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Chapter 16 Game Theory and Oligopoly

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Figure 16.1 The monopoly equilibrium

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Duopoly as a Prisoners Dilemma


A

Duopoly is an oligopoly in which there are only two firms in the industry.

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Table 16.1 Duopoly profit matrix

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From Table 16.1


L

is the dominant strategy for the both the First and the Second Firm Thus the Nash-equilibrium combination is (L,L) in which both firms produce 20 units and have a profit of $200. Yet, if they could agree to restrict their individual outputs to 15 units apiece, each could earn $450.
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The Oligopoly Problem


Oligopolists

have a clear incentive to collude or cooperate. Oligopolists have a clear incentive to cheat on any simple collusive or cooperative agreement. If an agreement is not a Nash equilibrium, it is not self-enforcing.

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The Cournot Duopoly Model

1.

2.

Central features of the Cournot Model: Each firm chooses a quantity of output instead of a price. In choosing an output, each firm takes its rivals output as given.

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Figure 16.2 Finding a Cournot best-response function

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From Figure 16.2


The

First firms best response function is: y1*=30 y2/2 The Second firms best response function is y2*=30 y1/2 Taken together, these two best response functions can be used to find the equilibrium strategy combination for Cournots model.
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Figure 16.3 The Cournot equilibrium

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The Cournot Model: Key Assumptions


The

profit of one firm decreases as the output of the other firm increases (other things equal). The Nash equilibrium output for each firm is positive.

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Isoprofit Curves
All

strategy combinations that give the first firm the chosen level of profits is known as an indifference curve or iosprofit curve. Profits are constant along the isoprofit curve.

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Figure 16.4 Title

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From Figure 16.4


y1*

maximizes profits for the first firm given the second firms output of y2*. Any strategy combinations below the indifference curve gives the first firm more profit than the Nash equilibrium. The result above relates to the key assumption that the first firms profit increases as the second firms output decreases.
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Figure 16.5 Joint profit not maximized in Nash equilibrium

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Cournots Model: Conclusions


In

the Nash equilibrium of this general version of the Cournot model, firms fail to maximize their joint profit. Relative to joint profit maximization, firms produce too much output in the Nash equilibrium.

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The Cournot Model with Many Firms


With only one firm in the market, the Cournot-Nash equilibrium is the monopoly equilibrium. As the number of firms increases, output increases. As a result, price and aggregate oligopoly profits decrease. When there are infinitely many firms, the Cournot model is, in effect, the perfectly competitive model.

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The Bertrand Model


The

Bertrand model substitutes prices for quantities as the variables to be chosen. The goal is to find the Nash (the Bertrand-Nash) equilibrium strategy combination when firms choose prices instead of quantities.

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The Bertrand Model: Firms Best Response Function


Funding the best response function entails answering the question: Given p2, what value of p1 maximizes the first firms profit. Four possibilities exist: 1. If its rival charges a price greater than the monopoly price (MP), the first firms best response is to charge a lower price (than MP) so it can capture the entire market.

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The Bertrand Model: Firms Best Response Function


2. If its rival charges a price less than the per unit cost of production (p2), the first firms best response is to choose any price greater than this because firm one will attract no business and incur a zero profit. This outcome is superior to matching or undercutting p2, and posting losses.

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The Bertrand Model: Firms Best Response Function


3. If the second firms price is greater than the per unit cost of production and less than the monopoly price. (see Figure 16.6)

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Figure 16.6 Finding a Bertrand best-response function

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The Bertrand Model: Firms Best Response Function


4. Suppose the second firm sets its price exactly equal to the per unit costs. Then if the first firm sets a lower price it will incur a loss on every unit it sells and profits will be negative. If the first firm sets a price above the per unit it will sell no units and profits are zero. If the first firm sets price equal to the per unit costs, it breaks even.

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The Bertrand-Nash Equilibrium

The Bertrand-Nash equilibrium strategy combination is the second firm and the first firm charging a price equal to the per unit cost of production. At this equilibrium, each firms profit is exactly zero.

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The Limited-Output Model


In

the long run, the number of firms (market structure ) is endogenous. The number of firms is an industry is determined by economic considerations. The key process in determining the longrun equilibrium is the possibility of entry.

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Barriers to Entry
A

natural barrier to entry is setup costs. Assume all firms incur setup costs of $S In any period, the rate of interest (i) determines the set up cost (K):K=iS Adding fixed costs to variable costs (40y) gives total cost function: C(y)=K+40Y
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Inducement to Entry
If

the fixed costs (K) is a barrier to entry, what is an inducement to entry? An inducement to entry is the excess of revenue over variable costs.

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Figure16.7 The inducement to entry

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Inducement to Entry
The

entrants best response function is: yE*=30-y/2 The entrants residual demand function is: Pe=(100-y)-ye The price that will prevail if the entrant produces ye* units is: Pe*=70-y/2 Profit per unit is: Pe* - 40=30-y/2
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Inducement to Entry
The

inducement to entry, ye* times (pe*40) is then (30-y/)2. This expression gives the revenue over variable costs that the entrant would earn if established firms continued to produce y units after entry. Entry will occur if inducement to enter exceeds K
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Inducement to Entry
Call

the smallest value of y such that no entry occurs the limit output (yL). (30-yL/2)2=K Solving for YL: YL= 60-2K1/2 If K=$100, YL=40 units, If K=$225, YL=30 units, etc. (see Figure 16.8)

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Inducement to Entry
Entry

will not occur if the output of established firms is greater than or equal to the limit output (yL) The limit price (pL) is the price associated with the limit output. In this example: pL=100-yL or pL = 40+2K1/2
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Figure 16.8 Identifying the limit price and the limit output

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Refinements of Limited Output


How

large must the fixed cost K be so that a third firm will not enter? The generalized no-entry condition for the Cournot models is then: [60/(n=2)2]K

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Figure 16.9 Cournot oligopoly and entry equilibrium

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Barriers to entry
Development

cost K is a barrier to entry, as it differentiates established firms and new potential entrants. The manner in which this differentiation affects the inducement to enter (profits) depends upon the nature of the oligopoly behaviour upon entry.
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Barriers to entry
The

more aggressive/less cooperative is oligopoly behaviour upon entry, the more effective setup costs are as a barrier. Any firms decision to incur the setup cost is a strategic decision because it affects the incentives of other firms.

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Positioning and Reacting


Positioning

is concerned with action taken by existing firms prior to entry. Reacting refers to actions of established firms subsequent to entry.

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