) BRI ) BRI
* ) * )
* ) * )
* ) * )
* ) * )
* ) * )
* ) * )
* ) * )
$$ * $$ *
$$ * ) $$ * )

# #
$* ) $* )
$$ ) $$ )
C * $$ S !$ C * $$ S #
) )
#)
* $ ) * $ )
$# $
$ $
)# $ #N
* $) N * $
* Z * Z $) $
$
BR#I * ) $$ BRE BR#I * ) $$ BRE
* *
* !$
) $$ ) $$
* ) $ ! ) $ !
qI qI

12
3.2.2 Imperfect information

Example: Milgrom & Roberts (1982), JET.

Two periods, production costs of firm I (incumbent) initially uncertain:

either they are low (L) in both periods or they are high (H) in both periods;
anyone outside the market initially believes that firm I has low costs with probability θ
and high costs with probability 1 − θ.

Period 1: Firm I is alone in the market, and knows its own production costs.
It charges a price p1 , making a profit limited by either M L or M H , depending on its
costs – it could make less by charging a price different from its static monopoly price.

Having observed firm I’s first-period price, firm E (potential entrant) decides whether
or not to enter the market in period 2 – it can base its decision on the observed price.

Period 2: Firm I remains in the market.

If firm E does not enter, it makes 0 and firm I makes a profit of either M L or M H ,
depending on its costs.
If firm E enters, firm I makes either DL or DH , depending on its costs, and firm E
makes either DEL < 0 or DEH > 0, depending on which type of firm I it is facing.

• Assume that an incumbent with low costs benefits more from deterring entry than
one with high costs:
M L − DL > M H − DH
and also that
θDEL + (1 − θ)DEH < 0
i.e. θ is large enough to deter entry unless firm E learns that firm I has high costs.

Firm I would like to discourage entry either by keeping firm E unsure, or by convincing
firm E that it is low-cost.
Firm I has an incentive to charge a low price in period 1 to do this . . .
But firm E knows about this, and might not be fooled . . .

A low-cost incumbent suffers an effective loss of M L − M L (p1 ), but makes a gain of

δ(M L − DL ) when entry is deterred. So, firm I is willing to charge any p1 satisfying
M L − M L (p1 ) ≤ δ(M L − DL )
if this means that firm E either learns nothing, or learns that firm I has low costs.

A high-cost incumbent suffers an effective loss of M H − M H (p1 ), but makes a gain of

δ(M H − DH ) when entry is deterred. So, firm I is willing to charge any p1 satisfying
M H − M H (p1 ) ≤ δ(M H − DH )
if this mimics the behaviour of a low-cost firm I implying that firm E learns nothing.
However, firm I is unwilling to charge p1 satisfying
M H − M H (p1 ) > δ(M H − DH )
to mimic the behaviour of a low-cost firm I and deter entry – it is better off if firm E
learns that firm I has high costs and then enters.

13
 Gain/Loss
"M L −. M L (p1 ) M H − M H (p1 )
...
. ... .. ..
... ...
... ... ...
... .. ..
... .. ..
δ(M L − DL ) × ...
...
...
...
...
...
...
.
...
...
. .
...
...
.

... .. ..
... .. .... ...
.
... ...
... ... ... ...
... ... ... ...
... ... ... ...
... ... ... ...
...
...
... ... ...
...
...
... ... ...
.. ..
...
...
... .
... ...
.
...
... ... ... ...
... ... ... ...
... ... .. ..
... ... .
... ....
... ...
... ... ... ...
... ... ... ...
... ... ... ...
... ... ... ...
... ... ... ...
δ(M H − DH ) ...
...
...
× ...
...
... ..
...
...
...
..
...
... ... . .
... ... .. ..
... ... ... ...
... ... ... ...
... ... ... ...
....
....
.... .
....
. .
....
.
.... . .
.... .... .... ....
.... .... .... ....
.... .... ... ...
.... ....
....... .
. ....
.
.... .... ... ...
.... .... ... ...
.... .... .... ....
.... .... .... ....
....
....
....
. ...... . .
....
..... . ....
...... ...... ..... ......
...... ...... ...... ......
....... ....... ...... .......
.......
........ ....... ............ .......
.
..
.
...
.
.. .
...
..
........ ........ ................. ........
..........
.......... ..........
............
...............................................................
............
....................... ..................................
........ !
p̃ p̂ pLm pH
m p1

Two equilibria stand out:

[P] Firm I charges the same first-period price pLm independent of its costs.

Firm E learns nothing and so stays out, leading to a total profit for a high-cost firm I
of M H (pLm ) + δM H .

Firm I cannot gain from increasing first-period price if it has high costs since this induces
entry, leading to a total profit for firm I of at most M H + δDH < M H (pLm ) + δM H .

Note: This implies that, if has high costs, firm I is, in principle, prepared to lower
first-period price as far as p̂ if this manages to deter entry.

In equilibria like [P]: • Inefficient entry • Welfare effect ambiguous

[S] Firm I charges a first-period price p̂ if it has low costs, and pH

m if it has high costs.

Firm E learns the costs of firm I and enters if and only if they are high.
That is, firm E is convinced that firm I has low costs if it observes a first-period price p̂.

So firm I makes a total profit of M H + δDH if has high costs, and a total profit of
M L (p̂) + δM L if it has low costs.

Firm I cannot gain from decreasing first-period price to p̂ if it has high costs – firm E
stays out but firm I makes M H (p̂) + δM H = M H + δDH .

Firm I cannot gain from increasing first-period price above p̂ if it has low costs – this is
a credible choice for a high-cost firm I (see the note above), so firm E enters and firm I
makes at most M L + δDL < M L (p̂) + δM L .

Note: This implies that, if it has low costs, firm I is, in principle, prepared to lower
first-period price as far as p̃ in order to convince firm E.

In equilibria like [S]: • Efficient entry • Welfare enhancing

14
3.3 Business strategies

Example: Bulow, Geanakoplos & Klemperer (1985), JPE.

Incumbent can make an investment K which affects both its own competitive position
in the subsequent market, and also an Entrant’s profit.

πI (K, xI (K), xE (K)) and πE (K, xE (K), xI (K))

• Direct effect • Indirect effect • Strategic effect

Assume that xI and xE are post-entry Nash equilibrium actions.

(So indirect effect is zero.)

The investment can make the incumbent either ‘Tough’ (e.g. cost reduction) or ‘Soft’
(e.g. increase client base through advertising).

• Entry deterrence: want πE ≤ 0, so look at dπE /dK

If investment makes I tough,
then overinvest.
If investment makes I soft,
then underinvest.

• Entry accommodation: want to max πI , so look at dπI /dK

If actions are strategic substitutes (e.g. quantities) and investment makes I tough,
then overinvest.
If actions are strategic substitutes (e.g. quantities) and investment makes I soft,
then underinvest.

But . . .
If actions are strategic complements (e.g. prices) and investment makes I tough,
then underinvest.
If actions are strategic complements (e.g. prices) and investment makes I soft,
then overinvest.

K makes Incumbent · · ·
Actions are Tough Soft
..
.

Strategic
substitutes overinvest underinvest
(quantities)

Strategic
complements underinvest overinvest
(prices)

15