This workbook is designed to explain the basic principles of game theory.

Important terms in the outline below are in red text.

An important idea is that of interdependence.
This means that one firm's decision affects another firm's decision and vice versa.
The degree of interdependence is a function of the number of firms in the industry

Number
of Firms

Name

Degree of
Interdependen
ce

Monopoly

None

Duopoly

Very Hgh

Several

Oligopoly

High

Many

Perfect
Competition

None

This file will explore the Perfect Competition, Monopoly, and Duopoly cases.

The product is electricity, which comes in units of kilowatt hours, kwh. A kilowatt is one thousand watts. A wat
Electric power companies charge a price per kwh.
In Nov of 2008, the US average retail price was 8.90 cents per kwh.
Source: http://www.eia.doe.gov/fuelelectric.html
The Parameters sheet contains the market demand curve and the cost function of each firm.
The PerfectCompetition sheet shows the outcome if the industry is perfectly competitive.
Electricity is not a perfectly competitive industry, but perfect competition is our benchmark.
The Monopoly sheet finds the profit-maximizing output and price that would be selected by a monopolist.
We offer two ways of finding the optimal solution: graph and Excel's Solver.

The ResidualDemand sheet introduces the Duopoly game. It presents the idea that one firm optimizes based o
Once again, there are two ways to find the optimal solution: graph and Excel's Solver.
Given a conjecture, there is a best response and the resulting relationship between conjecture and b

The Duopoly sheet presents the two firms playing the game. There is a Best Response Function for each firm a

The Summary sheet compares the results from the Perfect Competition, Monopoly, and Duopoly market structu
Begin your study of Game Theory by going to the Parameters sheet.

d vice versa.
the industry

t is one thousand watts. A watt is a unit of energy.

of each firm.

ion is our benchmark.

elected by a monopolist.

hat one firm optimizes based on a conjecture about what the other firm will do.
d Excel's Solver.
ship between conjecture and best response is called a Best Response, or Reaction, Function.

ponse Function for each firm and the intersection pinpoints the Nash equilibrium.

ly, and Duopoly market structures.

DEMAND
Market Demand is given by Q = a - bP

Inverse Demand is P = d0 - d1Q

a
b

where d0=a/b and d1=1/b

d_0
20
d_1
0.001

20000
1000

Price
0
2
4
6
8
10
12
14
16
18
20
SUPPLY
Each firm's cost function is TC = c3Q3 + c2Q2 + c1Q1 + c0
c_3
c_2
c_1
c_0

0
0
5
0

Quantity
20000
18000
16000
14000
12000
10000
8000
6000
4000
2000
0

A linear cost function is not

especially realistic, but it
makes the problem easier to
understand and does not
change the basic
conclusions of the analysis.

120000
100000
80000

cents60000

Industry cost = individual cost

40000

Quantity
0
2000
4000
6000
8000
10000
12000
14000
16000
18000
20000

Total Cost Marginal Cost

0
5
10000
5
20000
5
30000
5
40000
5
50000
5
60000
5
70000
5
80000
5
90000
5
100000
5
With each firm's MC constant,
the number of firms does not
affect the industry MC.
Whether the industry is
perfectly competitive,
monpolistic, or anything in
between, industrywide MC
remains unchanged.

20000
0
0

25
20

Price (cents/kwh)
15
10
5
0
0

With each firm's MC constant,

the number of firms does not
affect the industry MC.
Whether the industry is
perfectly competitive,
monpolistic, or anything in
between, industrywide MC
remains unchanged.

10
5
0
0

Market Demand

25
20

Price (cents/kwh)
15
10
5
0
0

5000

10000
Quantity

15000
(kwh)

20000

25000

Total Cos t

120000
100000
80000

cents60000
40000
20000
0
0

5000

10000

15000

Quantity (kwh)

20000

25000

Marginal Cos t

25
20

Price (cents/kwh)
15
10
5
0
0

5000

10000
15000
Quantity (kwh)

20000

25000

10
5
0
0

5000

10000
15000
Quantity (kwh)

20000

25000

This sheet assumes that there are many firms producing electricity.
Together, they have a Market Supply curve, which is the sum of the individual firm supply curves.
The market will settle down to an equilibrium price and quantity combination where Market Supply and Market Demand intersect.

Market for Electricity

25
20

Price (cents/kwh)
15
10
5

1
2

0
0

5000

10000
15000
Quantity (kwh)

20000

25000

The graph makes clear that the equilibrium price will be 5 cents per kwh and equilibrium quantity will be 15,000 kwh.
The Monopoly sheet examines what kind of outcome we would get if one firm had a monopoly in the market for electricity.

Price
0
2
4
6
8
10
12

Quantity
Demanded
20000
18000
16000
14000
12000
10000
8000

Quantity
Supplied
5
5
5
5
5
5
5

14
16
18
20

6000
4000
2000
0

5
5
5
5

y and Market Demand intersect.

25000

will be 15,000 kwh.

the market for electricity.

This sheet assumes that only one firm produces electricity.

This sheet offers two ways to find the optimal output-price combination.
1) Use the Choose Q control to find the optimal output and price.
2) Use Solver to find the monopolist's profit-maximizing solution

Parameters
a
b
c_3
c_2
c_1
c_0

20000
1000
0
0
5
0

Market for Electricity with a Monopolist

25
20
15

Price (cents/kwh)
10

Objective Function
profits

0 cents

1
2

Choice Variables
Q
P

0
0

15000 kwh
5 cents per kwh

5000

10000

-5

Quantity (kwh)
Choose Q

Price
0
2
4
6
8

Quantity
Demanded
20000
18000
16000
14000
12000

Quantity
Supplied

MR
5
5
5
5
5

-20
-16
-12
-8
-4

15000
1

Choose Q
15000
15000
0

0
5
5

20000

10
12
14
16
18
20

10000
8000
6000
4000
2000
0

5
5
5
5
5
5

0
4
8
12
16
20

with a Monopolist

1
2
15000
1

ntity (kwh)

20000

25000

This sheet assumes that two firms produce electricity and models Firm 1's optimal decision-making.

Firm 1 has to guess Firm 2's output decision before maximizing.

We introduce a new parameter, Conjectured Q2. A conjecture is a guess.
Given a value of Conjectured Q2, Firm 1 subtracts the amount of output produced by its rival from the Market Demand curve.
Those units of output are presumably sold and, thus, decrease the remaining demand for the product.
Firm 1 will choose the quantity that maximizes profit using the Residual Marginal Revenue curve, then read the price from the Demand cur
This sheet offers two ways to find the optimal output-price combination.
1) Use the Choose Q control to find the optimal output and price.
2) Use Solver to find the monopolist's profit-maximizing solution.
Parameters
Conjectured Q2
a
b
c_3
c_2
c_1
c_0

0
20000
1000
0
0
5
0

Market for Electricity with Two Firms

25
20

Price (cents/kwh)
15
10

Objective Function
profits

56250 cents

5
0

Choice Variables
Q
P

7500 kwh
12.5 cents per kwh

-5

5000

10000

15000
1

Quantity (kwh)
Choose Q

By varying the Conjectured 2, we generate Firm 1's Reaction, or Best Response, Function.

Conjectured
Q2
0
2500
5000
7500
10000
12500

Firm 1's
Optimal
Output

Market
Price

15000

Price
0
2
4
6
8
10
12
14
16
18
20

Quantity
Demanded
20000
18000
16000
14000
12000
10000
8000
6000
4000
2000
0

Quantity
Supplied

MR
5
5
5
5
5
5
5
5
5
5
5

-20
-16
-12
-8
-4
0
4
8
12
16
20

Residual Qd
Residual MR Choose Q
20000
-20
7500
18000
-16
7500
16000
-12
0
14000
-8
12000
-4
10000
0
8000
4
6000
8
4000
12
2000
16
0
20

Market Demand curve.

d for the product.
ead the price from the Demand curve.

et for Electricity with Two Firms

1
2
10000

15000
1

Quantity (kwh)
Choose Q

ponse, Function.

20000

25000

$
$

0
12.50
12.50

This sheet assumes that two firms produce electricity and you can have one firm maximize profits based on a conjecture about the output of
Instead of using both the Residual Demand graph and Excel's Solver, we'll let the buttons do the heavy lifting of finding the optimal solution
The buttons on this sheet use analytical solutions to crank out the optimal solution without you having to bother run Solver itself.
Thanks to Frank Howland for eliminating the need for Solver.

Firm 1's Maximization Problem

Parameters
a
20000
b
1000
c_3
0
c_2
0
c_1
5
c_0
0
Conjectured Q2
0.00

Firm 2's Maximization Problem

Parameters
a
20000
b
1000
c_3
0
c_2
0
c_1
5
c_0
0
Conjectured Q1
0.00

Objective Function
profits

Objective Function
profits

Choice Variables
q1
P

0 cents

0.00 kwh
20 cents per kwh

Choice Variables
q2
P

0.00
20

onjecture about the output of the other firm.

f finding the optimal solution given the other firm's chosen level of output.
run Solver itself.

cents

kwh
cents per kwh

Both Reaction Functions

12

q2

10
8
6

Firm
2

4
2
0
0

12
12

q2

10
10
88
66
44
22

q1

10

Firm 2's
1's Reaction
Inverse Reaction
FunctionFunction

12

Firm 2's
1's Reaction
Inverse Reaction
FunctionFunction

12
12

q2

10
10
88
66
44
22
00
00

22

44

q1
q1

66

88

10
10

12
12

Parameters
Demand: Q=a-bP
a
b

Inverse Demand: P=d0-d1Q

20000 d_0
20
1000 d_1
0.001

Output
Firm
Industry

Price

Monopoly

7,500

7,500

12.5

Duopoly at Nash
Equilibrium

5,000

10,000

10

Perfect
Competition

15,000/n
w/ n large

15,000

Total Cost = c3Q3 + c2Q2 + c1Q1 + c0

c_3
0
c_2
0
c_1
5
c_0
0