INDUSTRIAL ORGANIZATION

ECON 5700

Advanced Oligopoly
Recap and Today’s Plan

Last Class
• Bertrand Competition: setting price
• With constant MC, we get P=MC equilibrium.
• If one firm has lower cost, equilibrium is higher cost - 0.01.
• Cournot Competition: setting quantity/capacity
• Solve for best responses, sub-in to find equilibrium.
• Positive profits. No incentive to undercut once capacity is committed.
• Efficiencies, mergers, and collusion.

Today

• First-Mover Advantage
• Entry Deterrence
• Nash-in-Prices: competing with market power

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Oligopoly So Far

Oligopoly So Far
We have studied Bertrand and Cournot competition. These are single-period
games with simultaneous moves.

In many settings…
We can use our advanced Game
1. Firms move sequentially Theory techniques to analyze these
2. Firms interact repeatedly situations as well.

Example: First Mover Advantage

Recall the Cournot Equilibrium, where firms choose quantities. Suppose we are
looking at a duopoly, and one firm is allowed to move first. Does this change the
result?
Examples: Groupon expands rapidly, hiring sales forces in all major markets
before LivingSocial.
First-Mover Advantage: Hertz-Avis

Recall: Cournot Equilibrium for Hertz-Avis at PHL

Daily demand for rental cars at PHL is given by:
𝑃 100 𝑄
Both firms have marginal costs of $10. Equilibrium has both firms setting quantities of
30, resulting in a market price of $40 and profits for each of $900.

Suppose now that Hertz is able to choose its quantity first, and Avis chooses its
quantity 2nd. How does this change Hertz’ decision?

Hertz chooses a Avis then chooses its

Hertz knows Avis’ reaction
quantity anticipating optimal quantity given
function
Avis’ reaction Hertz’ choice

In the last class, we solved for Avis’ best response as a function of Hertz’ quantity:
𝑞 45 0.5𝑞
Hertz can now take this response into account when choosing its own quantity.
First Mover Advantage Diagram Payoffs
A Market price: 𝑃 𝑞 𝑞
𝜋 𝑃 𝑐 ∗𝑞
𝜋 𝑃 𝑐 ∗𝑞

A
H Market price: $40
A 𝜋 30 ∗ 30 900
𝜋 30 ∗ 30 900

A
Hertz goes first and can choose Avis goes second, and can
any 𝑞 they want. choose any 𝑞 they want.
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Hertz can Assume Avis will Play Best Response
𝑞 0 𝜋 1,000
A
𝜋 0 Avis Best Response
𝑞 45 0.5 ⋅ 𝑞

𝑞 15 𝜋 900
A
𝜋 225
𝑞 20 𝜋 1,000 Among these
A 𝜋 400 choices, 𝑞 50
H 𝑞 30 𝜋 900 looks best.
A 𝜋 900 We can solve for
the best solution
𝑞 33.75 analytically.
A 𝜋 759
𝜋 1,139

𝑞 45 𝜋 0
A
𝜋 2,025

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First Mover Advantage: Math Example (1)
Hertz’ Optimal Quantity when moving first
Total market demand for daily car rentals at PHL:
HEYp atEA C EH
𝑃 100 𝑄
Hertz’ residual demand as a function of Avis’ quantity (𝑞 ): Max100EA EH 10 EH
𝑃 100 𝑞 𝑞
9A 100 GHz
Substitute in Avis’ response function:
𝑃 100 45 0.5𝑞 𝑞 100 4510
𝑃 55 0.5𝑞
Choose an optimal price by setting MR=MC: Abal
𝑅 55𝑞 0.5𝑞 demand for
𝑀𝑅 55 𝑞 inverse
𝑀𝐶 10 p Lineaconstant
10 55 𝑞 me is
𝑞 45
So, the optimal quantity for Hertz to choose is 𝑞 ∗ 45.

What is the full market outcome here? What is the impact of being the first mover?
First Mover Advantage: Math Example (2)
Hertz (Moving First) Avis (Moving Second)
On the last slide, we saw Hertz would set Using Avis’ best response function, we
𝑞 45 have that they will set
𝑞 45 0.5𝑞 22.5

The market price can be found from the original demand equation:
𝑃 100 𝑞 𝑞 100 45 22.5 $32.50

Profits for each company are then

𝜋 𝑞 ⋅ 𝑃 𝑀𝐶 45 ∗ 32.50 10 $1,012.50
𝜋 𝑞 ⋅ 𝑃 𝑀𝐶 22.5 ∗ 32.50 10 $506.25

The Value of First Mover Advantage

The value to Hertz of moving first is its increase in profits, 1012.50 900 $112.50.
Note that this costs Avis $393.75 in profits (900 506.25 .
Who Wants to Lead?
stasaburs
Hertz Being the first-mover is
always a dominant strategy
Lead Follow
in Cournot competition (with
perfect information).
$900 $506 • Both firms would LIKE to
be the first mover, but
Lead

only one firm can be.

$900 $1012 • Having first-mover
Avis

advantage is valuable.
• If there are economies of
$1012 $900 scale, even more valuable.
Follow

Following can be an
$506 $900 advantage if demand is
uncertain, if product quality
can be improved over time,
etc.

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What about Deterring Entry?
In the previous example, Hertz used its first-mover advantage to increase profits.
What about preventing entry entirely?

Ways to deter entry Approach Concerns

Set a price equal to a potential Requires the incumbent to have a

Limit Pricing entrant’s marginal cost,
making entry unprofitable.
Set a market price below cost,
Predatory Pricing to drive an entrant out of the
market after they enter.
Maintain extra capacity so that Still may not make sense to use
Excess Capacity you could quickly scale up
output in the event of entry.
cost advantage, or for the
product to have economies of
scale.
Results in losses for the
incumbent until the entrant
leaves. The larger the incumbent,
the greater the losses.
that capacity after the entrant
enters.
Entry Deterrence in Action
Southwest Airlines (SWA) is a “low-cost” carrier. On May 9, 2004, it announced that it
was adding flights from PHL to six cities. (Goolsbee-Syverson QJE 2008)
• This makes PHL a “Southwest City”. Another “Southwest City” is Jacksonville, FL,
but Southwest does not introduce flights on the PHL-JAX route.
How do the “incumbents” (AAL, COA, UAL, DAL, NWA, TWA, USA) react on the PHL-JAX route?
Before May, 2004 After May, 2004

PHL Incumbents PHL Incumbents

Southwest
Southwest

Southwest
Price = $P Price < $P

Incumbents JAX Incumbents JAX

Simply the threat of entry affected competitors’ pricing decisions.

Example: Limiting Entry
Yamaha and Grand Pianos
Yamaha has been the leader of manufacturing grand pianos for some time. They are
responsible for the majority of global sales of mid-range grand pianos.

A potential entrant appears

• Steinway, the venerable brand that dominates the high-end of concert grand pianos,
has long thought about introducing a mid-range model to compete with Yamaha.

Is Steinway going to enter the market? Could Yamaha price in a way to discourage
Steinway from entering?
Demand for mid-range pianos: 𝑃 𝑄 110 2𝑄
Cost functions for firms: 𝑇𝐶 𝑄 45 20𝑄 0.2𝑄

Use the Cournot model and game theory to solve.

Limiting Entry: The Outcome
If Yamaha is the monopolist, we can solve for the optimal quantity (MR=MC).
Then, we can use Cournot to see if entry could be profitable for Steinway.

𝜋 $524𝑀
Game Tree: 𝜋 $177𝑀
Steinway

Yamaha 𝜋 $1,080𝑀
𝜋 0

Outcome
If Yamaha produces the monopoly quantity (20.45 thousand), Steinway would find entry
profitable. However, that entry will lower the market price, and Yamaha’s profits would
be less than half they expected.
Limiting Entry: The Goal
Here is the game tree: the goal is to find a 𝑄 such that Steinway will choose not to
enter:
𝜋 $524𝑀
𝜋 $177𝑀
Steinway

𝜋 $1,080𝑀
Yamaha
𝜋 0

𝜋 ???
𝜋 0
Steinway
Need a 𝑄 such that
𝜋 is negative
𝜋 ???
Question: what quantity here would 𝜋 0
make Steinway prefer not to enter?
 Solution: Solve for Steinway Profits as a Function of Yamaha
Quantity

1200
Yamaha q=20.45
1000 Steinway entry is profitable
Steinway (Follower) Profit, $K

800 Yamaha q=36

Here we see that
Steinway entry is
600 not profitable
Steinway would find
entry profitable if
400 Yamaha chose q=25,
but unprofitable if
200 Yamaha chose q>36

0
-200
0 10 20 30 40 50
Yamaha (Leader) Quantity in Thousands
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Limiting Entry: The Outcome
Should Yamaha increase its output from 20.45 to 36 to limit Steinway’s entry?
Yamaha profit at 𝑄 36 if Steinway doesn’t enter: 𝜋 $862.2𝑀
𝜋 $524𝑀
Game Tree: 𝜋 $177𝑀
Steinway

Yamaha 𝜋 $1080𝑀
𝜋 0

𝜋 $17𝑀
𝜋 0
Steinway

𝜋 $862.2𝑀
Equilibrium is now (𝑞 36,
“Don’t Enter”) 𝜋 0
Microsoft Limit Pricing: Academic Evidence

Microsoft’s pricing of Windows and Office:

Hall (2008) looks at Microsoft’s pricing of Windows and Office in the context of
limit pricing.

Are there other economics of scale?

• Not really – although there are network effects, which can have the same
impact on the market.

“Windows and Office are complements; having one makes the other more useful, so
customers tend to buy them together. Network effects are important for both
products. In a market with network effects from complementary products, a would-
be rival must make a frontal assault on both markets.”
…
“The type of entry that Microsoft fears the most—and that therefore constrains its
prices—is the frontal assault. … The result shows that Microsoft’s
prices for Windows and Office are substantially lower as a result of potential
competition.”
Discussion: Boeing-Airbus

Aircraft manufacturing is notable for Economies of Scale:

Data from the
production of the
Lockheed 1011:
• Clear relationship that
the more units you
produce, the lower
the cost of
production.

Note: Boeing also

benefits from
Economies of Scope:
producing related
military equipment has
a positive spillover on
commercial aircraft.
Boeing-Airbus

In the presence of strong economies of scale, incumbent firms (Airbus, Boeing)

can use pricing strategically:

• Both firms are concerned about entry in the mid-range

Pricing to Limit Entry
market by firms like Bombardier and Embraer
• An entrant would have a strict cost disadvantage before
they achieve a decent scale of operations
• Incumbents could price aggressively to make entry look
particularly unattractive, or altogether unprofitable.

Pricing to “Tip” the • If one firm in the duopoly is able to achieve enough of a
Market scale advantage over their rival, they may gain enough
of a cost advantage to be able to push the rival out of
the market altogether.

What might downstream firms (airlines) think about these tactics?

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Follow-up:

“Boeing has delivered

more than 7,700 of its
737s since the late
1960s. Because it
produces the planes so
efficiently, they are
highly profitable.”

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Predatory Pricing?
Recall: US Airways trying to drive competitors out of markets (Predatory Pricing)
US Airways has a monopoly on the BOS-PHL route, and has twice driven out entrants
through aggressive pricing. What is each firm thinking while this is happening?

US Airways (Incumbent) JetBlue (Entrant)

• Discounted profit of being a monopolist: • Discounted profit of being part of a

$50M.
• Discounted profit of being part of a
duopoly: $10M
• Cost of a price war: $1M/month
• Potential actions: “accommodate”, or
“fight”
• Information: the probability that JetBlue
exits next month if I fight is 𝜎
duopoly: $10M
• Cost of a price war: $1M/month
• Potential actions: “exit”, or “fight”
• Information: the probability that US
Airways accommodates next month if
I fight is 𝛼

We can formulate each month’s decisions as a game

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Price War on Entry
Ignore any monthly discounting for now.
• US profit if JBU exits: 30M
• US, JBU profits as a duopoly: 10M each
• US profits from price war: lose 1M this month, but get 𝜎 ⋅ 50𝑀 since I might be able to get
JetBlue to exit.
• JBU profits from price war: lose 1M this month, but get 𝛼 ⋅ 10𝑀 since US might stop
fighting me if I stay.

Monthly Game Board: JetBlue

Exit Stay

Accommodate (𝑛𝑜𝑡 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒) (10, 10)

US Airways
Fight (50, 0) ( 1 50𝜎, 1 10𝛼)

For what values of 𝜎, 𝛼 will they continue to fight a price war?

(i.e. for what values is (“Fight”, “Stay”) an equilibrium?)
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Price War on Entry

Monthly Game Board: JetBlue

Exit Stay

Accommodate (𝑛𝑜𝑡 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒) (10, 10)

US Airways
Fight (50, 0) ( 1 50𝜎, 1 10𝛼)

The price war is only an equilibrium as long as:

1 50𝜎 10 and 1 10𝛼 0

We can solve for the 𝜎 and 𝛼 such that these two equations hold.

Requires that 𝜎 0.22 and 𝛼 0.1.

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Price War on Entry

Monthly Game Board: JetBlue

Exit Stay

Accommodate (𝑛𝑜𝑡 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒) (10, 10)

US Airways
Fight (50, 0) ( 1 50𝜎, 1 10𝛼)

The price war is only an equilibrium as long as:

𝜎 0.22 and 𝛼 0.1.

• US must think that JBU’s probability of exiting next month if it fights this month
is at least 22%, and
• JBU must think that US’s probability of accommodating next month if it fights
this month is at least 10%.

Both sides will try to convince the other that the probabilities are below those
bounds to try to get them to switch.

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Nash-in-Prices: Final Model of Oligopoly
In the real world, we think the following assumptions are most realistic:

1. Firms set price, not

quantity Monopolistic Competition is where firms set
prices on products that are imperfect
2. Products are never fully substitutes for one another.
undifferentiated

Example: are FedEx and UPS good substitutes? Are their prices set above marginal cost?
FedEx and UPS
Suppose both FedEx (f) and UPS (u) have marginal costs for home delivery of $14.
They face demand curves from consumers:
𝑞 1.5 0.1𝑝 0.02𝑝
𝑞 1.5 0.08𝑝 0.03𝑝
Where quantities are in millions of packages per day and prices are per item.
This demand curves show that the two goods are imperfect substitutes. How?
Given my competitor’s price, I’m just back at the uniform pricing problem.
Nash-in-Prices
Step 1: Solve for Reaction Functions

Step 1A Write out FedEx Profit: 𝜋 𝑝 14 1.5 0.1𝑝 0.02𝑝

Choose FedEx Price to maximize profit: take derivative, rearrange.

Step 1B
𝜕𝜋
𝜕𝑝 : 1.5 0.1𝑝 0.02𝑝 0.1 𝑝 14 0
𝑝 14.5 0.1𝑝
Step 1C Repeat for other firm (UPS) to get their reaction function:
𝑝 16.375 0.1875𝑝
Step 2: Find Equilibrium as the Intersection of Reaction Functions
Substitute UPS’ reaction function into FedEx’s:
Step 2A
𝑝 14.5 0.1 16.375 0.1875𝑝
Solve for FedEx’s price:
Step 2B
𝑝 16.45
Substitute this price into UPS’ reaction function to get their price:
Step 2C 𝑝 19.46
Nash-in-Prices: Graphic

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FedEx Best Response

to UPS Price
30 At Equilibrium, both
firms are playing their
“best response” to
UPS Price

each other’s price.

20

UPS Best Response

to FedEx Price
10

Market Equilibrium
0
0 10 20 30 40
FedEx Price
Summary of Oligopoly Models

Bertrand Cournot Nash-in-Prices

Firms set price Firms set quantity Firms set price

Firm Actions

Products are Products are Products are

Products undifferentiated undifferentiated imperfect substitutes

Market price is Firms earn positive Firms earn positive

Outcome
marginal cost; or the profits. profits due to the
marginal cost of the As this would attract differentiation of
2nd-lowest cost entrants, this model their product.
producer. fits best when there
Firms earn zero are barriers to entry.
profits.
Summary & Direction

Today
• First-mover advantage
• Limit Pricing
• Nash-Price Equilibrium

Next Lecture

Infinitely repeated games

• Discounting
• Strategies: Grim-Trigger, Eye-for-an-Eye
• Price wars

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