Microeconomics

Lecture 9

Petr Špecián, Ph.D.

Mail: petr.specian@vse.cz
Office hours: see InSIS
Price Discrimination

2
Price Discrimination
Price discrimination: identical units of output sold at different prices
• Opens new profit opportunities

3
Targets for Price Discrimination
P

I. The remaining consumer surplus

II. The possibility of mutually beneficial trades
otherwise lost to DWL
𝐼
𝑃∗

𝐼𝐼 𝐸 𝑀𝐶 = 𝐴𝐶

𝑀𝑅 𝐴𝑅 = 𝐷

𝑄∗ 𝑄 ∗∗ Q 4
Types of Price Discrimination
1st-degree (perfect) price discrimination: Each unit of output is sold at
a different price according to a buyer’s willingness to pay

2nd-degree price discrimination: The price paid by a buyer varies with

the quantity demanded by the buyer

3rd-degree price discrimination (market separation): Price differs

across buyer groups

5
Price Discrimination – Conditions
The conditions that enable price discrimination:
1. Ability to determine consumers’ willingness to pay
2. Ability to prevent arbitrage

6
Market Separation
Consumers separated into two (or more) categories → different prices
• More inelastic demand, higher WTP → ↑P
• E.g., textbook publishers

7
Price Discrimination in a Separated Market
P

𝐴𝑅" = 𝐷"
𝑃"∗

𝐴𝑅# = 𝐷# 𝑃#∗ 𝑀𝑅"

𝑀𝐶

𝑀𝑅#
Q2 𝑄#∗ 𝑄"∗ Q1
8
Imperfect Competition

9
Week #10: Reading

NS Chapter 12

Recommended:
• NS Chapter 5

10
Games of Strategy
Perfect competition: parametric interaction
Monopoly: decision, not strategy

With oligopoly:
1. There are competitors
2. Individual firms influence the parameters of the common situation
→ Interaction becomes strategic

11
Pricing of Homogeneous Goods
Setting: Market, low number of firms, a single homogeneous good

General assumptions:
1. Demanders are price takers
2. No transaction or information costs
3. Fixed number of identical firms

ÞSingle equilibrium price

12
Pricing Under Imperfect Competition
P
Monopoly,
perfect cartel

Cournot model,
Stackelberg model
𝑀
𝑃$ Perfect competition,
𝐴 Bertrand model
𝑃&
𝐶 𝑀𝐶
𝑃%
𝑀𝑅 𝐷

𝑄$ 𝑄& 𝑄% Q 13
Nash Equilibrium
Best response: strategy that produces the highest payoff for a player
given what the other player is doing

Nash equilibrium: set of strategies, one for each player, that are each
best responses against one another (“mutual best response”)

14
Duopoly
Duopoly: only two firms in the industry
Cournot model: a duopoly where each
firm decides on the level of output, taking
the other firm’s output as given

Named after Antoine-Augustin Cournot

(1801-1877), a French mathematician

15
Cournot Model
Let’s start with a monopoly…

Assume:
• Zero costs
• Inverse demand curve: 𝑃 = 120 − 𝑄

16
Monopolist’s Output Choice
𝑷
120 Monopolist:
𝑃 = 120 − 𝑄
𝑇𝑅 = 120𝑄 − 𝑄 #
𝑀𝑅 = 120 − 2𝑄
120 − 2𝑄 = 0
60 𝑄 ∗ = 60

→ P = $60, 𝜋 = $3600
𝑀𝑅 𝐷

60 120 𝑸 17
Cournot Duopoly
Now, let’s bring in a second firm… → Cournot model
• Firm 𝐴 chooses its output level (𝑞𝐴) assuming the output of firm 𝐵
(𝑞𝐵) is fixed
• Market output:
𝑄 = 𝑞! + 𝑞" = 120 − 𝑃
• Demand for 𝐴’s product:
𝑞! = 120 − 𝑞" − 𝑃

𝑃 = 120 − 𝑞! − 𝑞"

18
Cournot Duopoly

𝑇𝑅# = 𝑃 ∗ 𝑞# = 120 − 𝑞# − 𝑞$ ∗ 𝑞#
𝑀𝑅# = 120 − 2𝑞# − 𝑞$
• For profit maximizing output, 𝑀𝑅# = 𝑀𝐶#

0 = 120 − 2𝑞# − 𝑞$
𝒒𝑩
𝒒𝑨 = 𝟔𝟎 −
𝟐
Beware! The optimum output of A depends on the output of B
19
Cournot Duopoly
#$%&'!
𝑞! = is a best-response function (or reaction function)
$

→ How much one firm will produce given what the other firm produces

20
Cournot Duopoly: Best-Response Functions
𝒒𝑩
120
"#()*!
A’s B-R function: 𝑞& = #

60 𝒒𝑨 21
Cournot Duopoly
Firm B, being identical with A, has a symmetrical B-R function:

120 − 𝑞!
𝑞" =
2

22
Cournot Duopoly: Best-Response Functions
𝒒𝑩
120

Firm A’s B-R

Cournot-Nash equilibrium
60
Firm B’s B-R
40

40 60 120 𝒒𝑨 23
Cournot Equilibrium
Nash equilibrium of the Cournot model (‘Cournot-Nash equilibrium’)
• Each firm makes the correct assumption about what the other firm
will produce
• 𝑃 & 𝜋 above PC level, below monopoly level

24
Collusion
C-N equilibrium profits: not the largest that the firms can earn in total

Agreement to reduce output → increase in profits

25
Cournot Duopoly with Isoprofit Curves
𝒒𝑩

𝑅𝐹&

𝜋,

𝐶 𝜋&

𝑅𝐹,

𝑀& 𝒒𝑨 26
Collusion Increases Profits for Both Firms
𝒒𝑩

𝑅𝐹&

𝜋,
𝜋!( > 𝜋! and 𝜋"( > 𝜋"
𝜋,-
𝑀,
𝐶 𝜋&
40
30
𝜋&- 𝑅𝐹,

30 40
𝑀& 𝒒𝑨 27
Collusion
Profit incentives to cooperate by lowering output
→ Collusion, cartel

Beware! The firms cannot do worse by colluding than without it

28
Is a cartel stable?
Each firm has a profit incentive to cheat by increasing its output
according to its B-R function
• Cheating is the dominant strategy → collusion is unstable
• Prisoner’s dilemma
𝐵

𝜋& , 𝜋, Hold agreement Cheat

Hold agreement 1800, 1800 1350, 2025
𝐴 Cheat 2025, 1350 1600, 1600
Cournot-Nash equilibrium
29
Cheating is More Profitable Than Cooperating
𝒒𝑩

𝑅𝐹&
𝜋!(( > 𝜋!( > 𝜋! but 𝜋"(( < 𝜋" < 𝜋"(

𝜋,- 𝜋,--

𝜋&-
30

𝜋&-- 𝑅𝐹,

30 45 𝒒𝑨 30
The Order of Play
Cournot model: firms choose their output levels simultaneously
• Competition as a simultaneous game
• Output levels as the strategic variables

31
The Order of Play
What if A chooses its output level first and then firm B responds?
• Firm A is then a leader, firm B is a follower

• Competition as a sequential game

• Output levels remain the strategic variables

32
Stackelberg Oligopoly
Sequential games with a leader and a follower
are von Stackelberg games

Heinrich von Stackelberg (1905-1946) was a

German economist

33
Stackelberg Games
Sequential games can be solved using backward induction
Q: What is the best response of the follower, firm B?
#$%&'"
A: Choose 𝑞" = 𝐵𝑅" 𝑞! =
$
Firm A knows this, anticipates B’s reaction

The leader makes a profit at least as large as its C-N equilibrium profit

34
Stackelberg Duopoly

𝒒𝑩
Follower’s B-R

𝐶
𝑞,,%
𝜋&,%
𝑞,,/
𝑆
𝜋&,/
𝑞&,% 𝑞&,/ 𝒒𝑨
35