FIN 30210:

Managerial Economics

Strategic Pricing
 Recall the market structure spectrum
High Market Low Market
Concentration Concentration

Monopoly Oligopoly Monopolistic Perfect

Competition Competition
• Very few large firms • Many firms • Many very small firms
• One firm
• Standardized or differentiated • differentiated products • Standardized products
• Significant artificial or legal
products • low barriers to entry • No barriers to entry
barriers to entry
• Significant barriers to entry • Market power • No market power (price takers)
• Market power
• Market power • Non-price competition • Zero economic profit (reasonable
• Economic profits
• Interdependent pricing strategies • Lots of advertising rate of return)

NO STRATEGIC STRATEGIC NO STRATEGIC NO STRATEGIC

INTERACTION INTERACTION INTERACTION INTERACTION
Cournot competition is an economic model used to describe an industry structure in which companies
compete on the amount of output they will produce, which they decide on independently of each other
and at the same time. It is named after Antoine Augustin Cournot (1801–1877) who was inspired by
observing competition in a spring water duopoly. It has the following features:
• All firms produce a homogeneous product (i.e. there is no product differentiation)
• Firms do not cooperate (i.e. there is no collusion)
• Firms have market power (i.e. each firm's output decision affects the good's price) Antoine Cournot
1801 - 1877
• The number of firms is fixed
• Firms compete in quantities, and choose quantities simultaneously;
• The firms are economically rational and act strategically, seeking to maximize profit.

Marketplace
q1

P  F  q1  q2 
q2
Cournot Competition (Two Firms)
There exists an Industry Demand Curve

P  120  20Q
Total Industry Production

Factory 1 Q  q1  q2
Factory 2

q1 q2

• Has a constant marginal cost equal to $20 • Has a constant marginal cost equal to $20
• Takes Factory 2’s production as given • Takes Factory 1’s production as given
• Chooses its own production level to • Chooses its own production level to
maximize profits maximize profits
Cournot Competition (Two Firms) P  120  20  q1  q2 
Factory 1 We need to solve for Factory 1’s strategy (Factory 1’s best response
to any decision factory 2 makes)

Treated as a constant!!

P   120  20q2   20q1

• Has a constant marginal cost equal TR  Pq1   120  20q2  q1  20q12

to $20
• Takes Factory 2’s production as
given MR   120  20q2   40q1
• Chooses its own production level to Profit maximizing
maximize profits means equating
marginal revenue
with marginal cost
 120  20q2   40q1  20

100  20q2
q1  Factory 1’s strategy
40
Cournot Competition (Two Firms)

Factory 1

q2

Suppose that firm 2

• Has a constant marginal cost equal chooses 2
to $20
• Takes Factory 2’s production as
2
given
• Chooses its own production level to
maximize profits

Factory 1’s strategy

q1
100  20  2 
100  20q2 q1   1.5
q1  40
40
Cournot Competition (Two Firms)
Suppose that firm 2 chooses a
production level equal to 5
Factory 1
P  120  20  5   20
If the price is driven down to marginal
cost, Firm 1 has no incentive to
q2 produce anything!

• Has a constant marginal cost equal 5

to $20
• Takes Factory 2’s production as
given
• Chooses its own production level to
maximize profits

Factory 1’s strategy

q1
100  20q2 0
q1 
40 100  20  5 
q1  0
40
 Suppose that firm 2 chooses a production level
Cournot Competition (Two Firms) equal to 0 (doesn’t enter the market)

P  120  20q1
Factory 1
TR  120q1  20q12
MR  120  40q1  20
q2 q1  2.5

• Has a constant marginal cost equal Firm 1 acts like a monopoly!!

to $20
• Takes Factory 2’s production as
given
• Chooses its own production level to
maximize profits

Factory 1’s strategy

0 q1
100  20q2 5
q1 
40 100  20  0 
q1   2.5
40
Cournot Competition (Two Firms)
In General, as firm 2 expands (this
Factory 1 drives down the price), firm 1’s
best response is to contract
q2

• Has a constant marginal cost equal

to $20
• Takes Factory 2’s production as
given
• Chooses its own production level to
maximize profits

0 q1
Factory 1’s strategy

100  20q2 The Cournot model has strategies that are strategic substitutes
q1 
40 – that is, strategies that mutually offset each other
Cournot Competition (Two Firms)
Factory 2
Factory 1
q2

• • Has a constant marginal cost

Has a constant marginal cost
equal to $20 equal to $20
• Takes Factory 2’s production
• Takes Factory 2’s production q2* as given
as given
• • Chooses its own production
Chooses its own production
level to maximize profits level to maximize profits

q1
Factory 1’s strategy
q1* Factory 2’s strategy

100  20q2 A Nash equilibrium is where both firms are 100  20q1
q1  q2 
40 playing their optimal strategies and neither 40
has an incentive to deviate!
Cournot Competition (Two Firms)
Factory 2
Factory 1
Firm 1 produces 4

100  20  .5 
q1   2.25
Firm 1 responds with 40

100  20  1.375  Factory2’s strategy

Factory 1’s strategy Firm 1 responds with q1  40
 1.8125

100  20q1
100  20q2 q2 
q1  40
40 And on, and on, and on, ……

100  20  2.25 
Firm 2 responds with q2   1.375
40

100  20  4 
Firm 2 responds with q2   .5
40
Cournot Competition (Two Firms)
Factory 2
Factory 1 q2

Factory 1’s strategy q2*  1.67 Factory 2’s strategy

100  20q2 100  20q1

q1  q2 
40 q1 40
q1*  1.67

 100  20q1 
100  20   100  20  1.67 
 40  q1  1.67 q2   1.67
q1  40
40
Cournot Competition (Two Firms)
Factory 1 Strategies
q2
100  20q2
q1 
40

q1  1.67 100  20q1

q2 
Profit  $53.33  1.67   20  1.67   $55.66 40

q2*  1.67
Factory 2
q1
q1*  1.67

q2  1.67 P  120  20  1.67  1.67   $53.33

Profit  $53.33  1.67   20  1.67   $55.66
Cournot Competition (Two Firms) Note that the optimal markup formula still
works!
Factory 1
q1  1.67 P
q2  1.67 $120

$86.60
Firm 1’s “Residual” Demand
$55.33
P   120  20q2   20q1  86.6  20q1 Industry Price Industry
Demand
Q P 1  53.33  D
     1.6 Q
P Qi 20  1.67 
q1  1.67 Q  3.33
D1 Firm 1’s
Firm 1 Output Industry Output Demand

P  MC 53.33  20 1
  .62  Gross Margins are inversely related
P 53.33 1.6 to the elasticity of demand
 P  120  20Q
Cournot Competition (Two Firms) MC  $20
Total = $350
Total = $238 Total = $234
Production Costs = $100
Production Costs = $50 Production Costs = $67
Profits = $0
Profits = $125 Profits = $55
Consumer Surplus =
$120
Consumer Surplus = $63
$120
Consumer Surplus = $120 $100
$112

$63
$70 $112
$250
$53
$125
$55
$20 MC
$20 MC $20 MC
$100 D
$50 D $67 D

Q Q Q
2.5 3.33 5

Monopoly 2 Firms Perfect

Competition
Q*  2.5M Q  3.33M Output Per Firm
Q*  5M
P  $70 q  1.67 Industry Output
P  $20
GM  .71 P  $53
HHI  10, 000 GM  .62 GM  0
HHI  5, 000 HHI  0
 Suppose that we add a third firm… P  120  20Q

Factory 1 Factory 2 Factory 3

MC  $20 MC  $20 MC  $20

100  20q1  20q3 100  20q1  20q2

q2  q3 
40 40
Treated as a constant!!

P  120  20q2  20q3   20q1

MR   120  20q2  20q3   40q1  20  MC

100  20q2  20q3

q1 
40
Suppose that we add a third firm… P  120  20Q

Total = $309
Factory 1 Factory 2 Factory 3 Production Costs = $75
$120 Profits = $94
Consumer Surplus =
$140

$140
$45
MC  $20 MC  $20 MC  $20 $94

$20 MC
100  20q2  20q3 100  20q1  20q3 100  20q1  20q2
q1  q2  q3  $75 D
40 40 40
3.75 Q

Since each firm has an identical strategy, each firm’s q  1.25

production will be equal in equilibrium! Q  3q  3.75
q1  q2  q3  q P  $45
GM  .55
q  1.25
HHI  3, 267
100  20q  20q Q  3q  3.75
q
40 P  $45
Profit   $45  $20  1.25  $31.25
We can expand the Cournot competition model to any number of firms (with
equal marginal costs)… P  A  BQ
MC  c
Number of Firms  N

Ac N  A  c A  N 
qi  Q P  c
( N  1) B ( N  1) B N 1  N 1
Output Per Firm Industry Output

Ac
So, as the number of firms in the industry increases… qi  0 Q
B
• Output per firm declines As N  
• Total Industry output increases Pc The market
• Price falls becomes perfectly
competitive
Example: The Global Petroleum Market
• 90 Million Barrels ($4.5 Billion)
Per Day
• $1.5 Trillion in Annual Revenues

“The Big Five”

The Big five combined for $93

Billion on Profits in 2013
Example: The Global Petroleum Market (90M Billion Barrels Per Day)
Millions of Barrels Per Day

Saudi Arabia: 11.6

USA: 11.9
Russia: 10.8

Canada: 4.8 China: 4.5

Top 5 Producers make up 50% of global production

Proven Oil Reserves (Total =1.3 Trillion BBL)

Canada: 175B

Iran: 151B

Venezuela: 296B
Iraq: 143B

Saudi Arabia: 265B

The top 5 countries control 80% of

total reserves
Top Ten Oil and Gas Companies by Revenue
Country Company 2015 % of Global
Revenues (Billions) Revenues

Saudi Arabia Saudi Aramco $478 8.8%

China Sinopec $455 8.3%
China China National Petroleum $428 7.9%
China PetroChina $367 6.7%
USA Exxon Mobil $268 5.0%
UK/Neth. Royal Dutch Shell $265 4.8%
Kuwait Kuwait Petroleum 251B 4.6%
UK BP $222 4.1%
France Total SA $212 3.9%
Russia Lukoil $144 2.7%

Total $2,839 56.8%

 Marginal Costs By Country
The Global Petroleum Market Country Marginal Cost Per Barrel
Russia $18
Variable 2016 Value
Canada $90
Market Price $50 Brazil $80
Market Quantity (Bar/D) 90M United States (Deep Water) $57
Elasticity of Demand -.05 United States (Shale) $73
Angola $40
Ecuador $20
If we assume a linear
Venezuela $20
demand curve Q
b  d   Kazakhstan $16

Qd  a  bP P Nigeria (Deep Water) $30

Nigeria (Onshore) $15
a  Qd  bP Oman $15
Qatar $15
Iran $15
Algeria $15
We get the following demand curve UAE $7
Iraq $6

Qd  95  .09 P Saudi Arabia

Average
$3
$30

Where P is the dollar price per barrel and Q is daily

quantity in Millions
So, lets assume the following…
Output Per Firm
Global Demand For Oil
Ac 1055  30
Qd  95  .09 P qi    4.43 (Millions of Barrels Per Day)
( N  1) B  21 11
OR
P  1055  11Q Industry Output

Global Marginal Cost Per Barrel

Q  20qi  88.6 (Millions of Barrels Per Day)

MC  $30 Price
P  1055  11 88.6   $80.40 (Dollars Per Barrel)

Number of Producers Worldwide

Industry Revenues
N  20
P  $80.40  88.6 M  365  $2.6T ($130B per firm)

Annual Industry Profits

P   $80.40  $30   88.6 M  365  $1.62T ($81B per firm)

So, what if the global oil market was monopolized (With a
marginal cost of $30 per barrel)?

P  1055  11Q
MR  1055  22 P  30  MC
Q  46.5 Million barrels per day

P  $543.50

Profit   $543.50  $30  46.5  $23,877 Million dollars per day

$8.7 Trillion per year!!!

Back to the two Firm Example… P  120  20Q
Factory 2
Factory 1 q2
Q  3.33M
P  $53
GM  .62
HHI  5, 000

q2*  1.67 MC  $20

MC  $20
Factory 2’s strategy
Factory 1’s strategy

100  20q2
q1 q2 
100  20q1
q1  q1*  1.67 40
40

Suppose that Factory 1’s Marginal costs increase to $30

Higher Marginal Costs Alter Firm 1’s Strategy…
Factory 1 q2 Factory 1’s old strategy
100  20q2
5 q1 
40

MC  $30 4.5

P   120  20q2   20q1

MR   120  20q2   40q1  30  MC
q1
2.25 2.5
Factory 1’s New strategy
90  20q2
q1 
40

Firm’s one’s best move given a rise in marginal costs will be to scale back
production to restore profit margins!
However, as Firm one scales back, firm two’s best response is to expand and grab market share

Factory 2
Factory 1 q2
Q  1.33  1.83  3.16
P  120  20  3.16   $56.8

(58%) q2*  1.83

q2*  1.67 MC  $20
MC  $30 (50%)

Factory 2’s strategy

Factory 1’s New strategy

90  20q2
q1 q2 
100  20q1
q1  q1*  1.33 q1*  1.67 40
40 (42%) (50%)

 100  20q1 
90  20   q1  1.33
 40 
q1 
40 q2  1.83
 Firm 2 becomes the dominant firm in the industry

Factory 2
Factory 1 q2

HHI  422  582  5128

GM  .56 (Industry Average)

(58%) q2*  1.83

q2*  1.67 MC  $20
MC  $30 (50%)

Factory 2’s strategy

Factory 1’s New strategy

90  20q2
q1 q2 
100  20q1
q1  q1*  1.33 q1*  1.67 40
40 (42%) (50%)

Profit  56.8  1.83  20  1.83  $67.34

Profit  56.8  1.33  30  1.33  $35.64

56.80  30 56.80  20
GM   .47 GM   .65
56.80 56.80
What the Frack?

Fracking is the process of drilling down into the

earth before a high-pressure water mixture is
directed at the rock to release the gas inside.
Water, sand and chemicals are injected into the
rock at high pressure which allows the gas to flow
out to the head of the well.
Current Estimates of Shale Oil Reserves (2.8 – 3.2T BBL)
Around 50% of US annual
production is shale oil
Oil Production Costs
On average, the “all-in,”
breakeven cost for U.S.
hydraulic shale is $65 per
barrel.
$30 $65 $100

Some Countries are well below the global average

Country Marginal Production Cost
Saudi Arabia $3 per Barrel
Iraq $6 per Barrel
UAE $7 per Barrel
Algeria $15 per Barrel
Iran $15 per Barrel
Venezuela $20 per Barrel
Russia (On Shore) $18 per Barrel
Average $12 per Barrel
*Source: Knoema
OPEC vs. The Frackers As the fracker’s become more efficient and
bring down their marginal costs through
Frackers Low Cost Countries technology, they will be able to capture an
increasing marking share in the global
MC  $65 MC  $12
petroleum market!

Low Cost
Countries

Frackers
Now, suppose that the two firms decide to form a cartel
Factory 1
P  120  20Q

TR  120Q  20Q 2

MC  $20
MR  120  40Q  20  MC
Factory 2
Q  2.5
P  $70

MC  $20 Cartel Outcome: P=$70

As a cartel, they would act

collectively as a monopoly.
Q  1.25 Q  1.25
Profit   $70  $20  1.25  $62.50 Profit   $70  $20  1.25  $62.50
 P  120  20Q
Cartel are very unstable arrangements
Suppose that Firm 1 has committed to the cartel
solution…what should firm 2 do? Cartel Outcome: P=$70

Firm 2
q1  1.25

Firm 1 Firm 2
P  120  20  q1  q2  q1  1.25 q2  1.25
Profit   $70  $20  1.25  $62.50 Profit   $70  $20  1.25  $62.50

MC  $20 P  120  20  1.25  q2 

Firm 2’s demand curve
given that firm 1 is P  95  20q2 So, if Firm 2 cheats on the
behaving like a cartel
cartel….
TR  95q2  20q22 Firm 1

MR  95  40q2  20  MC Profit   $57.50  $20  1.25  $46.88

Firm 2
q2  1.875
Profit   $57.50  $20  1.875  $70.31
P  120  20  1.25  1.875   $57.5
Cartel are very unstable arrangements P  120  20Q
Firm 2

This becomes a prisoner’s dilemma!!

Maintain Cartel Cheat

Firm 1 q2  1.25 q2  1.875

Maintain Cartel $62.50 $62.50 $46.88 $70.31

q1  1.25 P  $70 P  $57.50

Cheat $70.31 $46.88 $46.87 $46.87

q1  1.875 P  $57.50 P  $45

Both sides have a dominant strategy to cheat!

 Let’s apply the Folk Theorem to the cartel problem…. To maintain the cartel

Firm 1: “ I will produce at the cartel level today. $55 B $63

$70  
If you don’t cheat, I will trust you forever. If you i i
cheat, I will never trust you again

i  11.4%

Cheat

Cheating Profits
Regular Cournot Profits
$55 $55 $55B
PV  $70    ...  $70 
 1 i  1 i 2 i
$70 $55 $55 ……………
End of
Today
Time
Play PD Play PD Play PD ……………
Game Game Game

$63 $63 $63 …………… $63 $63 $63

PV  $63    ... 
 1 i  1 i 2 i
Don’t Cartel Profits
Cheat
 Variation: The Tit for Tat Strategy

Firm 1: “ I will produce at the cartel level today. If you don’t cheat, I will trust you forever. If
you cheat, I will punish you tomorrow and then we will try again to trust one another

Firm 1 Firm 1
Firm 1 Cartel Maintained
punishes punishes

q1  1.25 q1  1.25 q1  1.875 q1  1.25 q1  1.25 q1  1.25 q1  1.875

End of
Today
Play PD Play PD Play PD Play PD Play PD Play PD Play PD Play PD
Time
Game Game Game Game Game Game Game Game

q2  1.25 q2  1.875 q2  1.875 q2  1.25 q2  1.25 q2  1.875 q2  1.875

Firm 2 Firm 2 Firm 2

cheats cheats
 Founding Member

Libya Saudi Arabia Iraq Iran OPEC was established in

Algeria
1960 at a Treaty signing
Joined: 1962 Joined: 1960 Joined: 1960 Joined: 1960 in Baghdad
Joined: 1969

Founding Member

Venezuela Founding Member

Kuwait
Joined: 1960

Joined: 1960

Ecuador Qatar

Joined: 2007
Angola
Joined: 1961
Nigeria
UAE
Joined: 2007
Joined: 1971
Joined: 1967
 Country Quota (Barrels
per day 000s)
In 1986, OPEC conducted an in-depth analysis of their system of
allocating quotas with the view to set up a durable formula, equitable to Algeria 1,200
all members. They defined eight criteria that fall into two categories: oil Angola 1,506
related and socio-economic. The factors considered were:
Ecuador 426
 Proven Reserves
 Production capacity Iran 3,334
 Historical production share Kuwait 2,221
 Domestic Investment Needs Libya 1,472
 Domestic oil consumption OPEC uses a Tit for
Tat strategy to Nigeria 1,704
 Production costs
 Population maintain the cartel Qatar 730

 Dependence on oil exports with Saudi Arabia S. Arabia 8,014

 External debt (the largest UAE 2,226
producer acting as
Venezuela 2,010
the enforcer)
Iraq Currently Suspended
OPEC Total 24,843

*Sources: The Oil Drum

Energyeconomist.com
Its hard to obtain reliable information on quotas and production levels. OPEC reported production/quotas
from 1982 – 2007. There have been very few details given since (OPEC’s 2009 annual report only gave OPEC
totals).
The largest producer, Saudi Arabia, acts as the
Biggest Current Cheaters
“enforcer: to punish cheating countries Cheaters

Qatar (+16%) Ecuador (+20%)

*Sources: The Oil Drum Nigeria (+29%) Iran (+25%)

Energyeconomist.com
Its hard to obtain reliable information on quotas and production levels. OPEC reported production/quotas from 1982 –
2007. There have been very few details given since (OPEC’s 2009 annual report only gave OPEC totals).

OPEC Production vs. Quota (thousands of Barrels per day)

Production Quota Above/Below Quota
(April 2011) Barrels Percent
Algeria 1,200 1,200 0 0%
Angola 1,780 1,506 274 18.2% Had a quota imposed in 2009
Ecuador 500 426 71 16.7%
Iran 2,800 3,334 -534 -16.0%
Kuwait 2,600 2,221 379 17.1%
Has been under producing
Libya 1,400 1,472 -72 -4.9%
since 2011 Civil War
Nigeria 1,950 1,704 246 14.4%
Qatar 730 730 0 0% Has been overproducing
S. Arabia 9,200 8,014 1,186 14.8%
since 2003
UAE 2,700 2,226 474 21.3%
Venezuela 2,200 2,010 2,010 9.4% Has been under producing since 2002
Iraq 3,150 Quota Suspended in 1998
attempted Coup d'état against Cesar
Chavez

OPEC Total 30,210 24,843 4,034 16.2%

*Sources: The Oil Drum
Energyeconomist.com
 UBEC (Union of Banana Exporting Countries) was founded in 1974

Guatemala
Honduras

Nicaragua
Costa Rica
Panama
Colombia
Ecuador

Formerly United Fruit

Formerly Standard Fruit

 UBEC (Union of Banana Exporting Countries) was founded in 1974

• The Banana trade was monopolized by three companies: Guatemala

Del Monte, United Fruit (now Chiquita) and Standard Fruit
(now, Dole) Honduras
• A United Nations study showed that no more than 17
cents per dollar spent on Bananas went to the Banana Nicaragua
countries.
Costa Rica
• UPEB initially proposed an export tax of $1 for every 40lb.
Box. Panama
Colombia
Ecuador
Bananagate
Formerly United Fruit In 1975, Eli Black, president of United brands,
jumped to his death off the Pan Am building in
New York City. An SEC investigation revealed
that he had paid $2.5M in bribes to Honduran
President Oswaldo Lopez Arellano for
Formerly Standard Fruit Honduras to lower their tax to 25 cents. This
caused the collapse of UBEC
The Stackelberg leadership model is a strategic game in economics in which the leader firm moves first and
then the follower firms move sequentially. In game theory terms, the players of this game are a leader and
a follower and they compete on quantity. Once the leader has made its move, it cannot undo it - it is
committed to that action. Moving first may be possible if the leader was the incumbent monopoly of the
industry and the follower is a new entrant.

Heinrich Freiherr von

Stackelberg 
1905 - 1946

Firm 1 moves first. It Firm 2 moves second. It The market place

chooses a production observes firm 1’s determines the price
level production level and then
chooses a production
level

q1 q2 P  F  q1  q2 
Let’s stick with the same demand curve/marginal costs.
P  120  20Q

Taking Firm 2’s reaction as a given, Firm 1 now maximizes profits

So, we already know
from before what Firm 100  20q1
Firm 1 q2 
2’s strategy is 40

P  120  20  q1  q2 

MC  $20 P  70  10q1

MC  $20 TR  70q1  10q12

Factory 2’s strategy MR  70  20q1  20  MC

100  20q1 q1  2.5 Firm 1 acts as a
q2 
40 100  20  2.5  monopolist!
q2   1.25
40
P  120  20  2.5  1.25   $45
The Stackelberg leadership model is a strategic game in economics in which the leader firm moves first and
then the follower firms move sequentially. In game theory terms, the players of this game are a leader and
a follower and they compete on quantity. Once the leader has made its move, it cannot undo it - it is
committed to that action. Moving first may be possible if the leader was the incumbent monopoly of the
industry and the follower is a new entrant.

P  120  20Q Heinrich Freiherr von

Stackelberg 
1905 - 1946

Firm 1 moves first. It Firm 2 moves second. It The market place

chooses a production observes firm 1’s determines the price
level production level and then
chooses a production
level

q1  2.5 q2  1.25 P  $45

Profit   $45  $20  2.5  $62.50 Profit   $45  $20  1.25  $31.25

Firm 1 has a first mover advantage!!

Suppose that Firm 1 utilized it’s first mover advantage to the max and acted to drive Firm 2 out of business. Without
any fixed costs, price would need to be driven down to equal marginal cost. With a fixed cost, this isn’t necessary. All
we need is for firm 2’s profits to be zero when firm 2 is acting optimally (i.e. the best Firm 2 can do is zero profits)

Industry Demand Curve

P  120  20Q

Firm 1 (First Mover) Firm 2 (Second Mover)

(Found Earlier)
Factory 2’s strategy

MC  $20 MC  $20 100  20q1

q2 
Fixed Cost  $5 Fixed Cost  $5 40
1) First, we need to solve for firm 2’s profits as a function of firm 1’s production, assuming that firm 2 is acting optimally

Now, plug in the demand curve and firm 2’s

strategy into firm 2’s profits
Firm 2 (Second Mover)
MC  $20
P  70  10q1 Fixed Cost  $5
(Found Earlier)
Factory 2’s strategy profit   P  MC  q2  FC
MC  $20 100  20q1
q2  100  20q1
Fixed Cost  $5 40 q2 
40
Plug firm 2’s strategy into
the demand curve

P  120  20  q1  q2 
 50  10q1 
2

profit  5
20
P  70  10q1
Again, this is firm 2’s profits as a function of
firm 1’s choice of production
2) Now, we just solve for the production level of firm 1 where firm 2’s profits are zero!

Firm 1 (First Mover)

 50  10q1 
2

profit  5  0
20

MC  $20
 50  10q1 
2
Fixed Cost  $5
Firm 1 keeps firm 2 out  100
profit   $30  20  4  $5  $35 of the market, but is it
50  10q1  10
worth it?
Firm 2 (Second Mover)
q1  4
100  20  4 
q2   .5
40
P  120  20  4.5   $30
MC  $20
Fixed Cost  $5
profit   $30  20  .5  $5  $0 Mission Accomplished!!
If the predatory behavior works, then Firm 1 is a monopoly from then on out!

Firm 1 (First Mover) Predatory Strategy Profits

profit   $30  20  4  $5  $35

Monopoly Strategy Profits

MC  $20 profit   $70  20  2.5  $5  $120
Fixed Cost  $5

$55
PV 
i
$55 $55 $55 $55 $55 $55
Cournot
Behavior
Cournot
Behavior
Cournot
Behavior
Cournot
Behavior
Cournot
Behavior
Cournot
Behavior ………
End of
Today
Predatory
Behavior
Monopoly Monopoly Monopoly Monopoly Monopoly ……… Time

$120 $120 $120 $120 $120

$35
$120
PV  $35 
i
But, what if it doesn’t work and you need to continue to act like a predator?

Firm 1 (First Mover) Predatory Strategy Profits

profit   $30  20  4  $5  $35

Monopoly Strategy Profits

MC  $20 profit   $70  20  2.5  $5  $120
Fixed Cost  $5

$55
PV 
i
$55 $55 $55 $55 $55 $55
Cournot
Behavior
Cournot
Behavior
Cournot
Behavior
Cournot
Behavior
Cournot
Behavior
Cournot
Behavior ………
End of
Today
Predatory
Behavior
Predatory
Behavior
Predatory
Behavior
Predatory
Behavior
Predatory
Behavior
Predatory
Behavior
……… Time

$35 $35 $35 $35 $35 $35

$35
PV 
i
Example: The battle between OPEC and the Frackers!

Country Marginal Cost

Algeria $15
Angola $40
Ecuador $20

VS Iran
Kuwait
Libya
$15
$7
$40
Nigeria $15-$30
Qatar $15
S. Arabia $3
UAE $7

$30 $65 $100 Venezuela $20

Iraq $6

Average Marginal Cost = $65 OPEC Average $17

Lets take a look at the price of oil in recent years…

It seems that
OPEC
declared war
on the
frackers in

Dollars per Barrel

2015!
Average Fracker’s Break Even Price

Average OPEC Break Even Price

2015
Look at the Effects!

So, is OPEC winning

the war against the
frackers? Actually,
No.

2015
 The Saudi Government lives or
June 2008
dies on the price of oil!
• Oil maxes out at
March 2012
$151 a barrel. Saudi
• Oil at $106 a barrel.
break even price is
Saudi break even
$47 January 2016
price is $81
June 2006 • Oil bottoms out at
• Oil is at $86. Saudi $29 a barrel. Saudi
break even price is break even price is
$39 $93

January 2009
• Oil bottoms out at at
$47. Saudi break
even price is $72
2015
Saudi Arabian Budget Deficit as a Percentage of GDP
“However, the worlds biggest petro states need to sell oil at a certain price to balance their budgets.
Government spending cuts and deferred projects have helped lower the break even price somewhat for some
countries like Saudi Arabia, but some petro states still need oil above $100 a barrel to balance their budgets”

Venezuela: $150
Nigeria: $141
Iraq: $116

Iran: $136 Russia: $113

Libya: $111 Angola:$94

Saudi Arabia: $92

Kuwait:$68 UAE:$82

Qatar: $61
Bertrand competition is a model of competition named after Joseph Louis François Bertrand. It was
a response to the Cournot model. Cournot argued that when firms choose quantities, the
equilibrium outcome involves firms pricing above marginal cost. Bertrand argued that if firms chose
prices rather than quantities, then price would equal marginal cost.
• There are at least two firms producing a homogeneous (undifferentiated) product and can
not cooperate in any way. Joseph Louis Francois-Bertrand
• Firms compete by setting prices simultaneously and consumers want to buy everything 1822 - 1900
from a firm with a lower price (since the product is homogeneous and there are no
consumer search costs).
• If two firms charge the same price, consumers demand is split evenly between them.
• both firms have the same constant marginal of production

Marketplace
p1
q1  F  p1 , p2 

p2 q2  F  p1 , p2 
Bertrand Competition (Two Firms)
There exists an Industry Demand Curve

P  120  20Q

Q  6  .05 P
Factory 1 Factory 2

p1 p2

• Has a constant marginal cost equal to $20 • Has a constant marginal cost equal to $20
• Takes Factory 2’s price as given • Takes Factory 1’s price as given
• Chooses its own price level to maximize • Chooses its own price level to maximize
profits profits
Under Bertrand competition, each firm faces a much different demand curve than under
Cournot competition

If you are underpriced,

Factory 1 you lose the whole
p1 market
 0 if p1  p2

At equal 
prices, you
  6  .05 p1 
profit  ( p1  20)   if p1  p2
split the
p2 market
If you are   2 
MC  $20 the low price 
you capture

 ( p1  20)(6  .05 p1 ) if p1  p2
the whole
market
D
q1

As with the Cournot case, we need to figure out each form’s strategy
Bertrand Strategies
Firm 1’s Strategy
If you are underpriced,
you lose the whole

Factory 1
p1 market
 pm if p2  pm

At equal p1   p2  .01 if mc  p2  pm
 mc
prices, you

p2
split the
market  if p2  mc
If you are
the low price
you capture
MC  $20 the whole
market
D
q1

So, if your opponent charges above the monopoly price, you charge the monopoly price. If your opponent charges a
price above marginal cost, but below the monopoly price, you charge a penny below him. If your opponent charges a
price equal to marginal cost, you charge a price equal to marginal cost

Strategies in Bertrand competition are called strategic complements (they move together
rather than in opposite directions)
 Bertrand Equilibrium
Factory 1
p1  p2  $20 Factory 2
Q  6  .05  20   5
q1  q2  2.5
MC  $20 MC  $20
p1  $20 This is the only outcome where nobody p1  $20
has an incentive to deviate from their
profit  $0 profit  $0
current action
p1 p2

$20
$20

D
D
q1 q1
2.5 2.5
 P  120  20Q
Bertrand Competition (Two Firms) MC  $20
Total = $350
Total = $238 Total = $350
Production Costs = $100
Production Costs = $50 Production Costs = $100
Profits = $0
Profits = $125 Profits = $0
Consumer Surplus =
$120
Consumer Surplus = $63 $120 Consumer Surplus = $120 $100
$250

$63
$70
$250 $250
$125

$20 MC $20 MC
$20 MC
$100 D $100 D
$50 D

Q Q Q
2.5 5 5

Monopoly 2 Firms Perfect

Competition
Q*  2.5M Q  5M Industry Output Q*  5M
P  $70 q  2.5 Output Per Firm
P  $20
GM  .71 P  $20
HHI  10, 000 GM  0 GM  0
HHI  5, 000 HHI  0
Note, we can easily get around the marginal cost pricing by establishing
capacity constraints

Factory 1 P  120  20Q Factory 2

(We know that combined capacity
greater than 5 drives the price to
marginal cost)

Equilibrium
MC  $20 MC  $20
Capacity  2 p1  p2  $40 Capacity  2
Profit   $40  $20  2  $40 Profit   $40  $20  2  $40
Q  6  .05  20   4
q1  q2  2

So, how are capacities chosen? Cournot competition!

Example: Cellular Service

400 Number of Cellular contracts in the US

350

300

250

200
378 Million in
150 2015!!
100

50

0
9 8 5 9 8 6 9 8 7 9 8 8 9 8 9 9 9 0 99 1 9 9 2 9 9 3 9 9 4 9 9 5 9 9 6 9 9 7 9 9 8 9 9 9 0 0 0 0 0 1 0 0 2 0 0 3 0 0 4 0 0 5 0 0 6 0 0 7 0 0 8 0 0 9 0 1 0 0 1 1 0 1 2 0 1 3 0 1 4 0 1 5
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
Mobile Communications in the US

Top Cellular Carriers

2015
• Number of Cellular Subscriptions: 378M
40% • Number of Wireless Minutes Used: 2,300,000,000,000
• Total Revenues: $171B
35%

30%

25%

20%

15%

10%

5%

0%
Verizon AT&T Sprint T-Mobile Other
*Source: Statista
US Domestic Airline Net Income in Thousands
Industry 25,000...
$21B
20,000...
2015
15,000...
Flights: 8,059,688
Passengers: 696,010,768 10,000...
Revenue Miles: 630,657,745,000
Load Factor: 85% 5,000...

Revenue: $146,757,987,000 0
Net Income: $21,225,256,000
-5,000...

-10,000...

-15,000...

-20,000...

-25,000...

*Source: US Department of Transportation

 US Domestic Airline Market Shares
Industry
2015
Flights: 8,059,688
Passengers: 696,010,768
(18%)
Revenue Miles: 630,657,745,000
Load Factor: 85%
Revenue: $146,757,987,000
Net Income: $21,225,256,000 Other (39%) (14%)

(15%) (13%)
*Source: US Department of Transportation
Again, what if these two firms tried to collude to fix prices?

Factory 1 P  120  20Q Factory 2

(We know that combined capacity
greater than 5 drives the price to
marginal cost)

Equilibrium
MC  $20 MC  $20
Capacity  2 p1  p2  $40 Capacity  2
Profit   $40  $20  2  $40 Profit   $40  $20  2  $40
Q  6  .05  20   4
q1  q2  2
Cartels are very unstable arrangements P  120  20Q
Firm 2
Let’s suppose that there are only
two possibilities, charge the
monopoly price or the competitive
price. If your competitor is
charging the monopoly price, you
Maintain Cartel Cheat
have no incentive to cheat because Firm 1
your capacity constraint prevents p2  $70 p2  $40
you from capturing the whole
Maintain Cartel $62.50 $62.50 $0 $40
market!
p1  $70

Cheat $40 $0 $40 $40

p1  $40

It’s a Stag Hunt!!

 “Archer Daniels Midland. Most people have never head of us, but chances are, they've never had a
meal we're not a part of. Just read the side of the package. That's us. Now ADM is taking dextrose
from the corn and turning it into an amino acid called lysine. It's all very scientific, but if you're a
“stockholder, all that matters is corn goes in one end and profit comes out the other.”

Defendant Product Country Year Fine

Matt Damon in
The Informant Bridgestone Car Parts USA 2014 $425M
DeutscheBank Interest Rate Derivatives EU 2013 $619M

Philips TV Tubes EU 2012 $907M

Au Optronics LCD Panels USA 2012 $500M
Yazaki Corporation Car Parts USA 2012 $470M

LG Electronics LCD Panels USA 2009, 2012 $1,284M

Recent Price Saint-Gobain Car Glass EU 2008 $986M

F. Hoffman-Laroche Vitamins USA 1999, 2001 $500M

Fixing Cases BASF Vitamins USA 1999 $225M

SGL Carbon Graphite Electrodes USA 1999 $135M
UCAR International Graphite Electrodes USA 1998 $110M

Archer Daniels Midland Lysine & Citric Acid USA 1997 $100M
Haarman & Reimer Citric Acid USA 1997 $50M

Heerema Marine Construction USA 1998 $49M

British Airways takes its passengers for a Ride
In 2004, when jet fuel prices were on the rise, airlines started adding fuel surcharges to their ticket prices. British Airways
entered in to a secret agreement with Virgin airlines to simultaneously bump up their fuel surcharges from £5 to over £60.
This practice continued into 2006.

When Virgin Atlantic's lawyers realized what the company had done, they did the only
thing they could do: they ratted out British Airways. Virgin ended up getting immunity for
providing the goods on its former partner in collusion, while BA got walloped with record
fines. The British Office of Fair Trading nailed the airline for 121.5 million pounds, while
the American Department of Justice smacked it with an additional $300 million fine.
Ouch!
The Phases of the Moon Cartel (1950’s)
In 1960, General Electric, Westinghouse, Allis-Chalmers, and four individuals were indicted for fixing the prices of large
turbine generators in what became known as the “great electrical conspiracy.”
Moral of the story: why compete or collude when you can simply merge!