Industrie Ökonomik

Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
Industrial Organization
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
Dr. Silvio Städter
F Imperfect
Competition and
Strategic (Firm)
Interaction
Summer Term 2023 @ DIT
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial
Organization
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Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
A
E Some Basic Game
Theory Introduction
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial
Organization
2 / 304
Industrial
Organization
Dr. Silvio Städter Organizational Details I

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory See "Behavioral Economics"
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial
Organization
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Industrial
Organization
Dr. Silvio Städter Organizational Details II

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
• Literature: Most of the material covered can be found in
D Market Power in
Vertical Supply well-known textbooks such as Tirole (1988) or more
Chains
recent books such as Shy (1996), Cabral (2000), Martin
E Some Basic Game
Theory (2002), Motta (2004), Bester (2010), or Belleflamme and
F Imperfect Peitz (2010). Some additional references will be given
Competition and
Strategic (Firm) throughout the lecture. Finally, Gibbons (1992) or
Interaction
Osborne (2003) are recommended as introductory texts on
G Cooperation
among firms: Game Theory.
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
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Industrial
Organization
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Industrial
Organization
Dr. Silvio Städter Organizational Details III

A Introduction Belleflamme, P. and M. Peitz (2010). Industrial Organization:
B Markets and Markets and Strategies. Cambridge University Press.
Efficiency
Bester, H. (2010). Theorie der Industrieökonomik. Springer.
C Market Power in
Consumer Markets Cabral, L. M. (2000). Introduction to Industrial Organization.
D Market Power in
Vertical Supply
MIT Press.
Chains Gibbons, R. (1992). A Primer in Game Theory. Hemel
E Some Basic Game
Theory
Hempstead: Harvester-Wheatsheaf.
F Imperfect Martin, S. (2002). Advanced Industrial Economics. Blackwell.
Competition and
Strategic (Firm) Motta, M. (2004). Competition Policy: Theory and Practice.
Interaction
Cambridge: Cambridge University Press.
G Cooperation
among firms: Osborne, M. J. (2003). An Introduction to Game Theory.
Mergers and Cartels
H Market Entry and

Oxford University Press.
Exit Shy, O. (1996). Industrial Organization: Theory and
I Research and
Development
Applications. MIT Press.
J Behavioral Tirole, J. (1988). The Theory of Industrial Organization.
Industrial
Organization Cambridge, Mass.: MIT Press.
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Industrial
Organization
Dr. Silvio Städter What is Industrial Organization?

A Introduction
B Markets and
Efficiency • ªIndustrial Organization is concerned with the workings
C Market Power in
Consumer Markets
of markets and industries, in particular the way firms
D Market Power in
compete with each other.º (Cabral, 2000)
Vertical Supply
Chains
• Difference to standard Microeconomics: Focussing on
E Some Basic Game firm strategies in environments of imperfect competition
Theory (rather than perfect competition):
F Imperfect
Competition and
• pricing
Strategic (Firm) • product positioning
Interaction
• market entry
G Cooperation
among firms: • capacity choice
Mergers and Cartels • advertising
H Market Entry and • research and development (R&D)
Exit
• outsourcing
I Research and
Development
J Behavioral
Industrial
Organization
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Industrial
Organization
Dr. Silvio Städter Central issue: Market Power

A Introduction
B Markets and
Efficiency • Market power: Ability to set prices above (marginal)
C Market Power in
Consumer Markets
cost.
D Market Power in Example: If you are able to sell a good for EUR 100, but it
Vertical Supply
Chains costs you only EUR 10 to produce it, then you are
E Some Basic Game probably commanding a significant degree of market
Theory
power.
F Imperfect
Competition and • Questions of interest:
Strategic (Firm)
Interaction 1 Is there market power in a given market?
G Cooperation
among firms: 2 How do firms acquire and maintain market power?
Mergers and Cartels
H Market Entry and

3 What are the implications of market power?
Exit
4 Is there a role for public policy regarding market power?
I Research and
Development
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Organization
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Industrial
Organization
Dr. Silvio Städter Who are those guys?

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
Copyright: Nobel Media
I Research and
Development
J Behavioral
Industrial
Organization
8 / 304
Industrial
Organization
Dr. Silvio Städter Who are those guys?

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Copyright: Nobel Media
Exit
I Research and
Development Nobel Prize in Economics 2022 ªfor research on banks and financial crisesº
J Behavioral
Industrial
Organization
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Industrial
Organization
Dr. Silvio Städter Who is this man?

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
Copyright © CNRS - C. Lebedinsky
I Research and
Development
J Behavioral
Jean Tirole, Nobel Prize in Economics 2014 ªfor his analysis of market power and
Industrial regulationº
Organization
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Industrial
Organization
Dr. Silvio Städter Who is this man?

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
Copyright © CNRS - C. Lebedinsky
I Research and
Development
J Behavioral
Jean Tirole, Nobel Prize in Economics 2014 ªfor his analysis of market power and
Industrial regulationº
Organization
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Industrial
Organization
Dr. Silvio Städter Question 1: Is there market

A Introduction power in a given market?
B Markets and
Efficiency
C Market Power in
Consumer Markets • How can market power be measured?
D Market Power in
Vertical Supply
• Concentration measures such as
Chains Herfindahl-Hirschmann-Index of Concentration (HHI)
E Some Basic Game • HHI = ∑Ni=1 a2i , where ai = Nxi
Theory ∑j=1 xj
F Imperfect
• Econometric techniques to directly estimate price
Competition and
Strategic (Firm)
elasticities of (residual) demand
Interaction
• What information is needed (e.g., on firms’ cost, demand,
G Cooperation
among firms: prices, market shares etc.)?
Mergers and Cartels
H Market Entry and

• Does market power exist in all industries? How does it
Exit vary across industries or over time in a given industry?
I Research and
Development
J Behavioral
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Organization
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Industrial
Organization
Dr. Silvio Städter Question 2: How do firms

A Introduction acquire and maintain market
B Markets and
Efficiency power?
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

• Market power translates into higher profits
Theory ⇒ Creating and maintaining market power as an
F Imperfect
Competition and
important part of firms’ strategies.
Strategic (Firm)
Interaction • Acquiring market power: e.g., through patents
G Cooperation
among firms:
• Establishing and maintaining market power: e.g. by
Mergers and Cartels preempting current (and future) rivals
H Market Entry and
Exit
I Research and
Development
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Organization
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Industrial
Organization
Dr. Silvio Städter Question 3: What are the

A Introduction implications of market power?
B Markets and
Efficiency • Distribution: Market power typically comes along with
C Market Power in
Consumer Markets
higher prices which is beneficial to firms (producer
D Market Power in
surplus increases in price) to the detriment of consumers
Vertical Supply
Chains
(consumer surplus decreases in price)
E Some Basic Game • Allocative efficiency: Market power and higher prices
Theory
associated with it is not only a pure transfer from
F Imperfect
Competition and consumers to producers, but it typically also leads to an
Strategic (Firm)
Interaction inefficient allocation of goods and resources (i.e., the
G Cooperation decrease in consumer surplus is larger than the increase in
among firms:
Mergers and Cartels producer surplus)
H Market Entry and
Exit
• Rent-seeking: Unproductive resources spent by firms to
I Research and influence policymakers, e.g., to get favorable legislation
Development
which allows them to keep their strong position in the
J Behavioral
Industrial market.
Organization
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Industrial
Organization
Dr. Silvio Städter Question 4: Is there a role for

A Introduction public policy regarding market
B Markets and
Efficiency power? I
C Market Power in
Consumer Markets
D Market Power in
Primary role of public policy is to avoid the negative
Vertical Supply
Chains
consequences of market power:
E Some Basic Game • Regulation: Market power retained, but firms are not free
Theory
to choose crucial strategies (e.g., prices), but are
F Imperfect
Competition and controlled by the regulator (e.g., Bundesnetzagentur)
Strategic (Firm)
Interaction • Competition policy (ªantitrustº in the U.S.): Preventing
G Cooperation firms from taking actions that increase their market power
among firms:
Mergers and Cartels in a way that is detrimental to society:
H Market Entry and • Abuse of a dominant position in a market
Exit
• Merger control
I Research and
Development
• Cartel prosecution
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Organization
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Industrial
Organization
Dr. Silvio Städter Question 4: Is there a role for

A Introduction public policy regarding market
B Markets and
Efficiency power? II
C Market Power in
Consumer Markets • What is the role of economists in public policy responses?
D Market Power in • Recently, a ªmore economic approachº.
Vertical Supply
Chains • Lars-Hendrik Röller (2005), ªEconomic Analysis and
E Some Basic Game
Theory
Competition Policy Enforcement in Europeº:
F Imperfect
• Former chief economist at the European Union’s
Competition and
Strategic (Firm)
DG-Comp (Directorate General for Competition).
Interaction • Economic theory is necessary to ªframeº a case (e.g., to
G Cooperation arrive at a particular theory of ªharmº).
among firms:
Mergers and Cartels
• Economists are challenged to develop guidelines (as
H Market Entry and simple, yet economically sound, rules that are applicable
Exit in a wide set of circumstances).
I Research and • Ex ante analysis (e.g., market monitoring) and ex post
Development
analysis (e.g., how antitrust, state aid, or mergers have
J Behavioral
Industrial affected markets)
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Industrial
Organization
Dr. Silvio Städter Course Outline I

A Introduction
B Markets and
Efficiency A Introduction
C Market Power in
Consumer Markets B Markets and Efficiency
D Market Power in C Market Power in Consumer Markets
Vertical Supply
Chains 1 The basic monopoly model
E Some Basic Game 2 Price discrimination
Theory
F Imperfect
D Market Power in Vertical Supply Chains
Competition and
Strategic (Firm) E Some Basic Game Theory
Interaction
G Cooperation
F Imperfect Competition and Strategic Firm Interaction
among firms: 1 Price Competition
Mergers and Cartels
2 Quantity Competition
H Market Entry and
Exit 3 Quantity Competition with Capacity Choice
I Research and 4 Product differentiation
Development
J Behavioral
Industrial
Organization
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Industrial
Organization
Dr. Silvio Städter Course Outline II

A Introduction
B Markets and
Efficiency
C Market Power in
G Mergers and Cartels
Consumer Markets 1 Horizontal Mergers
D Market Power in 2 Vertical Mergers
Vertical Supply
Chains 3 Cartels
E Some Basic Game
Theory
H Market Entry and Exit
F Imperfect
1 Contestable Markets
Competition and 2 Strategically Deterring Entry and Forcing Exit
Strategic (Firm)
Interaction
I Research and Development
G Cooperation
among firms: J Behavioral Industrial Organization
Mergers and Cartels
1 Consumers with Behavioral Biases
H Market Entry and
Exit 2 Firms with Behavioral Biases
I Research and
Development
J Behavioral
Industrial
Organization
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Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
B
E Some Basic Game
Theory Markets and Efficiency
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial
Organization
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Industrial
Organization
Dr. Silvio Städter Definition of a market

A Introduction • A relevant market is given by all goods that are (to some
B Markets and
Efficiency
extent) substitutes for each other.
C Market Power in • In practice, this is an intricate issue:
Consumer Markets
• For example, is the relevant market ªflights between
D Market Power in
Vertical Supply Hamburg and Berlinº (with LH being a monopolist) or
Chains
ª‘flights and high-speed trains between Hamburg and
E Some Basic Game
Theory Berlinº (with LH competing against Deutsche Bahn)?
F Imperfect
• Substitutability on demand and supply side: Competitive
Competition and pressure in a market depends on the degree of
Strategic (Firm)
Interaction substitutability of different commodities for consumers
G Cooperation and producers.
among firms:
Mergers and Cartels • Throughout, we assume that the market under
H Market Entry and
Exit
consideration is well-defined and can be captured by a
I Research and
(downward-sloping) demand function q(p) (or inverse
Development
demand function p(q)), where p and q denote price and
J Behavioral
Industrial quantity, respectively.
Organization
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Industrial
Organization
Dr. Silvio Städter Performance of a market: (Static)

A Introduction efficiency
B Markets and • Pareto efficiency:
Efficiency
An allocation (prices and quantities) of a market is Pareto efficient if
C Market Power in
Consumer Markets there is no other allocation that makes at least one market participant
D Market Power in better off without making any other market participant worse off.
Vertical Supply
Chains • Problem: Rather weak criterium that does not distinguish
E Some Basic Game between many different allocations of distinct normative
Theory
appeal.
F Imperfect
Competition and • Alternative: Consumer and producer surplus (Dupuit 1844)
Strategic (Firm)
Interaction Definition: An allocation is efficient if it maximizes the sum of
G Cooperation producer and consumer surplus.
among firms:
Mergers and Cartels • consumer surplus: Aggregate consumers’ net utility from
H Market Entry and consumption (valuation for good minus price paid)
Exit
• producer surplus: Total firm profits
I Research and
Development
• Note that the definition is static. That is, it refers to a
J Behavioral
one-shot situation, taking as given consumer preferences
Industrial and firms’ production technologies (cost functions).
Organization
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Industrial
Organization
Dr. Silvio Städter Example: Perfect Competition

A Introduction • Firms and consumers are price takers.
B Markets and • In equilibrium every firm produces in such a way that its
Efficiency
C Market Power in
marginal costs equal the price (i.e., the marginal benefit)
Consumer Markets
• All consumers who want to purchase at the market price
D Market Power in
Vertical Supply do so.
Chains
E Some Basic Game

• No market participant is rationed (everyone is able to
Theory sell/purchase as much as he likes to at the market price).
F Imperfect
Competition and • The sum of producer and consumer surplus is maximized,
Strategic (Firm)
Interaction i.e., the allocation is efficient.
G Cooperation ⇒ Public policy intervention can only reduce welfare.
among firms:
Mergers and Cartels • Crucial assumptions:
H Market Entry and 1 no market power, i.e., firms and consumers are price
Exit
takers,
I Research and
Development 2 only static efficiency is taken into account (e.g., no R& D),
J Behavioral 3 no other sources of market failure (externalities,
Industrial
Organization
asymmetric information etc.)
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Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
1. The Basic Monopoly Model
2. Price Discrimination
C
D Market Power in
Vertical Supply
Chains
Market Power in Consumer
E Some Basic Game
Theory Markets
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
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Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
C.1
D Market Power in
Vertical Supply The Basic Monopoly Model
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial 23 / 304
Industrial
Organization
Dr. Silvio Städter The Model I

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets • Let’s relax the assumption that firms are price takers and
2. Price Discrimination consider the following set-up:
D Market Power in
Vertical Supply • There is a single producer with production costs C(q) for
Chains
q units of a commodity (with C′ , C′′ > 0)
E Some Basic Game
Theory • Demand is given by q(p), where q′ (p) < 0.
F Imperfect
Competition and • Suppose the producer can choose a price (and thereby a
Strategic (Firm)
Interaction quantity to produce) without motivating another firm to
G Cooperation enter the market.
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
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Industrial
Organization
Dr. Silvio Städter The Model II

A Introduction
• The producer’s problem is to maximize his profit
B Markets and
Efficiency
C Market Power in max π = q(p)p − C(q(p))

Consumer Markets p
• This yields as the first order condition:
D Market Power in
Vertical Supply
Chains
∂π
E Some Basic Game = q′ (p)p + q(p) − C′ q′ (p) = 0
Theory ∂p
F Imperfect
Competition and • Hence, the optimal price is given by
Strategic (Firm)
Interaction
q(p)
G Cooperation
pM = C ′ − > C′ (recall that q′ (p) < 0)
among firms:
Mergers and Cartels q′ (p)
H Market Entry and
Exit • Under monopoly, the market price exceeds marginal costs,
I Research and and is therefore higher than under perfect competition.
Development
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Industrial
Organization
Dr. Silvio Städter The Model - another approach

A Introduction • Take the inverse demand function p(q)
B Markets and • The producer’s problem is to maximize his profit
Efficiency
C Market Power in
Consumer Markets max π = p(q)q − C(q)
1. The Basic Monopoly Model q
D Market Power in • This yields as the first order condition:

Vertical Supply
Chains
∂π
E Some Basic Game
Theory = p′ (q)q + p(q) − C′ (q) = 0
∂q
F Imperfect
Competition and
Strategic (Firm) • Hence, the optimal quantity is implicitely given by
Interaction
G Cooperation
among firms:
p(q) + p′ (q)q = C′ (q)
Mergers and Cartels
H Market Entry and MR = MC

Exit
I Research and • Under monopoly, the total quantity sold is smaller than
Development
J Behavioral
under perfect competition.
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Industrial
Organization
Dr. Silvio Städter The Deadweight Loss of

A Introduction Monopoly
B Markets and
Efficiency The allocation under monopoly does not maximize the sum of
C Market Power in
Consumer Markets
producer and consumer surplus, i.e., it is inefficient.
2. Price Discrimination p
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect pM
Competition and MC(q)
Strategic (Firm) A B
Interaction pPC
C
G Cooperation
among firms: MR(q)
Mergers and Cartels
p(q)
H Market Entry and
Exit
I Research and
qM qPC q
Development
J Behavioral
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Industrial
Organization
Dr. Silvio Städter The Lerner-Rule I

A Introduction
Monopoly Pricing and the price-elasticity of demand
B Markets and
Efficiency
• The price elasticity of demand measures how strongly
C Market Power in
Consumer Markets demand reacts to price changes:
∆q
D Market Power in q ∆q p
Vertical Supply ε (p) = − ∆p = −
Chains ∆p q
p
E Some Basic Game
Theory
′
(p)p
F Imperfect • For small changes (∆ → 0), we have ε (p) = − qq(p) .
Competition and
Strategic (Firm)
Interaction • recall, that pM = C′ − qq(p)
′ (p)
G Cooperation
among firms:
• Rewriting yields
Mergers and Cartels
H Market Entry and pM − C ′ −q(pM ) 1

Exit
M
= ′
=
I Research and
p p q (p ) ε (pM )
M M
Development
J Behavioral
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Industrial
Organization
Dr. Silvio Städter The Lerner-Rule II

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
• The difference between price and marginal costs relative
M ′
D Market Power in to price ( p p−C
M ) is called ªmark-upº and is often used as a
Vertical Supply
Chains measure for the degree of market power.
M ′
E Some Basic Game
Theory • Note that p p−C
M < 1, which implies ε (pM ) > 1.
F Imperfect ⇒ the monopolist’s optimal price will always lie in the
Competition and
Strategic (Firm) elastic range of the demand function! (Why?)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
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Industrial
Organization
Dr. Silvio Städter How to regulate a monopoly I

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
2. Price Discrimination Regulation of a monopoly targets at reducing the welfare loss
D Market Power in due to monopoly power
Vertical Supply
Chains
Possible approaches (amongst others):
E Some Basic Game
Theory
1 A maximum price
F Imperfect
Competition and 2 A (negative) tax on the monopolists profit (subsidy)
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial 30 / 304
Industrial
Organization
Dr. Silvio Städter How to regulate a monopoly II

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
2. Price Discrimination 1. A maximum price p
D Market Power in
Vertical Supply
• since the monopolist equalizes MR and MC, set p such
Chains
that
E Some Basic Game
Theory MRreg = MC(qpc )
F Imperfect
Competition and • solution: set p = ppc
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
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Industrial
Organization
Dr. Silvio Städter How to regulate a monopoly III

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial 32 / 304
Industrial
Organization
Dr. Silvio Städter How to regulate a monopoly IV

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial 33 / 304
Industrial
Organization
Dr. Silvio Städter How to regulate a monopoly V

A Introduction
B Markets and
Efficiency 2. A (negative) tax on the monopolists profit (subsidy)
C Market Power in
Consumer Markets • Assume, a tax t is imposed on every unit sold by the
2. Price Discrimination monopolist
D Market Power in • Assume, that the monopolist has to pay the tax
Vertical Supply
Chains
• The monopolist’s profit is then
E Some Basic Game
Theory
F Imperfect [p(q) − t]q − C(q),

Competition and
Strategic (Firm)
Interaction yielding the FOC
G Cooperation
p(q) + p′ (q)q − t = C′ (q)

among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
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Industrial
Organization
Dr. Silvio Städter How to regulate a monopoly VI

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
• FOC perfect competitive market: ppc = C′ (qpc )
D Market Power in
How large has t to be, to get the same FOC for monopoly and
Vertical Supply perfect competition?
Chains
E Some Basic Game

Theory t = p′ (qpc )qpc
F Imperfect
Competition and
Strategic (Firm) • p′ (qpc ) < 0 =⇒ t < 0, i.e. a subsidy has to be paid to the
Interaction
monopolist
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
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Industrial
Organization
Dr. Silvio Städter How to regulate a monopoly VII

A Introduction
B Markets and
Efficiency
C Market Power in
Problems with monopoly regulation
Consumer Markets
• The regulator needs to know
1 the demand curve
D Market Power in
Vertical Supply
2 the monopolist’s cost structure, at least MC
Chains
• if the market data change (e.g. due to an exogenous shock
E Some Basic Game
Theory to demand), the regulator has to adopt the regulation (price
F Imperfect cap or subsidy)
Competition and
Strategic (Firm)
Interaction
• the regulatory measure might influence the monopolist in
G Cooperation other decisions, e.g. the decision to invest in R&D
among firms:
Mergers and Cartels (example: medication)
H Market Entry and
Exit
I Research and
Development
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Industrial
Organization
Dr. Silvio Städter Main take-aways from today’s

A Introduction lecture
B Markets and
Efficiency
C Market Power in
Consumer Markets
1 A perfectly competitive market maximizes social welfare
D Market Power in (producer + consumer surplus)
Vertical Supply
Chains 2 A monopoly reduces social welfare and is thus inefficient
E Some Basic Game
Theory
from an allocation perspective
F Imperfect 3 The monopoly price is too high, thus the traded amount of
Competition and
Strategic (Firm) the good is inefficiently low
Interaction
G Cooperation
4 Monopoly regulation can (theoretically) heal the
among firms:
Mergers and Cartels
monopoly’s inefficiency but faces practical problems
H Market Entry and
Exit
I Research and
Development
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Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
C.2
D Market Power in
Vertical Supply Price Discrimination
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial 38 / 304
Industrial
Organization
Dr. Silvio Städter Price Discrimination

A Introduction
• Price-discrimination = setting different prices for (nearly)
B Markets and
Efficiency the same good
C Market Power in
Consumer Markets
• Requires absence of resale
• Three forms of price discrimination:
D Market Power in • Third-Degree: Discriminate buyers according to
Vertical Supply
Chains
observable characteristics
E Some Basic Game
E.g., discounts for students or senior citizens,
Theory country-specific prices
F Imperfect • Second-Degree: Crucial characteristics not observable,
Competition and
Strategic (Firm) but seller can offer a menu of contracts, thereby inducing
Interaction
self-selection of buyers
G Cooperation
among firms:
E.g., weekend fares for airline tickets, railway tickets with
Mergers and Cartels and without ªZugbindungº, quantity discounts
H Market Entry and • First-Degree: Perfect observability of each buyer’s
Exit
characteristics and preferences, allows seller to charge
I Research and
Development each buyer a different price
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Industrial
Organization
Dr. Silvio Städter First-Degree Price

A Introduction Discrimination I
B Markets and • Extreme case with interesting welfare properties
Efficiency
C Market Power in
• Assume that the firm can observe the customers’
Consumer Markets
individual willingness to pay (WTP)
2. Price Discrimination • He thus wants to charge every customer the price
D Market Power in
Vertical Supply
according to his or her marginal WTP
Chains • Assume the aggregate WTP (inverse demand curve) to be
E Some Basic Game
Theory
P(Q)
F Imperfect
• The firm will charge a different price for every unit sold,
Competition and
Strategic (Firm) i.e. her profit is
Interaction Z Q
G Cooperation
among firms:
Π(Q) = P(Q) − C′ (Q)dQ
Mergers and Cartels 0
H Market Entry and • Maximizing over q yields the FOC:
Exit
I Research and P(Q∗ ) = C′ (Q∗ )

Development
J Behavioral
• Hence, the price of the last unit sold equals marginal costs.
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Industrial
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A Introduction Discrimination II
B Markets and
Efficiency
C Market Power in
Consumer Markets
• First-degree price discrimination hence yields an efficient
1. The Basic Monopoly Model allocation, i.e., the sum of consumer surplus and producer
D Market Power in
surplus is maximized.
Vertical Supply
Chains • But the distribution is very unequal, as the consumer
E Some Basic Game surplus is zero and all surplus is reaped by the monopolist.
Theory
F Imperfect
• However, charging different prices for different units sold
Competition and
Strategic (Firm)
(and for different customers), seems to be rather difficult
Interaction in practice
G Cooperation
among firms: • Notice, however, that the monopolist could get the same
Mergers and Cartels
outcome, when applying a two-part tariff with a fixed
H Market Entry and
Exit price p and a per-unit price p
I Research and
Development
J Behavioral
Industrial 41 / 304
Industrial
Organization

A Introduction Discrimination III
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in • p(qm ) = C′ (qm ) would apply, hence for every unit sold
Vertical Supply
Chains (and for every customer) price would be the same and the
E Some Basic Game efficient amount would be produced
Theory
F Imperfect
• However, the monopolist would reap all the consumer
Competition and
Strategic (Firm)
surplus via the fixed payment p. This fixed payment would
Interaction vary across consumers, according to their WTP.
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
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Industrial
Organization
Dr. Silvio Städter Second-Degree Price

A Introduction Discrimination I
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in • Assume that the monopolist cannot observe the

Vertical Supply
Chains customers’ individual willingness to pay, but knows, that
E Some Basic Game there are different WTPs
Theory
F Imperfect
• The monopolist can then implement a tariff in which
Competition and
Strategic (Firm)
customers self-select, i.e. buy the quantity at a certain
Interaction price, which is best for themselves
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial 43 / 304
Industrial
Organization

A Introduction Discrimination II
B Markets and
Efficiency
• Consider a monopolist, selling a good with a simple
C Market Power in two-part tariff (p, p)
Consumer Markets
1. The Basic Monopoly Model • Expenditures for customer i to purchase the product are
then: P(q) = p + pq, which means there is a quantity
D Market Power in
Vertical Supply discount, as the more a customer buys, the lower is the
Chains
per-unit-price
E Some Basic Game
Theory • Let the costs for the monopolist to produce a certain
F Imperfect
Competition and amount of the good be C(q)
Strategic (Firm)
Interaction • Assume, that there are two groups of customers i = a, b
G Cooperation with mi being the number of customers in each group
among firms:
Mergers and Cartels • Let Ui (q) be the utility each customer of group i gets from
H Market Entry and
Exit the good, assumptions:
I Research and Ua (0) = Ub (0) = 0; Ub′ (q) > Ua′ (q) > 0; Ua′′ , Ub′′ < 0
Development
• Hence, Ub (q) > Ua (q), ∀q > 0
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A Introduction Discrimination III
B Markets and
Efficiency
C Market Power in
Consumer Markets • A customer of group i will chose demand in order to
maximize his net utility from consumption
D Market Power in
Vertical Supply
Chains
max Ui (qi ) − p − pqi
q
E Some Basic Game
Theory
• Hence, demand q∗i (p) will be chosen such that
F Imperfect
Competition and Ui′ (q∗i (p)) = p
Strategic (Firm)
Interaction • Recall, that Ui (0) = 0 for i = a, b! Thus, the customer
G Cooperation
among firms:
only consumes a positive amount of the good, if
Mergers and Cartels Ui (q∗i (p) − p − pq∗i (p) ≥ 0, a so-called participation
H Market Entry and
Exit
constraint (PC)
I Research and
Development
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Industrial
Organization

A Introduction Discrimination IV
B Markets and
Efficiency
C Market Power in • With a unique tariff for both consumer groups, the
Consumer Markets
1. The Basic Monopoly Model monopolist’s profit is
D Market Power in
Vertical Supply Π = ma [pq∗a (p) + p]+mb [pq∗b (p) + p]−C(ma q∗a (p)+mb q∗b (p))
Chains
E Some Basic Game

Theory
• The PCs are
F Imperfect
Competition and
Strategic (Firm)
Ua (q∗a (p)) − p − pq∗a (p) ≥ 0
Interaction
G Cooperation and
among firms:
Mergers and Cartels Ub (q∗b (p)) − p − pq∗b (p) ≥ 0
H Market Entry and
Exit • Realize, that the second PC is redundant! Why?
I Research and
Development
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Industrial
Organization

A Introduction Discrimination V
B Markets and
Efficiency
C Market Power in
Consumer Markets
2. Price Discrimination • Answer: Consuming his optimal amount q∗b will always be
D Market Power in
Vertical Supply
better for a costumer of type b than consuming q∗a . Hence,
Chains
E Some Basic Game Ub (q∗b (p)) − p − pq∗b (p) ≥ Ub (q∗a (p)) − p − pq∗a (p)
Theory
F Imperfect
Competition and
• And as Ub (q) > Ua (q), ∀q > 0, it holds that
Strategic (Firm)
Interaction
G Cooperation
Ub (q∗a (p)) − p − pq∗a (p) > Ua (q∗a (p)) − p − pq∗a (p) ≥ 0
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
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Industrial
Organization

A Introduction Discrimination VI
B Markets and
Efficiency • Note further, that PC of type a will be binding in
C Market Power in
Consumer Markets
optimum. Why?
• If it was not binding, the monopolist could enhance p a
D Market Power in little bit, without violating the constraint. This would
Vertical Supply
Chains increase his profit.
E Some Basic Game
Theory
• Hence, the PC of type a rewrites
F Imperfect
Competition and p = Ua (q∗a (p)) − pq∗a (p)
Strategic (Firm)
Interaction
G Cooperation • Substituting in the monopolist’s profit function yields

among firms:
Mergers and Cartels
H Market Entry and Π = [ma + mb ] Ua (q∗a (p)) + mb [pq∗b (p) − pq∗a (p)]
Exit
I Research and
Development
−C(ma q∗a (p) + mb q∗b (p))
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Industrial
Organization

A Introduction Discrimination VII
B Markets and
Efficiency
C Market Power in
Consumer Markets
1. The Basic Monopoly Model • Maximizing over p and taking into account, that
Ua′ (xa∗ (p)) = p yields the FOC (and hence the price p∗ , the
D Market Power in
Vertical Supply monopolist sets):
Chains
E Some Basic Game

mb [q∗b (p∗ ) − q∗a (p∗ )]
Theory
p∗ = C′ (ma q∗a (p) + mb q∗b (p)) −
F Imperfect ma q∗a ′ (p∗ ) + mb q∗b ′ (p∗ )
Competition and
Strategic (Firm)
Interaction • Hence, the price exceeds marginal costs and is thus
G Cooperation
among firms:
inefficiently high (as compared to the perfect competition
Mergers and Cartels case or first-degree price discrimination)
H Market Entry and
Exit
I Research and
Development
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Industrial
Organization
Dr. Silvio Städter Third-Degree Price

A Introduction Discrimination
B Markets and • Most common form of price discrimination, also called market
Efficiency
segmentation
C Market Power in
Consumer Markets • Consider a monopolist selling the same good in two separate markets
i = 1, 2 (e.g. countries, groups of consumers etc..) at constant marginal
D Market Power in
cost of production c.
′
Vertical Supply
Chains • Demand in market i: qi (pi ), price elasticity of demand εi = − qi (pi )pi
q (p ) i i
E Some Basic Game • Profit of monopolist:
Theory
F Imperfect Π(p1 , p2 ) = p1 q1 (p1 ) + p2 q2 (p2 ) − c[q1 (p1 ) + q2 (p2 )]

Competition and
Strategic (Firm)
Interaction • From the first-order conditions one gets:
G Cooperation 1 1
among firms: pM
1 (1 − ) = pM
2 (1 − )=c
Mergers and Cartels ε1 ε2
H Market Entry and
Exit • It follows that pM M
1 > p2 iff ε1 < ε2
I Research and
Development
⇒ the optimal price is higher in market segments in which the price
elasticity of demand is lower.
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Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
D
Chains
E Some Basic Game

Theory
Market Power in Vertical Supply
F Imperfect
Competition and
Chains
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
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Dr. Silvio Städter Double Marginalization - The

A Introduction Porsche Case I
B Markets and
Efficiency
C Market Power in
• Until 1984, Porsche sold its cars through the retail
Consumer Markets network of VW/Audi.
D Market Power in
Vertical Supply • Retailers were allowed to set prices for Porsche cars
Chains
independently.
E Some Basic Game
Theory • Price-cost margins (i.e., difference between price and
F Imperfect
Competition and marginal costs) were about 18% for dealers.
Strategic (Firm)
Interaction • The respective contract between Porsche and retailers
G Cooperation expired 1984.
among firms:
Mergers and Cartels • In 1984, Porsche suggested the following new contract:
H Market Entry and
Exit
1 Porsche determines the price.
I Research and
2 Retailers receive 8% per sold car.
Development
• What would you do as a retailer?
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Dr. Silvio Städter Double Marginalization - The

A Introduction Porsche Case II
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
• Retailers rejected the new proposal and went to court
Chains
(appealing to franchise law according to which the
E Some Basic Game
Theory franchisee shall not be harmed by changes of the contract).
F Imperfect • Porsche withdrew the proposal.
Competition and
Strategic (Firm)
Interaction
• Why did Porsche make the proposal, even though
G Cooperation opposition by the retailers could have been expected?
among firms:
Mergers and Cartels • Is Porsche abusing market power?
H Market Entry and
Exit
I Research and
Development
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Dr. Silvio Städter A simple model I

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets Consider the following simple (sequential) game between a
D Market Power in producer and a retailer.
Vertical Supply
Chains • A monopolistic producer (P) sells units of a commodity to
E Some Basic Game
Theory
a monopolistic retailer (R) at price p̂. Other than that, R
F Imperfect
has no further costs.
Competition and
Strategic (Firm) • The retailer (R) sells the units to consumers at price p.
Interaction
G Cooperation
• Market demand is q(p) = 1 − p.
among firms:
Mergers and Cartels • The producer has unit costs c < 1.
H Market Entry and
Exit
I Research and
Development
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Dr. Silvio Städter A simple model II

A Introduction
B Markets and
Efficiency Monopoly benchmark
C Market Power in
Consumer Markets Suppose the producer sells directly to the costumers.
D Market Power in
Vertical Supply
• The monopolist maximizes
Chains
π M = pq(p) − cq(p) = p(1 − p) − c(1 − p) = (p − c)(1 − p).
E Some Basic Game
• First order condition ∂ πM
Theory
∂p = (1 − p) − (p − c) = 0.
F Imperfect
Competition and • Optimal monopoly price pM = 1+c
2 .
Strategic (Firm)
• Monopoly quantity qM = (1 − pM ) = 1−c
2 .
Interaction
G Cooperation
(1−c)2
among firms:
Mergers and Cartels
• Monopoly profit π M = qM (pM − c) = 4 .
H Market Entry and • Price and quantity under perfect competition:
Exit
I Research and
pC = c < pM and qC = 1 − pC = 1 − c > qM .
Development
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Dr. Silvio Städter A simple model III

A Introduction
The retailer’s problem
B Markets and
Efficiency
C Market Power in
• The retailer’s profit function is
Consumer Markets
D Market Power in π R = pq(p) − p̂q(p) = (p − p̂)q(p) = (p − p̂)(1 − p)

Vertical Supply
Chains
E Some Basic Game • His profit is maximized for p such that

Theory
F Imperfect ∂ πR
Competition and = (1 − p) − (p − p̂) = 0.
Strategic (Firm)
Interaction
∂p
G Cooperation
among firms: • For a given (whole sale) price p̂ it is therefore a best
Mergers and Cartels
response for the retailer to set
H Market Entry and
Exit
1 + p̂
I Research and p∗ (p̂) = .
Development 2
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Industrial
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Dr. Silvio Städter A simple model IV

A Introduction
The producer’s problem
B Markets and
Efficiency
• The producer anticipates that the retailers reacts to a
C Market Power in
Consumer Markets whole sale price of p̂ by
D Market Power in
Vertical Supply
1 + p̂
Chains
p∗ (p̂) = .
E Some Basic Game 2
Theory
F Imperfect • Hence, for wholesale price p̂, demand will be

Competition and
Strategic (Firm)
Interaction 1 − p̂
q∗ = 1 − p∗ (p̂) = .
G Cooperation 2
among firms:
Mergers and Cartels
• Then, the producer’s profit for wholesale price p̂ is
H Market Entry and
Exit
1 − p̂
I Research and
Development
π P = p̂q∗ − cq∗ = (p̂ − c)q∗ = (p̂ − c) .
2
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Dr. Silvio Städter A simple model V

A Introduction The producer’s problem (cont.)
B Markets and
Efficiency • With profits
C Market Power in 1 − p̂
Consumer Markets π P = (p̂ − c)
D Market Power in
2
Vertical Supply
Chains the optimal wholesale price is such that
E Some Basic Game
Theory ∂ π P 1 − p̂ p̂ − c
= − =0
F Imperfect
Competition and
∂ p̂ 2 2
Strategic (Firm)
Interaction or
1+c
G Cooperation
among firms: p̂∗ =
H Market Entry and which amounts to a price in the consumer market of
Exit
I Research and
1 + p̂∗ 3 + c
Development
p∗ = = .
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Dr. Silvio Städter A simple model VI

A Introduction
B Markets and
Efficiency
C Market Power in Consumer’s perspective

Consumer Markets
• Observe that
D Market Power in
Vertical Supply
Chains 3+c 1+c
p∗ = > = pM .
E Some Basic Game
Theory
4 2
F Imperfect • Hence, consumers pay a higher price to the supply chain
Competition and
Strategic (Firm) than they would pay to a monopolist who directly serves
Interaction
G Cooperation
the consumer market.
among firms:
Mergers and Cartels
• The two margins (for the producer and the retailer) lead to
H Market Entry and the term double marginalization for this phenomenon.
Exit
I Research and
Development
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Industrial
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Dr. Silvio Städter A simple model VII

A Introduction
Firms’ perspective
B Markets and • Profit for the retailer:
Efficiency
(1 − c)2
C Market Power in
Consumer Markets π R = p∗ q∗ − p̂∗ q∗ = (p∗ − p̂∗ )q∗ = (p∗ − p̂∗ )(1−p∗ ) = .
16
D Market Power in
Vertical Supply
Chains
• Profit for the producer:
E Some Basic Game
(1 − c)2
Theory
π P = p̂∗ q∗ −cq∗ = (p̂∗ −c)q∗ = (p̂∗ −c)(1−p∗ ) = .
F Imperfect 8
Competition and
Strategic (Firm) • The joint profit of retailer and producer is therefore
Interaction
G Cooperation
3(1 − c)2 (1 − c)2
among firms:
Mergers and Cartels πR + πP = < = πM.
16 4
H Market Entry and
Exit • Hence, a monopolist who acts directly on the consumer
I Research and
Development
market makes higher profits than the supply chain ± i.e.,
J Behavioral the monopolists suffer from their own market power (and
Industrial
Organization
rationing).
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Industrial
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Dr. Silvio Städter A simple model VIII

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
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Organization
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Industrial
Organization
Dr. Silvio Städter Porsche Case revisited

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
If both Porsche and its retailers have market power, Porsche’s
D Market Power in
Vertical Supply proposal
Chains
E Some Basic Game

• enhances Porsche’s profits (decreasing retailer margin and
Theory increasing number of cars sold)
F Imperfect
Competition and • enhances welfare (more cars sold at a lower price)
Strategic (Firm)
Interaction • may even enhance retailer’s profits (decreasing margin,
G Cooperation
among firms:
but increasing quantity)
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
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Industrial
Organization
Dr. Silvio Städter Strategies against Double

A Introduction Marginalization I
B Markets and What strategies do firms have to circumvent this problem?
Efficiency
C Market Power in 1. Vertical integration

Consumer Markets
• A merger between producer and retailer creates a monopolist.
D Market Power in
Vertical Supply
Chains
• Observe that both firms on the chain have an incentive to merge:
E Some Basic Game
As a monopolist who deals directly with consumers receives
Theory higher profits than both firms on the chain together, the new
F Imperfect monopolist can bid the entire profit of the other firm for the
Competition and
Strategic (Firm) acquisition and still make a profit.
Interaction
• E.g., an offer by the producer of slightly more than (1−c)2
G Cooperation 16 to the
among firms:
Mergers and Cartels retailer is profitable and will be accepted.
H Market Entry and • Note that also social welfare is increasing, as consumers get a
Exit
higher quantity at a lower price.
I Research and
Development • ªWhat is worse than a monopoly ± a chain of monopoliesº.
J Behavioral
Industrial • This should have consequences for merger regulation!
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A Introduction Marginalization II
B Markets and
Efficiency 2. Franchise fees
C Market Power in • A producer can also establish a vertical restraint via a
Consumer Markets
D Market Power in
two-part tariff. I.e., he asks for a fixed franchise fee and a
Vertical Supply
Chains
wholesale price p̂ per unit. What is the optimal p̂?
E Some Basic Game • Suppose the franchisor (the producer) asks for p̂ = c.
Theory
Then, the retailer faces exactly the same problem for profit
F Imperfect
Competition and maximization as an integrated monopolist. Hence, the
Strategic (Firm)
Interaction total quantity sold by the retailer and the consumer price
G Cooperation equals the total quantity sold and the consumer price by an
among firms:
Mergers and Cartels integrated monopolist. Can the producer or the retailer do
H Market Entry and any better?
Exit
I Research and
• No. With this two-part tariff, producer and retailer
Development
maximize their joint profit. The size of the fixed franchise
J Behavioral
Industrial fee now determines the distribution of these joint profits.
Organization
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Industrial
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A Introduction Marginalization III
B Markets and
Efficiency 3. ªMaximum Resale Priceº (Resale price maintenance)
C Market Power in
Consumer Markets
• The producer can dictate a price to the retailer.
D Market Power in • What is the optimal retail price from a producer’s
Vertical Supply
Chains perspective?
E Some Basic Game
Theory
p∗ = pM = p̂∗
F Imperfect
Competition and
• What are the profits for producer and retailer in this case?
Strategic (Firm)
Interaction
πP = πM
G Cooperation
among firms:
Mergers and Cartels
and
H Market Entry and
Exit πR = 0
I Research and
Development • Resale price maintenance is forbidden in many countries -
J Behavioral why?
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Industrial
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A Introduction Marginalization IV
B Markets and 4. Competition between retailers
Efficiency
C Market Power in
• Suppose there is perfect competition between retailers.
Consumer Markets
• At which price do they then sell the commodity?
D Market Power in
Vertical Supply
Chains
p∗ = MC =⇒ MC = p̂∗
E Some Basic Game
Theory
F Imperfect
• What is - as a consequence - the optimal price set by the
Competition and
Strategic (Firm)
producer?
Interaction p̂∗ = pM
G Cooperation
among firms:
Mergers and Cartels
• How are profits distributed in this case?
H Market Entry and
Exit πP = πM
I Research and
Development
and
J Behavioral
Industrial πiR = 0∀i
Organization
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B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains 1 First-degree price discrimination: Yields an efficient
E Some Basic Game allocation but very unequal distribution
Theory
F Imperfect
2 Second-degree price discrimination: Yields prices higher
Competition and
Strategic (Firm)
than marginal costs, hence an inefficient allocation
Interaction
3 Third-degree price discrimination: Prices are higher in
G Cooperation
among firms: market segments with lower price elasticity of demand
Mergers and Cartels
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B Markets and
Efficiency
4 ªWhat is worse than a monopoly ± a chain of monopoliesº
C Market Power in
Consumer Markets
5 Each firm in a vertical chain of monopolists takes a
D Market Power in
Vertical Supply mark-up on it’s marginal cost
Chains
E Some Basic Game

6 For each firm this creates a margin - two margins: double
Theory marginalization
F Imperfect
Competition and
7 Strategies against double marginalization that aim at the
Strategic (Firm)
Interaction
structure of the market
G Cooperation
a Vertical integration
among firms: b Competition at the retailer level
Mergers and Cartels
H Market Entry and

8 Strategies against double marginalization that aim at price
Exit setting
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b Resale price maintenance
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A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E
E Some Basic Game
Theory
1. Strict Dominance
Some Basic Game Theory
2. Iterated Dominance
3. Nash Equilibrium
4. Subgame Perfection
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Dr. Silvio Städter No Man is an Island

A Introduction
B Markets and
Efficiency
C Market Power in
• So far we have considered individual decision making
Consumer Markets
when outcomes depend only on the action chosen and the
D Market Power in
Vertical Supply state of the world that occurs.
Chains
• In reality, outcomes that I experience will depend on the
E Some Basic Game
Theory actions of others, and the outcomes for others will depend
1. Strict Dominance
2. Iterated Dominance on my actions.
3. Nash Equilibrium
4. Subgame Perfection • When outcomes for actors depend on the actions of each
F Imperfect
Competition and
other we have a situation of strategic interaction.
Strategic (Firm)
Interaction • The study of strategic interaction is referred to as game
G Cooperation theory.
among firms:
Mergers and Cartels
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Exit
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Dr. Silvio Städter Dealing with Strategic

A Introduction Interaction
B Markets and
Efficiency • In the past much economic analysis ignored strategic
C Market Power in interaction by assuming that economic actors interacted
Consumer Markets
through markets and each actor made up only a very small
D Market Power in
Vertical Supply part of the market.
Chains
E Some Basic Game

• Prior to 1900 there were few examples where interactions
Theory
1. Strict Dominance
of a finite number of actors were studied, a famous
3. Nash Equilibrium
example is the Cournot model of oligopoly.
• The development of game theory in the 20th century, led
F Imperfect
Competition and by the publication of a book by Von Neumann and
Strategic (Firm)
Interaction Morgenstern (1944), provided a formal structure for the
G Cooperation analysis of strategic interaction.
among firms:
Mergers and Cartels • The prediction made in the Cournot model of oligopoly
H Market Entry and
Exit
was a special case of what would later be known as a
I Research and Nash Equilibrium.
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Dr. Silvio Städter Self-Interested Individuals

A Introduction
B Markets and
Efficiency • The following quote taken from Adam Smith’s Wealth of
C Market Power in
Consumer Markets
Nations highlights the standard description of an
D Market Power in
economic decision maker:
Vertical Supply
Chains ªIt is not from the benevolence of the butcher, the brewer,
E Some Basic Game or the baker, that we expect our dinner, but from their
Theory
1. Strict Dominance regard to their own interest. We address ourselves, not to
3. Nash Equilibrium
their humanity but to their self-love, and never talk to
them of our own necessities but of their advantages.º
F Imperfect
Competition and • Economic analysis has focussed on a decision-maker that
Strategic (Firm)
Interaction acts purely out of self interest, observations of situations
G Cooperation
among firms:
with strategic interaction suggest that other motives may
Mergers and Cartels be at work.
H Market Entry and
Exit
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Dr. Silvio Städter What is a game?

A Introduction
B Markets and
Efficiency • Game Theory has been used to study interactions in many
C Market Power in contexts, many of these contexts are far from the popular
Consumer Markets
notion of a ªgameº.
D Market Power in
Vertical Supply
Chains
• For Economists the word game implies a process of
E Some Basic Game interaction with a prescribed population of participants, a
Theory
1. Strict Dominance
game has a set of rules and a set of payoffs associated to
3. Nash Equilibrium
every possible outcome of the game.
• There are two main methods for describing a game, the
F Imperfect
Competition and extensive form and the strategic form (also known as
Strategic (Firm)
Interaction normal form).
G Cooperation
among firms:
• The extensive form is basically a game-tree and the
Mergers and Cartels strategic form is a payoff table.
H Market Entry and
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Dr. Silvio Städter The Strategic Form

A Introduction
B Markets and
Efficiency
• A game can be described using three elements.
C Market Power in
Consumer Markets 1 Set of players.
D Market Power in 2 Set of strategies available to each player.
Vertical Supply
Chains 3 A payoff function that, given the input of a chosen strategy
E Some Basic Game for each player, specifies the outcome of the game for each
Theory
1. Strict Dominance
of the players.
3. Nash Equilibrium
• The set of players may consist of individuals, firms, teams
or any other unit at which decisions might be made.
F Imperfect
Competition and • A strategy of a player is a complete plan of action. It
Strategic (Firm)
Interaction defines an action taken at every node in a game at which
G Cooperation
among firms:
this player is supposed to move.
Mergers and Cartels
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A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply E.1
Chains
E Some Basic Game

Strict Dominance
Theory
1. Strict Dominance
3. Nash Equilibrium
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Dr. Silvio Städter The Prisoners’ Dilemma

A Introduction • One of the classic examples in game theory is the
B Markets and Prisoners’ Dilemma.
Efficiency
C Market Power in
• Two individuals (1 and 2) have been arrested on suspicion
Consumer Markets
of jointly committing a crime.
D Market Power in
Vertical Supply • Placed in separate cells they are given the option of
Chains
E Some Basic Game

incriminating themselves and their co-accused in
Theory exchange for a lighter sentence.
1. Strict Dominance
3. Nash Equilibrium
• If both ªdefectº on their partner, providing evidence, they
both receive a long sentence of 10 years.
F Imperfect
Competition and • If both ªcooperateº, not providing evidence, there is little
Strategic (Firm)
Interaction evidence to prosecute and they both receive a sentence of
G Cooperation 1 year.
among firms:
Mergers and Cartels • If one defects and the other one cooperates, the defector
H Market Entry and
Exit goes free while the cooperator receives a stiff sentence of
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A Introduction
B Markets and
Efficiency
• The situation can be represented in a table, the table
C Market Power in
Consumer Markets coincides with the strategic form of the respective game.
D Market Power in
Vertical Supply
12 D C
Chains D −10, −10 0, −12
E Some Basic Game C −12, 0 −1, −1
Theory
1. Strict Dominance
• In each cell of the table the payoff for the row player
3. Nash Equilibrium
(player 1 here) is listed first.
F Imperfect • The table includes the players in the top left cell, the lists
Competition and
Strategic (Firm) of strategies for each player in the first column and the first
Interaction
row, and the table tells us what the payoffs for players will
G Cooperation
among firms: be for each possible combination of the players’ strategies.
Mergers and Cartels
H Market Entry and

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Organization

A Introduction 12 D C
B Markets and D −10, −10 0, −12
Efficiency
C −12, 0 −1, −1
C Market Power in
Consumer Markets
D Market Power in
• What would be a reasonable prediction of behaviour?
Vertical Supply
Chains • Notice that no matter the strategy of the other player,
E Some Basic Game choosing D will give a player a higher a payoff.
Theory
1. Strict Dominance • If player 2 happens to choose D, player 1 would obtain a
3. Nash Equilibrium sentence of 10 years from D but 12 from C. If player 2
F Imperfect
were to choose C then player 1 goes free with D but has a
Competition and
Strategic (Firm)
one year sentence with C.
Interaction • Both players have a dominant strategy, if both players
G Cooperation
among firms: care only for their own freedom a reasonable prediction is
Mergers and Cartels
strategy profile (D, D).
H Market Entry and
Exit • There are other classes of games, such as Public Good
I Research and Games, which exhibit a very similar structure.
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A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply E.2
Chains
E Some Basic Game

Iterated Dominance
Theory
1. Strict Dominance
3. Nash Equilibrium
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Dr. Silvio Städter Iterated Dominance

A Introduction • In most games a single dominant strategy will not exist,
B Markets and
Efficiency other tools are needed to predict the behaviour of players.
C Market Power in • Rather than looking for a dominant strategy we can look
Consumer Markets
D Market Power in
for a dominated strategy. A strategy of a player i is
Vertical Supply
Chains
dominated if there exists another strategy that gives player
E Some Basic Game
i a higher payoff no matter the strategy chosen by other
Theory
1. Strict Dominance
players.
3. Nash Equilibrium
• If player i is rational it is reasonable to assume that he will
not choose a dominated strategy. If other players
F Imperfect
Competition and recognise that player i is rational, they will know that
Strategic (Firm)
Interaction player i will not choose the dominated strategy.
G Cooperation • The other players can analyse the game ignoring player i’s
among firms:
Mergers and Cartels dominated strategy, then we can eliminate their dominated
H Market Entry and
Exit
strategies from this reduced game. The process can be
I Research and
iterated forward.
Development
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Dr. Silvio Städter A Dominated Strategy

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains • The method of removing dominated strategies to analyse a
E Some Basic Game game is referred to as the Iterated Elimination of Strictly
Theory
1. Strict Dominance Dominated Strategies, or IESDS.
3. Nash Equilibrium • Its use is best illustrated with an example.
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Dr. Silvio Städter Example

A Introduction
B Markets and • Consider the following game:

Efficiency
C Market Power in
1\2 A B C
Consumer Markets X 2, 2 1, 0 0, 3
D Market Power in Y 4, 4 7, 2 6, 1
Vertical Supply Z 3, 5 2, 6 8, 3
Chains
E Some Basic Game

• Player 2 does not have a dominant or dominated strategy.
Theory
1. Strict Dominance
However, for player 1 the strategy X is dominated by both
3. Nash Equilibrium
Y and Z. If player 1 is rational, he will never choose X.
• If player 2 accepts that player 1 is rational, he can
F Imperfect
Competition and recognise that X will never be played, and hence can
Strategic (Firm)
Interaction consider the following reduced game:
G Cooperation 1\2 A B C
among firms:
Mergers and Cartels
Y 4, 4 7, 2 6, 1
Z 3, 5 2, 6 8, 3
H Market Entry and
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A Introduction
B Markets and • In this reduced game player 2 does have a dominated

Efficiency
strategy, C is dominated by both A and B.
C Market Power in
Consumer Markets • If player 1 accepts that 2 is rational, and also thinks that 2
D Market Power in
Vertical Supply
believes that 1 is rational, then player 1 knows that player
Chains 2 will not choose C. Then player 1 can consider a further
E Some Basic Game
Theory
reduced game:
1. Strict Dominance
1\2 A B
3. Nash Equilibrium Y 4, 4 7, 2
Z 3, 5 2, 6
F Imperfect
Competition and • In this game the strategy Z is dominated by Y so player 1
Strategic (Firm)
Interaction will never choose Z.
G Cooperation
among firms:
• If player 2 accepts that 1 is rational and also believes that
Mergers and Cartels 1 believes that 2 is rational, then player 2 will recognise
H Market Entry and
Exit
that 1 will not choose Z.
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A Introduction
B Markets and
Efficiency • Then finally player 2 can consider the reduced game:
C Market Power in 1\2 A B
Consumer Markets
Y 4, 4 7, 2
D Market Power in
Vertical Supply where it is clear the rational choice is to select A.
Chains
E Some Basic Game

• The unique strategy profile that survives the iterated
Theory
1. Strict Dominance
elimination of dominated strategies is (Y, A).
3. Nash Equilibrium
• To reach this prediction it is necessary to assume that there
4. Subgame Perfection is common knowledge of rationality, which is to say:
F Imperfect
Competition and
• All players are rational.
Strategic (Firm) • All players believe that all players are rational.
Interaction
• All players believe that all players believe that all players
G Cooperation
among firms: are rational.
Mergers and Cartels • ...
H Market Entry and
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Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply E.3
Chains
Nash Equilibrium
E Some Basic Game
Theory
1. Strict Dominance
3. Nash Equilibrium
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Industrial
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Dr. Silvio Städter Nash Equilibrium

A Introduction
B Markets and
Efficiency
• In many games, it turns out that no dominated strategy
C Market Power in
Consumer Markets exists. Then the elimination of dominated strategies is of
D Market Power in no help in predicting players’ behaviour.
Vertical Supply
Chains • The cornerstone of game theory is the concept of a Nash
E Some Basic Game
Theory
equilibrium.
1. Strict Dominance
• A Nash equilibrium is a strategy profile such that no
3. Nash Equilibrium
player could be made better off by selecting an alternative
F Imperfect strategy.
Competition and
Strategic (Firm) • The concept of Nash equilibrium has the big advantage
Interaction
G Cooperation
that at least one Nash equilibrium exists in virtually all
among firms: games.
Mergers and Cartels
H Market Entry and

Exit
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Industrial
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Dr. Silvio Städter Recall the Definition of a Nash

A Introduction Equilibrium
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains Definition (Nash Equilibrium)
E Some Basic Game
Theory A Nash equilibrium is a strategy profile, where all players
1. Strict Dominance
choose strategies that are best responses to the other players
3. Nash Equilibrium
strategies.
F Imperfect This is equivalent to saying that in a Nash Equilibrium, no
Competition and
Strategic (Firm) player has an incentive to unilaterally deviate.
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Industrial
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Dr. Silvio Städter Finding the Nash Equilibrium

A Introduction
B Markets and • To find a Nash equilibrium we search for the best

Efficiency
C Market Power in
response of each player to any possible strategy
Consumer Markets
combination of their opponents.
D Market Power in
Vertical Supply • The Nash equilibrium is the profile for which all of the
Chains
players are playing a best response. Consider again the
E Some Basic Game
Theory Prisoners’ Dilemma.
1. Strict Dominance
2. Iterated Dominance 12 D C
3. Nash Equilibrium
4. Subgame Perfection D −10, −10 0, −12
F Imperfect C −12, 0 −1, −1
Competition and
Strategic (Firm) • If player 1 was to select D the best response of player 2
Interaction
G Cooperation
would be to choose D, since −10 > −12. If player 1 was
among firms:
Mergers and Cartels
to select C the best response of player 2 would be to
H Market Entry and
choose D, since 0 > −1.
Exit
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Industrial
Organization

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
12 D C
D Market Power in
D −10, −10 0, −12
Vertical Supply C −12, 0 −1, −1
Chains
E Some Basic Game

Theory • Likewise, if player 2 was to select D the best response of
1. Strict Dominance
2. Iterated Dominance player 1 would be to choose D and if player 2 was to select
3. Nash Equilibrium
4. Subgame Perfection C the best response of player 1 would be to choose D.
F Imperfect
Competition and
• The unique Nash equilibrium is strategy profile (D, D),
Strategic (Firm)
Interaction
given this profile neither player has an incentive to deviate
G Cooperation
and choose a different strategy.
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Industrial
Organization

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
12 D C
D Market Power in
D −10, −10 0, −12
Vertical Supply C −12, 0 −1, −1
Chains
E Some Basic Game

Theory • Likewise, if player 2 was to select D the best response of
1. Strict Dominance
2. Iterated Dominance player 1 would be to choose D and if player 2 was to select
3. Nash Equilibrium
4. Subgame Perfection C the best response of player 1 would be to choose D.
F Imperfect
Competition and
• The unique Nash equilibrium is strategy profile (D, D),
Strategic (Firm)
Interaction
given this profile neither player has an incentive to deviate
G Cooperation
and choose a different strategy.
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply E.4
Chains
Subgame Perfection
E Some Basic Game
Theory
1. Strict Dominance
3. Nash Equilibrium
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Dr. Silvio Städter Refining Nash Equilibrium in

A Introduction Dynamic Games: Subgame
B Markets and
Efficiency Perfection
C Market Power in
Consumer Markets
D Market Power in • The concept of Nash Equilibrium sometimes makes

Vertical Supply
Chains implausible predictions in dynamic games (players taking
E Some Basic Game decisions at different points in time). To see this consider
Theory
1. Strict Dominance the following example.
3. Nash Equilibrium • There are two firms (1 and 2), and firm 1 faces a choice
F Imperfect
whether to enter a market in which firm 2 is so far the only
Competition and
Strategic (Firm)
participant. Firm 1 chooses to enter (E) or not (N).
Interaction
• Having observed firm 1’s participation decision, the choice
G Cooperation
among firms: for firm 2 is between fighting (F) and conceding (C). The
Mergers and Cartels
game can be described using the following game tree.
H Market Entry and
Exit
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Dr. Silvio Städter A Simple Entry Game

A Introduction
B Markets and
Efficiency F (−1, −1)
C Market Power in
Consumer Markets
2
D Market Power in
Vertical Supply E C
Chains (1, 1)
E Some Basic Game
Theory
1. Strict Dominance
1
3. Nash Equilibrium
F Imperfect
Competition and N
Strategic (Firm)
Interaction (0, 2)
G Cooperation
among firms:
Mergers and Cartels
• This representation is referred to as the extensive form. It
H Market Entry and
Exit displays the sequential structure of the game.
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Dr. Silvio Städter A Simple Entry Game

A Introduction
B Markets and
Efficiency
C Market Power in • Each of the firms has to take one decision in the game and
Consumer Markets
faces a choice between two options. This means they each
D Market Power in
Vertical Supply have two possible strategies.
Chains
E Some Basic Game

• The game can be represented in strategic form as follows:
Theory
1. Strict Dominance
12 F C
3. Nash Equilibrium
N 0, 2 0, 2
F Imperfect E −1, −1 1, 1
Competition and
Strategic (Firm)
Interaction
• Analysing this game we find that there are two Nash
G Cooperation equilibria, (E, C) and (N, F).
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Industrial
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Dr. Silvio Städter Non-credible Threats

A Introduction
B Markets and
Efficiency
• The strategy profile (N, F) is a Nash equilibrium, however
C Market Power in it has the undesirable feature that it involves a
Consumer Markets
non-credible threat.
D Market Power in
Vertical Supply • If firm 1 believes that firm 2 will choose F it is optimal to
Chains
E Some Basic Game

choose N, however is it reasonable to assume that 2 would
Theory
1. Strict Dominance
choose F if called upon?
3. Nash Equilibrium
• This would imply that firm 2 selects a payoff of −1 rather
than 1, something that most would view as irrational.
F Imperfect
Competition and ⇒ Firm 2’s threat of selecting F is non-credible.
Strategic (Firm)
Interaction • A refinement to the concept of Nash equilibria is required
G Cooperation
among firms: to rule out such undesirable equilibria. The standard
Mergers and Cartels
concept for this is subgame perfection.
H Market Entry and
Exit
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Dr. Silvio Städter Subgame Perfect Nash

A Introduction Equilibrium
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in • When a game is sequential we can often separate it into

Vertical Supply
Chains several subgames.
E Some Basic Game
Theory
• In the simple entry game there is a subgame that begins
1. Strict Dominance when firm 2 takes its choice.
3. Nash Equilibrium
• The Nash equilibrium profile (N, F) requires firm 2 to take
F Imperfect an action that is not optimal in this subgame.
Competition and
Strategic (Firm) • For an equilibrium to be subgame perfect it requires
Interaction
G Cooperation
optimal behavior by players in every subgame.
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Dr. Silvio Städter Backward Induction

A Introduction
• In finite games of perfect information, subgame perfect
B Markets and
Efficiency equilibria can be found by using backwards induction.
C Market Power in
Consumer Markets
• A game of perfect information is one in which there are no
D Market Power in simultaneous moves and at any move each player has full
Vertical Supply
Chains knowledge of the history of prior actions of all players
E Some Basic Game (i.e., all information sets are singletons).
Theory
1. Strict Dominance • Using backward induction, we start with the last decision
3. Nash Equilibrium node and we find the optimal action at that node.
F Imperfect
• Moving one node up in the game tree, we find the optimal
Competition and
Strategic (Firm)
decision at that node assuming the optimal action will be
Interaction taken at the final node (as determined in the previous step).
G Cooperation
among firms: • Proceed successively until the start of the game.
Mergers and Cartels
H Market Entry and

• For the entry game example, only the Nash Equilibrium
Exit (E, C) is subgame perfect.
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B Markets and
Efficiency
1 Game theory provides us with tools that enable us to make
C Market Power in
predictions about behaviour in situations with strategic
Consumer Markets
interaction.
D Market Power in
Vertical Supply 2 At least one stable strategy profile, the Nash equilibrium,
Chains
is guaranteed in most situations.
E Some Basic Game
Theory 3 However, there are also situations in which many
1. Strict Dominance
equilibria coexist, so that it might not be clear which
3. Nash Equilibrium
equilibrium is ultimately played.
F Imperfect 4 The tools of game theory use various notions of rationality
Competition and
Strategic (Firm) and mutual knowledge of others’ rationality.
Interaction
5 The strength of game theory as a predictive and
G Cooperation
among firms: descriptive tool will depend on whether the assumptions
Mergers and Cartels
of rationality are reasonable.
H Market Entry and
Exit 6 It is important to note that we do NOT assume that players
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are per se self-interested.
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Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
E
Chains
E Some Basic Game

Imperfect Competition and
Theory
F Imperfect
Competition and
Strategic (Firm) Interaction
Strategic (Firm)
Interaction
1. Price competition
2. Quantity Competition
3. Quantity Competition with
Capacity Choice
4. Product Differentiation
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
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Dr. Silvio Städter Degree of competition: Three

A Introduction market structures
B Markets and 1 Perfect competition: Every firm is a price-taker, i.e.,
Efficiency
• each firm neither expects the market price to depend on its
C Market Power in
Consumer Markets own output choice nor
D Market Power in
• on any other firm’s output decision
Vertical Supply • i.e., each firm optimizes independently.
Chains
E Some Basic Game

2 Monopoly: The firm does not take the price but rather
Theory anticipates that
F Imperfect • its output choice fully determines the market price and
Competition and
Strategic (Firm) • no other firm’s output choice influences its optimal
Interaction
decision
2. Quantity Competition • i.e., the firm solves a control problem
Capacity Choice
3 Oligopoly: Firm’s do not take the price but rather
G Cooperation
anticipate that
among firms: • their own output choice influences the market price and
Mergers and Cartels
• other firm’s output choice influence their own optimal
H Market Entry and
Exit decision
I Research and
• i.e., firms play a ªgameº
Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply F.1
Chains
Price competition
E Some Basic Game
Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization
Dr. Silvio Städter The Basic Bertrand Model I

A Introduction
B Markets and
Efficiency
C Market Power in • Players: Two firms 1 and 2. Both produce a homogeneous

Consumer Markets
D Market Power in
good at constant marginal costs c1 = c2 = c without any
Vertical Supply
Chains
fixed costs.
E Some Basic Game • Strategies: Prices p1 , p2 ∈ ℜ+
0 , chosen simultaneously.
Theory
F Imperfect
• Payoffs:
Competition and
Strategic (Firm)
Demand is given by q = D(p1 , p2 ) and all consumers buy
Interaction
from the firm with the lower price, i.e., if p1 ̸= p2 :
Capacity Choice q = D(min (p1 , p2 )).
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization
Dr. Silvio Städter The Basic Bertrand Model II

A Introduction
The Bertrand Nash equilibrium
B Markets and
Efficiency • Given p1 and p2 , demand for firm 1 is:
C Market Power in
Consumer Markets 
D Market Power in
 D(p1 ) if p1 < p2 ,
1
Vertical Supply D1 (p1 , p2 ) = D(p1 ) if p1 = p2 ,
Chains  2
E Some Basic Game
0 if p1 > p2
Theory
F Imperfect and similarly for player 2.

Competition and
Strategic (Firm) • Payoffs:
Interaction
1. Price competition π1 (p1 , p2 ) = (p1 − c)D1 (p1 , p2 )
Capacity Choice π2 (p1 , p2 ) = (p2 − c)D2 (p1 , p2 ).
G Cooperation
among firms:
Theorem: There exists a unique Nash equilibrium where
Mergers and Cartels p1 = p2 = c, i.e., firms share the market equally and make
H Market Entry and
Exit
profits of zero.
I Research and
Industrial
Organization
Dr. Silvio Städter The Basic Bertrand Model II

A Introduction
The Bertrand Nash equilibrium
B Markets and
Efficiency • Given p1 and p2 , demand for firm 1 is:
C Market Power in
Consumer Markets 
D Market Power in
 D(p1 ) if p1 < p2 ,
1
Vertical Supply D1 (p1 , p2 ) = D(p1 ) if p1 = p2 ,
Chains  2
E Some Basic Game
0 if p1 > p2
Theory
F Imperfect and similarly for player 2.

Competition and
Strategic (Firm) • Payoffs:
Interaction
1. Price competition π1 (p1 , p2 ) = (p1 − c)D1 (p1 , p2 )
Capacity Choice π2 (p1 , p2 ) = (p2 − c)D2 (p1 , p2 ).
G Cooperation
among firms:
Theorem: There exists a unique Nash equilibrium where
Mergers and Cartels p1 = p2 = c, i.e., firms share the market equally and make
H Market Entry and
Exit
profits of zero.
I Research and
Industrial
Organization
Dr. Silvio Städter The Basic Bertrand Model III

A Introduction
Proof of the theorem
B Markets and 1 In equilibrium, every firm has to set a price that
Efficiency
maximizes its profit for a given price set by the other firm.
C Market Power in
Consumer Markets 2 min(p1 , p2 ) < c? No. The firm with the lower price would
D Market Power in serve the whole market, but makes a loss on each unit sold.
Vertical Supply
Chains 3 p1 > p2 > c? No. Firm 1 would be strictly better off
E Some Basic Game
Theory
setting p1 = p2 .
F Imperfect 4 p1 > p2 = c? No. Firm 2 would be strictly better off
Competition and
Strategic (Firm) setting p2 = p1 .
Interaction
5 p1 = p2 > c? No. It is profitable for both firms to slightly
undercut the other firm’s price and thereby attract all
Capacity Choice
consumers (at almost the same price).
G Cooperation 6 Hence, the only remaining candidate is p1 = p2 = c.
among firms:
Mergers and Cartels 7 Is this an equilibrium? Yes. Undercutting attracts all
H Market Entry and
Exit
consumers, but leads to losses while a higher price leads to
I Research and
profits of zero.
Industrial
Organization
Dr. Silvio Städter The Bertrand Paradox

A Introduction
• The theorem is rather paradoxical: Even though only two
B Markets and
Efficiency firms compete, they offer the good at marginal costs and
C Market Power in do not make any profits (as under perfect competition).
Consumer Markets
• Note that the result also holds true for more than 2 firms!
D Market Power in
Vertical Supply • pi = c ∀ i ∈ {1, ..., n}
Chains
E Some Basic Game

• However, result crucially relies on underlying
Theory assumptions:
F Imperfect
Competition and
• Constant and identical marginal costs.
Strategic (Firm) • Consumers react on arbitrarily small price changes.
Interaction
• No capacity constraints.
• Homogeneous good.
Capacity Choice
4. Product Differentiation • In the following, these assumptions will be relaxed one by
G Cooperation
among firms:
one.
Mergers and Cartels
• In many IO model frameworks, the Bertrand case serves
H Market Entry and
Exit as a benchmark for tough product competition.
I Research and
Industrial
Organization
Dr. Silvio Städter Sustaining market power: Ways

A Introduction out of the Bertrand Paradox I
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory • Asymmetric marginal costs
F Imperfect
Competition and
• Switching costs
Strategic (Firm)
Interaction
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction out of the Bertrand Paradox II
B Markets and
Efficiency
C Market Power in
Consumer Markets Asymmetric marginal costs
D Market Power in
Vertical Supply
• Suppose c1 < c2 , i.e. firm 1 has the more efficient
Chains production technology.
E Some Basic Game
Theory • Assume also that when p1 = p2 , all consumers patronize
F Imperfect the firm with the lower marginal costs (firm 1)
Competition and
Strategic (Firm)
Interaction
• Let pM (c1 ) be the price which a monopolist would
optimally set if his marginal cost is c1 .
Capacity Choice
• We refer to the cost difference between the two firms as
drastic when pM (c1 ) < c2 ; when pM (c1 ) > c2 it is called
G Cooperation
among firms: non-drastic.
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction out of the Bertrand Paradox III
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply Theorem: Assume c1 < c2 . Then in any Nash equilibrium all
Chains
consumers will buy at firm 1. Moreover, it is consistent with
E Some Basic Game
Theory Nash equilibrium for firms to set prices
F Imperfect
Competition and
• p1 = pM (c1 ) and p2 = c2 when the cost difference is
Strategic (Firm)
Interaction
drastic, and
• p1 = c2 and p2 = c2 , when the cost difference is
Capacity Choice non-drastic.
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction out of the Bertrand Paradox IV
B Markets and Remarks:
Efficiency
C Market Power in
• If consumers are indifferent between both firms, in equilibrium,
Consumer Markets they must all purchase from firm 1 (as assumed). Otherwise,
D Market Power in firm 1 would have an incentive to undercut.
Vertical Supply
Chains • Firm 2 can never gain by setting another price.
E Some Basic Game
Theory • Also firm 1 can not gain by setting another price:
F Imperfect • In the drastic case, it chooses the monopoly price which
Competition and
Strategic (Firm) by definition is profit-maximizing.
Interaction
• In the non-drastic case, it chooses the maximum price for
which undercutting by firm 2 will not occur.
Capacity Choice
4. Product Differentiation • In equilibrium, firm 1 receives positive profits (e.g., returns to a
G Cooperation cost saving investment that pushed its costs below c2 ).
among firms:
Mergers and Cartels • Hence, there is a simple explanation for investment into cost
H Market Entry and reduction and (resulting) sustainable market power (in a
Exit
competitive environment).
I Research and
Industrial
Organization

A Introduction out of the Bertrand Paradox V
B Markets and Switching costs
Efficiency
C Market Power in
• Until now, consumers were assumed to react to arbitrarily
Consumer Markets small price differentials, i.e., they perceived the goods as
D Market Power in
Vertical Supply
fully homogeneous and could easily switch between them
Chains
at no cost.
E Some Basic Game • In reality, switching from one product brand or type to
Theory
F Imperfect
another often comes at a cost which may have various
Competition and origins:
Strategic (Firm)
Interaction
• Material investment
1. Price competition • technical compatibility (e.g., spare parts)
2. Quantity Competition • transaction costs (e.g., bank accounts)
Capacity Choice • Information costs
• usage skills (e.g., operating systems)
G Cooperation
among firms:
• uncertainty about quality (e.g., mobile phones)
Mergers and Cartels • Artificial costs
H Market Entry and • quantity discounts (e.g., frequent flyer programs)
Exit • Psychological costs
I Research and • (patriotic forms of) brand loyalty (e.g., BMW)
Industrial
Organization

A Introduction out of the Bertrand Paradox VI
B Markets and
Efficiency • Switching costs can sustain the market power of firms that
C Market Power in compete in prices.
Consumer Markets
D Market Power in
Impact of switching costs
Vertical Supply
Chains Two countervailing effects:
E Some Basic Game
Theory 1 Incentive to increase the price to use loyal consumers as
F Imperfect ªcash-cowsº.
Competition and
Strategic (Firm)
Interaction
2 Incentive to decrease prices to attract new customers.
2. Quantity Competition • The more the future is discounted, the higher the incentive
Capacity Choice to increase prices now (instead of hoping for a larger
G Cooperation
consumer base in the future).
among firms:
Mergers and Cartels
• The more consumers anticipate future price increases (and
H Market Entry and the less they discount future profits), the less profitable is a
Exit
price decrease today to attract consumers.
I Research and
Industrial
Organization

A Introduction out of the Bertrand Paradox VI
B Markets and
Efficiency • Switching costs can sustain the market power of firms that
C Market Power in compete in prices.
Consumer Markets
D Market Power in
Impact of switching costs
Vertical Supply
Chains Two countervailing effects:
E Some Basic Game
Theory 1 Incentive to increase the price to use loyal consumers as
F Imperfect ªcash-cowsº.
Competition and
Strategic (Firm)
Interaction
2 Incentive to decrease prices to attract new customers.
2. Quantity Competition • The more the future is discounted, the higher the incentive
Capacity Choice to increase prices now (instead of hoping for a larger
G Cooperation
consumer base in the future).
among firms:
Mergers and Cartels
• The more consumers anticipate future price increases (and
H Market Entry and the less they discount future profits), the less profitable is a
Exit
price decrease today to attract consumers.
I Research and
Industrial
Organization
Dr. Silvio Städter Summary

A Introduction
B Markets and
Efficiency
• Sometimes already one competitor is enough to extinguish
C Market Power in market power (Bertrand paradox).
Consumer Markets
• This is more likely if
D Market Power in
Vertical Supply • Production technologies are identical and have constant
Chains
returns to scale.
E Some Basic Game
Theory • Switching costs for consumers are small.
F Imperfect • There are further reasons why not all markets are prone to
Competition and
Strategic (Firm) aggressive competition. Therefore, as we will see next,
Interaction
market power can also be sustained if
2. Quantity Competition • Capacities are constrained.
Capacity Choice • Goods are not homogeneous.
G Cooperation • In these cases, an aggressive or expansionary strategy by

among firms:
Mergers and Cartels one firm induces retreat by the (or all) other firm(s).
H Market Entry and
Exit
I Research and
Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply F.2
Chains
Quantity Competition
E Some Basic Game
Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization
Dr. Silvio Städter The Basic Cournot Model I

A Introduction • Players: 2 identical firms produce a homogenous good
B Markets and
Efficiency
with constant marginal costs of c.
C Market Power in • Strategies: Firm 1 chooses quantity x1 ≥ 0, Firm 2
Consumer Markets
chooses quantity x2 ≥ 0. Both firms choose quantities
D Market Power in
Vertical Supply simultaneously and aggregate quantity is denoted by X
Chains
E Some Basic Game

• Market Demand: Given the quantity choices, the market
Theory
price is given by the (linear) demand function
F Imperfect
Competition and
Strategic (Firm)
Interaction
p = f (X) = A − X = A − (x1 + x2 )
• Payoffs: The profit of firm 1 is
Capacity Choice
G Cooperation π1 (x1 , x2 ) = x1 p − cx1 = x1 [A − (x1 + x2 )] − cx1

among firms:
Mergers and Cartels
H Market Entry and

• Note that, via the market price, the payoff of each firm
Exit depends on the quantities chosen by both firms.
I Research and
Industrial
Organization
Dr. Silvio Städter The Basic Cournot Model II

A Introduction
B Markets and
Efficiency
The Cournot Nash equilibrium
C Market Power in • Firm 1 chooses x1 to maximize
Consumer Markets
π1 = x1 [A − (x1 + x2 )] − x1 c.
D Market Power in
Vertical Supply • First order condition:
Chains
E Some Basic Game

∂ π1
Theory
= A − (x1 + x2 ) − x1 − c = 0
F Imperfect ∂ x1
Competition and
Strategic (Firm)
Interaction • Solving for x1 gives firm 1’s reaction function:
x1 = A−x22 −c
• Similarly, firm 2’s reaction function: x2 = A−x21 −c
Capacity Choice
G Cooperation • Nash Equilibrium: mutually best responses =⇒ solve the

among firms:
Mergers and Cartels equation system of the reaction functions
H Market Entry and
Exit
I Research and
Industrial
Organization
Dr. Silvio Städter The Basic Cournot Model III

A Introduction
• Profit maximizing quantities for both firms:
B Markets and
Efficiency A−c
x1,2 =
C Market Power in 3
Consumer Markets
D Market Power in
• Price:
Vertical Supply
Chains A − c A + 2c
p = A − x1 − x2 = A − 2 =
E Some Basic Game
Theory
3 3
F Imperfect • Profits:
Competition and
Strategic (Firm)
Interaction A−c A−c A−c (A − c)2
1. Price competition π1,2 = (p−c) = (A−2 −c) = >0
2. Quantity Competition 3 3 3 9
Capacity Choice
• both firms have positive profits (vs. perfect competition
G Cooperation and Bertrand competition with zero profits)
among firms:
Mergers and Cartels • total quantity produced: 2 A−c
3 < A − c = qpc = qBc
H Market Entry and • both firms excert a certain amount of market power when
Exit
I Research and
competing in quantities
Industrial
Organization
Dr. Silvio Städter The Cournot Model - n firms I

A Introduction • Players: n identical firms i = 1, ..., n produce a
B Markets and
Efficiency
homogenous good with constant marginal costs of c
C Market Power in • Strategies: Firm i chooses quantity xi ≥ 0. All firms
Consumer Markets
choose quantities simultaneously and aggregate quantity is
D Market Power in
Vertical Supply denoted by X
Chains
E Some Basic Game

• Market Demand: Given the quantity choices, the market
Theory
price is given by the (linear) demand function
F Imperfect
Competition and
Strategic (Firm)
Interaction
p = f (X) = A − X
• Payoffs: The profit of firm i is
Capacity Choice
G Cooperation πi (x1 , ..., xn ) = xi f (X) − cxi

among firms:
Mergers and Cartels
H Market Entry and

• Note that, via the market price, the payoff of each firm
Exit depends on the quantities chosen by all other firms.
I Research and
Industrial
Organization
Dr. Silvio Städter The Cournot Model - n firms II

A Introduction
B Markets and
Efficiency
The Cournot Nash equilibrium
C Market Power in • Firm i chooses xi to maximize
Consumer Markets
πi = xi [A − (x1 + ... + xi + ... + xn )] − xi c
D Market Power in
Vertical Supply
Chains
• First order conditions:
E Some Basic Game
Theory ∂ πi
= A−(x1 +...+xi +...+xn )−xi −c = 0 for all i = 1...n
F Imperfect ∂ xi
Competition and
Strategic (Firm)
Interaction • Solving for xi gives firm i’s reaction function:
xi = A−(x1 +...+xi−12+xi+1 +...xn )−c
Capacity Choice
• To solve this system of N equations with n unknowns, we
G Cooperation utilize the symmetry between firms, i.e., we consider an
among firms:
Mergers and Cartels equilibrium with x1 = x2 = ... = xn = xC
H Market Entry and
Exit
I Research and
Industrial
Organization
Dr. Silvio Städter The Cournot Model - n firms III

A Introduction • This gives
B Markets and
Efficiency
A − (n − 1)xC − c A−c
C Market Power in xC = ⇔ 2xC + (n − 1)xC = A − c ⇔ xC =
Consumer Markets 2 n+1
D Market Power in
Vertical Supply • Profits:
Chains
E Some Basic Game

Theory A−c A−c (A − c)2
π= (A − n − c) = >0
F Imperfect
Competition and
n+1 n+1 (n + 1)2
Strategic (Firm)
Interaction
Limit N → ∞
2
• Profits π = (A−c)2 are decreasing in n and converge to zero if n
2. Quantity Competition (n+1)
Capacity Choice
tends to infinity.
• The total quantity produced in the economy x1 + ... + xn = n A−c
n+1
G Cooperation
among firms: converges to (A − c) if n tends to infinity.
Mergers and Cartels
• The price with quantity A − c will be p = A − (A − c) = c
H Market Entry and
Exit
• Hence, the allocation resembles the (efficient) allocation under
I Research and
Development perfect competition. 118 / 304
Industrial
Organization
Dr. Silvio Städter The Cournot Model - n firms III

A Introduction • This gives
B Markets and
Efficiency
A − (n − 1)xC − c A−c
C Market Power in xC = ⇔ 2xC + (n − 1)xC = A − c ⇔ xC =
Consumer Markets 2 n+1
D Market Power in
Vertical Supply • Profits:
Chains
E Some Basic Game

Theory A−c A−c (A − c)2
π= (A − n − c) = >0
F Imperfect
Competition and
n+1 n+1 (n + 1)2
Strategic (Firm)
Interaction
Limit N → ∞
2
• Profits π = (A−c)2 are decreasing in n and converge to zero if n
2. Quantity Competition (n+1)
Capacity Choice
tends to infinity.
• The total quantity produced in the economy x1 + ... + xn = n A−c
n+1
G Cooperation
among firms: converges to (A − c) if n tends to infinity.
Mergers and Cartels
• The price with quantity A − c will be p = A − (A − c) = c
H Market Entry and
Exit
• Hence, the allocation resembles the (efficient) allocation under
I Research and
Development perfect competition. 118 / 304
Industrial
Organization
Dr. Silvio Städter The Cournot Model extended -

A Introduction Heterogenous firms I
B Markets and
Efficiency
C Market Power in • As before: n = 2 and f (x1 , x2 ) = A − x1 − x2

Consumer Markets
D Market Power in
• But different costs: c1 < c2 .
Vertical Supply
Chains • Profit of firm 1: π1 = (A − x1 − x2 )x1 − c1 x1
E Some Basic Game
Theory
• Profit of firm 2: π2 = (A − x2 − x1 )x2 − c2 x2
F Imperfect • Reaction functions:
Competition and
Strategic (Firm)
Interaction
2. Quantity Competition A − x2 − c1
3. Quantity Competition with x1 =
Capacity Choice
2
A − x1 − c2
G Cooperation
among firms:
x2 =
H Market Entry and
Exit
I Research and
Industrial
Organization

A Introduction Heterogenous firms I
B Markets and
Efficiency
C Market Power in • As before: n = 2 and f (x1 , x2 ) = A − x1 − x2

Consumer Markets
D Market Power in
• But different costs: c1 < c2 .
Vertical Supply
Chains • Profit of firm 1: π1 = (A − x1 − x2 )x1 − c1 x1
E Some Basic Game
Theory
• Profit of firm 2: π2 = (A − x2 − x1 )x2 − c2 x2
F Imperfect • Reaction functions:
Competition and
Strategic (Firm)
Interaction
2. Quantity Competition A − x 2 − c1
3. Quantity Competition with x1 =
Capacity Choice
2
A − x 1 − c2
G Cooperation
among firms:
x2 =
H Market Entry and
Exit
I Research and
Industrial
Organization

A Introduction Heterogenous firms II
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
• Game is no longer symmetric, solving the equation system
Vertical Supply
Chains
yields the equilibrium quantities:
E Some Basic Game
A − 2c1 + c2 A − 2c2 + c1
Theory
x1C = and x2C =
F Imperfect 3 3
Competition and
Strategic (Firm)
Interaction • Why does the optimal quantity of firm 1 depend on the
cost of firm 2 and vice versa?
Capacity Choice • Note, that firm 2 could optimally produce nothing, if the
G Cooperation
cost-difference is sufficiently high
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization
Dr. Silvio Städter Bertrand vs. Cournot

A Introduction • Equilibrium profits: In contrast to the Bertrand case,
B Markets and under Cournot firm profits are strictly positive even in a
Efficiency
symmetric framework.
C Market Power in
Consumer Markets • Sunk costs and entry: Fixed costs do not have any
D Market Power in
Vertical Supply
impact, unless equilibrium profits turn out to be negative
Chains (to be reconsidered in a discussion of market entry). In
E Some Basic Game
Theory
contrast, Bertrand competition excludes entry in the
F Imperfect presence of any fixed costs.
Competition and
Strategic (Firm) • Competitive advantages: (Slightly) larger marginal costs
Interaction
do not imply production (and profits) of zero. But profits
are increasing in cost savings.
Capacity Choice
4. Product Differentiation • Competitive pressure: Quantities (per firm) and profits
G Cooperation decrease in the number of competing firms while
among firms:
Mergers and Cartels aggregate quantity in the market increases.
H Market Entry and
Exit ⇒ Cournot (Bertrand) model often used as benchmark for
I Research and moderate (strong) product market competition
Industrial
Organization
Dr. Silvio Städter Bertrand vs. Cournot

A Introduction • Equilibrium profits: In contrast to the Bertrand case,
B Markets and under Cournot firm profits are strictly positive even in a
Efficiency
symmetric framework.
C Market Power in
Consumer Markets • Sunk costs and entry: Fixed costs do not have any
D Market Power in
Vertical Supply
impact, unless equilibrium profits turn out to be negative
Chains (to be reconsidered in a discussion of market entry). In
E Some Basic Game
Theory
contrast, Bertrand competition excludes entry in the
F Imperfect presence of any fixed costs.
Competition and
Strategic (Firm) • Competitive advantages: (Slightly) larger marginal costs
Interaction
do not imply production (and profits) of zero. But profits
are increasing in cost savings.
Capacity Choice
4. Product Differentiation • Competitive pressure: Quantities (per firm) and profits
G Cooperation decrease in the number of competing firms while
among firms:
Mergers and Cartels aggregate quantity in the market increases.
H Market Entry and
Exit ⇒ Cournot (Bertrand) model often used as benchmark for
I Research and moderate (strong) product market competition
Industrial
Organization
Dr. Silvio Städter Sequential Quantity Choices -

A Introduction The Stackelberg Model I
B Markets and
Efficiency
• As before: N = 2, f (x1 , x2 ) = A − x1 − x2 , and c1 = c2 .
C Market Power in • But now firms move sequentially: firm 1 choose its
Consumer Markets
quantity before firm 2, and firm 2 can observe the choice
D Market Power in
Vertical Supply by firm 1.
Chains
• Determining the SPNE, using backward induction:
E Some Basic Game
Theory 1. Best response of firm 2 for any previously chosen quantity
F Imperfect x1 :
Competition and
Strategic (Firm) max(A − x1 − x2 )x2 − cx2 ,
Interaction x2
2. Quantity Competition which leads to reaction function x2∗ (x1 ) = A−x21 −c .
Capacity Choice 2. Optimal choice of x1 anticipating optimal response of firm
2:
G Cooperation
among firms:
Mergers and Cartels max(A − x1 − x2 )x1 − cx1 s.t. x2 = x2∗ (x1 ),
x1
H Market Entry and
Exit
A−c A−c
which leads to x1S = 2 > xC and x2S = 4 < xC
I Research and
Industrial
Organization
Dr. Silvio Städter Sequential Quantity Choices -

A Introduction The Stackelberg Model I
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
• Equilibrium price: pS = A − x1S − x2S = A+3c C
E Some Basic Game 4 <p .
Theory
(A−c)2 (A−c)2
F Imperfect • Profits: π1S = 8 > π C and π2S = 16 < π
C
Competition and
Strategic (Firm)
Interaction ⇒ firm 1 enjoys a first mover advantage
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization
Dr. Silvio Städter Cournot vs. Stackelberg

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

B Markets and
Efficiency
C Market Power in
Consumer Markets 1 Competition in prices yields price = MC and zero profits
D Market Power in
Vertical Supply
for firms (Bertrand Paradox)
Chains
2 Asymmetric MC or switching costs solve the Bertrand
E Some Basic Game
Theory Paradox
F Imperfect
Competition and
3 Simultaneous competition in quantities (Cournot) yields
Strategic (Firm)
Interaction
positive profits for firms (as long as number of firms is not
1. Price competition infinite)
Capacity Choice 4 Sequential competition in quantities (Stackelberg) benefits
the leader and harms the follower (as compared to
G Cooperation
among firms: Cournot)
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply F.3
Chains
Quantity Competition with Capacity Choice
E Some Basic Game
Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization
Dr. Silvio Städter The Model by Kreps and

A Introduction Scheinkman (1983) I
B Markets and
Efficiency
C Market Power in
Consumer Markets • Recall, that Bertrand equilibrium (p = MC) is only stable,
D Market Power in
Vertical Supply
if there are no capacity constraints
Chains
• infinite capacity: by undercutting the competitors’ price, a
E Some Basic Game
Theory firm would gain by serving all the market ⇒ represents a
F Imperfect credible threat (off equilibrium!)
Competition and
Strategic (Firm) • in equilibrium, however, only half (or the respective share)
Interaction
1. Price competition of the market will be served by one firm
Capacity Choice
• nevertheless, all firms would have to hold (costly) capacity
to be able to serve the whole market ⇒ rather unrealistic
G Cooperation
among firms: assumption
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) II
B Markets and
Efficiency
• Players: 2 Firms choose a capacity at unit costs of c. For a
C Market Power in
Consumer Markets given capacity, production costs for a homogenous good
D Market Power in are zero within capacity limits and infinity beyond
Vertical Supply
Chains capacity limits.
E Some Basic Game • Strategies:
Theory
• Stage 1: Firms simultaneously choose capacities x1 and x2 .
F Imperfect
Competition and • Stage 2: Firms simultaneously choose prices p1 and p2
Strategic (Firm)
Interaction (i.e., they compete a la Bertrand).
2. Quantity Competition • Payoffs: Demand is given by p = A − X or X = A − p with
Capacity Choice total output X = x1 + x2 . Profits for firm i are
G Cooperation
among firms: πi = pi xi − cxi
Mergers and Cartels
H Market Entry and

Exit where xi denotes the quantity sold by firm i.
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) III
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains • Main result: In the equilibrium of this two-stage game,
E Some Basic Game firms set capacities equal to the quantities of the Cournot
Theory
F Imperfect
Nash equilibrium.
Competition and
Strategic (Firm)
⇒ Cournot model as reduced form of the (more realistic)
Interaction model with capacity choice and subsequent price
2. Quantity Competition competition.
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) IV
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Solving the model
Chains
E Some Basic Game

Similar to the solution of the double-marginalization problem,
Theory we proceed by backward induction
F Imperfect
Competition and • At stage 2, prices for a given capacity choice have to form
Strategic (Firm)
Interaction a Nash equilibrium.
2. Quantity Competition • At stage 1, capacities for anticipated price decisions have
Capacity Choice to form a Nash equilibrium.
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) V
B Markets and
Efficiency Monopoly benchmark
C Market Power in • Stage 2:
Consumer Markets
D Market Power in
• If the monopolist were unconstrained in capacity, he
Vertical Supply would maximize profits πM = x(A − x) = Ax − x2 , i.e., he
Chains
would choose xM = A2 .
E Some Basic Game
Theory • If his capacity choice is xM < xM , he sells xM with
F Imperfect p = A − xM .
Competition and
Strategic (Firm)
• If xM ≥ xM , he sells xM with p = A − xM .
Interaction
• Stage 1:
2. Quantity Competition • As capacity choice is costly, the monopolist will not build
Capacity Choice
more capacity in stage 1 than he needs in stage 2, i.e.,
G Cooperation
x = x.
among firms: • Hence, the monopolist chooses capacity such that
Mergers and Cartels
πM = x(A − x) − cx is maximized, i.e., he chooses
H Market Entry and
Exit xM = A−c
2 .
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) VI
B Markets and
Efficiency
C Market Power in
Consumer Markets
Solving the model - an upper bound to capacity
D Market Power in
Vertical Supply
Chains
• A monopolist not facing any capacity constraint produces
E Some Basic Game xM = A2 .
Theory
• Corresponding monopoly profits are:
F Imperfect 2
Competition and
Strategic (Firm)
πM = A2 (A − A2 ) = A4 .
Interaction 2 2
1. Price competition • Creating capacity such that cx > A4 or x > A4c can never be
3. Quantity Competition with optimal (independent of the number of firms).
Capacity Choice
2
• Hence, it can be assumed that x ≤ A4c
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) VII
B Markets and
Efficiency Rationing
C Market Power in
Consumer Markets If capacity is constrained, we have to specify which consumers
D Market Power in get a unit of the good if the number of consumers who wish to
Vertical Supply
Chains trade exceeds the capacity of the respective firm.
E Some Basic Game
Theory
• Suppose x consumers want to purchase at firm i with price
F Imperfect pi < pj and x > xi .
Competition and
Strategic (Firm) • Alternative 1: Efficient rationing: The xi traders with the
Interaction
1. Price competition highest willingness to pay are allowed to purchase.
3. Quantity Competition with • Alternative 2: Random rationing: xi out of x consumers
Capacity Choice
4. Product Differentiation (who wish to trade at pi ) are randomly selected.
G Cooperation
among firms: • Residual demand: For efficient rationing, demand by
Mergers and Cartels
consumers who did not trade at pi but still wish to trade at
H Market Entry and
Exit pj is given by xj = A − xi − pj .
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) VIII
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
Stage 2: Equilibrium Prices
E Some Basic Game
Theory • Suppose firms have chosen x1 and x2 , respectively.
F Imperfect
Competition and • Let p1 = A − x1 − x2
Strategic (Firm)
Interaction • and let 43 A ≤ c, i.e., capacity creation is not ªtooº cheap.
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) IX
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Equilibrium prices: Case p2 > p1 = A − x1 − x2
Vertical Supply
Chains • All x1 + x2 consumers want to purchase at firm 1, i.e., firm
E Some Basic Game 1 sells to x1 consumers and residual demand for firm 2 is
Theory
x 2 = A − x 1 − p2 .
F Imperfect
Competition and
Strategic (Firm)
• Firm 2’s profits are π2 = p2 x2 = p2 (A − x1 − p2 )
Interaction
• FOC: (A − x1 − p2 ) − p2 = 0
3. Quantity Competition with • Optimal price is then given by p̃2 = A−x
2 , i.e., profits are
1
Capacity Choice
4. Product Differentiation increasing for p2 < p̃2 and decreasing for p2 > p̃2 .
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) X
B Markets and
Efficiency
• Now observe that
C Market Power in
Consumer Markets dπ2
|p =p = A − 2p1 − x1 = A − 2(A − x1 − x2 ) − x1
D Market Power in dp2 2 1
Vertical Supply
Chains = x1 + 2x2 − A
E Some Basic Game A2 3A
Theory ≤ 3 − A = A( − 1)
F Imperfect 4c 4c
Competition and
Strategic (Firm)
• Hence, if 34 A ≤ c, it follows that d π2
Interaction dp2 |p2 =p1 < 0.
• d π2
dp2 |p2 =p1
< 0, however, implies that profits are monotone
Capacity Choice
decreasing in p2 for p2 > p1 and firm 2 does not benefit
G Cooperation from p2 > p1
among firms:
Mergers and Cartels • So if capacity costs are sufficiently large, setting a price
H Market Entry and
Exit
higher than the competitor is not beneficial ⇒ What’s the
I Research and
intuition behind?
Industrial
Organization

A Introduction Scheinkman (1983) XI
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply • Recall π2 = p2 x2
Chains
E Some Basic Game

Theory =⇒ dπ2 = dp2 x2 + p2 dx2
F Imperfect
Competition and dπ2 dx2
Strategic (Firm) =⇒ = x2 + p 2 = x2 − p2 =
Interaction dp2 dp2
(A − x1 − p2 ) − (A − x1 − x2 ) = −p2 + x2
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) XII
B Markets and
Efficiency
C Market Power in
Consumer Markets
Equilibrium prices: Case p2 < p1 = A − x1 − x2
D Market Power in
Vertical Supply • All x1 + x2 consumers want to purchase at firm 2, i.e., firm
Chains
E Some Basic Game

2 sells to x2 consumers and makes a profit of π2 = p2 x2 .
Theory
• For given capacity x2 , profits are therefore increasing in p2
F Imperfect
Competition and and firm 1 chooses p2 = p1 .
Strategic (Firm)
Interaction • Hence, firm 2 does not benefit from setting a price above
2. Quantity Competition or below p1 = A − x1 − x2 .
Capacity Choice
• p1 = p2 = A − x1 − x2 is a Nash equilibrium of the ªprice
G Cooperation choice subgameº.
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) XIII
B Markets and
Efficiency
Stage 1: Equilibrium capacity choice
C Market Power in
Consumer Markets • At stage 1 (capacity choice), firms anticipate equilibrium
D Market Power in
Vertical Supply
behavior in stage 2 (price choice).
Chains
• I.e., firm 1 expects profits
E Some Basic Game
Theory π1 = p1 x1 − cx1 = (A − x1 − x2 )x1 − cx1 from a capacity of
F Imperfect x1 if firm 2 chooses capacity x2 .
Competition and
Strategic (Firm)
Interaction
• Hence, the game at stage 1 (with capacity-strategies) is
equivalent to Cournot competition (with quantity
Capacity Choice
strategies).
• Reaction functions are given by x1 (x2 ) = A−c−x
2
2
and vice
G Cooperation
among firms: versa
Mergers and Cartels
H Market Entry and

• Equilibrium capacities are given by x1 = A−c3 and x2 = 3
A−c
Exit
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) XIV
B Markets and
Efficiency
C Market Power in
Consumer Markets
Interpretation
D Market Power in
Vertical Supply • Cournot equilibrium quantities and prices can be
Chains
E Some Basic Game

interpreted as (subgame perfect) equilibrium capacity and
Theory price choices in a sequential game with capacity choice
F Imperfect
Competition and
and subsequent price competition
Strategic (Firm)
Interaction • Kreps and Scheinkman demonstrate that the result holds
for general demand and cost functions
Capacity Choice • The result is not robust with respect to variations of the
G Cooperation
rationing scheme
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) XV
B Markets and
Efficiency Application
C Market Power in
Consumer Markets • The Kreps-Scheinkman model demonstrates that firms do
D Market Power in not necessarily choose infinite capacity in equilibrium and
Vertical Supply
Chains thereby overcome the Bertrand paradox.
E Some Basic Game
Theory
• Recall that firm’s capacity creation had to be sufficiently
F Imperfect costly for the results to apply (in the simple model, c ≥ 34 A
Competition and
Strategic (Firm) had to hold).
Interaction
• If capacity creation is sufficiently costly, Cournot’s model
2. Quantity Competition is a valuable shortcut and capacities are strategic
Capacity Choice substitutes.
• Human capital intensive sectors,
G Cooperation
among firms: • R&D intensive sectors,
Mergers and Cartels
• sectors with inflexible production lines and bottle-neck
H Market Entry and
Exit resources.
I Research and
Industrial
Organization

A Introduction Scheinkman (1983) XVI
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains • If capacity creation is sufficiently cheap, Bertrand’s model
E Some Basic Game is a valuable shortcut and prices are strategic
Theory
complements.
F Imperfect
Competition and • sectors with flexible product lines (electronic copying or
Strategic (Firm)
Interaction automated services),
1. Price competition • sectors with highly substitutable labor input.
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization

B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
1 A one-stage simultaneous move game (Cournot-Game)
E Some Basic Game
Theory where firms choose quantities yields the same result as a
F Imperfect two-stage game where firms first choose capacities and
Competition and
Strategic (Firm) then compete in prices (Kreps-Scheinkman) (at least under
Interaction
1. Price competition certain asumptions)
Capacity Choice
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
J
Chains
E Some Basic Game

Behavioral Industrial
Theory
F Imperfect
Competition and
Organization
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial
Organization
1. Consumers with Behavioral 287 / 304
Industrial
Organization
Dr. Silvio Städter Behavioral Economics and

A Introduction Industrial Organization
B Markets and
Efficiency
C Market Power in
Consumer Markets • Based on a substantial body of empirical (and in particular,
D Market Power in experimental) evidence various systematic deviations from
Vertical Supply
Chains the benchmark model of a (perfectly rational, egoistic)
E Some Basic Game
Homo Oeconomicus have been established:
Theory
F Imperfect • Plott und Smith (2008), Handbook of Experimental

Competition and
Strategic (Firm) Economics Results
Interaction
G Cooperation
among firms: • Camerer (2003), Behavioral Game Theory
Mergers and Cartels
H Market Entry and • Kagel und Roth (1995), Handbook of Experimental

Exit
I Research and
Economics
Development
J Behavioral
Industrial
Organization
Industrial
Organization
Dr. Silvio Städter Homo Oeconomicus versus

A Introduction Behavioral Economics
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in Homo Oeconomicus Behavioral Economics

Vertical Supply
Chains Decision-making perfect maximizer may not maximize,
E Some Basic Game
Theory
may make mistakes
F Imperfect Beliefs always correct overconfidence,
Competition and
Strategic (Firm) incorrect updating, etc.
Interaction
Preferences egoistic, stable, fairness and reciprocity,
G Cooperation
among firms: time-consistent reference points,
Mergers and Cartels
hyperbolic discounting, etc.
H Market Entry and
Exit
I Research and
Development
J Behavioral
Industrial
Organization
Industrial
Organization
Dr. Silvio Städter Behavioral Economics

A Introduction
B Markets and
Efficiency
• All deviations from the benchmark case of a ªHomo
C Market Power in
Consumer Markets Oeconomicusº are called ªbehavioral biasesª.
D Market Power in
Vertical Supply
Chains • Behavioral Economics investigates how behavioral biases
E Some Basic Game
Theory
affect behavior.
F Imperfect
Competition and • Behavioral biases may be present in:
Strategic (Firm)
Interaction
G Cooperation • consumers (which may be exploited by profit-maximizing

among firms:
Mergers and Cartels firms)
H Market Entry and
Exit • firms (with implications for their competitive behavior)
I Research and
Development
J Behavioral
Industrial
Organization
Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply J.1
Chains
E Some Basic Game

Consumers with Behavioral Biases
Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial
Organization
Industrial
Organization
Dr. Silvio Städter Consumers with Behavioral

A Introduction Biases I
B Markets and
Efficiency • Reference: Huck and Zhou (2011), ªConsumer Behavioral
C Market Power in Biases in Competition: A Surveyº
Consumer Markets
D Market Power in
Vertical Supply • Main questions:
Chains
E Some Basic Game

Theory • How do consumer biases affect competition among firms?
F Imperfect
Competition and • If consumer biases cause inefficiencies: how are the likely
Strategic (Firm)
Interaction to be reduces (e.g., through lower barriers to firm entry)?
G Cooperation
among firms:
Mergers and Cartels • Can biases be overcome through learning or education?
H Market Entry and
Exit • Does the presence of biased consumers make ªrationalº
I Research and
Development
consumers better or worse off?
J Behavioral
Industrial • When, why, and how should we intervene?
Organization
Industrial
Organization

A Introduction Biases II
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and Behavioral Biases According How They Affect Choice (Huck and
Development
Zhuo, 2011, p. 12)
J Behavioral
Industrial
Organization
Industrial
Organization

A Introduction Biases III
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and Behavioral Biases According To Their Source (Huck and Zhuo,
Development
2011, p. 13)
J Behavioral
Industrial
Organization
Industrial
Organization

A Introduction Biases IV
B Markets and Example: Paying not to go to the gym
Efficiency
C Market Power in
DellaVigna and Malmendier (AER, 2006) empirically
Consumer Markets investigate contract choice and actual attendance in a sample of
D Market Power in
Vertical Supply
U.S. gyms with over 7000 members
Chains • One of the key findings: for members who choose a flat
E Some Basic Game
Theory monthly fee (70 Dollars) pay-per-visit would have been
F Imperfect better (43 Dollar), thereby foregoing roughly 600 Dollars
Competition and
Strategic (Firm) of savings during the duration of their membership.
Interaction
• Hard to reconcile with rational behavior.
G Cooperation
among firms: • Consistent with (β − δ )-(hyperbolic)-discounting (where
Mergers and Cartels
H Market Entry and

consumers put heavy weight on ªtodayº as compared to
Exit ªtomorrowº), which gives rise to time-inconsistent
I Research and
Development
consumer behavior.
J Behavioral
• Contract design by firms can be seen as an optimal
Industrial
Organization response to such ªnaiveº consumers.
Industrial
Organization

A Introduction Biases V
B Markets and
Efficiency
C Market Power in • Incorporating behavioral biases into theoretical models

Consumer Markets
can provide new insights into potential inefficiencies in
D Market Power in
Vertical Supply markets
Chains
E Some Basic Game

Theory • Example: Heidhues and Koszegi (AER, 2010),
F Imperfect
Competition and
ªExploiting naivete about self-control in the credit
Strategic (Firm)
Interaction
marketº: Shows how features of (U.S.) credit card
G Cooperation
contract can be understood as (profit-maximizing)
among firms:
Mergers and Cartels
responses to consumers’ biases.
H Market Entry and
Exit
• For a textbook (at the graduate level), see Spiegler (2011),
I Research and
Development ªBounded Rationality and Industrial Organizationº
J Behavioral
Industrial
Organization
Industrial
Organization

A Introduction Biases VI
B Markets and
Efficiency What might be done?
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains
E Some Basic Game

Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and Potential Remedies to Improve Outcomes for Consumers (Huck and
Development
Zhuo, 2011, p. 54)
J Behavioral
Industrial
Organization
Industrial
Organization
Dr. Silvio Städter
A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply J.2
Chains
E Some Basic Game

Firms with Behavioral Biases
Theory
F Imperfect
Competition and
Strategic (Firm)
Interaction
G Cooperation
among firms:
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial
Organization
Industrial
Organization
Dr. Silvio Städter Firms with Behavioral Biases I

A Introduction
B Markets and
Efficiency
C Market Power in
Consumer Markets
• Reference: Armstrong and Huck (2010), ªBehavioral
D Market Power in Economics as Applied to Firms: A Primerº
Vertical Supply
Chains
E Some Basic Game • Main questions:

Theory
F Imperfect
Competition and • What might be wrong with assuming profit-maximizing
Strategic (Firm)
Interaction
firms (in a positive sense)?
G Cooperation
among firms: • If firms have ªbehavioral biasesº what implications does
Mergers and Cartels
this have?
H Market Entry and
Exit
I Research and
Development
J Behavioral
Industrial
Organization
Industrial
Organization
Dr. Silvio Städter Firms with Behavioral Biases II

A Introduction
Why profit-maximization might be a good description of
B Markets and
Efficiency firm behavior
C Market Power in Milton Friedman (1953, Essays in Positive Economics, p. 22):
Consumer Markets
ªLet the apparent determinant of business behavior be anything
D Market Power in
Vertical Supply at all - habitual reaction, random chance or whatnot. Whenever
Chains
E Some Basic Game

this determinant happens to lead to behavior consistent with
Theory rational and informed maximization of returns, the business
F Imperfect
Competition and
will prosper and acquire resources with which to expand;
Strategic (Firm)
Interaction
whenever it does not, the business will tend to lose resources
G Cooperation
and can be kept in existence only by the addition of resources
among firms:
Mergers and Cartels
from outside. The process of ’natural selection’ helps to
H Market Entry and
validate the hypothesis [of ’rational and informed maximization
Exit
of returns’] - or, rather, given natural selection, acceptance of
I Research and
Development the hypothesis can be based largely on the judgement that it
J Behavioral summarizes appropriately the conditions for survival.º
Industrial
Organization
Industrial
Organization
Dr. Silvio Städter Firms with Behavioral Biases III

A Introduction
B Markets and
Efficiency
Why profit-maximization might be a good description of
C Market Power in
Consumer Markets firm behavior
D Market Power in • Firms face competitive pressure:
Vertical Supply
Chains
E Some Basic Game • ªMistakesº may force a firm to exit.

Theory
F Imperfect
Competition and • Economies of scale in making good decision:
Strategic (Firm)
Interaction
G Cooperation • A lot is at stake, so it pays to put in effort.

among firms:
Mergers and Cartels
• Decisions are made repeatedly, so there are opportunities
H Market Entry and
Exit for learning.
I Research and
Development
J Behavioral
Industrial
Organization
Industrial
Organization
Dr. Silvio Städter Firms with Behavioral Biases IV

A Introduction
Why profit-maximization might not be a good description
B Markets and of reality
Efficiency • Firms face complex decisions in uncertain environments:
C Market Power in
Consumer Markets decision-making short-cuts or rules-of-thumb.
D Market Power in
Vertical Supply • Competition (strategic interaction) may require complex
Chains
strategies.
E Some Basic Game
Theory
F Imperfect
• Underperforming firms may take a long time to exits (also:
Competition and
Strategic (Firm)
delays in important decisions).
Interaction
G Cooperation
• Decision-making by groups (additional biases, agency
among firms:
Mergers and Cartels problems).
H Market Entry and
Exit • Personality traits of managers (competitiveness, private
I Research and benefits).
Development
J Behavioral • It might pay to be perceived as ªirrationalº (e.g., to deter

Industrial
Organization entry).
Industrial
Organization
Dr. Silvio Städter Empirical (and theoretical)

A Introduction research on behavioral biases in
B Markets and
Efficiency firms
C Market Power in
Consumer Markets • Collusion: experimental tests and potential effects of
D Market Power in
Vertical Supply public policy
Chains
E Some Basic Game

Theory • Imitative behavior and concerns for relative profit: effects
F Imperfect on competitive behavior (where it is shown that in some
Competition and
Strategic (Firm) setting imitation might even be ªunbeatableº).
Interaction
G Cooperation
among firms: • Social preferences: might make it easier to sustain
Mergers and Cartels
H Market Entry and

collusion.
Exit
I Research and
Development
• Overoptimism and other personality traits: desirability of
J Behavioral ªstrategic delegationº?
Industrial
Organization
Industrial
Organization

B Markets and
Efficiency
C Market Power in
Consumer Markets
D Market Power in
Vertical Supply
Chains 1 People may act differently than assumed by standard
E Some Basic Game economic theory - behavioral biases
Theory
F Imperfect
2 Firms may exploit customers with behavioral biases (e.g.
Competition and
Strategic (Firm)
credit market, gym-tarifs etc.)
Interaction
3 Firms themselves might not be perfectly
G Cooperation
among firms: profit-maximizing
Mergers and Cartels
H Market Entry and

Exit
I Research and
Development
J Behavioral
Industrial
Organization

Industrie Ökonomik

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Industrie Ökonomik

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Industrial

Dr. Silvio Städter

E Some Basic Game

H Market Entry and

Dr. Silvio Städter

H Market Entry and

Dr. Silvio Städter Organizational Details I

E Some Basic Game

H Market Entry and

Dr. Silvio Städter Organizational Details II

H Market Entry and

Dr. Silvio Städter Organizational Details III

H Market Entry and

Dr. Silvio Städter What is Industrial Organization?

Dr. Silvio Städter Central issue: Market Power

H Market Entry and

Dr. Silvio Städter Who are those guys?

E Some Basic Game

H Market Entry and

Dr. Silvio Städter Who are those guys?

E Some Basic Game

H Market Entry and

Dr. Silvio Städter Who is this man?

E Some Basic Game

H Market Entry and

Dr. Silvio Städter Who is this man?

E Some Basic Game

H Market Entry and

Dr. Silvio Städter Question 1: Is there market

H Market Entry and

Dr. Silvio Städter Question 2: How do firms

E Some Basic Game

Dr. Silvio Städter Question 3: What are the

Dr. Silvio Städter Question 4: Is there a role for

Dr. Silvio Städter Question 4: Is there a role for

Dr. Silvio Städter Course Outline I

Dr. Silvio Städter Course Outline II

Dr. Silvio Städter

H Market Entry and

Dr. Silvio Städter Definition of a market

Dr. Silvio Städter Performance of a market: (Static)

Dr. Silvio Städter Example: Perfect Competition

E Some Basic Game

Dr. Silvio Städter

H Market Entry and

Dr. Silvio Städter

E Some Basic Game

H Market Entry and

Dr. Silvio Städter The Model I

H Market Entry and

Dr. Silvio Städter The Model II

C Market Power in max π = q(p)p − C(q(p))

Dr. Silvio Städter The Model - another approach

D Market Power in • This yields as the first order condition:

H Market Entry and MR = MC

Dr. Silvio Städter The Deadweight Loss of

E Some Basic Game

Dr. Silvio Städter The Lerner-Rule I

H Market Entry and pM − C ′ −q(pM ) 1

Dr. Silvio Städter The Lerner-Rule II

H Market Entry and

Dr. Silvio Städter How to regulate a monopoly I

H Market Entry and

Dr. Silvio Städter How to regulate a monopoly II