Industrial Organization

Chapter 4
Monopoly

Prof. Pedro Mendi

School of Economics and Business

Universidad de Navarra

2023-24

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Contents

1 Basic monopoly analysis

2 Welfare implications of monopoly

3 Regulation

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Contents

1 Basic monopoly analysis

2 Welfare implications of monopoly

3 Regulation

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Monopoly

• Under perfect competition, each individual firm faces a

perfectly elastic demand curve, hence price equals marginal
cost.
• Monopoly is a situation where there is a single producer.
• Its existence depends on the existence of barriers to entry.
• A monopolist faces the market demand curve. Hence, the
equilibrium price is greater than marginal cost.

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Monopoly pricing

• The monopolist’s problem is one of choosing prices to

maximize profits. Alternatively,

max p(q) · q − c(q)

q

• The optimal output level satisfies:

p′ (q) · q + p(q) − c′ (q) = 0

• and rearranging:,
pm − c′ (q m ) 1
m
=
p εp
where the left-hand side is known as the Lerner index.

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Monopoly pricing

• Therefore, the mark-up is inversely proportional to the price

elasticity of demand
• Under perfect competition, this mark-up is zero
• The monopoly output maximizes the industry profits

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Monopoly pricing

• If demand is linear, i.e. If p = a − bq with a > 0 and b > 0,

then if marginal cost is constant at c,

a−c q pc a+c (a − c)2

qm = = , pm = , πm = .
2b 2 2 4b
thus, a monopolist’s output is decreasing in its marginal cost.
• In contrast, a more inefficient monopolist charges a higher
price

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Contents

1 Basic monopoly analysis

2 Welfare implications of monopoly

3 Regulation

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Welfare

• Since there is a positive mark-up, the level of output is

inefficiently low (relative to the perfectly competitive
outcome)
• The deadweight loss is
Z q pc
p(s) − c′ (s) ds


DW L =
qm

i.e. the total surplus generated by the units that are no longer
produced under monopoly
• If the demand is linear,

(a − c)2
DW L = .
8b

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Welfare
Graphically, for an upward-sloping marginal cost function,
p

MC

pM
A
pP C
B C
E
D

MR Demand

qM qP C q

Figure 1: Welfare analysis of monopoly

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Welfare

• Other negative aspects of monopoly:

• X-inefficiency: the best of all monopoly profits is a quiet life.
• Rent-seeking behavior.
• Potential benefits:
• Economies of scale.
• Incentives to perform R&D.

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Example

Assume a firm established in Aruba has total production cost C(q) =

q2
4 . This firm can sell its output in two different markets: Aruba and
the United States. Since the Aruban government introduced a zero-
import quota and this firm is the country’s only producer of the good,
the firm is a monopolist in Aruba, where demand is q A = 10 − pA .
In the US market, it acts as a price taker, with pU S = 5.
1 How much will the firm sell in Aruba? How much in the US?
2 Is the firm better off selling its output in Aruba only or in
both markets at the same time? Justify your answer.
3 What is the minimum value of pU S so that the Aruban firm
sells in both markets? What is the minimum value of pU S to
that the Aruban firm sells in the US market only?

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Contents

1 Basic monopoly analysis

2 Welfare implications of monopoly

3 Regulation

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Regulation

• Regulation is a government intervention in economic activity

using commands, controls, and incentives.
• Examples of regulation:
• Entry regulation.
• Firm regulation: direct oversight by the government.
• Social regulation: rules that apply to firms, consumers,
employers.

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Regulation

• A natural monopoly is a cost structure such that costs are

minimized with one supplier only.
• Firm regulation is a useful approach.
• Absent regulation, a monopolist would choose the monopoly
price.
• But we know that the welfare-maximizing price is such that
price equals marginal cost.
• Is there a problem with that?
• Consider:
• Low-power incentive mechanism: average cost pricing.
• High-power incentive mechanism: price cap regulation.

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 Industrial Organization
Chapter 5
Game Theory

Prof. Pedro Mendi

School of Economics and Business

Universidad de Navarra

2023-24

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Contents

1 Nash equilibrium

2 Sequential games

3 Repeated games

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Contents

1 Nash equilibrium

2 Sequential games

3 Repeated games

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Nash equilibrium

• Firms’ decisions on prices, quantities, advertising, or capacity

influence other firms’ decisions on these same variables, as
well as firms’ welfare.
• Game Theory allows us to formally analyze interdependence,
and predict the final outcome.
• Definition of game: formal representation in which a number
of individuals (players) interact in a setting of strategic
interdependence.
• We focus on games with complete information, and distinguish
between simultaneous-move and sequential/dynamic games.

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Nash equilibrium

• Consider first simultaneous-move games.

• A game may be described by:
1 Players.
2 Rules.
3 Actions.
4 Outcomes.
5 Each player’s payoff in each outcome.

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Nash equilibrium

• Example: matching pennies.

1 Two players.
2 Rules: Players 1 and 2 simultaneously choose H or T. If
pennies match, player 1 gets both pennies, otherwise, player 2
gets them.
3 Actions: choose H or T.
4 Outcomes: (H,H), (H,T), (T,H), (T,T).
5 Payoffs: (1,-1), (-1,1), (-1,1), (1,-1).
• We may use the extensive form or the normal form
representation of the game.

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Nash equilibrium

• A strategy profile s = (s1 , . . . , sI ) constitutes a Nash

equilibrium of a game if no player i = 1, . . . , I has a profitable
deviation, given the strategies played by the rest of the players.
• Notice that the definition of Nash equilibrium refers to
unilateral deviations, as opposed to joint deviations (see, for
instance, the prisoners’ dilemma game).
• Sometimes, the Nash equilibrium (in pure strategies) does not
exist, as in the matching pennies game.
• Sometimes, there are several equilibria, as in the ”Meeting in
New York” game.

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Contents

1 Nash equilibrium

2 Sequential games

3 Repeated games

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Sequential games

• Consider the following scenario, with an incumbent firm and a

potential entrant.
1 First, the potential entrant decides whether to enter the
market where the incumbent operates.
2 If the entrant enters, then the incumbent decides whether to
fight (for instance by pricing low) or accommodate (for
instance, by keeping the price high.
• Payoffs are as follows:
1 If the entrant stays out, payoffs are (πE , πI ) = (0, 2)
2 If the entrant enters and the incumbent fights, then payoffs are
(−3, −1).
3 If the entrant enters and the incumbent accommodates, then
payoffs are (2, 1).
• How do we analyze this situation?

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Sequential games

• The principle of sequential rationality requires players to

choose optimal actions at every point in the game tree (even
those that are not reached in equilibrium).
• Applying the principle of sequential rationality, players may
anticipate what other players will do, and choose accordingly.
• The principle of sequential rationality allows us to analyze
these games by means of backward induction.
• For instance, assume now that, following entry, entrant and
incumbent simultaneously choose whether to fight or
accommodate. Post-entry payoffs are:
1 If both fight, (−3, −1).
2 If only the incumbent fights, (−1, −2).
3 If only the entrant fights, (−2, −1).
4 If neither firm fights, (3, 1).

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Sequential games

• A subgame is a subset of the game that begins at a singleton

information set. It is a game within the game.
• A strategy profile s1 , ..., sI is a Subgame Perfect Nash
Equilibrium (SPNE) if it induces a Nash Equilibrium in every
possible subgame.
• A SPNE is always a NE. It adds the requirement of satisfying
the principle of sequential rationality.

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Contents

1 Nash equilibrium

2 Sequential games

3 Repeated games

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Repeated games

• In repeated games, players play the same stage game for a

number of periods.
• Payoffs are discounted at a rate 0 ≤ δ ≤ 1.
• Players observe all previous plays prior to playing the stage
game. This constitutes the history of the game up to period t.
• Strategies may be made conditional on the history of the
game.
• A Nash Equilibrium of the stage game is also an equilibrium of
the repeated game.
• The question is whether there are other equilibria in the
repeated game.

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Repeated games

• For instance, consider the following stage game:

• Two players simultaneously choose whether to cooperate.
• If both cooperate, they get (3, 3).
• If neither cooperates, they get (0, 0).
• If one cooperates and the other does not, the cooperating
party gets −1 and the non-cooperating party gets 4.
• What if the game is played a finite number of times?

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Repeated games

• For instance, consider the following stage game:

• Two players simultaneously choose whether to cooperate.
• If both cooperate, they get (3, 3).
• If neither cooperates, they get (0, 0).
• If one cooperates and the other does not, the cooperating
party gets −1 and the non-cooperating party gets 4.
• What if the game is played a finite number of times?
• If the game is played an infinite number of times, players may
resort to Nash reversion strategies.

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 Industrial Organization
Chapter 6
Oligopoly

Prof. Pedro Mendi

School of Economics and Business

Universidad de Navarra

2023-24

1 / 30
Contents

1 The Bertrand and Cournot Models

The Bertrand model
The Cournot model

2 The Stackelberg model

3 Introduction to product differentiation

4 Collusive behavior

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Contents

1 The Bertrand and Cournot Models

The Bertrand model
The Cournot model

2 The Stackelberg model

3 Introduction to product differentiation

4 Collusive behavior

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Price and quantity competition

• Oligopoly is a situation where a small number of firms interact

in an industry
• Two basic models:
• Price competition: The Bertrand model
• Quantity competition: The Cournot model
• These are the building blocks of more elaborate models

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The Bertrand model

• Assume two producers with constant marginal costs: c

• Demand is q(p).
• Both firms simultaneously post prices. The firm that posts a
lower price sells up to demand.
• If both firms post the same price, output is equally split
between the two firms.

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The Bertrand model

• In order to derive firm 1’s best response to firm 2 posting p2 ,

consider the following three cases:
1 If p2 > pM then firm 1 chooses p1 = pM .
2 If c < p2 ≤ pM then firm 1 chooses p1 = p2 − ε.
3 If p2 ≤ c then firm 1 chooses p1 = c.
• Firm 2’s problem is symmetric to firm 1’s.

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The Bertrand model

• If costs are asymmetric, say c1 < c2 , the equilibrium price is

slightly below c2 and firm 1 would be selling the whole output.
• Thus, only two firms are needed to get back to the
competitive situation: the Bertrand Paradox.
• This is a somewhat hard to believe result. Introduce
modifications to reconcile it with evidence.

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The Bertrand model

• Crucial assumptions:
• No capacity constraints: if capacity constraints are present,
firms might not be able to satisfy the whole demand.
• Product is homogeneous. If we assume product differentiation,
the solution is no longer competitive.
• Static setting: repeating the Bertrand game an infinite number
of periods may give rise to a different outcome.

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The Cournot model

• In the Cournot model, firms simultaneously choose quantities.

Price is determined by demand.
• Assume there are two firms, choosing q1 and q2
simultaneously. Marginal costs are constant at c.
• Given quantities, the equilibrium price is p(q1 + q2 ).

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The Cournot model

• Taking q2 as given, firm 1’s problem is

max p(q1 + q2 )q1 − cq1

q1

• Therefore, its reaction function is given by the first-order

condition,

p′ (q1 + q2 )q1 + p(q1 + q2 ) − c ≤ 0

• or
p−c dp qi αi
=− · =
p dQ p ε
where ε is the price elasticity of demand, and αi is firm i’s
market share.

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The Cournot model

• In the case of a linear demand function, the problem reads

max (a − b(q1 + q2 )) q1 − cq1

q1

• and firm 1’s reaction function is:

a − c − bq2
q1 (q2 ) =
2b
• Firm 2’s problem is symmetric, and hence the Nash
equilibrium is the intersection of the two reaction functions:
a−c
q1 = q2 =
3b

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The Cournot model

• In equilibrium, both firms make positive profits:

(a − c)2 (a − c)2 πM
π1N E = π2N E = < =
9b 8b 2
• On the other hand, firms are better off than under perfect
competition, where profits are zero.

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The Cournot model

• Increasing firm 1’s marginal cost shifts its reaction function

inwards:
a − c1 − bq2 ∂q1
q1 (q2 ) = ⇒ <0
2b ∂c1
• and thus, the firm with higher marginal cost will produce less
in equilibrium.

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The Cournot model

• Increasing firm 1’s marginal cost shifts its reaction function

inwards:
a − c1 − bq2 ∂q1
q1 (q2 ) = ⇒ <0
2b ∂c1
• and thus, the firm with higher marginal cost will produce less
in equilibrium.
• With asymmetric costs, the equilibrium is:
a − 2c1 + c2 a − 2c2 + c1
q1 = q2 =
3b 3b
(a − 2c1 + c2 )2 (a − 2c2 + c1 )2
π1 = π2 =
9b 9b
(if both firms produce in equilibrium).

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Contents

1 The Bertrand and Cournot Models

The Bertrand model
The Cournot model

2 The Stackelberg model

3 Introduction to product differentiation

4 Collusive behavior

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The Stackelberg model

• We proceed to examine strategic interaction in a dynamic

setting.
• Think of a situation where firms make their choices
sequentially. This may provide one of the firms with some sort
of advantage.
• Strategic behavior refers to the fact that the firm that moves
first might modify its strategy choice to influence the other
firm’s decision.
• Simplest example is sequential choice of capacities in a
duopoly: The Stackelberg model.

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The Stackelberg model

• In the Stackelberg model, there are two firms that choose

capacities. Firm 1 chooses first, and then firm 2 chooses after
observing firm 1’s choice.
• Analyze the game by backward induction:
1 Analyze firm 2’s problem first.
2 Analyze firm 1’s problem taking into account that its choice of
q1 affects firm 2’s choice of q2 .
• Capacity has a commitment value

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The Stackelberg model

• Firm 2’s problem is:

max (a − b(q1 + q2 ))q2 − cq2

q2

• giving rise to firm 2’s reaction function:

a − c − bq1
q2 (q1 ) =
2b

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The Stackelberg model

• Firm 2’s problem is:

max (a − b(q1 + q2 ))q2 − cq2

q2

• giving rise to firm 2’s reaction function:

a − c − bq1
q2 (q1 ) =
2b

• And firm 1 incorporates firm 2’s best-response function into

its problem, therefore:

max π1 (q1 , q2 (q1 ))

q1

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The Stackelberg model

• Firm 2’s problem is:

max (a − b(q1 + q2 ))q2 − cq2

q2

• giving rise to firm 2’s reaction function:

a − c − bq1
q2 (q1 ) =
2b

• And firm 1 incorporates firm 2’s best-response function into

its problem, therefore:

max π1 (q1 , q2 (q1 ))

q1

• Firm 1 chooses the optimal point on firm 2’s reaction function.

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The Stackelberg model
Graphically, if p = 1 − q,
q2

qP C q1 (q2 )

qM

q1 (q2 )

qM qP C q1

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The Stackelberg model

• Notice that firm 1’s choice is off its reaction function

• This requires irreversibility in its capacity choice
• Commitment value is related with irreversibility: sunk costs
have the greatest commitment value

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Contents

1 The Bertrand and Cournot Models

The Bertrand model
The Cournot model

2 The Stackelberg model

3 Introduction to product differentiation

4 Collusive behavior

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Product differentiation

• One of the key assumptions that leads to the striking result in

the Bertrand model is product homogeneity: the products of
the firms that compete in prices are identical.
• Why is that important?

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Product differentiation

• One of the key assumptions that leads to the striking result in

the Bertrand model is product homogeneity: the products of
the firms that compete in prices are identical.
• Why is that important?
• In practice, products vary in their characteristics and whenever
one firm undercuts its rival’s price, it may steal some
customers, but not the whole demand.
• We say that products are differentiated.

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Product differentiation

• In economic analysis, we typically consider two types of

product differentiation, namely horizontal and vertical.
• Horizontal product differentiation emanates from consumers
having different tastes on product characteristics, for instance,
color, flavor, or design.
• Vertical product differentiation refers to product characteristics
that can be objectively ranked, for instance quality, or
computer specs.
• The main consequence of product differentiation is that is
softens price competition, thus allowing firms to charge prices
greater than marginal cost.

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Product differentiation

• There are a number of approaches:

• Linear city model.
• Circular city model.
• Monopolistic competition.
• Competition with differentiated products.
• In all cases, firms manage to price above marginal cost.
Product differentiation provides firms with market power.

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Contents

1 The Bertrand and Cournot Models

The Bertrand model
The Cournot model

2 The Stackelberg model

3 Introduction to product differentiation

4 Collusive behavior

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Collusive behavior

• Collusion is firms’ attempts to sustain a price above the

equilibrium price.
• Colluding firms face the problem of how to sustain a collusive
arrangement.
• Given that other firms restrict their output levels, each
individual firm has an incentive to increase its own output.
• Collusion may then be sustained by introducing the possibility
of a credible punishment to firms that deviate.
• It may be readily seen that collusion is easier to sustain when:
• There are few and similar firms in the industry.
• Demand does not fluctuate much.
• Firms expect to stay in the industry for long.
• Firms compete in more than one market.
• Firms’ prices are observable.

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Collusive behavior

• Collusion goes back a long way. In fact, Adam Smith

remarked that:
”People of the same trade seldom meet together, even for
merriment and diversion, but the conversation ends in a
conspiracy against the public, or in some contrivance to raise
prices.”

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Collusion

• For instance, in Europe, prohibition follows from Article 81 of

the EC Treaty:
The following shall be prohibited as incompatible with the
common market: all agreements between undertakings,
decisions by associations of undertakings and concerted
practices which may affect trade between Member States and
which have as their object or effect the prevention, restriction
or distortion of competition within the common market, and
in particular those which (a) directly or indirectly fix purchase
or selling prices or any other trading conditions; (b) limit or
control production, markets, technical development, or
investment...
• In the United States, price fixing is illegal by the Sherman
Act, which was passed in 1890.

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Collusive behavior

• Recall the relationship between Cournot, monopoly, and

perfect competition.
• By restricting output, both firms would be better off.
• However, the outcome of the one-shot game is Nash
equilibrium (suboptimal).
• Can repetition of the game sustain outcomes different from
Nash equilibrium?
• Distinguish between finitely repeated and infinitely repeated
games.

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Collusive behavior

• If we repeat the stage game a finite number of times, the

outcome is the same as in the one-shot game.
• Reason: there is a period that the parties know that it will be
the final one. Then, apply backward induction.
• In the case of infinite repetition of the stage game (or
uncertainty about when the game ends), this argument no
longer holds.

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Collusive behavior

• Consider Nash reversion strategies such as:

( M  M M
q q q
2 if t = 1 or all elements of H t−1 are 2 , 2
qit (Ht−1 ) =
q N E otherwise.

• Then, firms will continue cooperation if

 M
d q qM
π + δπ Cour + δ 2 π Cour + ... ≤ (1 + δ + δ 2 + ...)
2 2

• Or,
2π d − π M
δ≥
2(π d − π Cour )
• Thus, collusion is less likely to be sustained with low discount
factors (more impatient agents).

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