Chapter 7
Oligopoly
Why do we need game theory?
Bertrand Model
• Assumptions:
• There are two firms in the industry.
• Homogeneous product.
• Simultaneously set prices
• Market demand is linear
• There is a fixed marginal cost (MC)
Bertrand Model
Bertrand Equilibrium
• Is there a dominant strategy equilibrium?
• Is there an IEDS?
• Is “firm 1 sets p1*= c, firm 2 sets p2*= c” a Nash Equilibrium?
• Why?
Bertrand Equilibrium
• Are there any other Nash Equilibria?
• P1 > P2 > c. not Nash. Why?
• P1 = P2 > c. not Nash Why?
• P1 > c > P2. not Nash. Why?
• Any equilibrium cannot involve charging lower than c, why?
• Any other cases?
The Bertrand Paradox
• Two firms compete by choosing prices simultaneously.
• The unique Nash equilibrium is where both firms choose p = c!
• Why is this a paradox?
• With only two competitors, the Nash equilibrium is the same as the competitive
equilibrium.
• One firm: monopoly; two firms: perfect competition.
• Which does not make sense with real world data.
Bertrand Model with Capacity Constraints
There are two firms. The inverse market demand is P(Q) = 12 − Q. No firm can produce more than K
= 3 units. Both firms have a constant marginal cost of MC = 2.
CLAIM #1: P1 = P2 = 2 is not a Nash equilibrium.
CLAIM #2: P1 = P2 = 6 is a Nash Equilibrium. (Note: At this price, the capacity is exactly satisfied!)
Bertrand Model with Capacity Constraints
CLAIM #1: P1 = P2 = 2 is not a Nash equilibrium
• When P1 = P2 = 2, both firms make zero profit. Now, let firm 1 deviate and set a higher price, for example P1 = 4.
• All consumers go to firm 2 first, and buy a total of 3 units. (full capacity).
• The residual demand for firm 1 is Q(P) = 12 – P – 3= 9-P
• P1 = 4, there is 5 units of residual demand for firm 1
• Because firm 1 can produce 3 units, (Capacity constraint K = 3) with P1 = 4 firm 1’s profit will be (P1 – 2)xq = (4 −
2)x3 = 6.
• Which is better than setting 2, hence P1 = P2 = 2 is not a Nash equilibrium
Bertrand Model with Capacity Constraints
• CLAIM #2: P1 = P2 = 6 is a Nash equilibrium
• Given P1 = P2 = 6, quantity demanded is 6, which is shared equally
between the firms. Each firm sells its full capacity at P = 6. Each firm
makes a profit of 12.
• To show that this is the Nash equilibrium we have to show the
following:
• “Given p2 = 6, firm 1 cannot increase its profit by setting a price other
than 6.”
• Decreasing P1 is not a profitable option because at P1 = 6 the firm is at
full capacity, it can’t sell more.
Bertrand Model with Capacity Constraints
• Can firm 1 make more profits by raising P1 ?
• Suppose Firm 1 tries that: raise price above 6, and leave some capacity unused. Can this be more
profitable?
• With P1 > 6 = P2 all consumers would go to Firm 2 first, and buy a total of 3 units. (full capacity).
• The residual demand for Firm 1 would be Q(P) = 12 − P − 3=9-P
• Ask: what is the best price on this residual demand curve for firm 1?
• What would a monopoly firm with MC = 2, and facing the demand Q(P) = 9 − P do?
• TR = P(Q)xQ = (9 – Q)xQ ; MR = 9 – 2Q, at Q = 3 we have MR = 3! & MC = 2
• Increase P (decrease Q), MR will always be above 3 (hence above 2). Increasing P is not profitable.
• Therefore setting the price above or below 6 is not any better. Hence, P1 = P2 = 6 is a Nash
equilibrium
Cournot Model
• Two firms in the market
• Instead of choosing price, the firms choose quantity.
Cournot Model
Once the firms choose their quantities, the price adjusts so as to clear the market:
That means: Once the firms choose their quantities, the price will reach the level at
which the quantity demanded equals the total quantity produced by the two firms.
Example: The market demand is Q(P) = 20 – 4P.
The inverse demand is P(Q) = 5 – Q/4.
If q1 = 3, and q2 = 5, the price will be 3.
Cournot Model
Cournot Model
• If you make the calculation for the second firm you find:
𝑎−𝑐 𝑞1
• 𝑞2 = +
2𝑏 2
• Solving two equations with two unknowns, you find the Nash Equilibrium
𝑎−𝑐
• 𝑞1 = 𝑞2 =
3𝑏
Cournot: Example
Demand QD(P) = 12 – P; Inverse demand P(Q) = 12 – Q
q1 : output level of firm 1; q2 : output level of firm 2
For both firms all costs are zero.
P is determined by the equation QD(P) = q1 + q2 12 – P = q1 + q2
We can write P = 12 – (q1 + q2)
Firm 1 chooses q1 to maximize Pxq1 = {12 – (q1 + q2)}xq1
Firm 2 chooses q2 to maximize Pxq2 ={12 – (q1 + q2)}xq2
Cournot: Example
Start with firm 1. Write the profit function (remember: all costs are zero)
π1(q1 , q2) = {12 – (q1 + q2)} x q1
Differentiate π1 with respect to q1, set equal to 0:
dπ1/dq1 = 12 – 2q1 – q2 = 0
Cournot: Example
dπ1/dq1 = 12 – 2q1 – q2 = 0.
Solve for q1; q1 = 6 – 0.5q2
Likewise if you solve for q2; q2 = 6 – 0.5q1
qNE1 = qNE2 = 4.
In the Nash equilibrium each firm will produce 4 units of output.
.
Cournot: Example
Consider this:
Both firms could have made more profit if they were to produce 3 units each.
But q1 = 3 and q2 = 3 is NOT a self sustaining arrangement!
q1 = 6 – 0.5q2
If q2 = 3, the best quantity for firm 1 is q1 = 4.5.
So unless there is a mechanism that punishes firms that produce more than 3 units, this is not going
to work.
Homework: Assume that Marginal Cost for the first firm is equal to 1, and for the second firm it is
equal to 2; solve for the equilibrium
Bertrand vs. Cournot
• Which has better assumptions?
• If capacity and output can be easily adjusted, then the Bertrand
model is a better approximation of duopoly competition. If, by
contrast, output and capacity are difficult to adjust, then the Cournot
model is a good approximation of duopoly competition.
Bertrand vs. Cournot
Bertrand vs. Cournot
Comparative Statics
Comparative Statics
Homework
• Solve 7.3, 7.5