Business Economics

Oligopoly

Sarat Chandra Akella

Fall 2021

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Strategic Interactions

Oligopolistic competition:
I Relatively small number of firms.

I The actions (prices, quantities, advertising decisions, . . . ) taken

by a firm affect rivals’ profits.
I Conversely, when a firm chooses its action, it needs to anticipate
the actions of rivals.
I In a dynamic setting, a firm also needs to anticipate the conse-
quences of its behavior today on rivals’ reactions tomorrow.
I ⇒ This is a framework of strategic interactions.

I We will use the toolkit of game theory to derive predictions on

firm behavior.

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Examples

I Cell phone services

I Personal computer industry
I Aircraft industry
I Automobile industry
I ...

Note: We will start by considering homogeneous products

→ Consumers cannot differentiate among brands, or distinguish among
the producers
Later we will consider heterogeneous products

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Roadmap

I Cournot competition
firms compete in quantities with simultaneous moves
I Bertrand competition
firms compete in prices with simultaneous moves
I Stackelberg competition
firms compete in quantities with sequential moves
I Extensions

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Cournot Competition

Augustin Cournot, a French mathematician, wrote in 1838 - well before

John Nash!

He proposed a method to analyze oligopolistic markets that actually

yields the Nash equilibrium of the game where firms simultaneously
choose their quantities.

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Cournot Competition

Let us define the Cournot game:

I Players: two firms denoted by i = 1, 2. (duopoly)
I Actions: production levels/quantities, qi for firm i
I Payoffs: profits, πi for firm i

πi (q1 , q2 ) = P (q1 + q2 )qi − Ci (qi )

Consider a simple numerical example with linear costs and linear de-
mand:
I Costs: C1 (q1 ) = 10q1 and C2 (q2 ) = 40q2
I Demand: P (Q) = 100 − Q where Q = q1 + q2

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Cournot Equilibrium
A Cournot equilibrium (q1c , q2c ) is a Nash equilibrium of this game.
Equilibrium conditions: quantities are best responses to each other.
I Given q2 = q2c , q1c solves maxq1 π1 (q1 , q2c ).

I Given q1 = q1c , q2c solves maxq2 π2 (q1c , q2 ).

In other words:
⇒ Each firm makes a profit-maximizing decision, anticipating the
profit-maximizing decision of competitors

⇒ To qualify as an equilibrium, firms’ choices must be profit-maximizing

against each others

The corresponding Cournot price is

pc = P (q1c + q2c ) = 100 − (q1c + q2c ).

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Cournot Best-Responses
I Firm 1’s profit, given quantity q2 :

π1 (q1 , q2 ) = (100 − q1 − q2 )q1 − 10q1 .

I It is maximized when q1 is such that

100 − 2q1 − q2 − 10 = 0.

[As usual, this optimality condition can be written as M R = M C].

I We derive the best response of firm 1 to quantity q2

1
q1 = R1 (q2 ) = 45 − q2
2
I R1 (·) is called the best-response function (or reaction function) of
firm 1.

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Cournot Best-Responses

I Firm 2’s profit, given quantity q1 :

π2 (q1 , q2 ) = (100 − q1 − q2 )q2 − 40q2 .

I It is maximized when q2 is such that

100 − q1 − 2q2 − 40 = 0.

I We derive the best-response function of firm 2:

1
q2 = R2 (q1 ) = 30 − q1
2

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Cournot Equilibrium

Graphically:
q2

R1 (q2 )

30

q2c R2 (q1 )
0 q1
q1c45

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Cournot Equilibrium
Analytically, we solve the following system of best responses:
(
q1c = R1 (q2c )
q2c = R2 (q1c )

This gives:
(
q1c = 40
q2c = 10

⇒ Qc = q1c + q2c = 50
⇒ pc = 100 − Qc = 50
Equilibrium profits:

π1c = (pc − 10)q1c = 1600

π2c = (pc − 40)q2c = 100

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Quantities are Strategic Substitutes

I Notice that both reaction functions are downward-sloping

→ If my rival increases his production, then I want to decrease mine

→ We say that quantities are strategic substitutes

I Intuition?

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Quantities are Strategic Substitutes

I The profit-maximizing quantity is such that M R = M C.

I M R1 (q1 ) = P (q1 + q2 ) + P 0 (q1 + q2 )q1

⇒ When q2 increases, the price P (q1 + q2 ) decreases and P 0 (q1 + q2 )

remains constant (in the linear case), so M R falls

⇒ Fewer incentives to produce

⇒ q1 decreases

⇒ R1 (q2 ) is a decreasing function

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Cournot Competition with N Firms
I Let Q = 100 − p, where Q = q1 + q2 + . . . + qN and M C = 10.
Take the perspective of one firm, say firm 1:
I Inverse demand for firm 1 is p = 100 − q1 − q2 − ... − qN

I M R1 (q1 ) = 100 − 2q1 − q2 − ... − qN

⇒ M R1 (q1 ) = M C ⇒ 100 − 2q1 − q2 − ... − qN = 10

I The best response curve for firm 1:
 
N
1 X 
q1 = 45 − qj
2 j,1

I Similar expression for the other firms’ best responses

I All firms face the same cost ⇒ q1 = q2 = . . . = qN = q c ⇒ Cournot

equilibrium is symmetric
I Simply solve q c = 45 − 1 90
2 (N − 1) q c ⇒ q c = N +1
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Cournot Competition
90
We found that the Cournot equilibrium with N firms is q c = N +1 .

Note that:
I If N = 1 ⇒ q c = 45 ⇒ This is the monopoly (cartel) outcome!

I If N = 2 ⇒ q c = 30 ⇒ This is the duopoly outcome!

I If N = ∞, then

lim q c = 0
N →∞
c
lim Q = 90
N →∞
lim pc = 10 = MC
N →∞

⇒ The Cournot outcome converges to the perfect competition out-

come as N −→ ∞!

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Market Structures

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Bertrand Competition

Joseph Bertrand, a French mathematician, wrote in 1883 - well before

John Nash!
He proposed a method to analyze oligopolistic markets that actually
yields the Nash equilibrium of the game where firms simultaneously
choose their prices.
Suppose that there are two firms, with equal marginal cost c.
Denote by D(p) the total demand for the product, with D0 (·) < 0.
Two assumptions:
1. Consumers always purchase from the cheapest seller (homogeneous
product).
2. If two sellers charge the same price, consumers are split 50/50
(tie-breaking rule).

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Bertrand Competition

Denote by Di (p1 , p2 ) firm i’s demand:



 0 if pi > pj


Di (p1 , p2 ) = D(p) 2 if pi = pj = p



D(pi ) if pi < pj


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Bertrand Competition

I Players: two firms, producing an identical product

I Actions: prices

I Profits:
πi (p1 , p2 ) = (pi − c)Di (p1 , p2 )

A Bertrand equilibrium (pb1 , pb2 ) is a Nash equilibrium of this game.

It is such that the price chosen by each firm is a best response to the
price chosen by the competing firm:

1. given p2 = pb2 , pb1 solves maxp1 π1 (p1 , pb2 )

2. given p1 = pb1 , pb2 solves maxp2 π2 (pb1 , p2 )

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Bertrand-Nash Equilibrium

Let p1 , p2 ≥ 0:
I Claim 1: (p1 , p2 ) cannot be a Nash equilibrium if p1 < c or p2 < c.
Proof: It is better for Firm 1 (or Firm 2) to shut down.
I Claim 2: (p1 , p2 ) cannot be a Nash equilibrium if c < p2 < p1 .
Proof: Firm 1 has a strictly profitable deviation: set p1 = p̄ such
that c < p̄ < p2 (similar argument rules out c < p1 < p2 ).
I Claim 3: (p1 , p2 ) cannot be a Nash equilibrium if c < p1 = p2 = p̂.
Proof: Firm 1 (or Firm 2) has a strictly profitable deviation: set
p1 = p̄ (or set p2 = p̄) such that c < p̄ < p̂.
I Claim 4: (p1 , p2 ) cannot be a Nash equilibrium if c = p2 < p1 .
Proof: Firm 2 has a strictly profitable deviation: set p2 = p̄ such
that c < p̄ < p1 (similar argument rules out c = p1 < p2 )

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Bertrand Competition

The only remaining possibility is p1 = p2 = c. Is this a Nash equilib-

rium?
I A downward deviation would not be profitable, since the deviating
firm would then make losses.
I An upward deviation would not be strictly profitable: the deviat-
ing firm makes 0 profit before and after the deviation.
⇒ pb1 = pb2 = c is the only Nash equilibrium.

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Bertrand Paradox

Theorem: There is a unique Nash equilibrium, and it is such that price

equals marginal cost
pb1 = pb2 = M C.

Bertrand Paradox: Under Bertrand competition with homogeneous

products and constant, symmetric marginal cost, firms make zero prof-
its.

Intuition: Firms have strong incentives to undercut each other, as long

as prices exceed marginal cost.

By undercutting its rival’s price by 1 cent, a firm can take over the
whole market.

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Bertrand Competition: Extensions

Bertrand outcome is not fully realistic, but it is a good benchmark to

explore extensions.

Why don’t we observe marginal cost pricing in industries where firms

compete in prices?

I Product differentiation

I Dynamic interactions / collusion (cartel’s behavior)

I Capacity constraints

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Product Differentiation

I When products are differentiated, a firm cannot attract the whole

demand by being one euro cheaper.

I Example: Coke and Pepsi.

I Suppose Coke and Pepsi initially have the same price, and let Coke
decrease its price. Then the demand for Pepsi decreases, but not
to zero. (Formally, the elasticity of demand when prices are equal
is not infinite).

⇒ Incentives to be cheaper than the competitor are less strong than

when the good is homogeneous.

⇒ Competition is less tough, so prices are higher.

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Product Differentiation (Exercise 28)

D1 (p1 , p2 ) = 10 − 2p1 + p2
D2 (p1 , p2 ) = 12 − 2p2 + p1
1 2
C1 (q1 ) = cq1 and C2 (q2 ) = q
2 2

We derive the best-response functions:

5 + c p2
R1 (p2 ) = +
2 4
9 3
R2 (p1 ) = + p1
2 8

Remark: the best response functions are increasing: if my competitor

increases his price, I will get (everything else equal) more customers,
and therefore I have stronger incentives to raise my own price.
⇒ We say that prices are strategic complements.
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Product Differentiation
I A Bertrand Nash equilibrium (pb1 , pb2 ) is such that

pb2
pb1 = R1 (pb2 ) = 5+c

2 + 4
9
pb2
 = R2 (pb1 ) = 2 + 38 pb1

Solving the system yields:

16
pb1 = 4+ c
29
6
pb2 = 6+ c
29

I In the Bertrand Nash equilibrium, both prices are increasing in

M C1 : if M C1 increases, firm 1 will charge a higher price. Firm
2 will also increase its price to optimally react to Firm 1’s price
increase (even if Firm 2’s cost function remains unchanged).

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Cournot vs. Bertrand
I Cournot competition: Firms compete on quantities
I Bertrand competition: Firms compete on prices

Which of these models is a better approximation of duopoly competi-

tion?
I If capacity and output can be easily adjusted, competition à la
Bertrand is more relevant
I Softwares, insurance, banking

I If capacities are hard to adjust in the short-run, competition à la

Cournot is more realistic
I Cement, cars, steel, etc.
I Many industries, such as the airline sector, alternate the two forms
of competitions depending on whether they operate at their capac-
ity constraint

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Stackelberg Competition: Cournot in Sequential Moves
Same market structure but assume firms move sequentially. Recall:
I Players: two firms denoted by i = 1, 2. (duopoly)
I Actions: production levels/quantities, qi for firm i
I Costs: C1 (q1 ) = 10q1 and C2 (q2 ) = 40q2
I Demand: P (Q) = 100 − Q where Q = q1 + q2
I Best responses (static game):

1
q1 = R1 (q2 ) = 45 − q2
2
1
q2 = R2 (q1 ) = 30 − q1
2
Timing:
1. Firm 1 sets its quantity q1 (Leader).
2. Firm 2 observes q1 and sets q2 (Follower).

Sequential game ⇒ we use backward induction to find the equilibrium.

Start with period 2, and assume that firm 1 has chosen quantity q1 .
What should firm 2 do? ⇒ Use its best-response function and set
q2 = R2 (q1 ) = 30 − 12 q1 .
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Recall: Backward Induction

Leader

0
q1 q1

F ollower

0 0
q2 q2 q2 q2

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Recall: Backward Induction

Leader

0
q1 q1

F ollower

0 0
q2 q2 q2 q2

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Recall: Backward Induction

Leader

0
q1 q1

F ollower

0 0
q2 q2 q2 q2

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Recall: Backward Induction

Leader

0
q1 q1

F ollower

0 0
q2 q2 q2 q2

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Stackelberg Competition
At stage 1: Firm 1 knows that, if it sets q1 , firm 2 will react by setting
R2 (q1 ).

⇒ Incorporate R2 (q1 ) into Firm 1’s profit maximization:

   
1 1
max 100 − q1 − (30 − q1 ) − 10 q1 = max 70 − q1 − 10 q1
q1 2 q1 2

⇒ M R1 (q1 ) = 70 − q1 = 10 = M C. Thus, we obtain:

I q1S = 60 > q1C = 40.

I q2S = 30 − 12 q1S = 0 < q2C = 10.
I QS = q1S + q2S = 60 > QC = 50.
I pS = 40 < pC = 50.
I Profits:
π1S = (pS − 10)q1S = 1800 > π1C = 1600

π2S = (pS − 40)q2S = 0 < π2C = 100

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Stackelberg Competition
What if Firm 2 moves first?
Firm 2 knows that, if it sets q2 , firm 1 will react by setting
q1 = R1 (q2 ) = 45 − 12 q2 .

⇒ Incorporate R1 (q2 ) into Firm 2’s profit maximization:

   
1 1
max 100 − (45 − q2 ) − q2 − 40 q2 = max 55 − q2 − 40 q2
q2 2 q2 2

⇒M R2 (q2 ) = 55 − q2 = 40 = M C. Then:
I q2S = 15 > q2C = 10
I q1S = 45 − 12 q2S = 37.5 < q1C = 40
I QS = q1S + q2S = 52.5 > QC = 50
I pS = 47.5 < pC = 50
I Profits:
π1S = (pS − 10)q1S = 1406.25 < π1C = 1600

π2S = (pS − 40)q2S = 112.5 > π2C = 100

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Stackelberg vs. Cournot

I There is a first-mover advantage:

I the Stackelberg leader produces more and makes higher profits than
in the Cournot game.
I Conversely, the follower produces less and makes lower profits than
in the Cournot game.

I The total output is larger in Stackelberg than in Cournot

⇒ The price is lower in Stackelberg than in Cournot

⇒ Consumer surplus is larger in Stackelberg than in Cournot!

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Stackelberg vs. Cournot
Remarks:
I The leader sets q1S > q1C . Why?

→ Quantities are strategic substitutes, so by producing more I force

my competitor to produce less.
I Assumptions: rationality and common knowledge of rationality

I Firm 1 anticipates Firm 2’s behaviour as a rational agent (like

Alice choosing Opera knowing Bob will also choose Opera)
I Firm 2 could threaten Firm 1 by claiming to choose a large quantity
q2S as its response. This would lower the price and hurt Firm 1
(like Bob could threaten to choose Football, no matter what Alice
chooses)
I Firm 1 can ignore such threats as they are not credible (like Alice
could ignore Bob’s threat knowing he will behave rationally)

In the real world, can we assume the Follower firm to always behave
rationally? Amazon? Or Jio?
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