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Bertrand model: Oligopoly model in which firms produce a homogeneous good, each
firm treats the price of its competitors as fixed, and all firms decide
simultaneously what price to charge.
Each firm assumes its rivals will keep their price level constant when it changes its own
price.
The model
Residual demands for Firm 1:
D1 ( p1 , p 2 ) D( p1 ) if p1 p 2
D1 ( p1 , p 2 ) 12 D( p1 ) if p1 p 2
D1 ( p1 , p 2 ) 0 if p1 p 2
D2 ( p1 , p2 ) 0 if p1 p 2
The Bertrand equilibrium
Bertrand equilibrium: if the two firms have identical marginal cost equal to c, then the
Bertrand equilibrium price is equal to c.
p1 = p2 = c (stable equilibrium)
Suppose p1 > p2 > c
Firm 2 captures the whole market and earns profits
Firm 1 will match or undercut firm 2s price
p2 > p1 > c
Firm 1 captures the whole market and earns profits
Firm 2 will match or undercut firm 1s price
p1 > p2 > c
Firm 1 will match or undercut firm 2s price
The adjustment will continue until p1 = p2 = c
Any pair of unequal prices cannot be the Bertrand equilibrium
The situation p1 = p2 > c is not stable.
As long as there is profit for the one who can capture the whole market, both firms will
have incentive to undercut the other firms price.
The outcome in Bertrand equilibrium is the same as the perfectly competitive market.
No firm can earn profit.
1
As pB = c in the equilibrium,
p B a (q1 q2 )
q1 q2 a p B
q1 q 2 a c
Since the two firms will share the market when their prices are equal, therefore,
ac
B
B
q1 q 2
2
B
B
1 2 0
Price competition with differentiated products
Market shares are now determined not just by prices, but by differences in the design,
performance, and durability of each firms product.
In these markets, more likely to compete using price instead of quantity
Example:
Duopoly with fixed costs of $20 but zero variable costs. Firms face the same demand
curves:
Firm 1s demand: q1 12 2 p1 p2
Firm 2s demand: q2 12 2 p2 p1
Quantity that each firm can sell decreases when it raises its own price but increases when
its competitor charges a higher price
Firm 1s maximizing problem:
Max 1 12 p1 2 p12 p1 p2 20
0 p1
FOC: 12 4 p1 p2 0
p1*
Firm 2s maximizing problem:
12 p 2*
(Firm 1s reaction function)
4
Max 2 12 p2 2 p22 p1 p2 20
0 p2
FOC: 12 4 p2 p1 0
p 2*
12 p1*
(Firm 1s reaction function)
4
q1* q2* 8
q1* q2* 16
Profit for Firm 1 = Profit for Firm 2 = 12
2
a cp 2*
p
(Firm 1s reaction function)
2b
*
1
a cp1*
p
(Firm 1s reaction function)
2b
*
2
Confess
Deny
Confess
-10, -10
-12, -2
Deny
-2, -12
-3, -3
By the same way, we can find that confess is a dominant strategy and deny is dominated
strategy for Bob.
In the prisoners dilemma, if both players are rational, they will choose to use their
dominant strategies, Confess. The Nash equilibrium for this game is (Confess, Confess)
with a payoff of 10 for each player.
We find that the payoff for both players will be much better {3, 3} if they both choose
deny, however in the prisoners dilemma the NE is (Confess, Confess).
Individual rationality does not imply socially optimal outcome in the prisoners dilemma
Nash equilibrium
Nash equilibrium: a collection of strategies, one for each player, such that no player can
improve his situation by choosing a different strategy that is available
to him, given that all other players stay put.
In other words, the strategy (s1*, s2*) constitutes a NE if given player 1s strategy s1*,
player 2 finds it optimal to choose s2*, and given player 2s strategy s2*, player 1 finds it
optimal to choose s1*. (Best response)
When the NE is reached, there is no incentive for any player to deviate from it. No player
can benefit or increase his/her payoff by deviating from the NE.
For example, Ann would not deviate if given Bob uses his dominate strategy confess.
Deviation would lower her payoff to 12 given Bob stay puts.
Firm A
Honor Agreement
Break Agreement
Firm B
Honor Agreement
Break Agreement
72, 72
54, 81
81, 54
64, 64
What is each firms equilibrium output and profit if they behave noncooperatively?
Use the Cournot model. Draw the firms reaction curves and show the equilibrium.
In the Cournot model, Firm 1 takes Firm 2s output as given and maximizes
profits. The profit function derived in 2.a becomes
2
1 = (50 - 5Q1 - 5Q2 )Q1 - (20 + 10Q1 ), or 40Q1 5Q1 5Q1Q2 20.
Q
= 40 10 Q1 - 5 Q2 = 0, or Q1 = 4 - 2 .
Firm 1s reaction function:
2
Q1
6
Q
Similarly, Firm 2s reaction function is Q2 3.8 1 .
2
Q1
1
Solving for the Cournot equilibrium, Q1 4
and
2 3.8 2 , or Q1 2.8.
Q2 = 2.4.
P = 50 5(2.8+2.4) = $24.
The profits for Firms 1 and 2 are equal to
1 = (24)(2.8) - (20 + (10)(2.8)) = 19.20
2 = (24)(2.4) - (10 + (12)(2.4)) = 18.80
c.
How much should Firm 1 be willing to pay to purchase Firm 2 if collusion is illegal
but the takeover is not?
In order to determine how much Firm 1 will be willing to pay to purchase Firm
2, we must compare Firm 1s profits in the monopoly situation versus those in
an oligopoly. The difference between the two will be what Firm 1 is willing to
pay for Firm 2. From part a, profit of firm 1 when it set marginal revenue equal
to its marginal cost was $60. This is what the firm would earn if it was a
monopolist. From part b, profit was $19.20 for firm 1. Firm 1 would therefore
be willing to pay up to $40.80 for firm 2.
Suppose the two firms form a cartel to maximize joint profits. How many widgets will
be produced? Calculate each firms profit.
Given the demand curve P = 300-Q MR=300-2Q
MR = 300 2Q = 60 = MC
Q = 120, P = 180
Each firm produces 60
Profit for each firm is: = 180(60)-60(60)=$7,200.
c.
Suppose Firm 1 were the only firm in the industry. How would the market output and
Firm 1s profit differ from that found in part (b) above?
MR = 300 2Q = 60 = MC
Q = 120, P = 180
Profit = $14,400.
d.
Returning to the duopoly of part (b), suppose Firm 1 abides by the agreement, but Firm
2 cheats by increasing production. How many widgets will Firm 2 produce? What will
be each firms profits?
Assuming their agreement is to split the market equally, Firm 1 produces 60
widgets. Firm 2 cheats by producing its profit-maximizing level, given Q1 = 60.
60
90.
Given Q1 = 60 into Firm 2s reaction function: Q2 120
2
Total industry output, QT, is equal to Q1 plus Q2: QT = 60 + 90 = 150.
P = 300 - 150 = $150.
1 = (150)(60) - (60)(60) = $5,400 and 2 = (150)(90) - (60)(90) = $8,100.
8