Industrial Organization

CLEF-Unibo

Oligopoly
“Standard models”

Giacomo Calzolari
Oligopoly: Static Games and
Cournot Competition
 Oligopoly theory
• No single theory
– employ game theoretic tools that are appropriate
– outcome depends upon information available
– And depends on the nature of strategic interaction, see later
• We will use the concepts by game theory and in particular
– the concept of equilibrium (Dominant Strategies or Nash or Subgame-Perfect)
– firms choose strategies, one for each player
– combination of strategies determines outcome
– outcome determines pay-offs, i.e. profits
• Why Game Theory? Few firms are aware of strategic inteaction: that
is of the fact that their decisions affect others’ profitability and thus
others’ decisions

3
 Oligopoly models

• There are three dominant oligopoly models:

– The relevant variable of choice for firms is how much to produce and sell, then the
market adjusts the price, e.g. in sectors where the marginal cost is high and
adjusting the quantities requires time and money like agriculture, cars (Cournot)
– The relevant variable is the price chosen by the firms and then the market adjusts
the quantity that firms will produce, e.g. Insurance market or in general where
marginal costs are low (Bertrand)
– Some firms act before than others (prices or quantities) (Stackelberg)
• They are distinguished by
– the decision variable that firms choose
• In reality some cases are mixed and we will have a model to deal with these when price
competition + capacity constraints
– the timing of the underlying game
• Concentrate on the Cournot model first

4
 The Cournot approach

• Assumptions
– Standardized products (no differentiation or perfect
substitutes, Cournot supposed this was spring water)
– Duopoly to begin with, firms 1 and 2
– No fixed cost to begin with
– Simultaneous firms’ decisions

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 Profit maximization
• Profit of firm 1:
1 = p q 1 - c q 1
• What is the price p? The demand function p(Q) where total
output is Q = q1+ q2 :

1 = p(Q) q1 - c q1

• First order condition for the optimal q1 ?

Marginal benefits=Marginal costs that its Ri’ = c
• As with monopolist? Where is strategic interaction?

6
 Strategic interaction?
• Marginal revenue in oligopoly is:
R(q) p
R1'   p q1
q 1 q1
• If the rival increases q2 then p diminishes and so
the marginal revenue of firm 1 does!

• The more the other produces the less I want

produce because my benefit is then lower.

7
 The Cournot model

• Let us specify and assume that the demand for the

product is
P = A - BQ = A - B(q1 + q2)
where q1 is output of firm 1 and q2 is output of firm 2
• Marginal cost for each firm is constant at c per unit
• To get the demand curve for one of the firms we treat the
output of the other firm as constant
• So for firm 2, demand is P = (A - Bq1) - Bq2

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 The Cournot model 2
If the output of
$
P = (A - Bq1) - Bq2 firm 1 is increased
the demand curve
The profit-maximizing
A - Bq1 for firm 2 moves
choice of output by firm
to the left
2 depends upon the
output of firm 1 A - Bq’1
Marginal revenue for Demand
firm 2 is Solve this
c MC
for output MR2
MR2 = (A - Bq1) - 2Bq2
q2
MR2 = MC q*2
Quantity

A - Bq1 - 2Bq2 = c  q*2 = (A - c)/2B - q1/2

9
 The Cournot model 3
q*2 = (A - c)/2B - q1/2
This is the reaction function for firm 2
It gives firm 2’s profit-maximizing choice of output
for any choice of output by firm 1
There is also a reaction function for firm 1
By exactly the same argument it can be written:
q*1 = (A - c)/2B - q2/2

Cournot-Nash equilibrium requires that both firms be on

their reaction functions.

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 Cournot-Nash equilibrium
q2
If firm 2 produces The reaction function
The Cournot-Nash
(A-c)/B (A-c)/B then firm for firm 1 is
equilibrium is at
1 will choose to q*1 = (A-c)/2B - q2/2
Firm 1’s reaction the intersection
function
produce no output
Ifoffirm
the reaction
2 produces
then firmThe reaction function
functions
nothing
(A-c)/2B 1 will produce the for firm 2 is
monopoly output q*2 = (A-c)/2B - q1/2
C
qC 2
(A-c)/2B
Firm 2’s reaction function
q1
qC1 (A-c)/2B (A-c)/B

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 Cournot-Nash equilibrium 2

q2 q*1 = (A - c)/2B - q*2/2

(A-c)/B
q*2 = (A - c)/2B - q*1/2

Firm 1’s reaction function

 q*2 = (A - c)/2B - (A - c)/4B
+ q*2/4
 3q*2/4 = (A - c)/4B
(A-c)/2B
C
 q*2 = (A - c)/3B
(A-c)/3B
Firm 2’s reaction function  q*1 = (A - c)/3B
q1
(A-c)/2B (A-c)/B
(A-c)/3B

12
 Cournot-Nash equilibrium 3

• In equilibrium each firm produces qC1 = qC2 = (A - c)/3B

• Total output is, therefore, Q* = 2(A - c)/3B
• Recall that demand is P = A - BQ
• So the equilibrium price is P* = A - 2(A - c)/3 = (A + 2c)/3
• Profit of firm 1 is (P* - c)qC1 = (A - c)2/9
• Profit of firm 2 is the same
• A monopolist would produce QM = (A - c)/2B
• Competition between the firms causes them to overproduce.
Price is lower than the monopoly price
• But output is less than the competitive output (A - c)/B where
price equals marginal cost
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 Reaction function
• In general, the reaction function of firm 1 (similar for
firm 2) is the optimal choice of firm 1 given its
expectation of output of firm 2
• It decreases with rival’s output because of the effect on
marginal revenue that we saw
• Notice the extremal points of the reaction function:
– If expects the rival does not produce, then your react
producing as monopolist
– If expect the rival produce large enough, then you react
producing nil and stay out of the market.
In particular if the the other produces such that p=c’ (as in
perfect competition) then you are indifferent between
producing or not (as in perfect competition)
Graphically… 14
Reaction function firm 1
If expect firm 2
produces an output qc:
q2
such that p=c’ then q1
qc =0

If expect firm 2
produces zero, then react
as a monopolist

qm q1

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 Nash Equilibrium

Firm 1
q2

Cournot Nash (no regret) Firm 2

qm q1
• Notice we are assuming identical costs and thus the two lines are symmetric

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 Nash & Monopoly & perfect competition

Nash
q2
qc

qm
q1 + q2 = qc

q 1 + q2 = qm

qm qc q1
• The Cournot Nash equilibrium generates an intermediate
quantity and thus an intermediate price:
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p c< pN < pm qc> qN >qm
 Cournot-Nash equilibrium: many firms

• What if there are more than two firms?

• Much the same approach.
• Say that there are N identical firms producing identical
products
• Total output Q = q1 + q2 + …This
+ qNdenotes output
of every firm other
• Demand is P = A - BQ = A - B(q1 + q2 + … + qN)
than firm 1
• Consider firm 1. It’s demand curve can be written:
P = A - B(q2 + … + qN) - Bq1
• Use a simplifying notation: Q-1 = q2 + q3 + … + qN
• So demand for firm 1 is P = (A - BQ-1) - Bq1

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 The Cournot model: many firms 2
If the output of
$ the other firms
P = (A - BQ-1) - Bq1
is increased
The profit-maximizing the demand curve
choice of output by firm 1 A - BQ-1 for firm 1 moves
depends upon the output of to the left
the other firms A - BQ’-1
Marginal revenue for
firm 1 is Solve this Demand
for output c MC
MR1 = (A - BQ-1) - 2Bq
q1 1 MR1

MR1 = MC q*1
Quantity

A - BQ-1 - 2Bq1 = c  q*1 = (A - c)/2B - Q-1/2

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 Cournot-Nash equilibrium: many firms
q*1 = (A - c)/2B - Q-1/2
How do we solve this
 Q*-1 = (N - 1)q*1 As the number of
for
The firms q* ?
arenumber
1 identical.
As the
firms increases output of
 q*1 = (A - c)/2B - (N - 1)q*1/2So in equilibrium they
of eachfirms
firm increases
falls
 (1 + (N - 1)/2)q*1 = (A - c)/2Bwillaggregate
have identical
As theoutput
number of
outputs
As
increases
theincreases
number of
 q*1(N + 1)/2 = (A - c)/2B firms price
firms
tends increases profit
to marginal cost
 q*1 = (A - c)/(N + 1)B
of each firm falls
 Q* = N(A - c)/(N + 1)B
 P* = A - BQ* = (A + Nc)/(N + 1)
Profit of firm 1 is P*1 = (P* - c)q*1 = (A - c)2/(N + 1)2B

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Cournot-Nash equilibrium: different costs

• What if the firms do not have identical costs?

• Much the same analysis can be used
• Marginal costs of firm 1 are c1 and of firmSolve
2 arethis
c 2.
• Demand is P = A - BQ = A - B(q1 + q2) for output
q1
• We have marginal revenue for firm 1 as before
• MR1 = (A - Bq2) - 2Bq1 A symmetric result
holds for output of
• Equate to marginal cost: (A - Bq2) - 2Bq1 = c1
firm 2
 q*1 = (A - c1)/2B - q2/2

 q*2 = (A - c2)/2B - q1/2

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Cournot-Nash equilibrium: different costs 2

q2 q*1 = (A - c1)/2B - q*2/2

The equilibrium
If the marginal
(A-c1)/B output cost
of firm 2 q*
of firm 2 2 = (A - c2)/2B - q*1/2
R1 fallsWhat happens
increases and of q*2 =to
its reaction (Athis
- c2)/2B - (A - c1)/4B
equilibrium
firmcurve shifts to when
1 falls
+ q*2/4
costs
the rightchange?
 3q*2/4 = (A - 2c2 + c1)/4B
(A-c2)/2B
 q*2 = (A - 2c2 + c1)/3B
R2 C
 q*1 = (A - 2c1 + c2)/3B
q1
(A-c1)/2B (A-c2)/B

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Cournot-Nash equilibrium: different costs 3

• In equilibrium the firms produce q C1

= (A - 2c1 + c2)/3B; qC2 = (A - 2c2 + c1)/3B
• Total output is, therefore, Q* = (2A - c1 - c2)/3B
• Recall that demand is P = A - B.Q
• So price is P* = A - (2A - c1 - c2)/3 = (A + c1 +c2)/3
• Profit of firm 1 is (P* - c1)qC1 = (A - 2c1 + c2)2/9
• Profit of firm 2 is (P* - c2)qC2 = (A - 2c2 + c1)2/9
• Equilibrium output is less than the competitive level
• Output is produced inefficiently: the low-cost firm should
produce all the output (recall constant marginal cost)
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 Concentration and profitability

• Assume there are N firms with different marginal costs

• We can use the N-firm analysis with a simple change
• Recall that demand for firm 1 is P = (A - BQ-1) - Bq1
• But then demand for firm i is P = (A - BQ-i) - Bqi
• Equate this to marginal cost ci
A - BQ-i - 2Bqi = ci
But Q*-i + q*i = Q*
This can be reorganized to give the equilibrium condition:
and A - BQ* = P*
A - B(Q*-i + q*i) - Bq*i - ci = 0

 P* - Bq*i - ci = 0  P* - ci = Bq*i

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 Concentration and profitability 2
P* - ci = Bq*i
The price-cost margin
Divide by P* and multiply the right-hand side
for each byisQ*/Q*
firm
P* - ci BQ* q*i determined by its
= market share and
P* P* Q*
demand elasticity
But BQ*/P* = 1/ and q*i/Q* =Average
si price-cost
so: P* - ci = si margin is
P*  determined by industry
Extending this we have (why? See next) concentration
P* - c H
=
P* 

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Notice: asymmetric costs and market shares
• In the model with asymmetric costs we have seen
that the firm with lower costs produces and sells
more, i.e. its market share is larger
• And it is important to notice that the size of a firm
(e.g. its market share) IT IS NOT the cause of
market power (measured by price cost margin or
Lerner):

(p-ci)/p = si/

The source and cause of asymmetry is rather the

different level of firms’ efficiency (i.e. costs)
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 Lerner and Herfindahl indexes
Let the price cost margin for each firm i be mi and we
know this is equal to si/, then we can build a
weighted average price cost margin of the industry,
weighting with market shares:
s1m1 + s2m2 + … + snmn = i(si2/)
and then…
(p-c)/p = H/

• This not only concentration increases the price cost

margin, but also the asymmetry (H index) does so

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 What about if …

• Firms face fixed costs F?

– We will see but the idea is simply that, since F, does
not affect the decisions on quantities, we proceed as
above
– And then check if the profit NET of –F is positive or
not (active or not in the market)

• Firms face increasing marginal costs (c’(q)>0)?

– Calculus a little bit more complicated but same idea

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END OF QUANTITY
COMPETITION
29
Static Games and Price
Competition
(Bertrand)
 Introduction

• In a wide variety of markets firms compete in prices

– Internet access
– Restaurants
– Consultants
– Financial services
• With monopoly setting price or quantity first makes no
difference
– Check?
• In oligopoly it matters a great deal
– nature of price competition is much more aggressive the quantity
competition

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 The INTEL/AMD duel
• We already saw them…
• 2006
– May AMD (Athlon Dual Core) cuts prices by 50%
– Few days after INTEL cuts the price (Pentium D) by 40% (and older cpus by
60%)
• 2007
– April AMD cuts by 50% on top cpus
– INTEL’s response cut by 40% on top dual core

• [2009 AMD accused INTEL of illegal and predatory practices,

exclusivity market share discounts, quantity discounts]

• But what is it this continuous price cuts? It is precisely price

competition
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 Price Competition: Bertrand
• In the Cournot model price is set by some market
clearing mechanism
• An alternative approach is to assume that firms
compete in prices: (the approach taken by Bertrand)
Then markets adjust quantities
• Leads to dramatically different results
• Take a simple example
– two firms producing an identical product (spring water?)
– firms choose the prices at which they sell their products
– each firm has constant marginal cost of c
– inverse demand is P = A – B.Q
– direct demand is Q = a – b.P with a = A/B and b= 1/B

33
 Bertrand competition
• We need the derived demand for each firm
– demand conditional upon the price charged by the other firm
• Take firm 2. Assume that firm 1 has set a price of p1
– if firm 2 sets a price greater than p1 she will sell nothing
– if firm 2 sets a price less than p1 she gets the whole market
– if firm 2 sets a price of exactly p1 consumers are indifferent
between the two firms: the market is shared, presumably
50:50
• So we have the derived demand for firm 2
– q2 = 0 if p2 > p1
– q2 = (a – bp2)/2 if p2 = p1
– q2 = a – bp2 if p2 < p1

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 Bertrand competition 2

• This can be illustrated as p2

There is a
follows:
• Demand is discontinuous jump at p2 = p1
• The discontinuity in
demand carries over to p1
profit

a - bp1 a q2
(a - bp1)/2

35
 Bertrand competition 3
Firm 2’s profit is:
2(p1,, p2) = 0 if p2 > p1

2(p1,, p2) = (p2 - c)(a - bp2) if p2 < p1

2(p1,, p2) = (p2 - c)(a - bp2)/2 if p2 = p1 For whatever

reason!
Clearly this depends on p1.
Suppose first that firm 1 sets a “very high” price:
greater than the monopoly price of pM = (a +c)/2b

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 What price
should firm 2
Bertrand competition 4 set?
With p1 >Firm
(a +2c)/2b, Firm
will only earn2’s
a profit looks like this:
positive
Firm profit by cutting its
2’s Profit At p2 The monopoly
price to (a + c)/2b or=less
p1
price
So firm 2 should just firm 2 gets half of the
undercut p1 a bit and monopoly profit
p2 < p1
get almost all the
What if firm 1
monopoly profit
prices at (a + c)/2b?

p2 = p1

p2 > p1

c (a+c)/2b p1 Firm 2’s Price

37
 Bertrand competition 5
Now suppose that firm 1 sets a price less than (a + c)/2b
Firm 2’s profit looks like this:
Firm 2’s Profit Whatasprice
As long p1 > c,
Of course, firm 1 should
Firm firmaim
2 should 2 just
will then undercut to undercut
set now? firm 1
firm 2 and so on
p2 < p1
Then firm 2 should also price
at c. Cutting price below cost
gains the whole market but loses
What
moneyif firm 1
on every customer
prices at c? p2 = p1

p2 > p1

c p1 (a+c)/2b Firm 2’s Price

38
 Bertrand competition 6

• We now have Firm 2’s best response to any price set by

firm 1:
– p*2 = (a + c)/2b if p1 > (a + c)/2b
– p*2 = p1 - “something small” if c < p1 < (a + c)/2b
– p*2 = c if p1 < c
• We have a symmetric best response for firm 1
– p*1 = (a + c)/2b if p2 > (a + c)/2b
– p*1 = p2 - “something small” if c < p2 < (a + c)/2b
– p*1 = c if p2 < c

39
 Bertrand competition 7
The best response
function for The best response
These best response
firm 1 functions look like this
function for
p2 firm 2
R1

R2
(a + c)/2b
The Bertrand
The equilibrium
equilibrium has
is with both
both firms charging
firms pricing at
c c marginal cost

p1
c (a + c)/2b

40
P-Competition and asymmetric costs

• If c2 > c1 firm 1 has an advantage

• Even if p2 = c2 firm can always «undercut»

• Equilibrium?
– p2 = c2
– p1 = c2 -  (a small discount)
– Hence the actual price paid by consumers depends
on the excluded firm

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P-Competition and asymmetric costs

c1 < c2
p2

The equilibrium is always at

c2 the interception of the best
response functions :
p1 = c2 - 

c1 p1

42
 Bertrand Equilibrium: modifications
• The Bertrand model makes clear that competition in prices is very different from
competition in quantities
• Why these differences?
– In q-competition, each firm has a moderate incentive to increase production (increase of profits is
“smooth”): market concentration matters for Q and p
– In p-competition, firms have a strong incentive to slightly reduce price; Market concentration
does not matter, two firms are enough to get the outcome of perfect competition
• Since many firms seem to set prices (and not quantities) this is a challenge to the
Cournot approach AND p-competition leads to an extreme result (can we believe
it?)
• But the extreme version of the difference seems somewhat forced, let us see: two
extensions can be considered
– impact of capacity constraints
– product differentiation
– Fixed cost, increasing marginal costs

43
 Product differentiation

• Original analysis also assumes that firms offer

homogeneous products
– That’s why a small difference in prices has huge effects on sales
• Creates incentives for firms to differentiate their
products
– to generate consumer loyalty
– do not lose all demand when they price above their rivals
• keep the “most loyal”
• Very important, we will come back on this in the future!

44
 What about if …

• In the standard model of price competition (no

capacity constraint, no product differentiaiton) the
firms are asymmetric?
– We saw, that although one firm will be inactive, the other
will be active and make profits.
• Firms face fixed cost F?
– It’s a problem in the standard model of price competition
with symmetric costs, variable profits are nil… and then -F
• Firms face increasing marginal costs?...

45
Standard Bertrand model with increasing marginal costs

C’

p1 = p2 = p* D

q1 q1+q2 q
• If I undercut p* I earn all the market, must produce a lot which now has a very
large marginal cost! It may be unprofitable (as in figure)!
• Finding the equilibrium can be difficult (again mixed strategies) but this is
another reason that may eliminate the paradox of Bertrand standard model. 46
 Capacity Constraints
• For the p = c equilibrium to arise, both firms need
enough capacity to fill all demand at p = c
• But when p = c they each get only half the market
• So, at the p = c equilibrium, there is huge excess capacity
• So capacity constraints may affect the equilibrium
• Consider an example
– daily demand for skiing on Mount Norman Q = 6,000 – 60P
– Q is number of lift tickets and P is price of a lift ticket
– two resorts: Pepall with daily capacity 1,000 and Richards with
daily capacity 1,400, both fixed
– marginal cost of lift services for both is $10

47
 The Example
• Is a price P = c = $10 an equilibrium?
– total demand is then 5,400, well in excess of capacity
• Suppose both resorts set P = $10: both then have
demand of 2,700
• Consider Pepall:
– raising price loses some demand
– but where can they go? Richards is already above capacity
– so some skiers will not switch from Pepall at the higher price
– but then Pepall is pricing above MC and making profit on the
skiers who remain
– so P = $10 cannot be an equilibrium

48
 The example 2
• Assume that at any price where demand at a resort
is greater than capacity there is efficient rationing
– serves skiers with the highest willingness to pay
• Then can derive residual demand
• Assume P = $60
– total demand = 2,400 = total capacity
– so Pepall gets 1,000 skiers
– residual demand to Richards with efficient rationing is Q =
5000 – 60P or P = 83.33 – Q/60 in inverse form
– marginal revenue is then MR = 83.33 – Q/30

49
 The example 3
• Residual demand and MR:
Price
• Suppose that Richards sets P
$83.
= $60. Does it want to 33
change? Demand
– since MR > MC Richards does $60
not want to raise price and lose M
skiers $36. R
66
$10 M
– since QR = 1,400 Richards is at
capacity and does not want to C
1,40 Quantity
reduce price 0
• Same logic applies to Pepall so P = $60 is a Nash
equilibrium for this game.

50
 Capacity constraints again

• Logic is quite general

– firms are unlikely to choose sufficient capacity to serve the
whole market when price equals marginal cost
• since they get only a fraction in equilibrium
– so capacity of each firm is less than needed to serve the whole
market
– but then there is no incentive to cut price to marginal cost
• So the efficiency property of Bertrand equilibrium
breaks down when firms are capacity constrained

51
 Linking Cournot e Bertrand
• Firms must choose:
a) FIRST production capacity, and then
b) THEN the price to sell production

• Kreps- Scheinkman have shown that the price in this case the
equilibrium price is above the maginal cost and the equilibrium
(price and quantity trade) can very much be that of the Cournot
equilibrium
The Q-competition model can be seen as a black box of the two
decisions (capacity and price), i.e. the long run equilibrium,
very useful!
Instead p-competition can be seen more a description of short
run, if capacity is large

52
END OF PRICE COMPETITION

53
Dynamic Games and First and
Second Movers

54
 Introduction
• In a wide variety of markets firms compete sequentially
– one firm makes a move
• new product
• advertising
– second firms sees this move and responds
• These are dynamic games
– may create a first-mover advantage
– or may give a second-mover advantage
– may also allow early mover to preempt the market
• Can generate very different equilibria from
simultaneous move games

55
 Stackelberg

• Interpret first in terms of Cournot

• Firms choose outputs sequentially
– leader sets output first, and visibly
– follower then sets output
• The firm moving first has a leadership advantage
– can anticipate the follower’s actions
– can therefore manipulate the follower
• For this to work the leader must be able to commit to
its choice of output
• Strategic commitment has value

56
 Stackelberg equilibrium
• Assume that there are two firms with identical products
• As in our earlier Cournot example, let demand be:
– P = A – B.Q = A – B(q1 + q2)
• Marginal cost for for each firm is c

• Firm 1 is the market leader and chooses q1

• In doing so it can anticipate firm 2’s actions
• So consider firm 2. Residual demand for firm 2 is:
– P = (A – Bq1) – Bq2
• Marginal revenue therefore is:
– MR2 = (A - Bq1) – 2Bq2

57
 Stackelberg
This isEquate equilibrium 2
marginal revenue
firm 2’s
with marginal cost
MR2 = (A - Bq1) – 2Bq best 2response
But firmq21 knows
MC = c function
what q2 is going Firm 1 knows that
From earlier example
 q*2 = (A - c)/2B - q1/2 we know
to be this is how firm 2
that this is the monopoly output. This is an will reactSotofirm
firm11’s
Demand for firm 1 is:
important result. The Stackelberg leader can
output choicefirm 2’s
anticipate
chooses the same output
P = (A - Bq2) – Bq1 as a monopolist
(A – c)/2B
would.
But firm 2 is not excluded from the market reaction
P = (A - Bq*2) – Bq1
Equate marginal revenue
P = (A - (A-c)/2) – Bq1/2 S
with marginal cost
(A – c)/4B
 P = (A + c)/2 – Bq1/2 Solve this equation R
Marginal revenue for firm 1 is: for output q1
2

q1
MR1 = (A + c)/2 - Bq1 (A – c)/2 (A – c)/B

(A + c)/2 – Bq1 = c
 q*1 = (A – c)/2  q*2 = (A – c)4B

58
 Stackelberg equilibrium 3
Aggregate output is 3(A-c)/4B
So the equilibrium price is (A+3c)/4 q2 Leadership
Firm benefits
1’s best response
theLeadership
leader firmbenefits
is1“like”
but
(A-c)/B
Firm 1’s profit is (A-c)2/8B function
R1 harms the follower
consumers but
Firm 2’s profit is (A-c) /16B
2 firm
Compare
firm 2 2’sthis with
reducestheaggregate
Cournot
We know that the Cournot profits
equilibrium
equilibrium is: (A-c)/2B

qC1 = qC2 = (A-c)/3B (A-c)/3B C

S
The Cournot price is (A+c)/3 (A-c)/4B
R2
Profit to each firm is (A-c)2/9B
q
(A-c)/3B (A-c)/2B (A-c)/ B 1

59
 Stackelberg and commitment
• It is crucial that the leader can commit to its output
choice
– without such commitment firm 2 should ignore any stated
intent by firm 1 to produce (A – c)/2B units
– the only equilibrium would be the Cournot equilibrium
• So how to commit?
– prior reputation
– investment in additional capacity
– place the stated output on the market
• Given such a commitment, the timing of decisions
matters
• But is moving first always better than following?
• Consider price competition

60
 Stackelberg and price competition
• With price competition matters are different
– first-mover does not have an advantage
– suppose products are identical
• suppose first-mover commits to a price greater than marginal cost
• the second-mover will undercut this price and take the market
• so the only equilibrium is P = MC
• identical to simultaneous game
– now suppose that products are differentiated
• suppose that there are two firms and firm 1 can set and commit to its
price first
• we know the demands to the two firms
• and we know the best response function of firm 2

• We will show that the result can be suprirsing: second mover advantage!

61
 Dynamic games and credibility

• The dynamic games above require that firms move in

sequence
– and that they can commit to the moves
• reasonable with quantity
• less obvious with prices
– with no credible commitment solution of a dynamic game
becomes very different
• Cournot first-mover cannot maintain output
• Bertrand firm cannot maintain price
• Consider a market entry game
– can a market be pre-empted by a first-mover?

62
 Credibility and predation

• Take a simple example

– two companies Microhard (incumbent) and Newvel (entrant)
– Newvel makes its decision first
• enter or stay out of Microhard’s market
– Microhard then chooses
• accommodate or fight
– pay-off matrix is as follows:

63
 What is the
An example of predation
But is
The Pay-Off Matrix
equilibrium for this
(Enter, Fight) game?
credible?
There appear to be Microhard
two equilibria to
this game (Enter, Fight)
is not an
Fight Accommodate
equilibrium
(Stay Out,
Enter Accommodate)
(0,
(0, 0)
0) (2, 2)
is not an
Newvel equilibrium

Stay Out (1, 5) (1, 5)

64
 Credibility and predation 2
• Options listed are strategies not actions
• Microhard’s option to Fight is not an action
• It is a strategy
– Microhard will fight if Newvel enters but otherwise remains
placid
• Similarly, Accommodate is a strategy
– defines actions to take depending on Newvel’s strategic choice
• Are the actions called for by a particular strategy
credible
– Is the promise to Fight if Newvel enters believable
– If not, then the associated equilibrium is suspect
• The matrix-form ignores timing.
– represent the game in its extensive form to highlight sequence of
moves

65
 Fight is
The example again
What if Newvel eliminated
decides to Enter?
(0,0)
(0,0) Microhard is
Fight better to
(2,2) Accommodate
Accommodate
Enter M2
(2,2)
Newvel
N1
Enter, Accommodate
Stay is the
unique equilibrium
Out for(1,5) Newvel will choose
this game to Enter since Microhard
will Accommodate

66
 The chain-store paradox
• What if Microhard competes in more than one market?
– threatening in one market one may affect the others
• But: Selten’s Chain-Store Paradox arises
– 20 markets established sequentially
– will Microhard “fight” in the first few as a means to prevent
entry in later ones?
– No: this is the paradox
• Suppose Microhard “fights” in the first 19 markets, will it “fight
” in the 20th?
• With just one market left, we are in the same situation as before
• “Enter, Accommodate” becomes the only equilibrium
• Fighting in the 20th market won’t help in subsequent markets . .
There are no subsequent markets
• So, “fight” strategy will not be adapted in the 20th market

67
 The chain-store paradox 2
• Now consider the 19th market
– Equilibrium for this market would be “Enter, Accommodate”
– The only reason to adopt “Fight” in the 19th market is to
convince a potential entrant in the 20th market that Microhard is
a “fighter”
– But Microhard will not “Fight” in the 20th market
– So “Enter, Accommodate” becomes the unique equilibrium for
this market, too
• What about the 18th market?
– “Fight” only to influence entrants in the 19th and 20th markets
• But the threat to “Fight” in these markets is not credible.
– “Enter, Accommodate” is again the equilibrium
• By repetition, we see that Microhard will not “Fight” in
any market

68
END OF DYNAMIC GAMES
AND FIRST AND SECOND
MOVERS
69