CENTRAL UNIVERSITY OF GUJARAT

SCHOOL OF SOCIAL SCIENCE

M.A. ECONOMICS

MICROECONOMICS – 1

ASSIGNMENT
ON
NON COLLUSIVE OLIGOPOLY –
STACKELBERG MODEL

SUBMITTED TO – DR. SARALA LENIN

SUBMITTED BY – KAVITA YADAV
CUG form number:
CUGPGCT0004880

A brief introduction of OLIGOPOLY

Definition: Oligopoly is a market structure dominated

by a small number of firms. These firms hold significant
market power and their decisions regarding pricing and
output are interdependent.

Key Features
Few Firms: A small number of companies control a
large portion of the market.
Interdependence: Firms must consider competitors’
actions when making strategic decisions.
Barriers to Entry: High barriers exist, making it
difficult for new firms to enter the market.
Product Differentiation: Products can be either
homogenous (like steel) or differentiated (like
smartphones).
Price Rigidity: Prices tend to remain stable due to the
risk of price wars.

Types of Oligopoly

Collusive Oligopoly:
Definition: In a collusive oligopoly, firms work
together to set prices and output levels to maximize
joint profits, often at the expense of consumer welfare.
Examples of Collusion: This can take the form of
explicit agreements (cartels) or tacit agreements where
firms implicitly agree to avoid price competition.
Effects: Leads to higher prices and reduced output
compared to competitive markets, benefiting the firms
involved.

Non-Collusive Oligopoly:
Definition: A non-collusive oligopoly is a market
structure where a few firms dominate the market but
do not engage in collusion to set prices or output levels.
Instead, firms operate independently while being
acutely aware of each other’s actions and strategies.

Characteristics
Few Dominant Firms: A small number of firms hold
significant market power, leading to interdependence in
decision-making.

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Product Differentiation: Products may be
homogenous (like steel) or differentiated (like
automobiles), allowing firms to compete on factors
beyond price.

Barriers to Entry: High barriers prevent new entrants

from easily joining the market, maintaining the status
of existing firms.

Price Rigidity: Firms tend to maintain stable prices, as

lowering prices could lead to price wars.

Strategic Behavior: Firms anticipate the reactions of

rivals when making decisions regarding pricing, output,
and marketing.

Models of Non-Collusive Oligopoly

Kinked Demand Curve Model:
 Proposed by Paul Sweezy, this model suggests that
demand is more elastic for price increases and less
elastic for price decreases.
 If a firm raises its prices, competitors won’t follow,
leading to a loss in market share. Conversely, if a
firm lowers its prices, competitors will match the
price cut, leading to lower revenues.
 This results in a kinked demand curve, creating
price stability in the market.

Cournot Model:
 Named after Augustin Cournot, this model assumes
firms choose quantities simultaneously.
 Each firm decides how much to produce based on
the output of competitors. The market price is
determined by the total quantity produced.

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  Firms aim to maximize profits, leading to a Nash
Equilibrium where no firm can increase profit by
unilaterally changing its output.

Bertrand Model:
 In this model, firms compete on price rather than
quantity.
 If firms set the same price, they share the market.
However, if one firm lowers its price, it captures
the entire market, leading to competitive price
reductions.
 The model predicts that prices will eventually equal
marginal cost in a homogenous product.

And Stackelberg Model

The Stackelberg model, developed by Heinrich von

Stackelberg in 1934, is a strategic
game in microeconomics that describes a
form of oligopoly where firms compete on
quantity. It highlights the leader-
follower dynamic, where one firm (the
leader) makes its production decision
first, and the other firms (followers) make
their decisions based on the leader's output.

o Key Features of the Stackelberg Model

 Leader and Followers:

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 Leader: The firm that moves first and sets its
output level. This firm has a strategic advantage as
it can influence the market outcome.
Followers: The other firms in the market that
react to the leader’s output decision. They make
their quantity decisions after observing the
leader’s choice.

 Assumptions:
 Firms produce a homogeneous product. That
is, they compete for market share. This is the
key difference compared to Bertrand
competition, in which firms compete in prices.
 There are no capacity constraints for firms.
 Firms aim to maximize their own profit.
 Firms have perfect knowledge of the market
and each other’s cost structures.

 Demand and Cost Functions:

The market demand can typically be represented

as P=a−bQ, where
P is the price,
Q is the total quantity produced by all firms, and
A and B are constants.

represented as C(qi) for firm 𝑖.

Each firm has its own cost function, generally

 Asymmetric Information
The leader has an advantage by making the first move,
which can lead to greater market power and influence
over prices. Followers react to the leader’s output,
which means they have less control over the market
outcome.

 Strategic Commitment

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The leader’s decision is a commitment that influences
the follower’s strategy. This commitment can deter
entry or influence competitors’ output levels,
enhancing the leader’s position in the market.

 Reaction Functions
Each firm has a reaction function, which describes how
its output decision depends on the output of the other
firm(s). The leader anticipates the follower’s response
when making its decision.

 Market Equilibrium
The equilibrium in the Stackelberg model is achieved
when the leader’s output maximizes its profit given the
expected reaction of the followers. The followers then
choose their output levels to maximize their own profits
based on the leader’s output.

 Price and Quantity Setting

The model can be used to analyze both price-setting
and quantity-setting behaviors. In quantity-setting,
firms decide how much to produce; in price-setting,
firms decide what price to charge.

 Market Power
The leader typically enjoys higher profits due to its first-
mover advantage, which allows it to capture a larger
market share. This can lead to a market outcome that
is different from perfect competition.

 Examples and Applications

The Stackelberg model is often used in industries like
telecommunications, where a dominant firm might set
prices or output that smaller firms must follow. It is also
relevant in analyzing strategic behaviors in various
market scenarios, including bidding and pricing
strategies.

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  .Extensions and Variations
 Variations of the model include multiple leaders
and followers, and it can be adapted to dynamic
settings where firms can adjust strategies over
time.

 The Stackelberg model provides valuable insights

into strategic interactions among firms,
emphasizing the importance of timing and
commitment in competitive markets.
Understanding this model helps in analyzing
various real-world scenarios, from pricing
strategies to market entry decisions

o How the Stackelberg Model Works

Leader’s Decision:
 The leader determines its optimal output level :-
“QL” By anticipating how the followers will
respond.

 The leader calculates the residual demand after its

output is set, taking into account the total market
demand and the outputs of the followers.

Follower’s Reaction:
 The followers decide their output levels :-
“QF” Based on the quantity produced by the
leader.

 Each follower will maximize its profit given the

leader’s output, leading to a best response
function that describes how followers will react to
any given level of the leader’s output.

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Equilibrium:
 The equilibrium is reached when the leader sets its
output to maximize its profit, anticipating the
reactions of the followers, and the followers set
their outputs accordingly.
 This results in a Nash Equilibrium where no firm
has the incentive to unilaterally change its output.

o Mathematical Representation
 Leader’s Profit Maximization:
The leader’s profit is given by:

Substitute P(Q) into the profit function to express it in

terms of ql and qf.

 Follower’s Profit Maximization:

Each follower’s profit is:

The follower’s output can be derived from its reaction

function based on the leader’s output.

 Solving the Model:

By setting the derivative of the profit functions with
respect to their outputs to zero, we can derive the
optimal output levels for both the leader and the
followers.

o The Stackelberg – Nash Equilibrium

explained through example
 To derive the Stackelberg-Nash equilibrium, we will
focus on the example of a duopoly. That is, there

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 are only two firms in the market. We will assume
that firm 1 (leader) and firm 2 (follower) both
produce the same good at the same production
cost c1 = c2 = c.

 We further assume that both firms face the same

linear demand function given by:

P(Q) = a – bQ Where a > 0 and b > 0.

 The total market quantity is the sum of production

by the leader (q1) and the follower (q2), which is Q
= q1 + q2. We can substitute this expression for
Q in the following equations. Firm 1’s total revenue
is then given by the market price p(Q) times the
quantity produced:
R1 = p(Q)q1 = (a−b(q1 +q2))q1 (analogous for

firm 2),

 And Firm 1’s total profits are calculated as the

difference between revenue and production costs:
π¹= p(Q)q¹−cq¹= (a−b(q¹+q²)−c)q¹
(analogous for firm 2).

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 From here we will assume a > c, which is a
necessary condition such that positive profits can
be realized.

 To find the Nash equilibrium of this sequential

game, we need to use backward induction. That
is, we first solve the optimization problem for the
follower in the second period, and with this
information determine the optimal choice by the
leader in the first period.

 In the second period, Firm 2 (follower) chooses q2,

taking the quantity produced by the leader in the
first period into consideration. So, to derive the
optimal output, we need to find the quantity q2
that maximizes the profit function for Firm 2,
taking q1 as given. For Firm 2, the problem is
thus similar to the Cournot model:

 As in the Cournot Model, the equation R2(q1) is the

best response function of Firm2 to any quantity
produced by Firm 1.

 To calculate the optimal quantity produced by Firm

1, we thus insert the optimal response of Firm 2
into Firm 1’s profit function in place of q2 and then
take the first derivative:

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  Given the quantity produced by the leader, q1*, we
can then calculate the output produced by the

follower:

Stackelberg equilibrium compared to Cournot

equilibrium

 Thus as we saw above , in the Stackelberg-Nash

equilibrium, the leader produces a larger quantity
and the follower produces a smaller quantity than
the same firms would have produced in the
Cournot-Nash equilibrium. q1s > q1C and q2S <
q2C. Graphically:-

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 Calculating the total quantity and the market price,
given q1* and q2*, we see that Stackelberg’s
sequential game leads to a more competitive
equilibrium – characterized by a larger total output
and lower price level – than Cournot’s
simultaneous game.

 The Stackelberg leader takes into account that

higher output causes the follower to produce less,
but also that higher output depresses the price
level. In this particular scenario, with a linear
demand function and identical costs, the two
effects happen to cancel exactly and in this case
we end up with a solution where the Stackelberg
leader produces the monopoly quantity (although
due to the depressed price level, receives less than
monopoly profits).

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  If we were to insert the production quantities and
price level into the profit functions, we would find
that the Stackelberg leader has higher profits, and
the Stackelberg follower lower profits, than the
same firms in the Cournot model. In the figure

below, illustrate the welfare gain in the Stackelberg

model compared to Cournot model, while area 3
illustrates the remaining deadweight loss
compared to a situation of perfect competition.
Importantly, the Stackelberg equilibrium is only more
efficient than the Cournot equilibrium if firms are
symmetric; that is, if both firms have the same
production cost.

o Stackelberg Vs Other Models

The comparison of the Stackelberg model to the other
models is given below:

Parameters Stackelberg Cournot

Bertrand

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Quantity. Medium Low
High
Price Medium High Low
Type of Move Sequential. Simultaneous.
Simultaneous

o The similarity to the Cournot Model

 Both models assume quantity to be the basis of
competition.
 Both models assume homogeneity of products
instead of the Bertrand model, including theory on
differentiated products.

o Limitations
The Stackelberg model, while insightful for
understanding oligopolistic competition, has several
limitations. Here are the key drawbacks:

[Link] Market Structure

Two-Firm Focus: The model typically involves only
two firms (one leader and one follower), which may not
accurately represent real-world markets with multiple
competitors. This simplification can overlook complex
competitive interactions.
Homogeneous Products: It assumes that firms
produce identical products, ignoring product
differentiation, which is common in many industries.

[Link] Analysis
Single Period: The model operates under a static
framework, assuming firms make decisions based on a
single time period. This fails to account for strategic
interactions over time or the impact of previous
decisions on future behavior.
Lack of Dynamic Strategy: Real-world firms may
adjust their strategies based on evolving market

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conditions and competitor actions, which the model
does not capture.

[Link] of Perfect Information

Complete Knowledge: The model assumes that both
firms have full knowledge of the demand and cost
functions. In reality, firms often operate under
uncertainty and may not have access to complete
information about their competitors.
Reaction Functions: The model relies on accurate
estimation of the follower’s reaction function. If the
leader misjudges the follower’s response, it can lead to
suboptimal outcomes.

[Link]-Mover Advantage Limitations

Not Always Sustainable: The first-mover advantage
may not always guarantee long-term profitability.
Subsequent changes in market conditions or follower
strategies can erode this advantage.
Potential for Retaliation: The follower may engage
in aggressive strategies in response to the leader’s
output, diminishing the expected benefits of being the
first mover.

[Link] Structure Assumptions

Constant Marginal Costs: The model typically
assumes constant marginal costs for simplicity. In
reality, firms may experience economies of scale or
increasing marginal costs, affecting their output
decisions.
Identical Cost Structures: It often assumes that both
firms have similar cost structures, which may not
reflect the diversity seen in actual industries.

[Link] Barriers
No Consideration for Entry: The model does not
account for potential market entry by new firms, which

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can alter the competitive landscape. In reality, high
profits attracted by a leader may lead to new entrants,
affecting both firms’ strategies.

[Link] Behavior Ignored

Limited Strategic Options: The model focuses on
quantity competition and does not consider price
competition, advertising, or other strategic actions that
firms may use to influence market outcomes.
Cooperative Behavior: It assumes non-collaborative
behavior between firms. In practice, firms might
engage in tacit collusion or cooperative strategies,
leading to different outcomes.

[Link] Stability
Potential for Multiple Equilibria: The model can
yield multiple equilibria depending on the assumptions
made about cost and demand functions, complicating
predictions about market behavior.
Sensitivity to Parameter Changes: The equilibrium
can be sensitive to changes in the parameters of the
demand and cost functions, making it difficult to
generalize results across different markets.

[Link] on Quantities Over Prices

Price Rigidity: By focusing on quantity competition,
the model does not address how firms set prices, which
can be a more relevant strategy in many markets.
Limited Realism: In many industries, firms may
primarily compete on price rather than quantity,
making the model less applicable.

o Implications of the Stackelberg Model

First-Mover Advantage: The leader can achieve
higher profits than the followers by committing to a

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certain level of output first, thereby influencing the
market dynamics.

Market Outcomes: The model can result in lower total

output compared to perfect competition but higher
total output than a monopoly. This means consumers
may face higher prices compared to a competitive
market.

Strategic Planning: Firms must consider their

position in the market—whether they are a leader or a
follower—and make strategic decisions accordingly.

Dynamic Competition: The Stackelberg model

highlights the importance of timing and strategic
interaction in oligopolistic markets, illustrating how
firms can gain competitive advantages.

o Conclusion
The Stackelberg model provides valuable insights into
how firms operate in an oligopolistic market, especially
regarding the strategic implications of being a leader or
a follower. It emphasizes the role of strategic decision-
making and the importance of anticipating competitors’
reactions in achieving market success.

o References
 Hal R. Varian – inter mediate microeconomics
 Alexander Stein:
[Link]
2021.0495
 Corresponding author: Tao Li :
[Link]
dsb.2017007

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 By Simone Schotte:
[Link]
competition-1526239
 Wikipedia:
[Link]
on

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