14 Pricing

14 November 2005. Eric Rasmusen, Erasmuse@indiana.edu. Http://www.rasmusen.org.
14.1 Quantities as Strategies: Cournot Equilibrium Revisited
Chapter 14 is about how firms with market power set prices. Section 14.1 extends the
Cournot Game of Section 3.5 in which two firms choose the quantities they sell, while
Section 14.2 extends the Bertrand model in which they choose prices to the case where
capacity is limited. Section 14.3 goes back to the origins of product differentiation, and
develops two Hotelling location models. Section 14.4 shows how to do comparative statics
in games, using the differentiated Bertrand model as an example and supermodularity and
the implicit function theorem as tools. Section 14.5 looks at another sort of differentiation:
choice of “vertical” quality, from good to bad, by monopoly or duopoly. Section 14.6
concludes this book with the problem facing a firm selling a durable good because buyers
foresee that it will be tempted to reduce the price over time to price-discriminate among
them. At that point, perhaps you’ll wonder how much this book will cost next year!
Cournot Behavior with General Cost and Demand Functions
In the next few sections, sellers compete against each other while moving simultaneously.
We will start by generalizing the Cournot Game of Section 3.5 from linear demand and
zero costs to a wider class of functions. The two players are firms Apex and Brydox, and
their strategies are their choices of the quantities q
a
and q
b
. The payoffs are based on the
total cost functions, c(q
a
) and c(q
b
), and the demand function, p(q), where q = q
a
+ q
b
.
This specification says that only the sum of the outputs affects the price. The implication
is that the firms produce an identical product, because whether it is Apex or Brydox that
produces an extra unit, the effect on the price is the same.
Let us take the point of view of Apex. In the Cournot-Nash analysis, Apex chooses its
output of q
a
for a given level of q
b
as if its choice did not affect q
b
. From its point of view,
q
a
is a function of q
b
, but q
b
is exogenous. Apex sees the effect of its output on price as
∂p
∂q
a
=
_
dp
dq
__
∂q
∂q
a
_
=
dp
dq
. (1)
Apex’s payoff function is
π
a
= p(q)q
a
−c(q
a
). (2)
To find Apex’s reaction function, we differentiate with respect to its strategy to obtain

a
dq
a
= p +
_
dp
dq
_
q
a

dc
dq
a
= 0, (3)
which implies
q
a
=
dc
dqa
−p
dp
dq
, (4)
458
or, simplifying the notation,
q
a
=
c

−p
p

. (5)
If particular functional forms for p(q) and c(q
a
) are available, equation (5) can be
solved to find q
a
as a function of q
b
. More generally, to find the change in Apex’s best
response for an exogenous change in Brydox’s output, differentiate (5) with respect to q
b
,
remembering that q
b
exerts not only a direct effect on p(q
a
+ q
b
), but possibly an indirect
effect via q
a
.
dq
a
dq
b
=
(p −c

)
_
p

+ p

_
dqa
dq
b
__
p
2
+
c

_
dqa
dq
b
_
−p

−p

_
dqa
dq
b
_
p

. (6)
Equation (6) can be solved for
dqa
dq
b
to obtain the slope of the reaction function,
dq
a
dq
b
=
(p −c

)p

−p
2
2p
2
−c

p

−(p −c

)p

(7)
If both costs and demand are linear, as in section 3.5, then c

= 0 and p

= 0, so equation
(7) becomes
dq
a
dq
b
= −
p
2
2p
2
= −
1
2
. (8)
Figure 1: Different Demand Curves
459
The general model faces two problems that did not arise in the linear model: nonunique-
ness and nonexistence. If demand is concave and costs are convex, which implies that p

< 0
and c

> 0, then all is well as far as existence goes. Since price is greater than marginal cost
(p > c

), equation (7) tells us that the reaction functions are downward sloping, because
2p
2
−c

p

−(p −c

)p

is positive and both (p −c

)p

and −p
2
are negative. If the reaction
curves are downward sloping, they cross and an equilibrium exists, as was shown in Figure
1a for the linear case represented by equation (8). We usually do assume that costs are at
least weakly convex, since that is the result of diminishing or constant returns, but there is
no reason to believe that demand is either concave as in Figure 1b or convex, as in Figure
1c. If the demand curves are not linear, the contorted reaction functions of equation (7)
might give rise to multiple Cournot equilibria as in Figure 2.
Figure 2: Multiple Cournot-Nash Equilibria
If demand is convex or costs are concave, so p

> 0 or c

< 0, the reaction functions
can be upward sloping, in which case they might never cross and no equilibrium would
exist. The problem can also be seen from Apex’s payoff function, equation (2). If p(q) is
convex, the payoff function might not be concave, in which case standard maximization
techniques break down. The problems of the general Cournot model teach a lesson to
modellers: sometimes simple assumptions such as linearity generate atypical results.
460
Many Oligopolists
Let us return to the simpler game in which production costs are zero and demand is linear.
For concreteness, we will use the same specific inverse demand function as in Chapter 3,
p(q) = 120 −q. (9)
Using (9), the payoff function, (2), becomes
π
a
= 120q
a
−q
2
a
−q
b
q
a
. (10)
In section 3.5, firms picked outputs of 40 apiece given demand function (9). This generated
a price of 40. With n firms instead of two, the demand function is
p
_
n

i=1
q
i
_
= 120 −
n

i=1
q
i
, (11)
and firm j’s payoff function is
π
j
= 120q
j
−q
2
j
−q
j

i=j
q
i
. (12)
Differentiating j’s payoff function with respect to q
j
yields

j
dq
j
= 120 −2q
j

i=j
q
i
= 0. (13)
The first step in finding the equilibrium is to guess that it is symmetric, so that q
j
= q
i
, (i =
1, . . . , n). This is an educated guess, since every player faces a first-order condition like
(13). By symmetry, equation (13) becomes 120 −(n + 1)q
j
= 0, so that
q
j
=
120
n + 1
. (14)
Consider several different values for n. If n = 1, then q
j
= 60, the monopoly optimum; and
if n = 2 then q
j
= 40, the Cournot output found in section 3.5. If n = 5, q
j
= 20; and as
n rises, individual output shrinks to zero. Moreover, the total output of nq
j
=
_
n
n+1
_
120
gradually approaches 120, the competitive output, and the market price falls to zero, the
marginal cost of production. As the number of firms increases, profits fall.
14.2 Capacity Constraints: The Edgeworth Paradox
In the last section we assumed constant marginal costs (of zero), and we assumed constant
marginal costs of 12 in Chapter 3 when we first discussed Cournot and Bertrand equilibrium.
What if it were increasing, either gradually, or abruptly rising to infinity at a fixed capacity?
In the Cournot model, where firms compete in quantities, increasing marginal costs
or a capacity constraint complicate the equations but do not change the model’s features
461
dramatically. Increasing marginal cost would reduce output as one might expect. If one
firm had a capacity that was less than the ordinary Cournot output, that firm would
produce only up to its capacity and the other firm would produce more than the ordinary
Cournot output, since their outputs are strategic substitutes.
What happens in the Bertrand model, where firms compete in prices, is less straight-
forward. In Chapter 3’s game, the demand curve was p(q) = 120 − q, which we also used
in the previous section of this chapter, and the constant marginal cost of firms Apex and
Brydox was c = 12. In equilibrium, p
a
= p
b
= 12 and q
a
= q
b
= 54. If Apex deviated to
a higher price such as p
a
= 20, its quantity would fall to zero, since all customers would
prefer Brydox’s low price.
What happens if we constrain each firm to sell no more than its capacity of K
a
= K
b
=
70? The industry capacity of 140 continues to exceed the demand of 108 at p
a
= p
b
= 12.
If, however, Apex deviates to the higher price of p
a
= 20, it can still get customers. All
108 customers would prefer to buy from Brydox, but Brydox could only serve 70 of them,
and the rest would have to go unhappily to Apex.
To discover what deviation is most profitable for Apex when p
a
= p
b
= 12, however,
we need to know what Apex’s exact payoff would be from deviation. That means we need
to know not only that 38 (108 minus 70) of the customers are turned away by Brydox, but
which 38 customers. If they are the customers at the top of the demand curve, who are
willing to pay prices near 100, Apex’s optimal deviation will be much different than if they
are ones towards the bottom, who are only willing to pay prices a little above 12.
Thus, in order to set up the payoff functions for the game, we need to specify a
rationing rule to tell us which consumers are served at the low price and which must buy
from the high-price firm. The rationing rule is unimportant to the payoff of the low-price
firm, but crucial to the high-price firm.
One possible rule is
Intensity rationing (or efficient rationing, or high-to-low rationing ). The con-
sumers able to buy from the firm with the lower price are those who value the product
most.
The inverse demand function from equation (9) is p = 120 − q, and under intensity
rationing the K consumers with the strongest demand buy from the low-price firm. Suppose
that Brydox is the low-price firm, charging (for illustration) a price of p
b
= 30, so 90
consumers wish to buy from it though only K can do so, and Apex is charging some higher
price p
a
. The residual demand facing Apex is either 0 (if p
a
> 120 −K) or
q
a
= 120 −p
a
−K. (15)
That is the demand curve in Figure 3(a).
462
Figure 3: Rationing Rules when p
b
= 30, p
a
> 30, and K = 70
Under intensity rationing, if K = 70 the demand function for Apex (Brydox’s is analo-
gous) is
q
a
=
_
¸
¸
¸
¸
¸
¸
¸
¸
_
¸
¸
¸
¸
¸
¸
¸
¸
_
Min{120 −p
a
, 70} if p
a
< p
b
(a)
120−pa
2
if p
a
= p
b
(b)
Max{(120 −p
a
−70), 0} if p
a
> p
b
, p
b
< 50 (c)
0 if p
a
> p
b
, p
b
≥ 50 (d)
(16)
Equation (16a) is true because if Apex has the lower price, all consumers will want to
buy from Apex if they buy at all. All of the (120 −p
a
) customers who want to buy at that
price will be satisfied if there are 70 or less; otherwise only 70. Equation (16b) simply says
the two firms split the market equally if prices are equal. Equation (16c) is true because if
Brydox’s price is the lowest and is less than 50, Brydox will sell 70 units, and the residual
demand curve facing Apex will be as in equation (15). If Brydox’s price is the lowest but
exceeds 50, then less than 70 customers will want to buy at all, so Brydox will satisfy all
of them and zero will be left for Apex – which is equation (16d).
The appropriate rationing rule depends on what is being modelled. Intensity rationing
is appropriate if buyers with more intense demand make greater efforts to obtain low prices.
If the intense buyers are wealthy people who are unwilling to wait in line, the least intense
buyers might end up at the low-price firm which is the case of the inverse-intensity
rationing (or low-to-high rationing) in Figure 3b. An intermediate rule is proportional
rationing, under which every type of consumer is equally likely to be able to buy at the
low price.
Proportional rationing. Each consumer has the same probability of being able to buy
from the low-price firm.
Under proportional rationing, if K = 70 and 90 consumers wanted to buy from Brydox,
2/9 (=
q(p
b
)−K
q(p
b
)
) of each type of consumer will be forced to buy from Apex (for example, 2/9
463
of the type willing to pay 120). The residual demand curve facing Apex, shown in Figure
3c and equation (17), intercepts the price axis at 120, but slopes down at a rate three times
as fast as market demand because there are only 2/9 as many remaining consumers of each
type.
q
a
= (120 −p
a
)
_
120 −p
b
−K
120 −p
b
_
(17)
We thus have three choices for rationing rules, with no clear way to know which to use.
Let’s use intensity rationing. That is the rule which makes deviation to high prices least
attractive, since the low-price firm keeps the best customers for itself, so if we find that the
normal Bertrand equilibrium breaks down there, we will know it would break down under
the other rationing rules too.
The Bertrand Game with Capacity Constraints
Players
Firms Apex and Brydox
The Order of Play
Apex and Brydox simultaneously choose prices p
a
and p
b
from the set [0, ∞).
Payoffs
Marginal cost is constant at c = 12. Demand is a function of the total quantity sold,
Q(p) = 120 − p. The payoff function for Apex (Brydox’s would be analogous) is, using
equation (16) for q
a
,
π
a
=
_
¸
¸
¸
¸
¸
¸
¸
¸
_
¸
¸
¸
¸
¸
¸
¸
¸
_
(p
a
−c) · Min{120 −p
a
, 70} if p
a
< p
b
(a)
(p
a
−c)
_
120−pa
2
_
if p
a
= p
b
(b)
(p
a
−c) · Max{(120 −p
a
−70), 0} if p
a
> p
b
, p
b
< 50 (c)
0 if p
a
> p
b
, p
b
≥ 50 (d)
(18)
The capacity constraint has a very important effect: (p
a
= 12, p
b
= 12) is no longer
a Nash equilibrium in prices, even though the industry capacity of 140 is well over the
market demand of 108 when price equals marginal cost. Apex’s profit would be zero in
that strategy profile. If Apex increased its price to p
a
= 20, Brydox would immediately
sell q
b
= 70, and to the most intense 70 of buyers. Apex would be left with all the buyers
between p
a
= 20 and p
a
= 12 on the demand curve for sales of q
a
= 30 and a payoff of
240 from equation (18c). So deviation by Apex is profitable. (Of course, p
a
= 20 is not
necessarily the most profitable deviation — but we do not need to check that; any profitable
deviation is enough to refute the proposed equilibrium.)
Equilibrium prices must be lower than 120, because that price yields a zero payoff
under any circumstance. There are three remaining possibilities (now that we have ruled
out p
a
= p
b
= 12) for prices chosen in the open interval [12,120).
464
(i) Equal prices with p
a
= p
b
> 12 are not an equilibrium. Even if the price is close
to 12, Apex would sell at most 54 units as its half of the market, which is less than its
capacity of 70. Apex could profitably deviate to just below p
b
and have a discontinuous
jump in sales for an increase in profit, just as in the basic Bertrand game.
(ii) Unequal prices with one equal to 12 are not an equilibrium. Without loss of
generality, suppose p
a
> p
b
= 12. Apex could not profitably deviate, but Brydox could
deviate to p
b
= p
a
− and make positive instead of zero profit.
(iii) Finally, unequal prices of (p
a
, p
b
) with both greater than 12 are not an equilibrium.
Without loss of generality, suppose p
a
> p
b
> 12. Apex’s profits are shown in equation
(18c). If π
a
= 0, it can gain by deviating to p
a
= p
b
− . If π
a
= (p
a
− c)(50 − p
a
), it can
gain by deviating to p
a
= p
b
−, because equation (18c) tells us that Apex’s payoff will rise
to either π
a
= (p
a
−c)(70) (if p
b
≥ 50) or π
a
= (p
a
−c)(120 −p
a
) (if p
b
< 50).
Thus, no equilibrium exists in pure strategies under intensity rationing, and similar
arguments rule out pure-strategy equilibria under other forms of rationing. This is known
as the Edgeworth paradox after Edgeworth (1897, 1922).
Nowadays we know that the resolution to many a paradox is mixed strategies, and that
is the case here too. A mixed-strategy equilibrium does exist, calculated using intensity
rationing and linear demand by Levitan & Shubik (1972). Expected profits are positive,
because the firms charge prices above marginal cost. In the symmetric equilibrium, the
firms mix using distribution F(p) with a support [p, ¯ p], where p > c and ¯ p is the monopoly
price for the residual demand curve (15), which happens to be ¯ p = 36 in our example.
The upper bound ¯ p is that monopoly price because F(¯ p and the firm choosing that price
certainly is the one with the highest price and so should maximize its profit using the
residual demand curve. The payoff from playing the lower bound, p, is (p − c)(70) from
equation (18c), so since that payoff must equal the payoff of 336 (=(p-c)q= (36-12) (50-36))
from ¯ p, we can conclude that (p = 16.8. The mixing distribution F(p) could then be found
by setting π(p) = 336 = F(p)(p −c)(50 −p) + (1 −F(p))(p −c)(70) and solving for F(p).
If capacities are large enough— above the capacity of K = Q(c) = 108 in this
example— the Edgeworth paradox disappears. The argument made above for why equal
prices of c is not an equilibrium fails, because if Apex were to deviate to a positive price,
Brydox would be fully capable of serving the entire market, leaving Apex with no con-
sumers.
If capacities are small enough— less than K = 36 in our example— the Edgeworth
paradox also disappears, but so does the Bertrand paradox. The equilibrium is in pure
strategies, with each firm using its entire capacity, so q
a
= q
b
= K and charging the same
price. There is no point in a firm reducing its price, since it cannot sell any greater quantity.
How about a deviation to increasing its price and reducing its quantity? Its best deviation
is to the price which maximizes profit using the residual demand curve (120−K−p). This
turns out to be p

= (120 −K + c)/2, in which case
q

=
120 −K −c
2
. (19)
465
But if
K <
120 −c
3
, (20)
then q

> K in equation (19) and is infeasible— the profit- maximizing price is from using
all the capacity. The critical level from inequaity (20) is K = 36 in our example. For any
lower capacities, firms simply dump their entire capacity onto the market and the price,
p
a
= p
b
= 120 −2K, exceeds marginal cost.
14.3 Location Models
In Chapter 3 we analyzed the Bertrand model with differentiated products using demand
functions whose arguments were the prices of both firms. Such a model is suspect because
it is not based on primitive assumptions. In particular, the demand functions might not be
generated by maximizing any possible utility function. A demand curve with a constant
elasticity less than one, for example, is impossible because as the price goes to zero, the
amount spent on the commodity goes to infinity. Also, the demand curves were restricted
to prices below a certain level, and it would be good to be able to justify that restriction.
Location models construct demand functions like those in Chapter 3 from primitive
assumptions. In location models, a differentiated product’s characteristics are points in a
space. If cars differ only in their mileage, the space is a one-dimensional line. If acceleration
is also important, the space is a two-dimensional plane. An easy way to think about this
approach is to consider the location where a product is sold. The product “gasoline sold
at the corner of Wilshire and Westwood,” is different from “gasoline sold at the corner of
Wilshire and Fourth.” Depending on where consumers live, they have different preferences
over the two, but, if prices diverge enough, they will be willing to switch from one gas
station to the other.
Location models form a literature in themselves. We will look at the first two models
analyzed in the classic article of Hotelling (1929), a model of price choice and a model of
location choice. Figure 4 shows what is common to both. Two firms are located at points
x
a
and x
b
along a line running from zero to one, with a constant density of consumers
throughout. In the Hotelling Pricing Game, firms choose prices for given locations. In the
Hotelling Location Game, prices are fixed and the firms choose the locations.
466
Figure 4: Location Models
The Hotelling Pricing Game
(Hotelling [1929])
Players
Sellers Apex and Brydox, located at x
a
and x
b
, where x
a
< x
b
, and a continuum of buyers
indexed by location x ∈ [0, 1].
The Order of Play
1 The sellers simultaneously choose prices p
a
and p
b
.
2 Each buyer chooses a seller.
Payoffs
Demand is uniformly distributed on the interval [0,1] with a density equal to one (think
of each consumer as buying one unit). Production costs are zero. Each consumer always
buys, so his problem is to minimize the sum of the price plus the linear transport cost,
which is θ per unit distance travelled.
π
buyer at x
= V −Min{θ|x
a
−x| + p
a
, θ|x
b
−x| + p
b
}. (21)
π
a
=
_
¸
¸
¸
¸
¸
¸
¸
¸
_
¸
¸
¸
¸
¸
¸
¸
¸
_
p
a
(0) = 0 if p
a
−p
b
> θ(x
b
−x
a
) (a)
(Brydox captures entire market)
p
a
(1) = p
a
if p
b
−p
a
> θ(x
b
−x
a
) (b)
(Apex captures entire market)
p
a
(
1

[(p
b
−p
a
) + θ(x
a
+ x
b
)]) otherwise (the market is divided) (c)
(22)
467
Brydox has analogous payoffs.
The payoffs result from buyer behavior. A buyer’s utility depends on the price he
pays and the distance he travels. Price aside, Apex is most attractive of the two sellers
to the consumer at x = 0 (“consumer 0”) and least attractive to the consumer at x = 1
(“consumer 1”). Consumer 0 will buy from Apex so long as
V −(θx
a
+ p
a
) > V −(θx
b
+ p
b
), (23)
which implies that
p
a
−p
b
< θ(x
b
−x
a
), (24)
which yields payoff (22a) for Apex. Consumer 1 will buy from Brydox if
V −[θ(1 −x
a
) + p
a
] < V −[θ(1 −x
b
) + p
b
], (25)
which implies that
p
b
−p
a
< θ(x
b
−x
a
), (26)
which yields payoff (22b) for Apex.
Very likely, inequalities (24) and (26) are both satisfied, in which case Consumer 0
goes to Apex and Consumer 1 goes to Brydox. This is the case represented by payoff (22c),
and the next task is to find the location of consumer x

, defined as the consumer who is
at the boundary between the two markets, indifferent between Apex and Brydox. First,
notice that if Apex attracts Consumer x
b
, he also attracts all x > x
b
, because beyond x
b
the consumers’ distances from both sellers increase at the same rate. So we know that if
there is an indifferent consumer he is between x
a
and x
b
. Knowing this, the consumer’s
payoff equation, (21), tells us that
V −[θ(x

−x
a
) + p
a
] = V −[θ(x
b
−x

) + p
b
], (27)
so that
p
b
−p
a
= θ(2x

−x
a
−x
b
), (28)
and
x

=
1

[(p
b
−p
a
) + θ(x
a
+ x
b
)], (29)
which generates demand curve (22c)– a differentiated Bertrand demand curve.
Remember, however, that equation (29) is valid only if there really does exist a con-
sumer who is indifferent – if such a consumer does not exist, equation (29) will generates
a number for x

, but that number is meaningless.
Since Apex keeps all the consumers between 0 and x

, equation (29) is the demand
function facing Apex so long as he does not set his price so far above Brydox’s that he loses
even consumer 0. The demand facing Brydox equals (1 − x

). Note that if p
b
= p
a
, then
from (29), x

=
xa+x
b
2
, independent of θ, which is just what we would expect. Demand is
linear in the prices of both firms, and looks similar to the demand curves used in Section
3.6 for the Bertrand game with differentiated products.
468
Now that we have found the demand functions, the Nash equilibrium can be calcu-
lated in the same way as in Section 14.2, by setting up the profit functions for each firm,
differentiating with respect to the price of each, and solving the two first-order conditions
for the two prices. If there exists an equilibrium in which the firms are willing to pick prices
to satisfy inequalities (24) and (26), then it is
p
a
=
(2 + x
a
+ x
b

3
, p
b
=
(4 −x
a
−x
b

3
. (30)
From (30) one can see that Apex charges a higher price if a large x
a
gives it more safe
consumers or a large x
b
makes the number of contestable consumers greater. The simplest
case is when x
a
= 0 and x
b
= 1, when (30) tells us that both firms charge a price equal to
θ. Profits are positive and increasing in the transportation cost.
We cannot rest satisfied with the neat equilibrium of equation (30), because the as-
sumption that there exists an equilibrium in which the firms choose prices so as to split
the market on each side of some boundary consumer x

is often violated. Hotelling did not
notice this, and fell into a common mathematical trap. Economists are used to models in
which the calculus approach gives an answer that is both the local optimum and the global
optimum. In games like this one, however, the local optimum is not global, because of the
discontinuity in the objective function. Vickrey (1964) and D’Aspremont, Gabszewicz &
Thisse (1979) have shown that if x
a
and x
b
are close together, no pure-strategy equilib-
rium exists, for reasons similar to why none exists in the Bertrand model with capacity
constraints. If both firms charge nonrandom prices, neither would deviate to a slightly dif-
ferent price, but one might deviate to a much lower price that would capture every single
consumer. But if both firms charged that low price, each would deviate by raising his price
slightly. It turns out that if, for example, Apex and Brydox are located symmetrically
around the center of the interval, x
a
≥ 0.25, and x
b
≤ 0.75, no pure-strategy equilibrium
exists (although a mixed-strategy equilibrium does, as Dasgupta & Maskin [1986b] show).
Hotelling should have done some numerical examples. And he should have thought
about the comparative statics carefully. Equation (30) implies that Apex should choose a
higher price if both x
a
and x
b
increase, but it is odd that if the firms are locating closer
together, say at 0.90 and 0.91, that Apex should be able to charge a higher price, rather
than suffering from more intense competition. This kind of odd result is a typical clue
that the result has a logical flaw somewhere. Until the modeller can figure out an intuitive
reason for his odd result, he should suspect an error. For practice, let us try a few numerical
examples, illustrated in Figure 5.
469
Figure 5: Numerical Examples for Hotelling Pricing
Example 1. Everything works out simply
Try x
a
= 0, x
b
= 0.7 and θ = 0.5. Then equation (30) says p
a
= (2+0+0.7)0.5/3 = 0.45 and
p
b
= (4−0−0.7)0.5/3 = 0.55. Equation (29) says that x

=
1
2∗0.5
[(0.55 −0.45) + 0.5(0.0 + 0.7)] =
0.45.
In Example 1, there is a pure strategy equilibrium and the equations generated sensible
numbers given the parameters we chose. But it is not enough to calculate just one numerical
example.
Example 2. Same location – but different prices?
Try x
a
= 0.9, x
b
= 0.9 and θ = 0.5. Then equation (30) says p
a
= (2.0 + 0.9 + 0.9)0.5/3 ≈
0.63 and p
b
= (4.0 −0.9 −0.9)0.5/3 ≈ 0.37.
Example 2 shows something odd happening. The equations generate numbers that
seem innocuous until one realizes that if both firms are located at 0.9, but p
a
= 0.63 and
p
b
= 0.37, then Brydox will capture the entire market! The result is nonsense, because
470
equation (30)’s derivation relied on the assumption that x
a
< x
b
, which is false in this
example.
Example 3. Locations too near each other.
x

< x
a
< x
b
. Try x
a
= 0.7, x
b
= 0.9 and θ = 0.5. Then equation (30) says that
p
a
= (2.0 + 0.7 + 0.9)0.5/3 = 0.6 and p
b
= (4 − 0.7 − 0.9)0.5/3 = 0.4. As for the split of
the market, equation (29) says that x

=
1
2∗0.5
[(0.4 −0.6) + 0.5(0.7 + 0.9)] = 0.6.
Example 3 shows a serious problem. If the market splits at x

= 0.6 but x
a
= 0.7
and x
b
= 0.9, the result violates our implicit assumption that the players split the market.
Equation (29) is based on the premise that there does exist some indifferent consumer, and
when that is a false premise, as under the parameters of Example 3, equation (29) will still
spit out a value of x

, but the value will not mean anything. In fact the consumer at x = 0.6
is not really indifferent between Apex and Brydox. He could buy from Apex at a total cost
of 0.6 + 0.1(0.5) = 0.65 or from Brydox, at a total cost of 0.4 + 0.3 (0.5) = 0.55. There
exists no consumer who strictly prefers Apex. Even Apex’s ‘home’ consumer at x = 0.7
would have a total cost of buying from Brydox of 0.4+0.5(0.9−0.7) = 0.5 and would prefer
Brydox. Similarly, the consumer at x = 0 would have a total cost of buying from Brydox
of 0.4 +0.5(0.9 −0.0) = 0.85, compared to a cost from Apex of 0.6 +0.5(0.7 −0.0) = 0.95,
and he, too, would prefer Brydox.
The problem in Examples 2 and 3 is that the firm with the higher price would do better
to deviate with a discontinuous price cut, to just below the other firm’s price. Equation
(30) was derived by calculus, with the implicit assumption that a local profit maximum
was also a global profit maximum, or, put differently, that if no small change could raise a
firm’s payoff, then it had found the optimal strategy. Sometimes a big change will increase
a player’s payoff even though a small change would not. Perhaps this is what they mean
in business by the importance of “nonlinear thinking” or “thinking out of the envelope.”
The everyday manager or scientist as described by Schumpeter (1934) and Kuhn (1970)
concentrates on analyzing incremental changes and only the entrepreneur or genius breaks
through with a discontinuously new idea, the profit source or paradigm shift.
Let us now turn to the choice of location. We will simplify the model by pushing
consumers into the background and imposing a single exogenous price on all firms.
The Hotelling Location Game
(Hotelling [1929])
Players
n Sellers.
The Order of Play
The sellers simultaneously choose locations x
i
∈ [0, 1].
Payoffs
Consumers are distributed along the interval [0,1] with a uniform density equal to one. The
471
price equals one, and production costs are zero. The sellers are ordered by their location
so x
1
≤ x
2
≤ . . . ≤ x
n
, x
0
≡ 0 and x
n+1
≡ 1. Seller i attracts half the consumers from the
gaps on each side of him, as shown in Figure 14.6, so that his payoff is
π
1
= x
1
+
x
2
−x
1
2
, (31)
π
n
=
x
n
−x
n−1
2
+ 1 −x
n
, (32)
or, for i = 2, . . . n −1,
π
i
=
x
i
−x
i−1
2
+
x
i+1
−x
i
2
. (33)
Figure 6: Payoffs in the Hotelling Location Game
With one seller, the location does not matter in this model, since the consumers
are captive. If price were a choice variable and demand were elastic, we would expect the
monopolist to locate at x = 0.5.
With two sellers, both firms locate at x = 0.5, regardless of whether or not demand
is elastic. This is a stable Nash equilibrium, as can be seen by inspecting Figure 4 and
imagining best responses to each other’s location. The best response is always to locate ε
closer to the center of the interval than one’s rival. When both firms do this, they end up
splitting the market since both of them end up exactly at the center.
472
Figure 7: Nonexistence of pure strategies with three players
With three sellers the model does not have a Nash equilibrium in pure strategies.
Consider any strategy profile in which each player locates at a separate point. Such a
strategy profile is not an equilibrium, because the two players nearest the ends would edge
in to squeeze the middle player’s market share. But if a strategy profile has any two players
at the same point a, as in Figure 7, the third player would be able to acquire a share of at
least (0.5 − ) by moving next to them at b; and if the third player’s share is that large,
one of the doubled-up players would deviate by jumping to his other side and capturing
his entire market share. The only equilibrium is in mixed strategies.
473
Figure 8: The Equilibrium Mixed-Strategy Density in the Three-Player
Location Game
Suppose all three players use the same mixing density, with m(x) the probability
density for location x, and positive density on the support [g, h], as depicted in Figure 8.
We will need the density for the distribution of the minimum of the locations of Players
2 and 3. Player 2 has location x with density m(x), and Player 3’s location is greater
than that with probability 1 −M(x), letting M denote the cumulative distribution, so the
density for Player 2 having location x and it being smaller is m(x)[1 −M(x)]. The density
for either Player 2 or Player 3 choosing x and it being smaller than the other firm’s location
is then 2m(x)[1 −M(x)].
If Player 1 chooses x = g then his expected payoff is
π
1
(x
1
= g) = g +
_
h
g
2m(x)[1 −M(x)]
_
x −g
2
_
dx, (34)
where g is the safe set of consumers to his left, 2m(x)[1 −M(x)] is the density for x being
the next biggest location of a firm, and
x−g
2
is Player 1’s share of the consumers between
his own location of g and the next biggest location.
If Player 1 chooses x = h then his expected payoff is, similarly,
π
1
(x
1
= h) = (1 −h) +
_
h
g
2m(x)M(x)
_
h −x
2
_
dx, (35)
where (1 −h) is the set of safe consumers to his right
In a mixed strategy equilibrium, Player 1’s payoffs from these two pure strategies must
be equal, and they are also equal to his payoff from a location of 0.5, which we can plausibly
474
guess is in the support of his mixing distribution. Going on from this point, the algebra
and calculus start to become fierce. Shaked (1982) has computed the symmetric mixing
probability density m(x) to be as shown in Figure 9,
m(x) =
_
_
_
2 if
1
4
≤ x ≤
3
4
0 otherwise
(36)
You can check this equilibrium by seeing that with the mixing density (36) (depicted
in Figure 9) the payoffs in equation (34) and (35) do equal each other. This method has
only shown what the symmetric equilibrium is like, however; it turns out that asymmetric
equilibria also exist (Osborne & Pitchik [1986]).
Figure 9: The Equilibrium Mixing Density for Location
Strangely enough, three is a special number. With more than three sellers, an
equilibrium in pure strategies does exist if the consumers are uniformly distributed, but
this is a delicate result (Eaton & Lipsey [1975]). Dasgupta & Maskin (1986b), as amended
by Simon (1987), have also shown that an equilibrium, possibly in mixed strategies, exists
for any number of players n in a space of any dimension m.
Since prices are inflexible, the competitive market does not achieve efficiency. A benev-
olent social planner or a monopolist who could charge higher prices if he located his outlets
closer to more consumers would choose different locations than competing firms. In par-
ticular, when two competing firms both locate in the center of the line, consumers are no
better off than if there were just one firm. As shown in Figure 10, the average distance
of a consumer from a seller would be minimized by setting x
1
= 0.25 and x
2
= 0.75, the
locations that would be chosen either by the social planner or the monopolist.
475
Figure 10: Equilibrium versus Efficiency
The Hotelling Location Model, however, is very well suited to politics. Often there is
just one dimension of importance in political races, and voters will vote for the candidate
closest to their own position, so there is no analog to price. The Hotelling Location Model
predicts that the two candidates will both choose the same position, right on top of the
median voter. This seems descriptively realistic; it accords with the common complaint
that all politicians are pretty much the same.
14.4 Comparative Statics and Supermodular Games
Comparative statics is the analysis of what happens to endogenous variables in a model
when the exogenous variables change. This is a central part of economics. When wages rise,
for example, we wish to know how the price of steel will change in response. Game theory
presents special problems for comparative statics, because when a parameter changes, not
only does Smith’s equilibrium strategy change in response, but Jones’s strategy changes as
a result of Smith’s change as well. A small change in the parameter might produce a large
change in the equilibrium because of feedback between the different players’ strategies.
Let us use a differentiated Bertrand game as an example. Suppose there are N firms,
and for firm j the demand curve is
Q
j
= Max{α −β
j
p
j
+

i=j
γ
i
p
i
, 0}, (37)
476
with α ∈ (0, ∞), β
i
∈ (0, ∞), and γ
i
∈ (0, ∞) for i = 1, . . . , N. Assume that the effect of
p
j
on firm j’s sales is larger than the effect of the other firms’ prices, so that
β
j
>

i=j
γ
i
. (38)
Let firm i have constant marginal cost κc
i
, where κ ∈ {1, 2} and c
i
∈ (0, ∞), and let us
assume that each firm’s costs are low enough that it does operate in equilibrium. (The
shift variable κ could represent the effect of the political regime on costs.)
The payoff function for firm j is
π
j
= (p
j
−κc
j
)(α −β
j
p
j
+

i=j
γ
i
p
i
). (39)
Firms choose prices simultaneously.
Does this game have an equilibrium? Does it have several equilibria? What happens
to the equilibrium price if a parameter such as c
j
or κ changes? These are difficult questions
because if c
j
increases, the immediate effect is to change firm j’s price, but the other firms
will react to the price change, which in turn will affect j’s price. Moreover, this is not a
symmetric game – the costs and demand curves differ from firm to firm, which could make
algebraic solutions of the Nash equilibrium quite messy. It is not even clear whether the
equilibrium is unique.
Two approaches to comparative statics can be used here: the implicit function theorem,
and supermodularity. We will look at each in turn.
The Implicit Function Theorem
The implicit-function theorem says that if f(y, z) = 0, where y is endogenous and z is
exogenous, then
dy
dz
= −
_
∂f
∂z
∂f
∂y
_
. (40)
It is worth knowing how to derive this. We start with f(y, z) = 0, which can be
rewritten as f(y(z), z)) = 0, since y is endogenous. Using the calculus chain rule,
df
dz
=
∂f
∂z
+
_
∂f
∂y
__
dy
dz
_
= 0. (41)
where the expression equals zero because after a small change in z, f will still equal zero
after y adjusts. Solving for
dy
dz
yields equation (40).
The implicit function theorem is especially useful if y is a choice variable and z a
parameter, because then we can use the first-order condition to set f(y, z) ≡
∂π
∂y
= 0 and
the second-order condition tells us that
∂f
∂y
=

2
π
∂y
2
≤ 0. One only has to make certain that
the solution is an interior solution, so the first- and second-order conditions are valid, and
477
keep in mind that if the solution is only a local maximum, not a global one, the maximizing
choice might “jump” up or down when an exogenous variable changes.
We do have a complication if the model is strategic: there will be more than one
endogenous variable, because more than one player is choosing variable values. Suppose
that instead of simply f(y, z) = 0, our implicit equation has two endogenous and two
exogenous variables, so f(y
1
, y
2
, z
1
, z
2
) = 0. The extra z
2
is no problem; in comparative
statics we are holding all but one exogenous variable constant. But the y
2
does add some
complexity to the mix. Now, using the calculus chain rule yields not equation (41) but
df
dz
1
=
∂f
∂z
1
+
_
∂f
∂y
1
__
dy
1
dz
1
_
+
_
∂f
∂y
2
__
dy
2
dz
1
_
= 0. (42)
Solving for
dy
1
dz
1
yields
dy
1
dz
1
= −
_
_
∂f
∂z
1
+
_
∂f
∂y
2
__
dy
2
dz
1
_
∂f
∂y
1
_
_
. (43)
It is often unsatisfactory to solve out for
dy
1
dz
1
as a function of both the exogenous vari-
ables z
1
and z
2
and the endogenous variable y
2
(though it is okay if all you want is to
discover whether the change is positive or negative), but ordinarily the modeller will also
have available an optimality condition for Player 2 also: g(y
1
, y
2
, z
1
, z
2
) = 0. This second
condition yields an equation similar to (43), so that two equations can be solved for the
two unknowns.
We can use the differentiated Bertrand game to see how this works out. Equilibrium
prices will lie inside the interval (c
j
, p) for some large number p, because a price of c
j
would yield zero profits, rather than the positive profits of a slightly higher price, and p
can be chosen to yield zero quantity demanded and hence zero profits. The equilibrium
or equilibria are, therefore, interior solutions, in which case they satisfy the first-order
condition
∂π
j
∂p
j
= α −2β
j
p
j
+

i=j
γ
i
p
i
+ κc
j
β
j
= 0, (44)
and the second-order condition,

2
π
j
∂p
2
j
= −2β
j
< 0. (45)
Next, apply the implicit function theorem by using p
i
and c
i
, i = 1, . . . , N, instead of
y
i
and z
i
, i = 1, 2, and by letting
∂π
j
∂p
j
= 0 from equation (44) be our f(y
1
, y
2
, z
1
, z
2
) = 0.
The chain rule yields
df
dc
j
= −2β
j
_
dp
j
dc
j
_
+

i=j
γ
i
_
dp
i
dc
j
_
+ κβ
j
= 0, (46)
so
dp
j
dc
j
=

i=j
γ
i
_
dp
i
dc
j
_
+ κβ
j

j
. (47)
478
Just what is
dp
i
dc
j
? For each i, we need to find the first-order condition for firm i and
then use the chain rule again. The first- order condition for Player i is that the derivative
of π
i
with respect to p
i
(not p
j
) equals zero, so
g
i

∂π
i
∂p
i
= α −2β
i
p
i
+

k=i
γ
k
p
k
+ κc
i
β
i
= 0. (48)
The chain rule yields (keeping in mind that it is a change in c
j
that interests us, not a
change in c
i
),
dg
i
dc
j
= −2β
i
_
dp
i
dc
j
_
+

k=i
γ
k
_
dp
k
dc
j
_
= 0. (49)
With equation (47), the (N − 1) equations (49) give us N equations for the N unknowns
dp
i
dc
j
, i = 1, . . . , N.
It is easier to see what is going on if there are just two firms, j and i. Equations (47)
and (49) are then
dp
j
dc
j
=
γ
i
_
dp
i
dc
j
_
+ κβ
j

j
. (50)
and
−2β
i
_
dp
i
dc
j
_
+ γ
j
_
dp
j
dc
j
_
= 0. (51)
Solving these two equations for
dp
j
dc
j
and
dp
i
dc
j
yields
dp
j
dc
j
=

i
β
j
κ

i
β
j
−γ
i
γ
j
(52)
and
dp
i
dc
j
=
γ
j
β
j
κ

i
β
j
−γ
i
γ
j
. (53)
Keep in mind that the implicit function theorem only tells about infinitesimal changes,
not finite changes. If c
n
increases enough, then the nature of the equilibrium changes
drastically, because firm n goes out of business. Even if c
n
increases a finite amount, the
implicit function theorem is not applicable, because then the change in p
n
will cause changes
in the prices of other firms, which will in turn change p
n
again.
We cannot go on to discover the effect of changing κ on p
n
, because κ is a discrete vari-
able, and the implicit function theorem only applies to continuous variables. The implicit
function theorem is none the less very useful when it does apply. This is a simple example,
but the approach can be used even when the functions involved are very complicated. In
complicated cases, knowing that the second-order condition holds allows the modeller to
avoid having to determine the sign of the denominator if all that interests him is the sign
of the relationship between the two variables.
Supermodularity
479
The second approach uses the idea of the supermodular game, an idea related to
that of strategic complements (Chapter 3.6). Suppose that there are N players in a game,
subscripted by i and j, and that player i has a strategy consisting of s
i
elements, subscripted
by s and t, so his strategy is the vector y
i
= (y
i
1
, . . . , y
i
s
i
). Let his strategy set be S
i
and
his payoff function be π
i
(y
i
, y
−i
; z), where z represents a fixed parameter. We say that the
game is a smooth supermodular game if the following four conditions are satisfied for
every player i = 1, . . . N:
A1

The strategy set is an interval in R
s
i
:
S
i
= [y
i
, y
i
]. (54)
A2

π
i
is twice continuously differentiable on S
i
.
A3

(Supermodularity) Increasing one component of player i’s strategy does not de-
crease the net marginal benefit of any other component: for all i, and all s and t such that
1 ≤ s < t ≤ s
i
,

2
π
i
∂y
i
s
∂y
i
t
≥ 0. (55)
A4

(Increasing differences in strategies) Increasing one component of j’s strategy
does not decrease the net marginal benefit of increasing any component of player i’s strat-
egy: for all j = i, and all s and t such that 1 ≤ s ≤ s
i
and 1 ≤ t ≤ s
j
,

2
π
i
∂y
i
s
∂y
j
t
≥ 0. (56)
In addition, we will be able to talk about the comparative statics of smooth super-
modular games if a fifth condition is satisfied, increasing differences in parameters.
A5

: (Increasing differences in parameters) Increasing parameter z does not decrease
the net marginal benefit to player i of any component of his own strategy: for all i, and all
s such that 1 ≤ s ≤ s
i
,

2
π
i
∂y
i
s
∂z
≥ 0. (57)
The heart of supermodularity is in assumptions A3

and A4

. Assumption A3

says
that the components of player i’s strategies are all complementary inputs; when one
component increases, it is worth increasing the other components too. This means that
even if a strategy is a complicated one, one can still arrive at qualitative results about
the strategy, because all the components of the optimal strategy will move in the same
direction together. Assumption A4

says that the strategies of players i and j are strategic
complements; when player i increases a component of his strategy, player j will want to
do so also. When the strategies of the players reinforce each other in this way, the feedback
between them is less tangled than if they undermined each other.
I have put primes on the assumptions because they are the special cases, for smooth
games, of the general definition of supermodular games in the Mathematical Appendix.
480
Smooth games use differentiable functions, but the supermodularity theorems apply more
generally. One condition that is relevant here is condition A5:
A5: (Increasing differences in parameters) π
i
has increasing differences in y
i
and z
for fixed y
−i
; for all y
i
≥ y
i
, the difference π
i
(y
i
, y
−i
, z) − π
i
(y
i
, y
−i
, z) is nondecreasing
with respect to z.
Is the differentiated Bertrand game supermodular? The strategy set can be restricted to [c
i
,
p] for player i, so A1

is satisfied. π
i
is twice continuously differentiable on the interval[c
i
, p],
so A2

is satisfied. A player’s strategy has just one component, p
i
, so A3

is immediately
satisfied. The following inequality is true,

2
π
i
∂p
i
∂p
j
= γ
j
> 0, (58)
so A4

is satisfied. And it is also true that

2
π
i
∂p
i
∂c
i
= κβ
i
> 0, (59)
so A5

is satisfied for c
i
.
From equation (44),
∂π
i
∂p
i
is increasing in κ, so π
i
(p
i
, p
−i
, κ)−π
i
(p

i
, p
−i
, κ) is nondecreas-
ing in κ for p
i
> p

i
, and A5 is satisfied for κ.
Thus, all the assumptions are satisfied. This being the case, a number of theorems
can be applied, including the following two.
Theorem 1. If the game is supermodular, there exists a largest and a smallest Nash
equilibrium in pure strategies.
Theorem 2. If the game is supermodular and assumption (A5) or (A5

) is satisfied, then
the largest and smallest equilibrium are nondecreasing functions of the parameter z.
Applying Theorems 1 and 2 yields the following results for the differentiated Bertrand
game:
1. There exists a largest and a smallest Nash equilibrium in pure strategies (Theorem 1).
2. The largest and smallest equilibrium prices for firm i are nondecreasing functions of the
cost parameters c
i
and κ (Theorem 2).
Supermodularity, unlike the implicit function theorem, has yielded comparative statics
on κ, the discrete exogenous variable. It yields weaker comparative statics on c
i
, however,
because it just finds the effect of c
i
on p

i
to be nondecreasing, rather than telling us its
value or whether it is actually increasing.
For more on supermodularity, see Milgrom & Roberts (1990), Fudenberg & Tirole
(1991, pp. 489-497), or Vives’s 2005 survey.
481
*14.5 Vertical Differentiation
In previous sections of this chapter we have been looking at product differentiaton, but
differentiation in dimensions that cannot be called “good” versus “bad”. Rather, location
along a line is a matter of taste and “de gustibus non est disputandum”. Another form of
product differentiation is from better to worse, as analyzed in Shaked & Sutton (1983) and
around pages 150 and 296 of Tirole (1988). Here, we will look at that in a simpler game
in which there are just two types of buyers and two levels of quality, but we will compare
a monopoly to a duopoly under various circumstances.
Vertical Differentiation I: Monopoly Quality Choice
Players
A seller and a continuum of buyers.
The Order of Play
0 Nature assigns quality values to a continuum of buyers of length 1. Half of them are
“weak” buyers (θ = 0) who value high quality at 20 and low quality at 10. Half of them
are “strong” buyers (θ = 1) who value high quality at 50 and low quality at 15.
1 The seller picks quality s to be either s
L
= 0 or s
H
= 1.
2 The seller picks price p from the interval [0, ∞).
3 Each buyer chooses one unit of a good, or refrains from buying. The seller produces at
constant marginal cost c = 1, which does not vary with quality.
Payoffs
π
seller
= (p −1)q. (60)
and
π
buyer
= (10 + 5θ) + (10 + 25θ)s −p. (61)
The seller should clearly set the quality to be high,since then he can charge more to the
buyer (though note that this runs contrary to a common misimpression that a monopoly
will result in lower quality than a competitive market.) The price should be either 50,
which is the most the strong buyers would pay, or 20, the most the weak buyers would pay.
Since π(50) = 0.5(50 − 1) = 24.5 and π(20) = 0.5(20 − 1) + 0.5(20 − 1) = 19, the seller
should choose p = 50. Separation (by inducing only the strong buyer to buy) is better for
the seller than pooling.
Next we will allow the seller to use two quality levels. A social planner would just
use one– the maximal one of s = s

— since it is no cheaper to produce lower quality. The
monopoly seller might use two, however, because it helps him to price-discriminate.
Vertical Differentiation II: Crimping the Product
482
Players
A seller and a continuum of buyers.
The Order of Play
0 Nature assigns quality values to a continuum of buyers of length 1. Half of them are
“weak” buyers (θ = 0) who value high quality at 20 and low quality at 10. Half of them
are “strong” buyers (θ = 1) who value high quality at 50 and low quality at 15.
1 The seller decides to sell both qualities s
L
= 0 and s
H
= 1 or just one of them.
2 The seller picks prices p
L
and p
H
from the interval [0, ∞).
3 Each buyer chooses one unit of a good, or refrains from buying. The seller produces at
constant marginal cost c = 1, which does not vary with quality.
Payoffs
π
seller
= (p
L
−1)q
L
+ (p
H
−1)q
H
. (62)
and
π
buyer
= (10 + 5θ) + (10 + 25θ)s −p. (63)
This is a problem of mechanism design. The seller needs to pick p
1
, and p
2
to satisfy
incentive compatibility and participation constraints if he wants to offer two qualities with
positive sales of both, and he also needs to decide if that is more profitable than offering
just one quality.
We already solved the one-quality problem in Vertical Differentiation I, yielding profit
of 24.5. The monopolist cannot simply add a second, low- quality, low-price good for
the weak buyers, because the strong buyers, who derive zero payoff from the high-quality
good, would switch to the low-quality good, which would give them a positive payoff. In
equilibrium, the monopolist will have to give the strong buyers a positive payoff. Their
participation constraint will be non-binding, as we have found so many times before for
the “good” type.
Following the usual pattern, the participation constraint for the weak buyers will be
binding, so p
L
= 10. The self-selection constraint for the strong buyers will also be binding,
so
π
strong
(L) = 15 −p
L
= 50 −p
H
. (64)
Since p
L
= 10, this results in p
H
= 45. The price for high quality must be at least 35 higher
than the price for low quality to induce separation of the buyer types.
Profits will now be:
π
seller
= (10 −1)(0.5) + (44 −1)(0.5) = 26. (65)
This exceeds the one-quality profit of 24.5, so it is optimal for the seller to sell two qualities.
This result, is, of course, dependent on the parameters chosen, but it is nonetheless a
fascinating special case, and one which is perhaps no more special than the other special
case, in which the seller finds that profits are maximized with just one quality. The outcome
of allowing price discrimination is a pareto improvement. The seller is better off, because
483
profit has risen from 24.5 to 26. The strong buyers are better off, because the price they pay
has fallen from 50 to 45. And the weak buyers are no worse off. In Vertical Differentiation
I their payoff was zero because they chose not to buy; in Vertical Differentiation I their
payoffs are zero because they buy at a price exactly equal to their value for the good.
Indeed, we can go further. Suppose the cost for the low-quality good was actually
higher than for the high-quality good, e.g., p
L
= 3 and p
H
= 1, because the good is normally
produced as high quality and needs to be purposely damaged before it becomes low quality.
The price-discrimination profit in (65) would then be π
seller
= (10−3)(0.5)+(44−1)(0.5) =
25. Since that is still higher than 24.5, the seller would still price- discriminate. The buyers’
payoffs would be unaffected. Thus, allowing the seller to damage some of the good at a
cost in real resources of 2 per unit, converting it from high to low quality, can result in a
pareto improvement!
This is the point made in Deneckere & McAfee (1996), which illustrates the theory
with real-world examples of computer chips and printers purposely damaged to allow price
discrimination. See too McAfee (2002, p. 265), which tells us, for example, that Sony made
two sizes of minidisc in 2002, a 60-minute and a 74-minute version. Production of both
starts with a capacity of 74 minutes, but Sony added code to the 60-minute disc to make
14 minutes of it unusable. That code is an extra fixed cost, but IBM’s 1990 Laserprinter
E is an example of a damaged product with extra marginal cost. The Laserprinter E was
a version of the original Laserprinter that was only half as fast. The reason? IBM added
five extra chips to the Laserprinter E to slow it down.
We will analyze one more version of the product differentiation game: with two sellers
instead of one. This will show how the product differentiation which increases profits in
the way we have seen in the Hotelling games can occur vertically as well as horizontally.
Vertical Differentiation III: Duopoly Quality Choice
Players
Two sellers and a continuum of buyers.
The Order of Play
0 Nature assigns quality values to a continuum of buyers of length 1. Half of them are
“weak” buyers (θ = 0) who value high quality at 20 and low quality at 10. Half of them
are “strong” buyers (θ = 1) who value high quality at 50 and low quality at 15.
1 Sellers 1 and 2 simultaneously choose values for s
1
and s
2
from the set {s
L
= 0, s
H
= 1}.
They may both choose the same value.
2 Sellers 1 and 2 simultaneously choose prices p
1
and p
2
from the interval [0, ∞).
3 Each buyer chooses one unit of a good, or refrains from buying. The sellers produce at
constant marginal cost c = 1, which does not vary with quality.
Payoffs
π
seller
= (p −1)q (66)
484
and
π
buyer
= (10 + 5θ) + (10 + 25θ)s −p. (67)
If both sellers both choose the same quality level, their profits will be zero, but if
they choose different quality levels, profits will be positive. Thus, there are three possible
equilibria in the quality stage of the game: (Low, High), (High, Low), and a symmetric
mixed-strategy equilibrium. Let us consider the pure-strategy equilibria first, and without
loss of generality suppose that Seller 1 is the low-quality seller and Seller 2 is the high-
quality seller.
(1) The equilibrium prices of Vertical Differentiation II, (p
L
= 10, p
H
= 45), will no longer
be equilibrium prices. The problem is that the low-quality seller would deviate to p
L
= 9,
doubling his sales for a small reduction in price.
(2) Indeed, there is no pure-strategy equilibrium in prices. We have seen that (p
L
=
10, p
H
= 45) is not an equilibrium, even though p
H
= 45 is the high- quality seller’s
best response to p
L
= 10. P
L
> 10 will attract no buyers, so that cannot be part of
an equilibrium. Suppose P
L
∈ (1, 10). The response of the high-quality seller will be to
set p
H
= p
L
+ 35, in which case the low-quality seller can increase his profits by slightly
reducing p
L
and doubling his sales. The only price left for the low-quality seller that does
not generate negative profits is p
L
= 1, but that yields zero profits, and so is worse than
p
L
= 10. So no choice of p
L
is part of a pure-strategy equilibrium.
(3) As always, an equilibrium does exist, so it must be in mixed strategies, as shown below.
The Asymmetric Equilibrium: Pure Strategies for Quality, Mixed for Price
The low-quality seller picks p
L
on the support [5.5, 10] using the cumulative distribution
F(p
L
) = 1 −
_
39.5
p
L
+ 34
_
(68)
with an atom of probability
39.5
44
at p
L
= 10.
The high-quality seller picks p
H
on the support [40.5, 45] using the cumulative distribution
G(p
H
) = 2 −
_
9
p
H
−36
_
(69)
Weak buyers from the low-quality seller if 10 − p
L
≥ 20 − p
H
, which is always true in
equilibrium. Strong buyers buy from the low-quality seller if 15 −p
L
> 50 −p
H
, which has
positive probability, and otherwise from the high-quality seller.
This equilibrium is noteworthy because it includes a probability atom in the mixed-
strategy distribution, something not uncommon in pricing games. The low- quality seller
usually chooses p
L
= 10, but with some probability he mixes between 5.5 and 10. The
intuition for why this happens is that for the low- quality seller the weak buyers are “safe”
customers, for whom the monopoly price is 10, but unless the low-quality seller chooses
485
to shade the price with some probability to try to attract the strong customers, the high-
quality seller will maintain such a high price (p
H
= 45) as to make such shading irresistable.
To start deriving this equilibrium, let us conjecture that the low-quality seller will
not include any prices above 10 in his mixing support but will include p
L
= 10 itself.
That is plausible because he would lose all the low-quality buyers at prices above 10, but
p
L
= 10 yields maximal profits whenever p
H
is low enough that only weak consumers buy
low quality.
The low-quality seller’s profit from p
L
= 10 is π
L
(p = 10) = 0.5(10 − 1) = 4.5. Thus,
the lower bound of the support of his mixing distribution (denote it by a
L
) must also yield
a profit of 4.5. There is no point in charging a price less than the price which would capture
even the strong consumers with probability one, in which case
π
L
(a
L
) = 0.5(a
L
−1) + 0.5(a
L
−1) = 4.5, (70)
and a
L
= 5.5. Thus, the low-quality seller mixes on [5.5, 10].
On that mixing support, the low-quality seller’s profit must equal 4.5 for any price.
Thus,
π
L
(p
L
) = 4.5 = 0.5(p
L
−1) + 0.5(p
L
−1)Prob(15 −p
L
> 50 −p
H
)
= 0.5(p
L
−1) + 0.5(p
L
−1)Prob(p
H
> 35 + p
L
)
= 0.5(p
L
−1) + 0.5(p
L
−1)[1 −G(35 + p
L
)]
(71)
Thus, the G(p
H
) function is such that
1 −G(35 + p
L
) =
4.5
0.5(p
L
−1)
−1 (72)
and
G(35 + p
L
) = 2 −
_
4.5
0.5(p
L
−1)
_
. (73)
We want a G function with the argument p
H
, not (35 + p
L
), so let’s
G(p
H
) = 2 −
_
4.5
0.5([p
H
−35] −1)
_
= 2 −
_
9
p
H
−36
_
. (74)
As explained in Chapter 3, what we have just done is to find the strategy for the high-
quality seller that makes the low-quality seller indifferent among all the values of p
L
in his
mixing support.
We can find the support of the high-quality seller’s mixing distribution by finding
values a
H
and b
H
such that G(a
H
) = 0 and G(b
H
) = 1, so
G(a
H
) = 2 −
_
9
a
H
−36
_
= 0, (75)
which yields a
H
= 40.5, and
G(b
H
) = 2 −
_
9
(0) · b
H
−36
_
= 1, (76)
486
which yields b
H
= 45. Thus the support of the high-quality seller’s mixing distribution is
[40.5, 45].
Now let us find the low-quality seller’s mixing distribution, F(p
L
). At p
H
= 40.5,
the high-quality seller has zero probability of losing the strong buyers to the low-quality
seller, so his profit is 0.5(40.5 −1) = 19.75. Now comes the tricky step. At p
h
= 45, if the
high-quality seller had probability one of losing the strong buyers to the low-quality seller,
his his profit would be zero, and he would strictly prefer p
H
= 40.5. Thus, it must be that
at p
h
= 45 there is strictly positive probability that p
L
= 10— not just a positive density.
So let us continue, using our finding that the profit of the high-quality seller must be 19.75
from any price in the mixing support. Then,
π
H
(p
H
) = 19.75 = 0.5(p
H
−1)Prob(15 −p
L
< 50 −p
H
)
= 0.5(p
H
−1)Prob(p
H
−35 < p
L
)
= 0.5(p
H
−1)[1 −F(p
H
−35)]
(77)
so
F(p
H
−35) = 1 −
_
19.75
0.5(p
H
−1)
_
. (78)
Using the same substitution trick as in equation (74), putting p
L
instead of (p
H
− 35) as
the argument for F, we get
F(p
L
) = 1 −
_
19.75
0.5(p
L
+35−1)
_
= 1 −
_
39.5
p
L
+34
_
(79)
In particular, note that
F(5.5) = 1 −
_
39.5
5.5 + 34
_
= 0, (80)
confirming our earlier finding that the minimum p
L
used is 5.5, and
F(10) = 1 −
_
39.5
10 + 34
_
= 1 −
39.5
44
< 1. (81)
Equation (81) shows that at the upper bound of the low-quality seller’s mixing support the
cumulative mixing distribution does not equal 1, an oddity we usually do not see in mixing
distributions. What it implies is that there is an atom of probability at p
L
= 10, soaking
up all the remaining probability beyond what equation (81) yields for the prices below 10.
The atom must equal
39.5
44
≈ 0.9.
Happily, this solves our paradox of zero high-quality seller profit at p
H
= 45. If p
L
= 10
has probability
39.5
44
, the profit from p
H
= 45 is 0.5(
39.5
44
)(45 − 1) = 19.75. Thus, the profit
from p
H
= 45 is the same as from p
H
= 40.5, and the seller is willing to mix between them.
One of the technical lessons of Chapter 3 was that if your attempt to calculate mixing
probability results in probabilities of less than zero or more than one, then probably the
equilibrium is not in mixed strategies (algebra mistakes being another possibility). The
lesson here is that if your attempt to calculate the support of a mixing distribution results
487
in impossible bounds, then you should consider the possibility that the distribution has
atoms of probability.
The duopoly sellers’ profits are 4.5 (for low-quality) and 19.75 (for high quality) in
the asymmetric equilibrium of Vertical Differentiation III, a total of 24.25 for the industry.
This is less than either the 24.5 earned by the nondiscriminating monopolist of Vertical Dif-
ferentiation I or the 26 earned by the discriminating monopolist of Vertical Differentiation
II. But what about the mixed-strategy equilibrium for Vertical Differentiation III?
The Symmetric Equilibrium: Mixed Strategies for Both Quality and Price
Each player chooses low quality with probability α = 4.5/24.25 and high quality
otherwise. If they choose the same quality, they next both choose a price equal to 1,
marginal cost. If they choose different qualities, they choose prices according to the mixing
distributions in the asymmetric equilibrium.
This equilibrium is easier to explain. Working back from the end, if they choose the
same qualities, the two firms are in undifferentiated price competition and will choose prices
equal to marginal cost, with payoffs of zero. If they choose different qualities, they are in
the same situation as they would be in the asymmetric equilibrium, with expected payoffs
of 4.5 for the low-quality firm and 19.75 for the high-quality firm. As for choice of product
quality, the expected payoffs from each quality must be equal in equilibrium, so there must
be a higher probability of both choosing high-quality:
π(Low) = α(0) + (1 −α)4.5 = π(High) = α(19.75) + (1 −α)(0). (82)
Solving equation (82) yields α = 4.5/24.25 ≈ 0.17, in which case each player’s payoff
is about 3.75. Thus, even if a player is stuck in the role of low-quality seller in the pure-
strategy equilibrium, with an expected payoff of 4.5, that is better than the expected payoff
he would get in the “fairer” symmetric equilibrium.
We can conclude that if the players could somehow arrange what equilibrium would
be played out, they would arrange for a pure-strategy equilibrium, perhaps by use of cheap
talk and some random focal point variable.
Or, perhaps they could change the rules of the game so that they would choose qualities
sequentially. Suppose one seller gets to choose quality first. He would of course choose
high quality, for a payoff of 19.75. The second-mover, hwoever, choosing low-quality, would
have a payoff of 4.5, better than the expected payoff in the symmetric mixed-strategy
equilibrium of the simultaneous quality-choice game. This is the same phenomenon as the
pareto superiority of a sequential version of the Battle of the Sexes over the symmetric
mixed-strategy equilibrium of the simultaneous-move game.
What if Seller 1 chooses both quality and price first, and Seller 2 responds with quality
and price? If Seller 1 chooses low quality, then his optimal price is p
L
= 10, since the second
player will choose high quality and a price low enough to attract the strong buyers—
p
H
= 45, in equilibrium— so Seller 1’s payoff would be 0.5(10-1) = 4.5. If Seller 1 chooses
488
high quality, then his optimal price is p
H
= 40.5, since the second player will choose low
quality and would choose a price high enough to lure away the strong buyers if p
H
< 40.5.
If, however, p
H
= 40.5, Seller 2 would give up on attracting the strong buyers and pick
p
L
= 10. Thus, if Seller 1 chooses both quality and price first, he will choose high quality
and p
H
= 40.5 while Seller 2 will choose low quality and p
L
= 10, resulting in the same
payoffs as in the asymmetric equilibrium of the simultaneous-move game, though no longer
in mixed strategies.
What Product Differentiation III shows us is that product differentiation can take
place in oligopoly vertically as well as horizontally. Head-to-head competition reduces
profits, so firms will try to differentiate in any way that they can. This increases their
profits, but it can also benefit consumers— though more obviously in the case of horizontal
differentiation than in vertical. Keep in mind, though, that in our games here we have
assumed that high quality costs no more than low quality. Usually high quality is more
expensive, which means that having more than one quality level can be efficient. Often
poor people prefer lower quality, given the cost of higher quality, and even a social planner
would provide a variety of quality levels. Here, we see that even when only high quality
would be provided in the first-best, it is better that a monopolist provide two qualities than
one, and a duopoly is still better for consumers.
*14.6 Durable Monopoly
Introductory economics courses are vague on the issue of the time period over which trans-
actions take place. When a diagram shows the supply and demand for widgets, the x-axis is
labelled “widgets,” not “widgets per week” or “widgets per year.” Also, the diagram splits
off one time period from future time periods, using the implicit assumption that supply
and demand in one period is unaffected by events of future periods. One problem with this
on the demand side is that the purchase of a good which lasts for more than one use is an
investment; although the price is paid now, the utility from the good continues into the
future. If Smith buys a house, he is buying not just the right to live in the house tomorrow,
but the right to live in it for many years to come, or even to live in it for a few years and
then sell the remaining years to someone else. The continuing utility he receives from this
durable good is called its service flow. Even though he may not intend to rent out the
house, it is an investment decision for him because it trades off present expenditure for
future utility. Since even a shirt produces a service flow over more than an instant of time,
the durability of goods presents difficult definitional problems for national income accounts.
Houses are counted as part of national investment (and an estimate of their service flow
as part of services consumption), automobiles as durable goods consumption, and shirts as
nondurable goods consumption, but all are to some extent durable investments.
In microeconomic theory, “durable monopoly” refers not to monopolies that last a long
time, but to monopolies that sell durable goods. These present a curious problem. When
a monopolist sells something like a refrigerator to a consumer, that consumer drops out
489
of the market until the refrigerator wears out. The demand curve is, therefore, changing
over time as a result of the monopolist’s choice of price, which means that the modeller
should not make his decisions in one period and ignore future periods. Demand is not time
separable, because a rise in price at time t
1
affects the quantity demanded at time t
2
.
The durable monopolist has a special problem because in a sense he does have a
competitor – himself in the later periods. If he were to set a high price in the first period,
thereby removing high-demand buyers from the market, he would be tempted to set a
lower price in the next period to take advantage of the remaining consumers. But if it were
expected that he would lower the price, the high-demand buyers would not buy at a high
price in the first period. The threat of the future low price forces the monopolist to keep
his current price low.
This presents another aspect of product differentiation: the durability of a good. Will
a monopolist produce a shoddier, less durable product? Durability is different from the
vertical differentiation we have already analyzed because durability has temporal implica-
tions. The buyer of a less durable product will return to the market sooner than the buyer
of a more durable one, regardless of other aspects of product quality.
To formalize this situation, let the seller have a monopoly on a durable good which lasts
two periods. He must set a price for each period, and the buyer must decide what quantity
to buy in each period. Because this one buyer is meant to represent the entire market
demand, the moves are ordered so that he has no market power, as in the principal-agent
models in Chapter 7 and onwards. Alternatively, the buyer can be viewed as representing
a continuum of consumers (see Coase [1972] and Bulow [1982]). In this interpretation,
instead of “the buyer” buying q
1
in the first period, q
1
of the buyers each buy one unit in
the first period.
Durable Monopoly
Players
A buyer and a seller.
The Order of Play
1 The seller picks the first-period price, p
1
.
2 The buyer buys quantity q
1
and consumes service flow q
1
.
3 The seller picks the second-period price, p
2
.
4 The buyer buys additional quantity q
2
and consumes service flow (q
1
+ q
2
).
Payoffs
Production cost is zero and there is no discounting. The seller’s payoff is his revenue, and
the buyer’s payoff is the sum across periods of his benefits from consumption minus his
expenditure. The buyer’s benefits arise from his being willing to pay as much as
B(q
t
) = 60 −
q
t
2
(83)
for the marginal unit service flow consumed in period t, as shown in Figure 10. The payoffs
are therefore
π
seller
= q
1
p
1
+ q
2
p
2
(84)
490
and, since a consumer’s total benefit is the sum of a triangle plus a rectangle of benefit, as
shown in Figure 10,
π
buyer
= [consumer surplus
1
] + [consumer surplus
2
]
= [total benefit
1
−expenditure
1
] + [total benefit
2
−expenditure
2
]
=
__
(60−B(q
1
))q
1
2
+ B(q
1
)q
1
_
−p
1
q
1
_
+
__
60−B(q
1
+q
2
)
2
(q
1
+ q
2
) + B(q
1
+ q
2
)(q
1
+ q
2
)
_
−p
2
q
2
_
(85)
Thinking about durable monopoly is hard because we are used to one-period models
in which the demand curve, which relates the price to the quantity demanded, is identical
to the marginal-benefit curve, which relates the marginal benefit to the quantity consumed.
Here, the two curves are different. The marginal benefit curve is the same each period, since
it is part of the rules of the game, relating consumption to utility. The demand curve will
change over time and depends on the equilibrium strategies, depending as it does on the
number of periods left in which to consume the good’s services, expected future prices, and
the quantity already owned. Marginal benefit is a given for the buyer; quantity demanded
is his strategy.
The buyer’s total benefit in period 1 is the dollar value of his utility from his purchase of
q
1
, which equals the amount he would have been willing to pay to rent q
1
. This is composed
of the two areas shown in Figure 11a, the upper triangle of area
_
1
2
_
(q
1
+ q
2
) (60 −B(q
1
+ q
2
))
and the lower rectangle of area (q
1
+ q
2
)B(q
1
+ q
2
). From this must be subtracted his ex-
penditure in period 1, p
1
q
1
, to obtain what we might call his consumer surplus in the first
period. Note that p
1
q
1
will not be the lower rectangle, unless by some strange accident,
and the “consumer surplus” might easily be negative, since the expenditure in period 1 will
also yield utility in period 2 because the good is durable.
491
Figure 11: The Buyer’s Marginal Benefit per Period in Durable Monopoly
To find the equilibrium price path one cannot simply differentiate the seller’s utility
with respect to p
1
and p
2
, because that would violate the sequential rationality of the seller
and the rational response of the buyer. Instead, one must look for a subgame perfect
equilibrium, which means starting in the second period and discovering how much the
buyer would purchase given his first-period purchase of q
1
, and what second-period price
the seller would charge given the buyer’s second-period demand function.
In the first period, the marginal unit consumed was the q
1
−th. In the second period,
it will be the (q
1
+q
2
) −th. The residual demand curve after the first period’s purchases is
shown in Figure 11b. It is a demand curve very much like the demand curve resulting from
intensity rationing in the capacity-constrained Bertrand game of Section 14.2, as shown in
Figure 11a. The most intense portion of the buyer’s demand, up to q
1
units, has already
been satisfied, and what is left begins with a marginal benefit of B(q
1
), and falls at the
same slope as the original marginal benefit curve. The equation for the residual demand is
therefore, using equation (83),
p
2
= B(q
1
) −
q
2
2
= 60 −
_
1
2
_
q
1

_
1
2
_
q
2
. (86)
Solving for the monopoly quantity, q

2
, the seller maximizes q
2
p
2
, solving the problem
Maximize
q
2
q
2
_
60 −
_
1
2
_
(q
1
+ q
2
)
_
, (87)
which generates the first-order condition
60 −q
2

_
1
2
_
q
1
= 0, (88)
so that
q

2
= 60 −
_
1
2
_
q
1
. (89)
From equations (86) and (89), it can be seen that p

2
= 30 −q
1
/4.
We must now find q

1
. In period one, the buyer looks ahead to the possibility of buying
in period two at a lower price. Buying in the first period has two benefits: consumption of
the service flow in the first period and consumption of the service flow in the second period.
The price he would pay for a unit in period one cannot exceed the marginal benefit from
the first- period service flow in period one plus the foreseen value of p
2
, which from (89) is
30 − q
1
/4. If the seller chooses to sell q
1
in the first period, therefore, he can do so at the
price
p
1
(q
1
) = B(q
1
) + p
2
= (60 −
_
1
2
_
q
1
) + (30 −
_
1
4
_
q
1
),
= 90 −
_
3
4
_
q
1
.
(90)
492
Knowing that in the second period he will choose q
2
according to (89), the seller combines
(89) with (90) to give the maximand in the problem of choosing q
1
to maximize profit over
the two periods, which is
π
seller
= (p
1
q
1
+ p
2
q
2
) =
_
90 −
3q
1
4
_
q
1
+
_
30 −
q
1
4
_
(60 −
q
1
2
)
= 1800 + 60q
1

5q
2
1
8
,
(91)
which has the first-order condition
60 −
5q
1
4
= 0, (92)
so that
q

1
= 48 (93)
and, making use of (90), p

1
= 54.
It follows from (89) that q

2
= 36 and p
2
= 18. The seller’s profits over the two periods
are π
s
= 3, 240 (= 54(48) + 18(36)).
The purpose of these calculations is to compare the situation with three other mar-
ket structures: a competitive market, a monopolist who rents instead of selling, and a
monopolist who commits to selling only in the first period.
A competitive market bids down the price to the marginal cost of zero. Then, p
1
= 0
and q
1
= 120 from (83) because buyers buy till their marginal benefit is zero, and profits
equal zero also.
If the monopolist rents instead of selling, then equation (83) is like an ordinary demand
equation, because the monopolist is effectively selling the good’s services separately each
period. He could rent a quantity of 60 each period at a rental fee of 30 and his profits
would sum to π
s
= 3, 600. That is higher than 3,240, so profits are higher from renting
than from selling outright. The problem with selling outright is that the first-period price
cannot be very high or the buyer knows that the seller will be tempted to lower the price
once the buyer has bought in the first period. Renting avoids this problem.
If the monopolist can commit to not producing in the second period, he will do just as
well as the monopolist who rents, since he can sell a quantity of 60 at a price of 60, the
sum of the rents for the two periods. An example is the artist who breaks the plates for his
engravings after a production run of announced size. We must also assume that the artist
can convince the market that he has broken the plates. People joke that the best way an
artist can increase the value of his work is by dying, and that, too, fits the model.
If the modeller ignored sequential rationality and simply looked for the Nash equilib-
rium that maximized the payoff of the seller by his choice of p
1
and p
2
, he would come to
the commitment result. An example of such an equilibrium is (p
1
= 60, p
2
= 200, Buyer
purchases according to q
1
= 120 −p
1
, and q
2
= 0). This is Nash because neither player has
incentive to deviate given the other’s strategy, but it fails to be subgame perfect, because
the seller should realize that if he deviates and chooses a lower price once the second period
is reached, the buyer will respond by deviating from q
2
= 0 and will buy more units.
493
With more than two periods, the difficulties of the durable-goods monopolist become
even more striking. In an infinite-period model without discounting, if the marginal cost
of production is zero, the equilibrium price for outright sale instead of renting is constant
– at zero! Think about this in the context of a model with many buyers. Early consumers
foresee that the monopolist has an incentive to cut the price after they buy, in order to
sell to the remaining consumers who value the product less. In fact, the monopolist would
continue to cut the price and sell more and more units to consumers with weaker and weaker
demand until the price fell to marginal cost. Without discounting, even the high-valuation
consumers refuse to buy at a high price, because they know they could wait until the price
falls to zero. And this is not a trick of infinity: a large number of periods generates a price
close to zero.
We can also use the durable monopoly model to think about the durability of the
product. If the seller can develop a product so flimsy that it only lasts one period, that
is equivalent to renting. A consumer is willing to pay the same price to own a one-hoss
shay that he knows will break down in one year as he would pay to rent it for a year. Low
durability leads to the same output and profits as renting, which explains why a firm with
market power might produce goods that wear out quickly. The explanation is not that
the monopolist can use his market power to inflict lower quality on consumers– after all,
the price he receives is lower too– but that the lower durability makes it credible to high-
valuation buyers that the seller expects their business in the future and will not reduce his
price.
With durable-goods monopoly, this book is concluded. Is this book itself a durable
good? As I am now writing its fourth edition, I cannot say that it is perfectly durable,
because it has improved with each edition, and I can honestly say that a rational consumer
who liked the first edition should have bought each successive edition. If you can benefit
from this book, your time is valuable enough that you should substitute book reading for
solitary thinking even at the expensive prices my publisher and I charge.
Yet although I have added new material, and improved my presentation of the old
material, the basic ideas remain the same. The central idea is that in modern economic
modelling the modeller starts by thinking about players, actions, information, and pay-
offs, stripping a situation down to its essentials. Having done that, he sees what payoff-
maximizing equilibrium behavior arises from the assumptions. This book teaches a variety
of common ways that assumptions link to conclusions just as a book on chess strategy
teaches how variety of common configurations of a chessboard lead to winning or losing.
Just as with a book on chess, however, the important thing is not just to know common
tricks and simplifications, but to be able to recognize the general features of a situation
and know what tricks to apply. Chess is just a game, but game theory, I hope, will provide
you with tools for improving your life and the policies you recommend to others.
494
Notes
N14.1 Quantities as Strategies: The Cournot Equilibrium Revisited
• Articles on the existence and uniqueness of a pure-strategy equilibrium in the Cournot model
include Roberts & Sonnenschein (1976), Novshek (1985), and Gaudet & Salant (1991).
• Merger in a Cournot model. A problem with the Cournot model is that a firm’s best
policy is often to split up into separate firms. Apex gets half the industry profits in a
duopoly game. If Apex split into firms Apex
1
and Apex
2
, it would get two thirds of the
profit in the Cournot triopoly game, even though industry profit falls.
This point was made by Salant, Switzer & Reynolds (1983) and is the subject of problem
14.2. It is interesting that nobody noted this earlier, given the intense interest in Cournot
models. The insight comes from approaching the problem from asking whether a player
could improve his lot if his strategy space were expanded in reasonable ways.
• An ingenious look at how the number of firms in a market affects the price is Bresnahan
& Reiss (1991), which looks empirically at a number of very small markets with one, two,
three or more competing firms. They find a big decline in the price from one to two firms,
a smaller decline from two to three, and not much change thereafter.
Exemplifying theory, as discussed in the Introduction to this book, lends itself to explain-
ing particular cases, but it is much less useful for making generalizations across industries.
Empirical work associated with exemplifying theory tends to consist of historical anecdote
rather than the linear regressions to which economics has become accustomed. Generaliza-
tion and econometrics are still often useful in industrial organization, however, as Bresnahan
& Reiss (1991) shows. The most ambitious attempt to connect general data with the modern
theory of industrial organization is Sutton’s 1991 book, Sunk Costs and Market Structure,
which is an extraordinarily well- balanced mix of theory, history, and numerical data.
N14.2 Prices as Strategies: The Bertrand Equilibrium
• As Morrison (1998) points out, Cournot actually does (in Chapter 7) analyze the case of
price competition with imperfect substitutes, as well as the quantity competition that bears
his name. It is convenient to continue to contrast “Bertrand” and “Cournot” competition,
however, though a case can be made for simplifying terminology to “price” and “quantity”
competition instead. For the history of how the Bertrand name came to be attached to
price competition, see Dimand & Dore (1999).
• Intensity rationing has also been called efficient rationing. Sometimes, however, this
rationing rule is inefficient. Some low-intensity consumers left facing the high price decide
not to buy the product even though their benefit is greater than its marginal cost. The
reason intensity rationing has been thought to be efficient is that it is efficient if the rationed-
out consumers are unable to buy at any price.
• OPEC has tried both price and quantity controls (“OPEC, Seeking Flexibility, May Choose
Not to Set Oil Prices, but to Fix Output,” Wall Street Journal, October 8, 1987, p. 2; “Saudi
King Fahd is Urged by Aides To Link Oil Prices to Spot Markets,” Wall Street Journal,
October 7, 1987, p. 2). Weitzman (1974) is the classic reference on price versus quantity
control by regulators, although he does not use the context of oligopoly. The decision
495
rests partly on enforceability, and OPEC has also hired accounting firms to monitor prices
(“Dutch Accountants Take On a Formidable Task: Ferreting Out ‘Cheaters’ in the Ranks
of OPEC,” Wall Street Journal, February 26, 1985, p. 39).
• Kreps & Scheinkman (1983) show how capacity choice and Bertrand pricing can lead to
a Cournot outcome. Two firms face downward-sloping market demand. In the first stage
of the game, they simultaneously choose capacities, and in the second stage they simulta-
neously choose prices (possibly by mixed strategies). If a firm cannot satisfy the demand
facing it in the second stage (because of the capacity limit), it uses intensity rationing (the
results depend on this). The unique subgame perfect equilibrium is for each firm to choose
the Cournot capacity and price.
• Haltiwanger & Waldman (1991) have suggested a dichotomy applicable to many different
games between players who are responders, choosing their actions flexibly, and those
who are nonresponders, who are inflexible. A player might be a nonresponder because
he is irrational, because he moves first, or simply because his strategy set is small. The
categories are used in a second dichotomy, between games exhibiting synergism, in which
responders choose to do whatever the majority do (upward sloping reaction curves), and
games exhibiting congestion, in which responders want to join the minority (downward
sloping reaction curves). Under synergism, the equilibrium is more like what it would be if
all the players were nonresponders; under congestion, the responders have more influence.
Haltiwanger and Waldman apply the dichotomies to network externalities, efficiency wages,
and reputation.
• There are many ways to specify product differentation. This chapter looks at horizontal
differentiation where all consumers agree that products A and B are more alike than A
and C, but they disagree as to which is best. Another way horizontal differentiation might
work is for each consumer to like a particular product best, but to consider all others as
equivalent. See Dixit & Stiglitz (1977) for a model along those lines. Or, differentiation
might be vertical: all consumers agree that A is better than B and B is better than C but
they disagree as to how much better A is than B. Firms therefore offer different qualities at
different prices. Shaked & Sutton (1983) have explored this kind of vertical differentation.
N14.3 Location models
• For a booklength treatment of location models, see Greenhut & Ohta (1975).
• Vickrey notes the possible absence of a pure-strategy equilibrium in Hotelling’s model in
pp.323-324 of his 1964 book Microstatics. D’Aspremont, Gabszewicz & Thirse (1979) work
out the mixed-strategy equilibrium for the case of quadratic transportation costs, and Os-
borne & Pitchik (1987) do the same for Hotelling’s original model.
• Location models and switching cost models are attempts to go beyond the notion of a
market price. Antitrust cases are good sources for descriptions of the complexities of pricing
in particular markets. See, for example, Sultan’s 1974 book on electrical equipment in the
1950s, or antitrust opinions such as US v. Addyston Pipe & Steel Co., 85 F. 271 (1898).
• It is important in location models whether the positions of the players on the line are
moveable. See, for example, Lane (1980).
496
• The location games in this chapter model use a one-dimensional space with end points, i.e.,
a line segment. Another kind of one-dimensional space is a circle (not to be confused with
a disk). The difference is that no point on a circle is distinctive, so no consumer preference
can be called extreme. It is, if you like, Peoria versus Berkeley. The circle might be used
for modelling convenience or because it fits a situation: e.g., airline flights spread over
the 24 hours of the day. With two players, the Hotelling location game on a circle has a
continuum of pure-strategy equilibria that are one of two types: both players locating at the
same spot, versus players separated from each other by 180

. The three-player model also
has a continuum of pure-strategy equilibria, each player separated from another by 120

,
in contrast to the nonexistence of a pure-strategy equilibrium when the game is played on
a line segment.
• Characteristics such as the color of cars could be modelled as location, but only on a
player-by-player basis, because they have no natural ordering. While Smith’s ranking of
(red=1, yellow=2, blue=10) could be depicted on a line, if Brown’s ranking is (red=1,
blue=5, yellow=6) we cannot use the same line for him. In the text, the characteristic was
something like physical location, about which people may have different preferences but
agree on what positions are close to what other positions.
N14.6 Durable Monopoly
• The proposition that price falls to marginal cost in a durable monopoly with no discount-
ing and infinite time is called the “Coase Conjecture,” after Coase (1972). It is really a
proposition and not a conjecture, but alliteration was too strong to resist.
• Gaskins (1974) has written a well-known article on the problem of the durable monopolist
who foresees that he will be creating his own future competition in the future because his
product can be recycled, using the context of the aluminum market.
• Leasing by a durable monopoly was the main issue in the antitrust case US v. United Shoe
Machinery Corporation, 110 F. Supp. 295 (1953), but not because it increased monopoly
profits. The complaint was rather that long-term leasing impeded entry by new sellers of
shoe machinery, a curious idea when the proposed alternative was outright sale. More likely,
leasing was used as a form of financing for the machinery consumers; by leasing, they did
not need to borrow as they would have to do if it was a matter of financing a purchase. See
Wiley, Ramseyer, and Rasmusen (1990).
• Another way out of the durable monopolist’s problem is to give best-price guarantees to
consumers, promising to refund part of the purchase price if any future consumer gets a
lower price. Perversely, this hurts consumers, because it stops the seller from being tempted
to lower his price. The “most-favored- consumer” contract, which is the analogous contract
in markets with several sellers, is analyzed by Holt & Scheffman (1987), for example, who
demonstrate how it can maintain high prices, and Png & Hirshleifer (1987), who show how
it can be used to price discriminate between different types of buyers.
• The durable monopoly model should remind you of bargaining under incomplete informa-
tion. Both situations can be modelled using two periods, and in both situations the problem
for the seller is that he is tempted to offer a low price in the second period after having
offered a high price in the first period. In the durable monopoly model this would happen
497
if the high-valuation buyers bought in the first period and thus were absent from considera-
tion by the second period. In the bargaining model this would happen if the buyer rejected
the first-period offer and the seller could conclude that he must have a low valuation and
act accordingly in the second period. With a rational buyer, neither of these things can
happen, and the models’ complications arise from the attempt of the seller to get around
the problem.
In the durable-monopoly model this would happen if the high-valuation buyers bought in
the first period and thus were absent from consideration by the second period. In the
bargaining model this would happen if the buyer rejected the first-period offer and the
seller could conclude that he must have a low valuation and act accordingly in the second
period. For further discussion, see the survey by Kennan & Wilson (1993).
498
Problems
14.1. Differentiated Bertrand with Advertising (medium)
Two firms that produce substitutes are competing with demand curves
q
1
= 10 −αp
1
+βp
2
(94)
and
q
2
= 10 −αp
2
+βp
1
. (95)
Marginal cost is constant at c = 3. A player’s strategy is his price. Assume that α > β/2.
(a) What is the reaction function for firm 1? Draw the reaction curves for both firms.
(b) What is the equilibrium? What is the equilibrium quantity for firm 1?
(c) Show how firm 2’s reaction function changes when β increases. What happens to the
reaction curves in the diagram?
(d) Suppose that an advertising campaign could increase the value of β by one, and that this
would increase the profits of each firm by more than the cost of the campaign. What does
this mean? If either firm could pay for this campaign, what game would result between
them?
14.2. Cournot Mergers (easy) (See Salant, Switzer, & Reynolds [1983])
There are three identical firms in an industry with demand given by P = 1 − Q, where Q =
q
1
+q
2
+q
3
. The marginal cost is zero.
(a) Compute the Cournot equilibrium price and quantities.
(b) How do you know that there are no asymmetric Cournot equilibria, in which one firm
produces a different amount than the others?
(c) Show that if two of the firms merge, their shareholders are worse off.
14.3. Differentiated Bertrand (medium)
Two firms that produce substitutes have the demand curves
q
1
= 1 −αp
1
+β(p
2
−p
1
) (96)
and
q
2
= 1 −αp
2
+β(p
1
−p
2
), (97)
where α > β. Marginal cost is constant at c, where c < 1/α. A player’s strategy is his price.
(a) What are the equations for the reaction curves p
1
(p
2
) and p
2
(p
1
)? Draw them.
(b) What is the pure-strategy equilibrium for this game?
499
(c) What happens to prices if α, β, or c increase?
(d) What happens to each firm’s price if α increases, but only firm 2 realizes it (and firm 2
knows that firm 1 is uninformed)? Would firm 2 reveal the change to firm 1?
Problem 14.4. Asymmetric Cournot Duopoly (easy)
Apex has variable costs of q
2
a
and a fixed cost of 1000, while Brydox has variables costs of 2q
2
b
and no fixed cost. Demand is p = 115 −q
a
−q
b
.
(a) What is the equation for Apex’s Cournot reaction function?
(b) What is the equation for Brydox’ Cournot reaction function?
(c) What are the outputs and profits in the Cournot equilibrium?
Problem 14.5. Price Discrimination (medium)
A seller faces a large number of buyers whose market demand is given by P = α−βQ. Production
marginal cost is constant at c.
(a) What is the monopoly price and profit?
(b) What are the prices under perfect price discrimination if the seller can make take-it-or-
leave-it offers? What is the profit?
(c) What are the prices under perfect price discrimination if the buyer and sellers bargain over
the price and split the surplus evenly? What is the profit?
500
The Kleit Oligopoly Game: A Classroom Game for Chapter 14
The widget industry in Smallsville has N firms. Each firm produces 150 widgets per month.
All costs are fixed, because labor is contracted for on a yearly basis, so we can ignore production
cost for the purposes of this case. Widgets are perishable; if they are not sold within the month,
they explode in flames.
There are two markets for widgets, the national market, and the local market. The price in
the national market is $20 per widget, with the customers paying for delivery, but the price in
the local market depends on how many are for sale there in a given month. The price is given by
the following market demand curve:
P = 100 −
Q
N
,
where Q is the total output of widgets sold in the local market. If, however, this equation would
yield a negative price, the price is just zero, since the excess widgets can be easily destroyed.
$20 is the opportunity cost of selling a widget locally– it is what the firm loses by making
that decision. The benefit from the decision depends on what other firms do. All firms make their
decisions at the same time on whether to ship widgets out of town to the national market. The
train only comes to Smallsville once a month, so firms cannot retract their decisions. If a firm
delays making its decision till too late, then it misses the train, and all its output will have to be
sold in Smallsville.
General Procedures
For the first seven months, each of you will be a separate firm. You will write down two
things on an index card: (1) the number of the month, and (2) your LOCAL-market sales for that
month. Also record your local and national market sales on your Scoresheet. The instructor will
collect the index cards and then announce the price for that month. You should then calculate
your profit for the month and add it to your cumulative total, recording both numbers on your
Scoresheet.
For the last five months, you will be organized into five different firms. Each firm has a
capacity of 150, and submits a single index card. The card should have the number of the firm
on it, as well as the month and the local output. The instructor will then calculate the market
price, rounding it to the nearest dollar to make computations easier. Your own computations will
be easier if you pick round numbers for your output.
If you do not turn in an index card by the deadline, you have missed the train and all 150 of
your units must be sold locally. You can change your decision up until the deadline by handing
in a new card noting both your old and your new output, e.g., “I want to change from 40 to 90.”
Procedures Each Month
1. Each student is one firm. No talking.
2. Each student is one firm. No talking.
3. Each student is one firm. No talking.
4. Each student is one firm. No talking.
501
5. Each student is one firm. No talking.
6. Each student is one firm. You can talk with each other, but then you write down your
own output and hand all outputs in separately.
7. Each student is one firm. You can talk with each other, but then you write down your
own output and hand all outputs in separately.
8. You are organized into Firms 1 through 5, so N=5. People can talk within the firms, but
firms cannot talk to each other. The outputs of the firms are secret.
9. You are organized into Firms 1 through 5, so N=5. People can talk within the firms, but
firms cannot talk to each other. The outputs of the firms are secret.
10. You are organized into Firms 1 through 5, so N=5. You can talk to anyone you like, but
when the talking is done, each firm writes down its output secretly and hands it in.
11. You are organized into Firms 1 through 5, so N=5. You can talk to anyone you like,
but when the talking is done, each firm writes down its output secretly and hands it in. Write
the number of your firm with your output. This number will be made public once all the outputs
have been received.
You may be wondering about the “Kleit”. Andrew Kleit is an economics professor Penn-
sylvania State University who originated the ancestor of this oligopoly game game for classroom
use.
502

or, simplifying the notation, qa = c −p . p (5)

If particular functional forms for p(q) and c(qa ) are available, equation (5) can be solved to find qa as a function of qb . More generally, to find the change in Apex’s best response for an exogenous change in Brydox’s output, differentiate (5) with respect to qb , remembering that qb exerts not only a direct effect on p(qa + qb ), but possibly an indirect effect via qa . (p − c ) p + p dqa = dqb p2 Equation (6) can be solved for
dqa dqb dqa dqb

c +

dqa dqb

−p −p p

dqa dqb

.

(6)

to obtain the slope of the reaction function, (7)

dqa (p − c )p − p 2 = dqb 2p 2 − c p − (p − c )p

If both costs and demand are linear, as in section 3.5, then c = 0 and p = 0, so equation (7) becomes p2 dqa 1 =− 2 =− . (8) dqb 2p 2

Figure 1: Different Demand Curves

459

The general model faces two problems that did not arise in the linear model: nonuniqueness and nonexistence. If demand is concave and costs are convex, which implies that p < 0 and c > 0, then all is well as far as existence goes. Since price is greater than marginal cost (p > c ), equation (7) tells us that the reaction functions are downward sloping, because 2p 2 − c p − (p − c )p is positive and both (p − c )p and −p 2 are negative. If the reaction curves are downward sloping, they cross and an equilibrium exists, as was shown in Figure 1a for the linear case represented by equation (8). We usually do assume that costs are at least weakly convex, since that is the result of diminishing or constant returns, but there is no reason to believe that demand is either concave as in Figure 1b or convex, as in Figure 1c. If the demand curves are not linear, the contorted reaction functions of equation (7) might give rise to multiple Cournot equilibria as in Figure 2.

Figure 2: Multiple Cournot-Nash Equilibria If demand is convex or costs are concave, so p > 0 or c < 0, the reaction functions can be upward sloping, in which case they might never cross and no equilibrium would exist. The problem can also be seen from Apex’s payoff function, equation (2). If p(q) is convex, the payoff function might not be concave, in which case standard maximization techniques break down. The problems of the general Cournot model teach a lesson to modellers: sometimes simple assumptions such as linearity generate atypical results. 460

Many Oligopolists Let us return to the simpler game in which production costs are zero and demand is linear. For concreteness, we will use the same specific inverse demand function as in Chapter 3, p(q) = 120 − q. Using (9), the payoff function, (2), becomes
2 πa = 120qa − qa − qb qa .

(9)

(10)

In section 3.5, firms picked outputs of 40 apiece given demand function (9). This generated a price of 40. With n firms instead of two, the demand function is
n n

p
i=1

qi

= 120 −
i=1

qi ,

(11)

and firm j’s payoff function is
2 πj = 120qj − qj − qj i=j

qi .

(12)

Differentiating j’s payoff function with respect to qj yields dπj = 120 − 2qj − dqj qi = 0.
i=j

(13)

The first step in finding the equilibrium is to guess that it is symmetric, so that qj = qi , (i = 1, . . . , n). This is an educated guess, since every player faces a first-order condition like (13). By symmetry, equation (13) becomes 120 − (n + 1)qj = 0, so that qj = 120 . n+1 (14)

Consider several different values for n. If n = 1, then qj = 60, the monopoly optimum; and if n = 2 then qj = 40, the Cournot output found in section 3.5. If n = 5, qj = 20; and as n n rises, individual output shrinks to zero. Moreover, the total output of nqj = n+1 120 gradually approaches 120, the competitive output, and the market price falls to zero, the marginal cost of production. As the number of firms increases, profits fall.

14.2 Capacity Constraints: The Edgeworth Paradox In the last section we assumed constant marginal costs (of zero), and we assumed constant marginal costs of 12 in Chapter 3 when we first discussed Cournot and Bertrand equilibrium. What if it were increasing, either gradually, or abruptly rising to infinity at a fixed capacity? In the Cournot model, where firms compete in quantities, increasing marginal costs or a capacity constraint complicate the equations but do not change the model’s features 461

but crucial to the high-price firm. which we also used in the previous section of this chapter. In equilibrium. since all customers would prefer Brydox’s low price. where firms compete in prices. Apex deviates to the higher price of pa = 20. pa = pb = 12 and qa = qb = 54. but Brydox could only serve 70 of them. charging (for illustration) a price of pb = 30. Increasing marginal cost would reduce output as one might expect. In Chapter 3’s game. who are only willing to pay prices a little above 12. however. and the constant marginal cost of firms Apex and Brydox was c = 12. (15) 462 . To discover what deviation is most profitable for Apex when pa = pb = 12. If one firm had a capacity that was less than the ordinary Cournot output. Suppose that Brydox is the low-price firm. or high-to-low rationing ). and under intensity rationing the K consumers with the strongest demand buy from the low-price firm. we need to specify a rationing rule to tell us which consumers are served at the low price and which must buy from the high-price firm. but which 38 customers. and Apex is charging some higher price pa . If they are the customers at the top of the demand curve. The rationing rule is unimportant to the payoff of the low-price firm. we need to know what Apex’s exact payoff would be from deviation. and the rest would have to go unhappily to Apex. If Apex deviated to a higher price such as pa = 20. One possible rule is Intensity rationing (or efficient rationing. Apex’s optimal deviation will be much different than if they are ones towards the bottom. All 108 customers would prefer to buy from Brydox. The residual demand facing Apex is either 0 (if pa > 120 − K) or qa = 120 − pa − K. however. The inverse demand function from equation (9) is p = 120 − q. If. The consumers able to buy from the firm with the lower price are those who value the product most. who are willing to pay prices near 100. What happens in the Bertrand model. since their outputs are strategic substitutes. its quantity would fall to zero. is less straightforward. That is the demand curve in Figure 3(a). in order to set up the payoff functions for the game. What happens if we constrain each firm to sell no more than its capacity of Ka = Kb = 70? The industry capacity of 140 continues to exceed the demand of 108 at pa = pb = 12. it can still get customers. that firm would produce only up to its capacity and the other firm would produce more than the ordinary Cournot output.dramatically. so 90 consumers wish to buy from it though only K can do so. That means we need to know not only that 38 (108 minus 70) of the customers are turned away by Brydox. the demand curve was p(q) = 120 − q. Thus.

all consumers will want to buy from Apex if they buy at all. pa > 30. and the residual demand curve facing Apex will be as in equation (15). All of the (120 − pa ) customers who want to buy at that price will be satisfied if there are 70 or less. otherwise only 70. pb < 50 (c)        0 if pa > pb . 70}      120−pa   if pa = pb (b)  2 (16) qa =   M ax{(120 − pa − 70). then less than 70 customers will want to buy at all. Proportional rationing. 2/9 q(pb ) 463 . If Brydox’s price is the lowest but exceeds 50. 0} if pa > pb . Intensity rationing is appropriate if buyers with more intense demand make greater efforts to obtain low prices. 2/9 (= q(pb )−K ) of each type of consumer will be forced to buy from Apex (for example. if K = 70 the demand function for Apex (Brydox’s is analogous) is  if pa < pb (a)  M in{120 − pa . pb ≥ 50 (d) Equation (16a) is true because if Apex has the lower price. so Brydox will satisfy all of them and zero will be left for Apex – which is equation (16d). Equation (16b) simply says the two firms split the market equally if prices are equal. if K = 70 and 90 consumers wanted to buy from Brydox. Equation (16c) is true because if Brydox’s price is the lowest and is less than 50. the least intense buyers might end up at the low-price firm which is the case of the inverse-intensity rationing (or low-to-high rationing) in Figure 3b.Figure 3: Rationing Rules when pb = 30. Each consumer has the same probability of being able to buy from the low-price firm. The appropriate rationing rule depends on what is being modelled. If the intense buyers are wealthy people who are unwilling to wait in line. and K = 70 Under intensity rationing. under which every type of consumer is equally likely to be able to buy at the low price. Brydox will sell 70 units. Under proportional rationing. An intermediate rule is proportional rationing.

The payoff function for Apex (Brydox’s would be analogous) is.) Equilibrium prices must be lower than 120. and to the most intense 70 of buyers. There are three remaining possibilities (now that we have ruled out pa = pb = 12) for prices chosen in the open interval [12. That is the rule which makes deviation to high prices least attractive. Apex would be left with all the buyers between pa = 20 and pa = 12 on the demand curve for sales of qa = 30 and a payoff of 240 from equation (18c). since the low-price firm keeps the best customers for itself. Payoffs Marginal cost is constant at c = 12. we will know it would break down under the other rationing rules too. Q(p) = 120 − p. any profitable deviation is enough to refute the proposed equilibrium.  if pa < pb (a)  (pa − c) · M in{120 − pa . pb ≥ 50 (d) The capacity constraint has a very important effect: (pa = 12. Demand is a function of the total quantity sold. If Apex increased its price to pa = 20. even though the industry capacity of 140 is well over the market demand of 108 when price equals marginal cost. pa = 20 is not necessarily the most profitable deviation — but we do not need to check that. 120 − pb − K qa = (120 − pa ) (17) 120 − pb We thus have three choices for rationing rules. with no clear way to know which to use. So deviation by Apex is profitable. The residual demand curve facing Apex. 0} if pa > pb . pb < 50 (c)        0 if pa > pb . so if we find that the normal Bertrand equilibrium breaks down there. pb = 12) is no longer a Nash equilibrium in prices. 70}        (pa − c) 120−pa if pa = pb (b)  2 (18) πa =   (pa − c) · M ax{(120 − pa − 70). Let’s use intensity rationing. The Bertrand Game with Capacity Constraints Players Firms Apex and Brydox The Order of Play Apex and Brydox simultaneously choose prices pa and pb from the set [0.of the type willing to pay 120).120). because that price yields a zero payoff under any circumstance. intercepts the price axis at 120. ∞). 464 . shown in Figure 3c and equation (17). (Of course. Brydox would immediately sell qb = 70. but slopes down at a rate three times as fast as market demand because there are only 2/9 as many remaining consumers of each type. using equation (16) for qa . Apex’s profit would be zero in that strategy profile.

in which case q∗ = 120 − K − c . no equilibrium exists in pure strategies under intensity rationing. If πa = (pa − c)(50 − pa ). 2 (19) 465 . Without loss of generality. and similar arguments rule out pure-strategy equilibria under other forms of rationing. with each firm using its entire capacity. because equation (18c) tells us that Apex’s payoff will rise to either πa = (pa − c)(70) (if pb ≥ 50) or πa = (pa − c)(120 − pa ) (if pb < 50). If πa = 0. ¯ The upper bound p is that monopoly price because F (¯ and the firm choosing that price ¯ p certainly is the one with the highest price and so should maximize its profit using the residual demand curve.8. (ii) Unequal prices with one equal to 12 are not an equilibrium. Thus. p]. Apex could not profitably deviate. Apex would sell at most 54 units as its half of the market. In the symmetric equilibrium. If capacities are small enough— less than K = 36 in our example— the Edgeworth paradox also disappears. Apex could profitably deviate to just below pb and have a discontinuous jump in sales for an increase in profit. (iii) Finally. Expected profits are positive. This turns out to be p∗ = (120 − K + c)/2. which happens to be p = 36 in our example. unequal prices of (pa . and that is the case here too. suppose pa > pb > 12. pb ) with both greater than 12 are not an equilibrium. so since that payoff must equal the payoff of 336 (=(p-c)q= (36-12) (50-36)) from p. The mixing distribution F (p) could then be found ¯ by setting π(p) = 336 = F (p)(p − c)(50 − p) + (1 − F (p))(p − c)(70) and solving for F (p). it can gain by deviating to pa = pb − . Brydox would be fully capable of serving the entire market. because if Apex were to deviate to a positive price. There is no point in a firm reducing its price. The equilibrium is in pure strategies. p. is (p − c)(70) from equation (18c).(i) Equal prices with pa = pb > 12 are not an equilibrium. suppose pa > pb = 12. where p > c and p is the monopoly price for the residual demand curve (15). the ¯ ¯ firms mix using distribution F (p) with a support [p. A mixed-strategy equilibrium does exist. just as in the basic Bertrand game. it can gain by deviating to pa = pb − . we can conclude that (p = 16. 1922). leaving Apex with no consumers. but so does the Bertrand paradox. since it cannot sell any greater quantity. If capacities are large enough— above the capacity of K = Q(c) = 108 in this example— the Edgeworth paradox disappears. The payoff from playing the lower bound. Without loss of generality. Apex’s profits are shown in equation (18c). Nowadays we know that the resolution to many a paradox is mixed strategies. but Brydox could deviate to pb = pa − and make positive instead of zero profit. Even if the price is close to 12. so qa = qb = K and charging the same price. How about a deviation to increasing its price and reducing its quantity? Its best deviation is to the price which maximizes profit using the residual demand curve (120 − K − p). calculated using intensity rationing and linear demand by Levitan & Shubik (1972). This is known as the Edgeworth paradox after Edgeworth (1897. which is less than its capacity of 70. because the firms charge prices above marginal cost. The argument made above for why equal prices of c is not an equilibrium fails.

pa = pb = 120 − 2K. K< But if 14. with a constant density of consumers throughout. but. An easy way to think about this approach is to consider the location where a product is sold. they have different preferences over the two. In particular. a differentiated product’s characteristics are points in a space. If cars differ only in their mileage. Such a model is suspect because it is not based on primitive assumptions. Location models form a literature in themselves. Figure 4 shows what is common to both. the demand functions might not be generated by maximizing any possible utility function. The product “gasoline sold at the corner of Wilshire and Westwood. the amount spent on the commodity goes to infinity. 466 . the space is a two-dimensional plane. for example.120 − c . Location models construct demand functions like those in Chapter 3 from primitive assumptions. is impossible because as the price goes to zero. A demand curve with a constant elasticity less than one. For any lower capacities. Two firms are located at points xa and xb along a line running from zero to one. firms choose prices for given locations. they will be willing to switch from one gas station to the other. In the Hotelling Location Game.maximizing price is from using all the capacity. exceeds marginal cost. the space is a one-dimensional line. In location models. a model of price choice and a model of location choice. We will look at the first two models analyzed in the classic article of Hotelling (1929). if prices diverge enough. In the Hotelling Pricing Game.” Depending on where consumers live. (20) 3 then q ∗ > K in equation (19) and is infeasible— the profit. If acceleration is also important. firms simply dump their entire capacity onto the market and the price. the demand curves were restricted to prices below a certain level. and it would be good to be able to justify that restriction. The critical level from inequaity (20) is K = 36 in our example.” is different from “gasoline sold at the corner of Wilshire and Fourth. Also.3 Location Models In Chapter 3 we analyzed the Bertrand model with differentiated products using demand functions whose arguments were the prices of both firms. prices are fixed and the firms choose the locations.

so his problem is to minimize the sum of the price plus the linear transport cost. The Order of Play 1 The sellers simultaneously choose prices pa and pb . which is θ per unit distance travelled. (21)   pa (0) = 0         pa (1) = pa πa =          1 pa ( 2θ [(pb − pa ) + θ(xa + xb )]) if pa − pb > θ(xb − xa ) (Brydox captures entire market) if pb − pa > θ(xb − xa ) (Apex captures entire market) otherwise (the market is divided) 467 (a) (b) (22) (c) . θ|xb − x| + pb }. Each consumer always buys. 1]. located at xa and xb .1] with a density equal to one (think of each consumer as buying one unit). πbuyer at x = V − M in{θ|xa − x| + pa . where xa < xb .Figure 4: Location Models The Hotelling Pricing Game (Hotelling [1929]) Players Sellers Apex and Brydox. 2 Each buyer chooses a seller. and a continuum of buyers indexed by location x ∈ [0. Payoffs Demand is uniformly distributed on the interval [0. Production costs are zero.

Apex is most attractive of the two sellers to the consumer at x = 0 (“consumer 0”) and least attractive to the consumer at x = 1 (“consumer 1”). Very likely. inequalities (24) and (26) are both satisfied. which implies that pa − pb < θ(xb − xa ). so that pb − pa = θ(2x∗ − xa − xb ). Knowing this. The payoffs result from buyer behavior. the consumer’s payoff equation. that equation (29) is valid only if there really does exist a consumer who is indifferent – if such a consumer does not exist. (21). which yields payoff (22b) for Apex. then from (29). because beyond xb the consumers’ distances from both sellers increase at the same rate.Brydox has analogous payoffs. First. and 1 [(pb − pa ) + θ(xa + xb )]. and looks similar to the demand curves used in Section 3.6 for the Bertrand game with differentiated products. in which case Consumer 0 goes to Apex and Consumer 1 goes to Brydox. Consumer 0 will buy from Apex so long as V − (θxa + pa ) > V − (θxb + pb ). The demand facing Brydox equals (1 − x∗ ). which yields payoff (22a) for Apex. which implies that pb − pa < θ(xb − xa ). tells us that V − [θ(x∗ − xa ) + pa ] = V − [θ(xb − x∗ ) + pb ]. notice that if Apex attracts Consumer xb . Demand is 2 linear in the prices of both firms. A buyer’s utility depends on the price he pays and the distance he travels. Price aside. x∗ = (28) (29) (27) (26) (25) (24) (23) Remember. x∗ = xa +xb . defined as the consumer who is at the boundary between the two markets. which is just what we would expect. 468 . and the next task is to find the location of consumer x∗ . equation (29) will generates a number for x∗ . but that number is meaningless. Consumer 1 will buy from Brydox if V − [θ(1 − xa ) + pa ] < V − [θ(1 − xb ) + pb ]. he also attracts all x > xb . So we know that if there is an indifferent consumer he is between xa and xb . independent of θ. Note that if pb = pa . however. equation (29) is the demand function facing Apex so long as he does not set his price so far above Brydox’s that he loses even consumer 0. 2θ which generates demand curve (22c)– a differentiated Bertrand demand curve. This is the case represented by payoff (22c). indifferent between Apex and Brydox. Since Apex keeps all the consumers between 0 and x∗ .

91.75. We cannot rest satisfied with the neat equilibrium of equation (30). Equation (30) implies that Apex should choose a higher price if both xa and xb increase. Economists are used to models in which the calculus approach gives an answer that is both the local optimum and the global optimum.25. 469 . for reasons similar to why none exists in the Bertrand model with capacity constraints. as Dasgupta & Maskin [1986b] show). But if both firms charged that low price. no pure-strategy equilibrium exists (although a mixed-strategy equilibrium does. If there exists an equilibrium in which the firms are willing to pick prices to satisfy inequalities (24) and (26). however. but one might deviate to a much lower price that would capture every single consumer. 3 3 (30) From (30) one can see that Apex charges a higher price if a large xa gives it more safe consumers or a large xb makes the number of contestable consumers greater. because of the discontinuity in the objective function. For practice. This kind of odd result is a typical clue that the result has a logical flaw somewhere. And he should have thought about the comparative statics carefully. rather than suffering from more intense competition. he should suspect an error. say at 0. by setting up the profit functions for each firm. Gabszewicz & Thisse (1979) have shown that if xa and xb are close together. The simplest case is when xa = 0 and xb = 1. when (30) tells us that both firms charge a price equal to θ. no pure-strategy equilibrium exists.90 and 0. then it is pa = (4 − xa − xb )θ (2 + xa + xb )θ . differentiating with respect to the price of each. Hotelling did not notice this. Profits are positive and increasing in the transportation cost. neither would deviate to a slightly different price. In games like this one. If both firms charge nonrandom prices. and fell into a common mathematical trap. each would deviate by raising his price slightly. for example.Now that we have found the demand functions. the Nash equilibrium can be calculated in the same way as in Section 14. and solving the two first-order conditions for the two prices. and xb ≤ 0. Hotelling should have done some numerical examples. illustrated in Figure 5. Until the modeller can figure out an intuitive reason for his odd result. the local optimum is not global. It turns out that if.2. that Apex should be able to charge a higher price. because the assumption that there exists an equilibrium in which the firms choose prices so as to split the market on each side of some boundary consumer x∗ is often violated. xa ≥ 0. Apex and Brydox are located symmetrically around the center of the interval. let us try a few numerical examples. but it is odd that if the firms are locating closer together. Vickrey (1964) and D’Aspremont. pb = .

9 + 0. there is a pure strategy equilibrium and the equations generated sensible numbers given the parameters we chose.5.7)] = 0.45.5/3 = 0.5/3 ≈ 0.0 + 0. xb = 0.5/3 ≈ 0.9.55.9)0. The equations generate numbers that seem innocuous until one realizes that if both firms are located at 0.63 and pb = 0. Same location – but different prices? Try xa = 0. Everything works out simply Try xa = 0.63 and pb = (4.37. because 470 . then Brydox will capture the entire market! The result is nonsense.9)0.5 [(0.9 and θ = 0.45) + 0.55 − 0.37.7)0. but pa = 0.9.7 and θ = 0.45 and 1 pb = (4−0−0. Equation (29) says that x∗ = 2∗0. In Example 1. Then equation (30) says pa = (2. Example 2 shows something odd happening. Then equation (30) says pa = (2+0+0. But it is not enough to calculate just one numerical example.5/3 = 0.0 + 0.7)0.9 − 0.0 − 0.5. Example 2.Figure 5: Numerical Examples for Hotelling Pricing Example 1.5(0. xb = 0.

1(0.5(0.4 + 0. equation (29) will still spit out a value of x∗ . Locations too near each other. The problem in Examples 2 and 3 is that the firm with the higher price would do better to deviate with a discontinuous price cut.6 and pb = (4 − 0. Then equation (30) says that pa = (2.5/3 = 0.5 and would prefer Brydox. Equation (29) is based on the premise that there does exist some indifferent consumer. We will simplify the model by pushing consumers into the background and imposing a single exogenous price on all firms.9−0.0 + 0. put differently. Try xa = 0. then it had found the optimal strategy.4 − 0. 1]. The Order of Play The sellers simultaneously choose locations xi ∈ [0.0) = 0.6 is not really indifferent between Apex and Brydox. with the implicit assumption that a local profit maximum was also a global profit maximum.7 and xb = 0. that if no small change could raise a firm’s payoff.6 + 0. As for the split of 1 the market.6 + 0. Similarly. compared to a cost from Apex of 0.4+0.9)0. as under the parameters of Example 3.6.0) = 0.95. xb = 0. Example 3 shows a serious problem. the result violates our implicit assumption that the players split the market. the profit source or paradigm shift.9 − 0.7) = 0.5(0.7 + 0. at a total cost of 0. Example 3. Payoffs Consumers are distributed along the interval [0.65 or from Brydox.5(0.85.” The everyday manager or scientist as described by Schumpeter (1934) and Kuhn (1970) concentrates on analyzing incremental changes and only the entrepreneur or genius breaks through with a discontinuously new idea.equation (30)’s derivation relied on the assumption that xa < xb . would prefer Brydox.5/3 = 0.7 − 0.4.9)0. In fact the consumer at x = 0.9 and θ = 0.7.5) = 0. too.5) = 0. x∗ < xa < xb .7 − 0. If the market splits at x∗ = 0. and he. Equation (30) was derived by calculus. or. Let us now turn to the choice of location.5(0. and when that is a false premise. Even Apex’s ‘home’ consumer at x = 0.5.6) + 0. He could buy from Apex at a total cost of 0.6 but xa = 0. Perhaps this is what they mean in business by the importance of “nonlinear thinking” or “thinking out of the envelope.1] with a uniform density equal to one. There exists no consumer who strictly prefers Apex.3 (0. The Hotelling Location Game (Hotelling [1929]) Players n Sellers. which is false in this example.5 [(0. but the value will not mean anything.7 would have a total cost of buying from Brydox of 0.55.9. equation (29) says that x∗ = 2∗0. Sometimes a big change will increase a player’s payoff even though a small change would not.7 + 0. the consumer at x = 0 would have a total cost of buying from Brydox of 0.4 + 0. to just below the other firm’s price.9)] = 0. The 471 .

as shown in Figure 14. . x0 ≡ 0 and xn+1 ≡ 1. If price were a choice variable and demand were elastic. The sellers are ordered by their location so x1 ≤ x2 ≤ . When both firms do this. . πi = x2 − x1 . so that his payoff is π1 = x1 + πn = or. they end up splitting the market since both of them end up exactly at the center. we would expect the monopolist to locate at x = 0.5. With two sellers. 2 2 (33) Figure 6: Payoffs in the Hotelling Location Game With one seller.6. ≤ xn . . and production costs are zero. . n − 1.price equals one. for i = 2. as can be seen by inspecting Figure 4 and imagining best responses to each other’s location. the location does not matter in this model. Seller i attracts half the consumers from the gaps on each side of him. 472 . The best response is always to locate ε closer to the center of the interval than one’s rival. This is a stable Nash equilibrium. 2 xi − xi−1 xi+1 − xi + .5. both firms locate at x = 0. . regardless of whether or not demand is elastic. since the consumers are captive. 2 (31) (32) xn − xn−1 + 1 − xn .

The only equilibrium is in mixed strategies. But if a strategy profile has any two players at the same point a. 473 . as in Figure 7. because the two players nearest the ends would edge in to squeeze the middle player’s market share. one of the doubled-up players would deviate by jumping to his other side and capturing his entire market share. Such a strategy profile is not an equilibrium. Consider any strategy profile in which each player locates at a separate point. and if the third player’s share is that large.Figure 7: Nonexistence of pure strategies with three players With three sellers the model does not have a Nash equilibrium in pure strategies. the third player would be able to acquire a share of at least (0.5 − ) by moving next to them at b.

letting M denote the cumulative distribution. Player 1’s payoffs from these two pure strategies must be equal. If Player 1 chooses x = g then his expected payoff is h π1 (x1 = g) = g + g 2m(x)[1 − M (x)] x−g 2 dx. h]. and they are also equal to his payoff from a location of 0. and Player 3’s location is greater than that with probability 1 − M (x). and positive density on the support [g. We will need the density for the distribution of the minimum of the locations of Players 2 and 3. (35) where (1 − h) is the set of safe consumers to his right In a mixed strategy equilibrium.5.Figure 8: The Equilibrium Mixed-Strategy Density in the Three-Player Location Game Suppose all three players use the same mixing density. If Player 1 chooses x = h then his expected payoff is. so the density for Player 2 having location x and it being smaller is m(x)[1 − M (x)]. Player 2 has location x with density m(x). h π1 (x1 = h) = (1 − h) + g 2m(x)M (x) h−x 2 dx. with m(x) the probability density for location x. similarly. as depicted in Figure 8. and x−g is Player 1’s share of the consumers between 2 his own location of g and the next biggest location. The density for either Player 2 or Player 3 choosing x and it being smaller than the other firm’s location is then 2m(x)[1 − M (x)]. 2m(x)[1 − M (x)] is the density for x being the next biggest location of a firm. which we can plausibly 474 . (34) where g is the safe set of consumers to his left.

Figure 9: The Equilibrium Mixing Density for Location Strangely enough. A benevolent social planner or a monopolist who could charge higher prices if he located his outlets closer to more consumers would choose different locations than competing firms. the locations that would be chosen either by the social planner or the monopolist. the average distance of a consumer from a seller would be minimized by setting x1 = 0. exists for any number of players n in a space of any dimension m. an equilibrium in pure strategies does exist if the consumers are uniformly distributed. but this is a delicate result (Eaton & Lipsey [1975]). This method has only shown what the symmetric equilibrium is like. Since prices are inflexible. In particular. when two competing firms both locate in the center of the line. the algebra and calculus start to become fierce. Dasgupta & Maskin (1986b).75. 475 .  3  2 if 1 ≤ x ≤ 4 4 m(x) = (36)  0 otherwise You can check this equilibrium by seeing that with the mixing density (36) (depicted in Figure 9) the payoffs in equation (34) and (35) do equal each other. Going on from this point. As shown in Figure 10. three is a special number. as amended by Simon (1987). consumers are no better off than if there were just one firm. With more than three sellers. however. have also shown that an equilibrium. it turns out that asymmetric equilibria also exist (Osborne & Pitchik [1986]). Shaked (1982) has computed the symmetric mixing probability density m(x) to be as shown in Figure 9.25 and x2 = 0. the competitive market does not achieve efficiency. possibly in mixed strategies.guess is in the support of his mixing distribution.

Figure 10: Equilibrium versus Efficiency The Hotelling Location Model. (37) 476 . because when a parameter changes. When wages rise. Game theory presents special problems for comparative statics. The Hotelling Location Model predicts that the two candidates will both choose the same position. we wish to know how the price of steel will change in response. for example. and voters will vote for the candidate closest to their own position. This seems descriptively realistic. right on top of the median voter. Often there is just one dimension of importance in political races. 14. Suppose there are N firms. it accords with the common complaint that all politicians are pretty much the same. not only does Smith’s equilibrium strategy change in response. and for firm j the demand curve is Qj = M ax{α − βj pj + i=j γi pi . A small change in the parameter might produce a large change in the equilibrium because of feedback between the different players’ strategies.4 Comparative Statics and Supermodular Games Comparative statics is the analysis of what happens to endogenous variables in a model when the exogenous variables change. is very well suited to politics. 0}. however. but Jones’s strategy changes as a result of Smith’s change as well. so there is no analog to price. This is a central part of economics. Let us use a differentiated Bertrand game as an example.

the immediate effect is to change firm j’s price. 2} and ci ∈ (0. Moreover.and second-order conditions are valid. dz The implicit function theorem is especially useful if y is a choice variable and z a parameter. βi ∈ (0. where κ ∈ {1. We start with f (y. ∞). and γi ∈ (0.) The payoff function for firm j is πj = (pj − κcj )(α − βj pj + i=j γi pi ). z) = 0. then ∂f dy ∂z = − ∂f . Using the calculus chain rule. (The shift variable κ could represent the effect of the political regime on costs. It is not even clear whether the equilibrium is unique. since y is endogenous. Solving for dy yields equation (40). and let us assume that each firm’s costs are low enough that it does operate in equilibrium. z) ≡ ∂π = 0 and ∂y the second-order condition tells us that ∂f = ∂ π ≤ 0. z) = 0. so the first. .with α ∈ (0. so that βj > i=j γi . One only has to make certain that ∂y ∂y 2 the solution is an interior solution. which could make algebraic solutions of the Nash equilibrium quite messy. because then we can use the first-order condition to set f (y. and 477 2 . z)) = 0. (41) where the expression equals zero because after a small change in z. Two approaches to comparative statics can be used here: the implicit function theorem. (40) dz ∂y It is worth knowing how to derive this. . ∞). f will still equal zero after y adjusts. df ∂f = + dz ∂z ∂f ∂y dy dz = 0. We will look at each in turn. which can be rewritten as f (y(z). where y is endogenous and z is exogenous. this is not a symmetric game – the costs and demand curves differ from firm to firm. but the other firms will react to the price change. The Implicit Function Theorem The implicit-function theorem says that if f (y. which in turn will affect j’s price. and supermodularity. Does this game have an equilibrium? Does it have several equilibria? What happens to the equilibrium price if a parameter such as cj or κ changes? These are difficult questions because if cj increases. (38) Let firm i have constant marginal cost κci . . Assume that the effect of pj on firm j’s sales is larger than the effect of the other firms’ prices. ∞). (39) Firms choose prices simultaneously. ∞) for i = 1. . N .

and by letting ∂pj = 0 from equation (44) be our f (y1 . Now. p) for some large number p. ∂ 2 πj = −2βj < 0. z) = 0. z1 . not a global one. using the calculus chain rule yields not equation (41) but ∂f df = + dz1 ∂z1 Solving for dy1 dz1 ∂f ∂y1 dy1 dz1 + ∂f ∂y2 dy2 dz1 = 0. z2 ) = 0. . z2 ) = 0. z1 . We do have a complication if the model is strategic: there will be more than one endogenous variable. Suppose that instead of simply f (y. ∂p2 j (45) Next. i = 1. y2 . interior solutions. z2 ) = 0. the maximizing choice might “jump” up or down when an exogenous variable changes. y2 . z1 . 2. . N. . . therefore. because a price of cj would yield zero profits. Equilibrium prices will lie inside the interval (cj . (42) yields  dy1 = − dz1 ∂f ∂z1 + ∂f ∂y2 ∂f ∂y1 dy2 dz1  . in which case they satisfy the first-order condition ∂πj γi pi + κcj βj = 0. This second condition yields an equation similar to (43). i = 1. (44) = α − 2βj pj + ∂pj i=j and the second-order condition. because more than one player is choosing variable values. (46) γi dpi dcj + κβj . (43) 1 It is often unsatisfactory to solve out for dy1 as a function of both the exogenous varidz ables z1 and z2 and the endogenous variable y2 (though it is okay if all you want is to discover whether the change is positive or negative). our implicit equation has two endogenous and two exogenous variables. The equilibrium or equilibria are. The extra z2 is no problem. But the y2 does add some complexity to the mix. but ordinarily the modeller will also have available an optimality condition for Player 2 also: g(y1 . The chain rule yields df = −2βj dcj so dpj = dcj i=j dpj dcj + i=j γi dpi dcj + κβj = 0. and p can be chosen to yield zero quantity demanded and hence zero profits.keep in mind that if the solution is only a local maximum. We can use the differentiated Bertrand game to see how this works out. y2 . so that two equations can be solved for the two unknowns. rather than the positive profits of a slightly higher price. (47) 2βj 478 . apply the implicit function theorem by using pi and ci . instead of ∂πj yi and zi . so f (y1 . in comparative statics we are holding all but one exogenous variable constant.

knowing that the second-order condition holds allows the modeller to avoid having to determine the sign of the denominator if all that interests him is the sign of the relationship between the two variables. This is a simple example. Equations (47) and (49) are then dpi γi dcj + κβj dpj = . If cn increases enough. because firm n goes out of business. Even if cn increases a finite amount. We cannot go on to discover the effect of changing κ on pn . dg i dpi dpk = −2βi + = 0. The implicit function theorem is none the less very useful when it does apply. not a change in ci ). (50) dcj 2βj and −2βi Solving these two equations for dpi dcj dpj dcj + γj dpi dcj dpj dcj yields = 0. k=i (48) The chain rule yields (keeping in mind that it is a change in cj that interests us. which will in turn change pn again. then the nature of the equilibrium changes drastically. . i = 1. because κ is a discrete variable. The first. the implicit function theorem is not applicable. (51) and dpj 2βi βj κ = dcj 4βi βj − γi γj and γj βj κ dpi = . Supermodularity 479 . because then the change in pn will cause changes in the prices of other firms. dcj 4βi βj − γi γj (52) (53) Keep in mind that the implicit function theorem only tells about infinitesimal changes.order condition for Player i is that the derivative of πi with respect to pi (not pj ) equals zero. but the approach can be used even when the functions involved are very complicated. In complicated cases. . N . and the implicit function theorem only applies to continuous variables. not finite changes. the (N − 1) equations (49) give us N equations for the N unknowns dpi . dcj It is easier to see what is going on if there are just two firms.dpi Just what is dcj ? For each i. so gi ≡ ∂πi = α − 2βi pi + ∂pi γk pk + κci βi = 0. . j and i. . we need to find the first-order condition for firm i and then use the chain rule again. (49) γk dcj dcj dcj k=i With equation (47).

. and all s and t such that 1 ≤ s ≤ si and 1 ≤ t ≤ sj . of the general definition of supermodular games in the Mathematical Appendix. (57) i ∂ys ∂z The heart of supermodularity is in assumptions A3 and A4 . Suppose that there are N players in a game. we will be able to talk about the comparative statics of smooth supermodular games if a fifth condition is satisfied. increasing differences in parameters. . Let his strategy set be S i and his payoff function be π i (y i .6). subscripted by i and j. and all s such that 1 ≤ s ≤ si . . player j will want to do so also. where z represents a fixed parameter. 480 . and all s and t such that 1 ≤ s < t ≤ si . ∂ 2πi ≥ 0. when one component increases.The second approach uses the idea of the supermodular game. . ysi ). A5 : (Increasing differences in parameters) Increasing parameter z does not decrease the net marginal benefit to player i of any component of his own strategy: for all i. N : A1 The strategy set is an interval in Rs : S i = [y i . y i ]. and that player i has a strategy consisting of si elements. an idea related to that of strategic complements (Chapter 3. for smooth games. subscripted i i by s and t. A3 (Supermodularity) Increasing one component of player i’s strategy does not decrease the net marginal benefit of any other component: for all i. . so his strategy is the vector y i = (y1 . Assumption A4 says that the strategies of players i and j are strategic complements. it is worth increasing the other components too. . i ∂ys ∂yt (56) (54) i In addition. ∂ 2πi j ≥ 0. the feedback between them is less tangled than if they undermined each other. one can still arrive at qualitative results about the strategy. . ∂ 2πi ≥ 0. Assumption A3 says that the components of player i’s strategies are all complementary inputs. when player i increases a component of his strategy. When the strategies of the players reinforce each other in this way. We say that the game is a smooth supermodular game if the following four conditions are satisfied for every player i = 1. (55) i i ∂ys ∂yt A4 (Increasing differences in strategies) Increasing one component of j’s strategy does not decrease the net marginal benefit of increasing any component of player i’s strategy: for all j = i. y −i . This means that even if a strategy is a complicated one. z). because all the components of the optimal strategy will move in the same direction together. I have put primes on the assumptions because they are the special cases. A2 π i is twice continuously differentiable on S i .

For more on supermodularity. however. but the supermodularity theorems apply more generally. One condition that is relevant here is condition A5: A5: (Increasing differences in parameters) π i has increasing differences in y i and z for fixed y −i . It yields weaker comparative statics on ci . p] for player i. the discrete exogenous variable. There exists a largest and a smallest Nash equilibrium in pure strategies (Theorem 1). y −i . A player’s strategy has just one component. the difference π i (y i . see Milgrom & Roberts (1990). p−i . a number of theorems can be applied. p−i . Thus. From equation (44). p]. and A5 is satisfied for κ. pi . Theorem 1. πi is twice continuously differentiable on the interval[ci . 2. 489-497). then the largest and smallest equilibrium are nondecreasing functions of the parameter z. ∂pi ∂pj so A4 is satisfied. ∂ 2 πi = γj > 0. The largest and smallest equilibrium prices for firm i are nondecreasing functions of the cost parameters ci and κ (Theorem 2). all the assumptions are satisfied. Is the differentiated Bertrand game supermodular? The strategy set can be restricted to [ci . including the following two. pp.Smooth games use differentiable functions. κ) is nondecreas∂p ing in κ for pi > pi . rather than telling us its i value or whether it is actually increasing. unlike the implicit function theorem. Supermodularity. κ) − πi (pi . Theorem 2. (59) (58) 481 . so A3 is immediately satisfied. has yielded comparative statics on κ. z) is nondecreasing with respect to z. y −i . because it just finds the effect of ci on p∗ to be nondecreasing. Applying Theorems 1 and 2 yields the following results for the differentiated Bertrand game: 1. so A2 is satisfied. or Vives’s 2005 survey. ∂πii is increasing in κ. z) − π i (y i . Fudenberg & Tirole (1991. so A1 is satisfied. for all y i ≥ y i . This being the case. If the game is supermodular. so πi (pi . If the game is supermodular and assumption (A5) or (A5 ) is satisfied. there exists a largest and a smallest Nash equilibrium in pure strategies. ∂pi ∂ci so A5 is satisfied for ci . And it is also true that ∂ 2 πi = κβi > 0. The following inequality is true.

5(20 − 1) = 19. 2 The seller picks price p from the interval [0. as analyzed in Shaked & Sutton (1983) and around pages 150 and 296 of Tirole (1988). or 20. 1 The seller picks quality s to be either sL = 0 or sH = 1.5 Vertical Differentiation In previous sections of this chapter we have been looking at product differentiaton. 3 Each buyer chooses one unit of a good. (61) (60) The seller should clearly set the quality to be high. which does not vary with quality. The seller produces at constant marginal cost c = 1. Half of them are “weak” buyers (θ = 0) who value high quality at 20 and low quality at 10. Vertical Differentiation II: Crimping the Product 482 . and πbuyer = (10 + 5θ) + (10 + 25θ)s − p.since then he can charge more to the buyer (though note that this runs contrary to a common misimpression that a monopoly will result in lower quality than a competitive market. Next we will allow the seller to use two quality levels. The monopoly seller might use two. but we will compare a monopoly to a duopoly under various circumstances. location along a line is a matter of taste and “de gustibus non est disputandum”. Payoffs πseller = (p − 1)q. ∞).5(50 − 1) = 24. Vertical Differentiation I: Monopoly Quality Choice Players A seller and a continuum of buyers. Separation (by inducing only the strong buyer to buy) is better for the seller than pooling. but differentiation in dimensions that cannot be called “good” versus “bad”. Another form of product differentiation is from better to worse. because it helps him to price-discriminate.5(20 − 1) + 0. Since π(50) = 0. we will look at that in a simpler game in which there are just two types of buyers and two levels of quality. or refrains from buying. Half of them are “strong” buyers (θ = 1) who value high quality at 50 and low quality at 15.5 and π(20) = 0. Here. The Order of Play 0 Nature assigns quality values to a continuum of buyers of length 1. Rather. the seller should choose p = 50. A social planner would just use one– the maximal one of s = s∗ — since it is no cheaper to produce lower quality.*14. the most the weak buyers would pay. however.) The price should be either 50. which is the most the strong buyers would pay.

Half of them are “weak” buyers (θ = 0) who value high quality at 20 and low quality at 10. We already solved the one-quality problem in Vertical Differentiation I. and he also needs to decide if that is more profitable than offering just one quality. The self-selection constraint for the strong buyers will also be binding. but it is nonetheless a fascinating special case. (65) This exceeds the one-quality profit of 24. in which the seller finds that profits are maximized with just one quality. so pL = 10. 3 Each buyer chooses one unit of a good.5. Half of them are “strong” buyers (θ = 1) who value high quality at 50 and low quality at 15. The outcome of allowing price discrimination is a pareto improvement.Players A seller and a continuum of buyers. so it is optimal for the seller to sell two qualities. which would give them a positive payoff. The seller is better off. the monopolist will have to give the strong buyers a positive payoff. because 483 . and p2 to satisfy incentive compatibility and participation constraints if he wants to offer two qualities with positive sales of both.quality. low. ∞). This result. The price for high quality must be at least 35 higher than the price for low quality to induce separation of the buyer types. as we have found so many times before for the “good” type. The seller needs to pick p1 . The seller produces at constant marginal cost c = 1.5) = 26. 2 The seller picks prices pL and pH from the interval [0. this results in pH = 45. Payoffs πseller = (pL − 1)qL + (pH − 1)qH . is. In equilibrium. which does not vary with quality. Profits will now be: πseller = (10 − 1)(0. The Order of Play 0 Nature assigns quality values to a continuum of buyers of length 1. would switch to the low-quality good. Following the usual pattern. The monopolist cannot simply add a second. low-price good for the weak buyers. so πstrong (L) = 15 − pL = 50 − pH . or refrains from buying. of course.5) + (44 − 1)(0. the participation constraint for the weak buyers will be binding. dependent on the parameters chosen. yielding profit of 24.5. (64) Since pL = 10. and one which is perhaps no more special than the other special case. and πbuyer = (10 + 5θ) + (10 + 25θ)s − p. because the strong buyers. (63) (62) This is a problem of mechanism design. Their participation constraint will be non-binding. who derive zero payoff from the high-quality good. 1 The seller decides to sell both qualities sL = 0 and sH = 1 or just one of them.

We will analyze one more version of the product differentiation game: with two sellers instead of one. because the price they pay has fallen from 50 to 45. the seller would still price.5) = 25. 265). The strong buyers are better off. And the weak buyers are no worse off. can result in a pareto improvement! This is the point made in Deneckere & McAfee (1996).discriminate. but IBM’s 1990 Laserprinter E is an example of a damaged product with extra marginal cost.g. See too McAfee (2002. Suppose the cost for the low-quality good was actually higher than for the high-quality good. pL = 3 and pH = 1. which tells us. a 60-minute and a 74-minute version.profit has risen from 24. but Sony added code to the 60-minute disc to make 14 minutes of it unusable. we can go further. 3 Each buyer chooses one unit of a good. Payoffs πseller = (p − 1)q 484 (66) . The sellers produce at constant marginal cost c = 1.5. sH = 1}. This will show how the product differentiation which increases profits in the way we have seen in the Hotelling games can occur vertically as well as horizontally. Half of them are “strong” buyers (θ = 1) who value high quality at 50 and low quality at 15. Since that is still higher than 24. The Laserprinter E was a version of the original Laserprinter that was only half as fast. 1 Sellers 1 and 2 simultaneously choose values for s1 and s2 from the set {sL = 0. The Order of Play 0 Nature assigns quality values to a continuum of buyers of length 1. because the good is normally produced as high quality and needs to be purposely damaged before it becomes low quality. for example. Half of them are “weak” buyers (θ = 0) who value high quality at 20 and low quality at 10. 2 Sellers 1 and 2 simultaneously choose prices p1 and p2 from the interval [0. e.5 to 26. allowing the seller to damage some of the good at a cost in real resources of 2 per unit. p. which illustrates the theory with real-world examples of computer chips and printers purposely damaged to allow price discrimination. The reason? IBM added five extra chips to the Laserprinter E to slow it down. The price-discrimination profit in (65) would then be πseller = (10−3)(0. Production of both starts with a capacity of 74 minutes.5)+(44−1)(0. Indeed. in Vertical Differentiation I their payoffs are zero because they buy at a price exactly equal to their value for the good. or refrains from buying. converting it from high to low quality. Thus. which does not vary with quality. The buyers’ payoffs would be unaffected. That code is an extra fixed cost. Vertical Differentiation III: Duopoly Quality Choice Players Two sellers and a continuum of buyers. that Sony made two sizes of minidisc in 2002.. In Vertical Differentiation I their payoff was zero because they chose not to buy. ∞). They may both choose the same value.

and so is worse than pL = 10. 45] using the cumulative distribution G(pH ) = 2 − 9 pH − 36 (69) Weak buyers from the low-quality seller if 10 − pL ≥ 20 − pH .5 and 10. will no longer be equilibrium prices. The Asymmetric Equilibrium: Pure Strategies for Quality.and πbuyer = (10 + 5θ) + (10 + 25θ)s − p. doubling his sales for a small reduction in price. but with some probability he mixes between 5. (67) If both sellers both choose the same quality level. and a symmetric mixed-strategy equilibrium. (High. as shown below. 10] using the cumulative distribution F (pL ) = 1 − with an atom of probability 39. pH = 45). Strong buyers buy from the low-quality seller if 15 − pL > 50 − pH . and otherwise from the high-quality seller.5 44 39. Mixed for Price The low-quality seller picks pL on the support [5. there are three possible equilibria in the quality stage of the game: (Low. even though pH = 45 is the high. which is always true in equilibrium. pH = 45) is not an equilibrium. PL > 10 will attract no buyers. The high-quality seller picks pH on the support [40. profits will be positive. (pL = 10. (1) The equilibrium prices of Vertical Differentiation II. The problem is that the low-quality seller would deviate to pL = 9. (2) Indeed. their profits will be zero. in which case the low-quality seller can increase his profits by slightly reducing pL and doubling his sales. there is no pure-strategy equilibrium in prices. so that cannot be part of an equilibrium. something not uncommon in pricing games.quality seller usually chooses pL = 10.quality seller the weak buyers are “safe” customers. We have seen that (pL = 10. Thus. Suppose PL ∈ (1.5. Low). for whom the monopoly price is 10. an equilibrium does exist. which has positive probability.quality seller’s best response to pL = 10. 10). so it must be in mixed strategies. The intuition for why this happens is that for the low. The only price left for the low-quality seller that does not generate negative profits is pL = 1.5. This equilibrium is noteworthy because it includes a probability atom in the mixedstrategy distribution. but if they choose different quality levels. Let us consider the pure-strategy equilibria first.5 pL + 34 (68) at pL = 10. The low. The response of the high-quality seller will be to set pH = pL + 35. (3) As always. High). So no choice of pL is part of a pure-strategy equilibrium. and without loss of generality suppose that Seller 1 is the low-quality seller and Seller 2 is the highquality seller. but that yields zero profits. but unless the low-quality seller chooses 485 .

5(10 − 1) = 4. (76) 9 aH − 36 = 0.5 0.5 for any price.5([pH − 35] − 1) =2− 9 pH − 36 . not (35 + pL ).5(pL − 1) + 0. The low-quality seller’s profit from pL = 10 is πL (p = 10) = 0.5(pL − 1) + 0. (75) .5(pL − 1)P rob(pH > 35 + pL ) = 0.5 0. so G(aH ) = 2 − which yields aH = 40. in which case πL (aL ) = 0. the low-quality seller mixes on [5. the highquality seller will maintain such a high price (pH = 45) as to make such shading irresistable.5(pL − 1)P rob(15 − pL > 50 − pH ) = 0.5.5. Thus. the lower bound of the support of his mixing distribution (denote it by aL ) must also yield a profit of 4. the low-quality seller’s profit must equal 4.5(pL − 1) 4. what we have just done is to find the strategy for the highquality seller that makes the low-quality seller indifferent among all the values of pL in his mixing support.to shade the price with some probability to try to attract the strong customers.5(pL − 1)[1 − G(35 + pL )] Thus. and G(bH ) = 2 − 9 (0) · bH − 36 486 = 1. Thus. (74) As explained in Chapter 3. let us conjecture that the low-quality seller will not include any prices above 10 in his mixing support but will include pL = 10 itself. πL (pL ) = 4.5(aL − 1) = 4.5. so let’s G(pH ) = 2 − 4.5(aL − 1) + 0. On that mixing support. (72) (71) (70) (73) We want a G function with the argument pH .5(pL − 1) . and aL = 5. There is no point in charging a price less than the price which would capture even the strong consumers with probability one.5.5.5 −1 0.5 = 0. the G(pH ) function is such that 1 − G(35 + pL ) = and G(35 + pL ) = 2 − 4. Thus. 10]. We can find the support of the high-quality seller’s mixing distribution by finding values aH and bH such that G(aH ) = 0 and G(bH ) = 1. To start deriving this equilibrium.5(pL − 1) + 0. That is plausible because he would lose all the low-quality buyers at prices above 10.5. but pL = 10 yields maximal profits whenever pH is low enough that only weak consumers buy low quality.

5. if the high-quality seller had probability one of losing the strong buyers to the low-quality seller.75 = 0. then probably the equilibrium is not in mixed strategies (algebra mistakes being another possibility). Thus. it must be that at ph = 45 there is strictly positive probability that pL = 10— not just a positive density. At pH = 40.5 5. the profit 44 44 from pH = 45 is the same as from pH = 40. F (pL ).5(pH − 1)[1 − F (pH − 35)] so F (pH − 35) = 1 − 19. At ph = 45.5. the high-quality seller has zero probability of losing the strong buyers to the low-quality seller.5. 45].5 . and F (10) = 1 − 39.5(pL +35−1) =1− 39.75.5 − 1) = 19. putting pL instead of (pH − 35) as the argument for F . 44 (81) Equation (81) shows that at the upper bound of the low-quality seller’s mixing support the cumulative mixing distribution does not equal 1.which yields bH = 45. soaking up all the remaining probability beyond what equation (81) yields for the prices below 10. Thus.5(40.9.5) = 1 − 39. If pL = 10 has probability 39.75.5.5. an oddity we usually do not see in mixing distributions. Thus the support of the high-quality seller’s mixing distribution is [40. 44 Happily. (78) (77) Using the same substitution trick as in equation (74). his his profit would be zero.5 ≈ 0. using our finding that the profit of the high-quality seller must be 19. Then. so his profit is 0. Now let us find the low-quality seller’s mixing distribution. What it implies is that there is an atom of probability at pL = 10. and the seller is willing to mix between them.75 from any price in the mixing support. Now comes the tricky step.5 )(45 − 1) = 19.75 0. So let us continue. πH (pH ) = 19. (80) 19.5(pH − 1)P rob(15 − pL < 50 − pH ) = 0. we get F (pL ) = 1 − In particular.5 + 34 = 0. the profit from pH = 45 is 0. this solves our paradox of zero high-quality seller profit at pH = 45.5 10 + 34 =1− 39. The lesson here is that if your attempt to calculate the support of a mixing distribution results 487 .5( 39. and he would strictly prefer pH = 40. One of the technical lessons of Chapter 3 was that if your attempt to calculate mixing probability results in probabilities of less than zero or more than one.5 pL +34 (79) confirming our earlier finding that the minimum pL used is 5. The atom must equal 39.5(pH − 1) .5(pH − 1)P rob(pH − 35 < pL ) = 0. note that F (5.5 < 1.75 0.

they next both choose a price equal to 1.5(10-1) = 4. What if Seller 1 chooses both quality and price first. the two firms are in undifferentiated price competition and will choose prices equal to marginal cost. If Seller 1 chooses 488 . the expected payoffs from each quality must be equal in equilibrium.5 for the low-quality firm and 19.5/24.5 earned by the nondiscriminating monopolist of Vertical Differentiation I or the 26 earned by the discriminating monopolist of Vertical Differentiation II. even if a player is stuck in the role of low-quality seller in the purestrategy equilibrium. (82) Solving equation (82) yields α = 4. Or. with payoffs of zero. they would arrange for a pure-strategy equilibrium. perhaps they could change the rules of the game so that they would choose qualities sequentially. with expected payoffs of 4. in which case each player’s payoff is about 3. a total of 24.17.75 for the high-quality firm.75. would have a payoff of 4. If they choose the same quality. hwoever. We can conclude that if the players could somehow arrange what equilibrium would be played out.in impossible bounds. As for choice of product quality. so there must be a higher probability of both choosing high-quality: π(Low) = α(0) + (1 − α)4. The duopoly sellers’ profits are 4. if they choose the same qualities. Suppose one seller gets to choose quality first. that is better than the expected payoff he would get in the “fairer” symmetric equilibrium. they are in the same situation as they would be in the asymmetric equilibrium. since the second player will choose high quality and a price low enough to attract the strong buyers— pH = 45. This is the same phenomenon as the pareto superiority of a sequential version of the Battle of the Sexes over the symmetric mixed-strategy equilibrium of the simultaneous-move game. This equilibrium is easier to explain. with an expected payoff of 4.5.5.25 ≈ 0. and Seller 2 responds with quality and price? If Seller 1 chooses low quality. better than the expected payoff in the symmetric mixed-strategy equilibrium of the simultaneous quality-choice game. then his optimal price is pL = 10.5 = π(High) = α(19.5/24. in equilibrium— so Seller 1’s payoff would be 0. for a payoff of 19.75. then you should consider the possibility that the distribution has atoms of probability. If they choose different qualities. If they choose different qualities. perhaps by use of cheap talk and some random focal point variable.25 for the industry.75) + (1 − α)(0). marginal cost. they choose prices according to the mixing distributions in the asymmetric equilibrium. This is less than either the 24. choosing low-quality. The second-mover.75 (for high quality) in the asymmetric equilibrium of Vertical Differentiation III.25 and high quality otherwise. But what about the mixed-strategy equilibrium for Vertical Differentiation III? The Symmetric Equilibrium: Mixed Strategies for Both Quality and Price Each player chooses low quality with probability α = 4. Working back from the end. He would of course choose high quality.5 (for low-quality) and 19.5. Thus.

though. then his optimal price is pH = 40. using the implicit assumption that supply and demand in one period is unaffected by events of future periods. These present a curious problem. given the cost of higher quality.high quality. Usually high quality is more expensive. Seller 2 would give up on attracting the strong buyers and pick pL = 10. so firms will try to differentiate in any way that they can. If. but it can also benefit consumers— though more obviously in the case of horizontal differentiation than in vertical. When a monopolist sells something like a refrigerator to a consumer. Houses are counted as part of national investment (and an estimate of their service flow as part of services consumption). resulting in the same payoffs as in the asymmetric equilibrium of the simultaneous-move game. however.5. the x-axis is labelled “widgets.” Also.5 while Seller 2 will choose low quality and pL = 10.5. Here. but the right to live in it for many years to come. or even to live in it for a few years and then sell the remaining years to someone else. Thus. since the second player will choose low quality and would choose a price high enough to lure away the strong buyers if pH < 40. “durable monopoly” refers not to monopolies that last a long time. *14. When a diagram shows the supply and demand for widgets. The continuing utility he receives from this durable good is called its service flow. though no longer in mixed strategies. but all are to some extent durable investments. he will choose high quality and pH = 40. Since even a shirt produces a service flow over more than an instant of time. Keep in mind. that consumer drops out 489 . automobiles as durable goods consumption. he is buying not just the right to live in the house tomorrow. One problem with this on the demand side is that the purchase of a good which lasts for more than one use is an investment. it is better that a monopolist provide two qualities than one. If Smith buys a house. which means that having more than one quality level can be efficient. the utility from the good continues into the future. and shirts as nondurable goods consumption. but to monopolies that sell durable goods. it is an investment decision for him because it trades off present expenditure for future utility. In microeconomic theory. Often poor people prefer lower quality. Even though he may not intend to rent out the house.5. that in our games here we have assumed that high quality costs no more than low quality. pH = 40. and even a social planner would provide a variety of quality levels. the diagram splits off one time period from future time periods. Head-to-head competition reduces profits.6 Durable Monopoly Introductory economics courses are vague on the issue of the time period over which transactions take place. if Seller 1 chooses both quality and price first. and a duopoly is still better for consumers. the durability of goods presents difficult definitional problems for national income accounts. although the price is paid now. This increases their profits.” not “widgets per week” or “widgets per year. What Product Differentiation III shows us is that product differentiation can take place in oligopoly vertically as well as horizontally. we see that even when only high quality would be provided in the first-best.

Payoffs Production cost is zero and there is no discounting. therefore. and the buyer’s payoff is the sum across periods of his benefits from consumption minus his expenditure. The durable monopolist has a special problem because in a sense he does have a competitor – himself in the later periods. the moves are ordered so that he has no market power. The demand curve is. regardless of other aspects of product quality. The seller’s payoff is his revenue.of the market until the refrigerator wears out. To formalize this situation. The buyer of a less durable product will return to the market sooner than the buyer of a more durable one. 3 The seller picks the second-period price. Will a monopolist produce a shoddier. less durable product? Durability is different from the vertical differentiation we have already analyzed because durability has temporal implications. which means that the modeller should not make his decisions in one period and ignore future periods. Because this one buyer is meant to represent the entire market demand. instead of “the buyer” buying q1 in the first period. Demand is not time separable. If he were to set a high price in the first period. The Order of Play 1 The seller picks the first-period price. q1 of the buyers each buy one unit in the first period. the high-demand buyers would not buy at a high price in the first period. This presents another aspect of product differentiation: the durability of a good. as in the principal-agent models in Chapter 7 and onwards. He must set a price for each period. 2 The buyer buys quantity q1 and consumes service flow q1 . as shown in Figure 10. the buyer can be viewed as representing a continuum of consumers (see Coase [1972] and Bulow [1982]). But if it were expected that he would lower the price. The buyer’s benefits arise from his being willing to pay as much as qt (83) B(qt ) = 60 − 2 for the marginal unit service flow consumed in period t. let the seller have a monopoly on a durable good which lasts two periods. The threat of the future low price forces the monopolist to keep his current price low. and the buyer must decide what quantity to buy in each period. thereby removing high-demand buyers from the market. p1 . 4 The buyer buys additional quantity q2 and consumes service flow (q1 + q2 ). The payoffs are therefore πseller = q1 p1 + q2 p2 (84) 490 . p2 . he would be tempted to set a lower price in the next period to take advantage of the remaining consumers. Alternatively. changing over time as a result of the monopolist’s choice of price. because a rise in price at time t1 affects the quantity demanded at time t2 . Durable Monopoly Players A buyer and a seller. In this interpretation.

expected future prices. which relates the price to the quantity demanded. the two curves are different. as shown in Figure 10. unless by some strange accident. πbuyer = [consumer surplus1 ] + [consumer surplus2 ] = [total benef it1 − expenditure1 ] + [total benef it2 − expenditure2 ] = + (60−B(q1 ))q1 2 + B(q1 )q1 − p1 q1 (q1 + q2 ) + B(q1 + q2 )(q1 + q2 ) − p2 q2 (85) 60−B(q1 +q2 ) 2 Thinking about durable monopoly is hard because we are used to one-period models in which the demand curve. since a consumer’s total benefit is the sum of a triangle plus a rectangle of benefit. This is composed of the two areas shown in Figure 11a. p1 q1 . The marginal benefit curve is the same each period. since it is part of the rules of the game. since the expenditure in period 1 will also yield utility in period 2 because the good is durable. quantity demanded is his strategy. to obtain what we might call his consumer surplus in the first period. Here. the upper triangle of area 1 (q1 + q2 ) (60 − B(q1 + q2 )) 2 and the lower rectangle of area (q1 + q2 )B(q1 + q2 ).and. relating consumption to utility. Marginal benefit is a given for the buyer. The demand curve will change over time and depends on the equilibrium strategies. depending as it does on the number of periods left in which to consume the good’s services. which relates the marginal benefit to the quantity consumed. The buyer’s total benefit in period 1 is the dollar value of his utility from his purchase of q1 . Note that p1 q1 will not be the lower rectangle. is identical to the marginal-benefit curve. From this must be subtracted his expenditure in period 1. and the “consumer surplus” might easily be negative. and the quantity already owned. which equals the amount he would have been willing to pay to rent q1 . 491 .

(87) which generates the first-order condition 60 − q2 − so that ∗ q2 = 60 − 1 2 1 2 q1 = 0. 2 ∗ We must now find q1 . because that would violate the sequential rationality of the seller and the rational response of the buyer. one must look for a subgame perfect equilibrium. The residual demand curve after the first period’s purchases is shown in Figure 11b. The most intense portion of the buyer’s demand. using equation (83). up to q1 units. the marginal unit consumed was the q1 − th. the seller maximizes q2 p2 . has already been satisfied. The equation for the residual demand is therefore. p2 = B(q1 ) − q2 = 60 − 2 1 2 q1 − 1 2 q2 . as shown in Figure 11a. (86) ∗ Solving for the monopoly quantity. the buyer looks ahead to the possibility of buying in period two at a lower price. it can be seen that p∗ = 30 − q1 /4. In the second period. In the first period. q2 . which from (89) is 30 − q1 /4. and what is left begins with a marginal benefit of B(q1 ). (90) 492 . and what second-period price the seller would charge given the buyer’s second-period demand function.Figure 11: The Buyer’s Marginal Benefit per Period in Durable Monopoly To find the equilibrium price path one cannot simply differentiate the seller’s utility with respect to p1 and p2 . 1 4 q1 ). The price he would pay for a unit in period one cannot exceed the marginal benefit from the first. In period one.2. Instead. he can do so at the price p1 (q1 ) = B(q1 ) + p2 = (60 − = 90 − 3 4 1 2 q1 ) + (30 − q1 . and falls at the same slope as the original marginal benefit curve. therefore. (89) From equations (86) and (89). It is a demand curve very much like the demand curve resulting from intensity rationing in the capacity-constrained Bertrand game of Section 14. solving the problem M aximize q2 q2 60 − 1 2 (q1 + q2 ) . Buying in the first period has two benefits: consumption of the service flow in the first period and consumption of the service flow in the second period. If the seller chooses to sell q1 in the first period. it will be the (q1 + q2 ) − th. which means starting in the second period and discovering how much the buyer would purchase given his first-period purchase of q1 . (88) q1 .period service flow in period one plus the foreseen value of p2 .

the seller combines (89) with (90) to give the maximand in the problem of choosing q1 to maximize profit over the two periods. p1 = 0 and q1 = 120 from (83) because buyers buy till their marginal benefit is zero. The problem with selling outright is that the first-period price cannot be very high or the buyer knows that the seller will be tempted to lower the price once the buyer has bought in the first period. then equation (83) is like an ordinary demand equation. Buyer purchases according to q1 = 120 − p1 . 8 q1 4 (60 − q1 ) 2 (91) = 1800 + 60q1 − which has the first-order condition 60 − so that ∗ q1 = 48 5q1 = 0.240. because the seller should realize that if he deviates and chooses a lower price once the second period is reached. and a monopolist who commits to selling only in the first period. which is πseller = (p1 q1 + p2 q2 ) = 90 − 3q1 4 q1 + 30 − 2 5q1 . If the monopolist can commit to not producing in the second period. 1 ∗ It follows from (89) that q2 = 36 and p2 = 18. he will do just as well as the monopolist who rents. We must also assume that the artist can convince the market that he has broken the plates. making use of (90). the sum of the rents for the two periods. If the modeller ignored sequential rationality and simply looked for the Nash equilibrium that maximized the payoff of the seller by his choice of p1 and p2 . Renting avoids this problem. 240 (= 54(48) + 18(36)). and q2 = 0). Then. The seller’s profits over the two periods are πs = 3. too. People joke that the best way an artist can increase the value of his work is by dying. The purpose of these calculations is to compare the situation with three other market structures: a competitive market. 4 (92) (93) and. This is Nash because neither player has incentive to deviate given the other’s strategy. fits the model. so profits are higher from renting than from selling outright. and profits equal zero also. An example of such an equilibrium is (p1 = 60. and that. but it fails to be subgame perfect. If the monopolist rents instead of selling. because the monopolist is effectively selling the good’s services separately each period. p∗ = 54. the buyer will respond by deviating from q2 = 0 and will buy more units. since he can sell a quantity of 60 at a price of 60. a monopolist who rents instead of selling. 493 . A competitive market bids down the price to the marginal cost of zero. 600. p2 = 200. That is higher than 3. An example is the artist who breaks the plates for his engravings after a production run of announced size. he would come to the commitment result.Knowing that in the second period he will choose q2 according to (89). He could rent a quantity of 60 each period at a rental fee of 30 and his profits would sum to πs = 3.

This book teaches a variety of common ways that assumptions link to conclusions just as a book on chess strategy teaches how variety of common configurations of a chessboard lead to winning or losing. The explanation is not that the monopolist can use his market power to inflict lower quality on consumers– after all. Chess is just a game. If the seller can develop a product so flimsy that it only lasts one period. the basic ideas remain the same. Having done that. in order to sell to the remaining consumers who value the product less. the price he receives is lower too– but that the lower durability makes it credible to highvaluation buyers that the seller expects their business in the future and will not reduce his price. and payoffs. Without discounting. however. Just as with a book on chess. and improved my presentation of the old material. stripping a situation down to its essentials. Yet although I have added new material. the monopolist would continue to cut the price and sell more and more units to consumers with weaker and weaker demand until the price fell to marginal cost. In fact. he sees what payoffmaximizing equilibrium behavior arises from the assumptions. The central idea is that in modern economic modelling the modeller starts by thinking about players.With more than two periods. Is this book itself a durable good? As I am now writing its fourth edition. even the high-valuation consumers refuse to buy at a high price. which explains why a firm with market power might produce goods that wear out quickly. 494 . the important thing is not just to know common tricks and simplifications. because it has improved with each edition. and I can honestly say that a rational consumer who liked the first edition should have bought each successive edition. but to be able to recognize the general features of a situation and know what tricks to apply. actions. If you can benefit from this book. the difficulties of the durable-goods monopolist become even more striking. We can also use the durable monopoly model to think about the durability of the product. because they know they could wait until the price falls to zero. that is equivalent to renting. Early consumers foresee that the monopolist has an incentive to cut the price after they buy. With durable-goods monopoly. I cannot say that it is perfectly durable. this book is concluded. will provide you with tools for improving your life and the policies you recommend to others. the equilibrium price for outright sale instead of renting is constant – at zero! Think about this in the context of a model with many buyers. And this is not a trick of infinity: a large number of periods generates a price close to zero. Low durability leads to the same output and profits as renting. if the marginal cost of production is zero. I hope. In an infinite-period model without discounting. your time is valuable enough that you should substitute book reading for solitary thinking even at the expensive prices my publisher and I charge. but game theory. A consumer is willing to pay the same price to own a one-hoss shay that he knows will break down in one year as he would pay to rent it for a year. information.

It is convenient to continue to contrast “Bertrand” and “Cournot” competition. Empirical work associated with exemplifying theory tends to consist of historical anecdote rather than the linear regressions to which economics has become accustomed.” Wall Street Journal. but to Fix Output. The reason intensity rationing has been thought to be efficient is that it is efficient if the rationedout consumers are unable to buy at any price.2 Prices as Strategies: The Bertrand Equilibrium • As Morrison (1998) points out. 2).” Wall Street Journal. however. p. as well as the quantity competition that bears his name. They find a big decline in the price from one to two firms. as Bresnahan & Reiss (1991) shows. Exemplifying theory. and numerical data.1 Quantities as Strategies: The Cournot Equilibrium Revisited • Articles on the existence and uniqueness of a pure-strategy equilibrium in the Cournot model include Roberts & Sonnenschein (1976). although he does not use the context of oligopoly. lends itself to explaining particular cases. this rationing rule is inefficient. • An ingenious look at how the number of firms in a market affects the price is Bresnahan & Reiss (1991). which looks empirically at a number of very small markets with one.Notes N14. it would get two thirds of the profit in the Cournot triopoly game. October 8. The most ambitious attempt to connect general data with the modern theory of industrial organization is Sutton’s 1991 book. A problem with the Cournot model is that a firm’s best policy is often to split up into separate firms. • Intensity rationing has also been called efficient rationing. This point was made by Salant. If Apex split into firms Apex1 and Apex2 . May Choose Not to Set Oil Prices. see Dimand & Dore (1999). October 7. Some low-intensity consumers left facing the high price decide not to buy the product even though their benefit is greater than its marginal cost. and Gaudet & Salant (1991). two. 2. Seeking Flexibility. however. p. 1987. history.2. 1987. Apex gets half the industry profits in a duopoly game. For the history of how the Bertrand name came to be attached to price competition. Sunk Costs and Market Structure. however. Novshek (1985). given the intense interest in Cournot models. Generalization and econometrics are still often useful in industrial organization. Weitzman (1974) is the classic reference on price versus quantity control by regulators. • OPEC has tried both price and quantity controls (“OPEC. but it is much less useful for making generalizations across industries. It is interesting that nobody noted this earlier. Sometimes. The insight comes from approaching the problem from asking whether a player could improve his lot if his strategy space were expanded in reasonable ways. and not much change thereafter. • Merger in a Cournot model. though a case can be made for simplifying terminology to “price” and “quantity” competition instead. Switzer & Reynolds (1983) and is the subject of problem 14. which is an extraordinarily well. as discussed in the Introduction to this book. three or more competing firms. Cournot actually does (in Chapter 7) analyze the case of price competition with imperfect substitutes.balanced mix of theory. “Saudi King Fahd is Urged by Aides To Link Oil Prices to Spot Markets. a smaller decline from two to three. N14. even though industry profit falls. The decision 495 .

between games exhibiting synergism. Lane (1980). and those who are nonresponders. Gabszewicz & Thirse (1979) work out the mixed-strategy equilibrium for the case of quadratic transportation costs. See. in which responders choose to do whatever the majority do (upward sloping reaction curves). Antitrust cases are good sources for descriptions of the complexities of pricing in particular markets. or antitrust opinions such as US v. A player might be a nonresponder because he is irrational. for example. 39). Or. Firms therefore offer different qualities at different prices. but to consider all others as equivalent. Another way horizontal differentiation might work is for each consumer to like a particular product best. in which responders want to join the minority (downward sloping reaction curves). • Location models and switching cost models are attempts to go beyond the notion of a market price. 1985. and games exhibiting congestion.rests partly on enforceability. N14. This chapter looks at horizontal differentiation where all consumers agree that products A and B are more alike than A and C. 496 . • Haltiwanger & Waldman (1991) have suggested a dichotomy applicable to many different games between players who are responders. Sultan’s 1974 book on electrical equipment in the 1950s. See Dixit & Stiglitz (1977) for a model along those lines. and Osborne & Pitchik (1987) do the same for Hotelling’s original model. and reputation. If a firm cannot satisfy the demand facing it in the second stage (because of the capacity limit). who are inflexible.323-324 of his 1964 book Microstatics. Two firms face downward-sloping market demand. differentiation might be vertical: all consumers agree that A is better than B and B is better than C but they disagree as to how much better A is than B. • Vickrey notes the possible absence of a pure-strategy equilibrium in Hotelling’s model in pp.” Wall Street Journal. or simply because his strategy set is small. the equilibrium is more like what it would be if all the players were nonresponders. See. it uses intensity rationing (the results depend on this). and in the second stage they simultaneously choose prices (possibly by mixed strategies). see Greenhut & Ohta (1975). • There are many ways to specify product differentation. because he moves first.. choosing their actions flexibly. Under synergism.3 Location models • For a booklength treatment of location models. Addyston Pipe & Steel Co. The unique subgame perfect equilibrium is for each firm to choose the Cournot capacity and price. Haltiwanger and Waldman apply the dichotomies to network externalities. • It is important in location models whether the positions of the players on the line are moveable. 271 (1898). D’Aspremont. efficiency wages. The categories are used in a second dichotomy. Shaked & Sutton (1983) have explored this kind of vertical differentation. p. under congestion. they simultaneously choose capacities. the responders have more influence. but they disagree as to which is best. In the first stage of the game. February 26. and OPEC has also hired accounting firms to monitor prices (“Dutch Accountants Take On a Formidable Task: Ferreting Out ‘Cheaters’ in the Ranks of OPEC. • Kreps & Scheinkman (1983) show how capacity choice and Bertrand pricing can lead to a Cournot outcome. 85 F. for example.

and Rasmusen (1990). because they have no natural ordering. who show how it can be used to price discriminate between different types of buyers. blue=5. so no consumer preference can be called extreme. The difference is that no point on a circle is distinctive. blue=10) could be depicted on a line. if Brown’s ranking is (red=1. In the durable monopoly model this would happen 497 . but alliteration was too strong to resist. using the context of the aluminum market. Ramseyer. they did not need to borrow as they would have to do if it was a matter of financing a purchase.. but not because it increased monopoly profits. about which people may have different preferences but agree on what positions are close to what other positions. the characteristic was something like physical location. • Characteristics such as the color of cars could be modelled as location. if you like.6 Durable Monopoly • The proposition that price falls to marginal cost in a durable monopoly with no discounting and infinite time is called the “Coase Conjecture. which is the analogous contract in markets with several sellers. and in both situations the problem for the seller is that he is tempted to offer a low price in the second period after having offered a high price in the first period. N14. this hurts consumers. 110 F. promising to refund part of the purchase price if any future consumer gets a lower price. It is. Peoria versus Berkeley. who demonstrate how it can maintain high prices. a curious idea when the proposed alternative was outright sale.g. With two players. In the text. • The durable monopoly model should remind you of bargaining under incomplete information.e.consumer” contract. • Gaskins (1974) has written a well-known article on the problem of the durable monopolist who foresees that he will be creating his own future competition in the future because his product can be recycled. The “most-favored. is analyzed by Holt & Scheffman (1987). 295 (1953). The complaint was rather that long-term leasing impeded entry by new sellers of shoe machinery.” after Coase (1972). and Png & Hirshleifer (1987). While Smith’s ranking of (red=1. in contrast to the nonexistence of a pure-strategy equilibrium when the game is played on a line segment. yellow=6) we cannot use the same line for him. versus players separated from each other by 180◦ . It is really a proposition and not a conjecture.. by leasing. More likely.• The location games in this chapter model use a one-dimensional space with end points. leasing was used as a form of financing for the machinery consumers. but only on a player-by-player basis. yellow=2. The circle might be used for modelling convenience or because it fits a situation: e. for example. • Another way out of the durable monopolist’s problem is to give best-price guarantees to consumers. Supp. Another kind of one-dimensional space is a circle (not to be confused with a disk). a line segment. See Wiley. airline flights spread over the 24 hours of the day. Perversely. because it stops the seller from being tempted to lower his price. each player separated from another by 120◦ . the Hotelling location game on a circle has a continuum of pure-strategy equilibria that are one of two types: both players locating at the same spot. Both situations can be modelled using two periods. i. The three-player model also has a continuum of pure-strategy equilibria. • Leasing by a durable monopoly was the main issue in the antitrust case US v. United Shoe Machinery Corporation.

and the models’ complications arise from the attempt of the seller to get around the problem. In the bargaining model this would happen if the buyer rejected the first-period offer and the seller could conclude that he must have a low valuation and act accordingly in the second period. 498 . With a rational buyer. In the bargaining model this would happen if the buyer rejected the first-period offer and the seller could conclude that he must have a low valuation and act accordingly in the second period. In the durable-monopoly model this would happen if the high-valuation buyers bought in the first period and thus were absent from consideration by the second period. see the survey by Kennan & Wilson (1993).if the high-valuation buyers bought in the first period and thus were absent from consideration by the second period. For further discussion. neither of these things can happen.

(b) How do you know that there are no asymmetric Cournot equilibria. A player’s strategy is his price. (b) What is the pure-strategy equilibrium for this game? (97) (96) 499 . & Reynolds [1983]) There are three identical firms in an industry with demand given by P = 1 − Q. 14. Switzer. Marginal cost is constant at c. (a) Compute the Cournot equilibrium price and quantities. in which one firm produces a different amount than the others? (c) Show that if two of the firms merge.2.3. where Q = q1 + q2 + q3 . their shareholders are worse off. What does this mean? If either firm could pay for this campaign.Problems 14. Marginal cost is constant at c = 3. The marginal cost is zero. where α > β. A player’s strategy is his price. Differentiated Bertrand (medium) Two firms that produce substitutes have the demand curves q1 = 1 − αp1 + β(p2 − p1 ) and q2 = 1 − αp2 + β(p1 − p2 ). Assume that α > β/2. and that this would increase the profits of each firm by more than the cost of the campaign. (a) What are the equations for the reaction curves p1 (p2 ) and p2 (p1 )? Draw them. where c < 1/α. (b) What is the equilibrium? What is the equilibrium quantity for firm 1? (c) Show how firm 2’s reaction function changes when β increases. (a) What is the reaction function for firm 1? Draw the reaction curves for both firms. what game would result between them? (95) (94) 14. Differentiated Bertrand with Advertising (medium) Two firms that produce substitutes are competing with demand curves q1 = 10 − αp1 + βp2 and q2 = 10 − αp2 + βp1 . Cournot Mergers (easy) (See Salant.1. What happens to the reaction curves in the diagram? (d) Suppose that an advertising campaign could increase the value of β by one.

or c increase? (d) What happens to each firm’s price if α increases. (a) What is the monopoly price and profit? (b) What are the prices under perfect price discrimination if the seller can make take-it-orleave-it offers? What is the profit? (c) What are the prices under perfect price discrimination if the buyer and sellers bargain over the price and split the surplus evenly? What is the profit? 500 . (a) What is the equation for Apex’s Cournot reaction function? (b) What is the equation for Brydox’ Cournot reaction function? (c) What are the outputs and profits in the Cournot equilibrium? Problem 14. Price Discrimination (medium) A seller faces a large number of buyers whose market demand is given by P = α−βQ. but only firm 2 realizes it (and firm 2 knows that firm 1 is uninformed)? Would firm 2 reveal the change to firm 1? Problem 14.4. Production marginal cost is constant at c. Demand is p = 115 − qa − qb . while Brydox has variables costs of 2qb and no fixed cost. β.(c) What happens to prices if α.5. Asymmetric Cournot Duopoly (easy) 2 2 Apex has variable costs of qa and a fixed cost of 1000.

and (2) your LOCAL-market sales for that month. Each student is one firm. Each student is one firm. No talking. All costs are fixed. If a firm delays making its decision till too late. with the customers paying for delivery. No talking. the national market. The price is given by the following market demand curve: Q P = 100 − . You should then calculate your profit for the month and add it to your cumulative total. The benefit from the decision depends on what other firms do. you have missed the train and all 150 of your units must be sold locally. The train only comes to Smallsville once a month. If. The card should have the number of the firm on it.” Procedures Each Month 1. as well as the month and the local output. There are two markets for widgets. For the last five months. “I want to change from 40 to 90. N where Q is the total output of widgets sold in the local market. 501 . 3. $20 is the opportunity cost of selling a widget locally– it is what the firm loses by making that decision.. You will write down two things on an index card: (1) the number of the month. this equation would yield a negative price. Your own computations will be easier if you pick round numbers for your output. Each student is one firm. Widgets are perishable. The price in the national market is $20 per widget. because labor is contracted for on a yearly basis. then it misses the train. each of you will be a separate firm. 4. the price is just zero. but the price in the local market depends on how many are for sale there in a given month. so we can ignore production cost for the purposes of this case. and all its output will have to be sold in Smallsville. however. Each firm has a capacity of 150. The instructor will then calculate the market price. The instructor will collect the index cards and then announce the price for that month. rounding it to the nearest dollar to make computations easier. recording both numbers on your Scoresheet.The Kleit Oligopoly Game: A Classroom Game for Chapter 14 The widget industry in Smallsville has N firms. If you do not turn in an index card by the deadline. and the local market. 2. if they are not sold within the month. You can change your decision up until the deadline by handing in a new card noting both your old and your new output. they explode in flames.g. since the excess widgets can be easily destroyed. so firms cannot retract their decisions. All firms make their decisions at the same time on whether to ship widgets out of town to the national market. No talking. Each student is one firm. Each firm produces 150 widgets per month. Also record your local and national market sales on your Scoresheet. General Procedures For the first seven months. No talking. and submits a single index card. you will be organized into five different firms. e.

but when the talking is done. so N=5. 6. You are organized into Firms 1 through 5. Each student is one firm. each firm writes down its output secretly and hands it in. each firm writes down its output secretly and hands it in. so N=5. You are organized into Firms 1 through 5. You can talk to anyone you like. People can talk within the firms. No talking. but then you write down your own output and hand all outputs in separately. but when the talking is done. People can talk within the firms. but firms cannot talk to each other. This number will be made public once all the outputs have been received. so N=5. 7. 11. Each student is one firm. Write the number of your firm with your output. 8. You can talk with each other. The outputs of the firms are secret. Each student is one firm. You may be wondering about the “Kleit”. 502 . You can talk with each other. 9. so N=5. 10.5. but firms cannot talk to each other. You can talk to anyone you like. Andrew Kleit is an economics professor Pennsylvania State University who originated the ancestor of this oligopoly game game for classroom use. The outputs of the firms are secret. but then you write down your own output and hand all outputs in separately. You are organized into Firms 1 through 5. You are organized into Firms 1 through 5.

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