1

Course outline I
Introduction
Game theory
Price setting
monopoly
oligopoly
Quantity setting
monopoly
oligopoly
Process innovation
Homogeneous
goods
2
Quantity and cost competition
Bertrand versus Cournot
Simultaneous quantity competition (Cournot)
Sequential quantity competition (Stackelberg)
Quantity Cartel
Concentration and competition
3
Price or quantity competition?
p
1
p
2
2
1
H
H
x
1
x
2
2
1
H
H
Bertrand (1883)
Cournot (1838)
4
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




and proved that capacities in a Nash equilibrium are
determined by Cournots model.
Capacity + Bertrand = Cournot
p
1


p
2
k
1


k
2
2
1
H
H
5
Cournot versus Stackelberg
Cournot duopoly (simultaneous quantity
competition)


Stackelberg duopoly (sequential quantity
competition)

x
2
x
1

H
H
1
2
x
1
x
2
2
1
H
H
6
Homogeneous duopoly
(linear case)
Two firms (i=1,2) produce a homogenous
good.
Outputs: x
1
and x
2
, X= x
1
+x
2

Marginal costs: c
1
and c
2

Inverse demand function:

Profit function of firm 1:

( ) ( )
2 1
x x b a bX a X p + = =
( ) ( ) ( ) ( )
1 1 2 1 1 1 1 2 1 1
, x c x x b a x c x X p x x + = = H
7
Cournot-Nash equilibrium
Profit functions:
Reaction functions:


Nash equilibrium:
) , (
2 1
C C
x x
) , ( ), , (
2 1 2 2 1 1
x x x x H H
) , ( max arg ) (
) , ( max arg ) (
2 1 2 1 2
2 1 1 2 1
2
1
x x x x
x x x x
x
R
x
R
H =
H =
C C R
C C R
x x x
x x x
2 1 2
1 2 1
) (
) (
=
=
8
Computing the Cournot equilibrium
(accommodation)
Profit function of firm 1

Reaction function of firm 1

Nash equilibrium


1 1 2 1 1 1 1 2 1 1
) ) ( ( ) ( ) , ( x c x x b a x c x X p x x + = = H
2 2
) ( : analogous
2 2
) (
1 2
1 2
2 1
2 1
x
b
c a
x x
x
b
c a
x x
R R

=
b
c c a
b
c c a
c c a
p
b
c c a
x
b
c c a
x
C C
C
C C
9
) 2 (
: analogous
9
) 2 (
3
) (
3
2
,
3
2
2
1 2
2
2
2 1
1
2 1
1 2
2
2 1
1
+
= H
+
= H
+ +
=
|
.
|

\
|
+
=
+
=
9
Depicting the Cournot equilibrium
x
1
Cournot-Nash
equilibrium
C
) (
2 1
x x
R
) (
1 2
x x
R
x
2
M
x
2
C
x
2
C
x
1
M
x
1
10
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 c
2
= 2.

3
23
and
3
20
: S.
2 1
= =
C C
x x
11
Common interests
c
1
, c
2
+
Obtaining government subsidies and
negotiating with labor unions.

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

12
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 c
1
=0.2 and c
2
=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?
3
2
b) 9 . 1 a) : S. = =
dt
dp
p
13
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
14
Direct approach, analytically


Direct approach (reduction of your own
marginal costs):

( ) ( ) ( ) ( )
2 1 2 2 1 1 2 1 1 2 1 1
, , , , , , c c x c c x c c c c
C C C
H = H
0
1
2
2
1
1
1
1
1
1
1
1
1
<
c
c
c
H c
+
c
c
c
H c
+
c
H c
=
c
H c
c
x
x c
x
x c c
C C C

0 <

0 =

0 <

0 >
direct
effect
strategic
effect

0 <
15
Direct approach, graphically
x
2
x
1
equilibria: increase in
production of firm 1
) (
2 1
x x
R
) (
1 2
x x
R
16
Exercise (direct approach)
Who has a higher incentive to reduce own
costs, a monopolist or a firm in Cournot-
Duopoly?
17
Indirect approach, analytically


Indirect approach (raising rivals cost):




=0 <0 <0 =0
0
2
1
1
1
2
2
2
1
2
1
2
1
>
c
H c
+
c
H c
+
c
H c
=
H
dc
dx
x dc
dx
x c dc
d
C C C

( ) ( ) ( ) ( )
2 1 2 2 1 1 2 1 1 2 1 1
, , , , , , c c x c c x c c c c
C C C
H = H


0 >
direct
effect
strategic
effect
18
Indirect approach, graphically
x
2
x
1
equilibria: increase
in production of firm 1
) (
2 1
x x
R
) (
1 2
x x
R
19
Reaction curve in the linear case
x
1
) (
1 2
x x
R
x
2
M
x
2
L
x
1
Note: alone leads to a price of .
b
c a
x
L
2
1

=
2
c

<

=
otherwise
b
c a
x if
x
b
c a
x x
R
0
2 2
) (
2
1
1 2
1 2
20
Blockaded entry, graphically
x
2
x
1
C
M
firm 1
as a monopolist
) (
2 1
x x
R
) (
1 2
x x
R
M
x
1
M
x
2
0
2
= x
L
x
1
21
Blockaded entry
Entry is blockaded for each firm:

Entry is blockaded for firm 2:



a c and a c > >
2 1
) (
2
1
) (
2
i.e.
1 1 2
1 2
1 1
c a c p c
b
c a
b
c a
x x
M
M L
+ = >

s
and a c <
1
22
Blockaded entry (overview)
c
2
c
1
duopoly
no
supply
firm 1 as a
monopolist
firm 2 as a
monopolist
a
2
1
a
2
1
a
a
23
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.
24
Stackelberg equilibrium
Profit functions

Followers reaction function (2
nd
stage)

Leaders optimal quantity (1
st
stage)


Nash equilibrium:
) , ( ), , (
2 1 2 2 1 1
x x x x H H
) , ( max arg ) (
2 1 2 1 2
2
x x x x
x
R
H =
( ) ) ( , max arg
1 2 1 1 1
1
x x x x
R
x
S
H =
) , (
2 1
R S
x x
25
Finding the profit-maximizing point
on the followers reaction curve
Accommodation
x
1
) (
1 2
x x
R
x
2
M
x
2
b
c a
x
L
2
1

=
Blockade or
deterrence
1
x
R
x
2
26
Computing the Stackelberg
equilibrium (accommodation)
Reaction function of firm 2:

Profit function of firm 1:

Nash equilibrium


with and
2 2
) (
1 2
1 2
x
b
c a
x x
R

=
1 1
1 2
1 1 2 1 1
2 2
)) ( , ( x c
x
b
c a
x b a x x x
R
|
|
.
|

\
|

|
.
|

\
|

+ = H
b
c c a
x
x
b
c c a
x
S
R S
4
3 2
,
2
2
2 1
2
2
2 1
1
+
=
|
.
|

\
|
+
=
4
2
2 1
c c a
p
S
+ +
=
27
Depicting the Stackelberg
outcome (both firms produce)
x
2
x
1
quantities in a
Stackelberg equilibrium
C
S
) (
2 1
x x
R
) (
1 2
x x
R
M
x
2
C
x
2
S
x
1
C
x
1
S
x
2
28
Exercise (equilibria)
Which is an equilibrium in the Stackelberg
model?





Are there any additional Nash equilibria ?
( ) ( )
( )
( )? ,
, ,
, ,
2 1
2 1
1 2 1
C C
R S
S R S
x x
x x
x x x
29
Cournot versus Stackelberg
Profit function of firm 1

First order condition for firm 1



) ( ) ( ) , (
1 1 1 2 1 1
x C x X p x x = H
) ( ) (
) ( ) (
1 1
!
1
2
1 1
1
2
1
1
1
1
1
1
1
x MC
dx
dx
dX
dp
x
dX
dp
x X p
dx
dx
dx
dx
dX
dp
x X p
dx
dX
dX
dp
x X p
dx
dR
R
R
= + + =
|
.
|

\
|
+ + = + =
direct effect follower or strategic effect,
Cournot: 0, Stackelberg: >0
30
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 c
1
= 3, c
2
= 2.

Possible or not: ?
S C
1 1
H > H
( )
R S
x x
2 1
, 10 : S. =
31
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!
3
50
: S. = p
32
Blockaded entry
p
x
1
x
L
1
blockaded entry
for firm 2
) (
1
x p
M
x
1
M
p
1
2
c
1
c
a
L
x
1
M
33
Reaction functions in the case of
blockaded entry
L
x
1
1
x
2
x
M
x
1
) (
1 2
x x
R
) (
2 1
x x
R
34
Profit function of firm 1 in the
case of blockaded entry of firm 2
( ) 0 ,
1 1
x H
1
x
1
H
L
x
1
M
x
1
M
1
H
( ) ( )
1 2 1 1
, x x x
R
H
35
Deterring firm 2s entry
p
x
1

H
1
L
) (
1
x p
a
M
p
1
2
c
1
c
M
x
1
L
x
1
36
Deterrence pays,
( ) 0 ,
1 1
x H
1
x
1
H
L
x
1
M
x
1
M
1
H
( ) ( )
1 2 1 1
, x x x
R
H
( ) ( )
0
,
1
1
1 2 1 1
>
H
L
x
R
dx
x x x d
37
Deterrence does not pay
( ) 0 ,
1 1
x H
1
x
1
H
L
x
1
M
x
1
M
1
H
( ) ( )
1 2 1 1
, x x x
R
H
S
x
1
( ) ( )
0
,
1
1
1 2 1 1
<
H
L
x
R
dx
x x x d
38
Blockaded and deterred entry I
Entry is blockaded for each firm:

Blockaded entry (firm 2):




| |
a c and
c a
c
a c and x x or c p c
M L M
<
+
>
< s >
1
1
2
1 1 1 1 2
2
) (
a c and a c > >
2 1
39
Blockaded and deterred entry II
Deterred entry (firm 2):
Entry is not blockaded if

Deterrence pays if




Deterrence if
( ) ( )
1 2
1 2 1 2 1
1
1 2 1 1
3
2
3
1
2
3
2
1
2
1
2
1 ,
0
1
c a c
c c a c c a bx
dx
x x x d
L
x
R
L
+ >
+ = + + =
H
<
M
p
c a
c
1
1
2
2
=
+
<
2 3
2
3
1
1
2 1
c a
c c a
+
< s +
40
Blockade and deterrence
firm 1 as a
monopolist
c
2
c
1
duopoly
no supply
blockade
firm 2 as a
monopolist
a
a
2
1
a
3
1
a
2
1
a
41
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 c
2
=1?
c) Find firm 1s limit output level for c
2
=1.
Should the incumbent deter entry?
on accomodati , 12 5 . 0 c)
blockaded not is entry b) entry, blockaded a) : S.
1 1
L S
H = > = H
42
Deterrence and sunk costs I
We now introduce quasifix costs of 3:
p(X)=4-0.25X
( )
( )

=
> +
=

=
> +
=
0 0
0 3
function cost s Follower'
0 0
0 2 3
function cost s Leader'
2
2 2
2 2
1
1 1
1 1
x ,
x , x
x C
x ,
x , x
x C
43
Deterrence and sunk costs II
b) Entry blockaded ?


Comparison is not sufficient
( )
( ) ( ) ( ) 3 4 4 0 , 0 0 1 0 , 4
3 4 , 4
1 1 1
? ?
1
= = H = > = H
= =
M M
M M
p x
p x
( )
2 1
c x p
M
<
>
( ) ( )
( ) ( ) ( ) ( )
blockaded not Entry
0 1 4 1 3 4 4 4 25 , 0 4 4 , 4
4
2
1
6
2
1 2 1 1 2

> = + + = H
= =
M R R
x x x x x
44
Deterrence and sunk costs III
c) Should firm 1 deter?
( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) | | ( ) ( ) ( )
( ) | | ( ) ( ) ( )
| | ( ) ( )
( )
L Lq Lq Lq
Lq Lq
Lq Lq Lq Lq
Lq Lq Lq
Lq Lq Lq Lq
Lq R Lq R Lq R Lq
Lq R Lq R Lq R Lq
L Lq Lq
x x x x
x x
x x x x
x x x
x x x x
x x x x x x x
x x C x x X p x x x
x x x
1 2 1 1 1 1
2
1 16
1
1 2
3
1 2
1
2
1 16
1
1 4
5
1 4
3
1 2
1
1 2
1
1 8
1
2
5
1 2
1
1 2
1
1 2
1
1 4
1
1 2 1 2 1 2 1 4
1
1 2 2 1 2 1 2 1 2
1 1 1
12 3 4 12 : , 3 4 12
6
6 3 15
6 3 6
6 3 6 6 4
3 4
, 0
(why?) costs, quasifixed ith quantity w limit
= < = = + =
+ =
+ + =
=
+ + =
+ + =
= H =
< =
45
Deterrence and sunk costs IV
( ) ( ) ( ) ( ) ( )
( ) ( ) ) " deterrence and entry " exercise (see ,
2
1
71 , 0
3 8 24 3 0 3 4 12 0 3 4 12 4 0 ,
1 2 1 1
4
1
1 1
S R S S
Lq
x x x
x
H = > ~
+ + + = H
deterrence pays
46
Deterrence and sunk costs V
1
x
2
x
( )
1 2
x x
R
M
x
1
S
x
1
6
12
Lq
x
1
47
Deterrence
Deterrence and sunk costs VI
4
1
=
M
x
2
1
=
S
x
Accommodation Accommodation Blockade
2 , 7
5 , 0 44 , 1
3 4 9
S
x
1
F
C
48
Strategic trade policy
H
1

H
2
x
d
x
f
s

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)).
49
Exercise (Strategic trade policy)
In the setting just described, assume
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


Which subsidy s maximizes domestic welfare?
( ) ( ) ( ) c s c sx c s c s W
C
d
C
d
, , H =
2 1
: c c c = =
4
: S.
*
c a
s

=
50
Direct effect of subsidy for domestic welfare is zero.
Strategic effect:

Solution (Strategic trade policy) -
interpretation
0 >
c
c

c
H c
s
x
x
C
f
f
d
<0 <0
d
x
f
x
R
d
x
R
f
x
s R
d
x
,
s
M
x
M
x
Cournot-Nash-
equilibria
( ) ( ) ! ! , , c c x c s c x
S
d
C
d
=
(firm d Stackelberg
leader)
51
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
52
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.
53
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.
54
The quantity cartel
The firms seek to maximize joint profits



Optimization conditions




Compare monopoly with two factories.
0 ) ( ) ( ) (
) (
0 ) ( ) ( ) (
) (
!
2 2 2 1
2
2 1
!
1 1 2 1
1
2 1
= + + =
c
H + H c
= + + =
c
H + H c
x MC
dX
dp
x x X p
x
x MC
dX
dp
x x X p
x
) ( ) ( ) )( (
) , ( ) , (
2 2 1 1 2 1
2 1 2 2 1 1
x C x C x x X p
x x x x
+ =
H + H
55
The cartel agreement
The optimization condition is given by


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.
0 ) ( ) (
2
!
1 1 1
1
1
> = + =
H
dX
dp
x x MC
dX
dp
x X p
dx
d
56
Cartel quantities
x
2
x
1
C
S
K
M
x
1 2
1
quantities in a
symmetric cartel
) (
2 1
x x
R
) (
1 2
x x
R
C
x
1
M S
x x
1 1
=
S M
x x
2 2
2
1
=
C
x
2
M
x
2
57
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
58
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.
59
The outcomes of our models
quantity
price
a
monopoly (M) and cartel (K)
Cournot (C)
Stackelberg (S)
perfect competition (PC)
p
M
p
C
p
S
p
PC
= c
X
M
X
C
X
S
X
PC
60
Antitrust laws and enforcement,
Germany
laws
Gesetz gegen unlauteren Wettbewerb (1896)
Gesetz gegen Wettbewerbsbeschrnkungen
(GWB), (1957)
enforcement
Bundeskartellamt
61
Exercise: Calculate C
2
for





C
k
concentration ratio
n k
i
i
s s s s
X
x
s n > > > > > =
2 1
and firms,
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 ?
monopoly:
perfect comp.:
firms identical for 0 lim
1 1
=
= = =

n
k
n
n
k
k n
Setup:
n ,k
n
k
C s C
k
k
i
i k
s = =

=
: firms identical n for ,
1
Definition:
62
GWB, 19 (3)
One firm is called market dominating if
C
1
>1/3.
A group of firms is called market
dominating if

. 5 , 3 / 2
or
3 , 2 / 1
s >
s >
k C
k C
k
k
63
The Herfindahl (Hirschman) index
Definition:



Exercise: Calculate H for

= =
=
|
.
|

\
|
=
n
i
i
n
i
i
s
X
x
H
1
2
2
1
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 ?
0 : ) (
n competitio perfect
1
: firms identical
1 : monopoly

=
=
H n
n
H n
H
64
n firms in Cournot competition
Total industry output:
Firm is profit function:

Firm is marginal revenue:


n
x x x X + + + = ...
2 1
( )
i i i n n i
x C x x x p x x + + = H ) ... ( ) ,..., (
1 1
( )
|
|
.
|

\
|
=
|
.
|

\
|
+ =
+ =
+ +
+ = + =
p X
i i
i
i
n
i
i
i i
s
p
dX
dp
p
X
X
x
p
dX
dp
x p
dx
x x d
dX
dp
x p
dx
dp
x p x MR
,
1
1 1
1 ) (
c

65
Lerner index of market power
First order condition:

Lerner index for one firm:

Lerner index for the industry:
) ( ) ( ) (
!
i
i
i i
x MC
dx
dX
dX
dp
x X p x MR = + =
p X
i
p X
i
i
s
p
s
p p
p
MC p
,
,
!
1
c
c
=
|
|
.
|

\
|

=

p X
n
i
p X
i
i
n
i
i
i
H s
s
p
MC p
s
,
1
,
!
1
c c
= =

= =
66
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

a) Calculate the inverse market demand function!
b) Calculate the reaction function of firm j and the total market
output and p
C
in the symmetric Cournot-
equilibrium! Hint: Use
c) Now the number of firms and costumers is multiplied by
Calculate again p
C
and MC
j
! Prove that for the gap
between price and marginal costs converges to zero!

( ) . 5 , 0
2
j j j
x x C =
C
n
C C C
x x x X + + + =
2 1
.

Theorie der Industriekonomik; Bester
n j j j
x x x x X + + + + + =
+
.. ...
1 1 1
( )
n m
n
p
n m
m
n
X p
C
m
X
+ +
=
+ +
=
=
1
1 ,
1
X b)
1 a) : S.
C