Pure Monopoly

A monopolized market has a single

seller.
The monopolists demand curve is
Chapter Twenty-Four the (downward sloping) market
demand curve.
Monopoly So the monopolist can alter the
market price by adjusting its output
level.

Pure Monopoly Why Monopolies?

$/output unit
Higher output y causes a
p(y) What causes monopolies?
lower market price, p(y).
a legal fiat; e.g. US Postal Service

Output Level, y

Why Monopolies? Why Monopolies?

What causes monopolies?
a legal fiat; e.g. US Postal Service
a patent; e.g. a new drug
What causes monopolies?
a legal fiat; e.g. US Postal Service
a patent; e.g. a new drug
sole ownership of a resource; e.g.
a toll highway

1
 Why Monopolies? Why Monopolies?
What causes monopolies? What causes monopolies?
a legal fiat; e.g. US Postal Service a legal fiat; e.g. US Postal Service
a patent; e.g. a new drug a patent; e.g. a new drug
sole ownership of a resource; e.g. sole ownership of a resource; e.g.
a toll highway a toll highway
formation of a cartel; e.g. OPEC formation of a cartel; e.g. OPEC
large economies of scale; e.g. local
utility companies.

Pure Monopoly Profit-Maximization

( y ) = p( y ) y c ( y ).
Supposethat the monopolist seeks
to maximize its economic profit, At the profit-maximizing output level y*
( y ) = p( y ) y c ( y ). d( y ) d dc ( y )
= ( p ( y ) y) =0
What output level y* maximizes
dy dy dy
profit? so, for y = y*,
d dc ( y )
(p ( y ) y) = .
dy dy

Profit-Maximization Profit-Maximization
$ $
R(y) = p(y)y R(y) = p(y)y
c(y)

y y

2
 Profit-Maximization Profit-Maximization
$ $
R(y) = p(y)y R(y) = p(y)y
c(y) c(y)

y*
y y

(y) (y)

Profit-Maximization Profit-Maximization
$ $
R(y) = p(y)y R(y) = p(y)y
c(y) c(y)

y* y*
y y

(y) (y)

Profit-Maximization Marginal Revenue

$ Marginal revenue is the rate-of-change of
R(y) = p(y)y
c(y) revenue as the output level y increases;
d dp( y )
MR( y ) = ( p ( y ) y ) = p( y ) + y .
dy dy

y*
y
At the profit-maximizing
output level the slopes of
the revenue and total cost (y)
curves are equal; MR(y*) = MC(y*).

3
 Marginal Revenue Marginal Revenue
Marginal revenue is the rate-of-change of E.g. if p(y) = a - by then
revenue as the output level y increases; R(y) = p(y)y = ay - by2
d dp( y )
MR( y ) = ( p ( y ) y ) = p( y ) + y . and so
dy dy MR(y) = a - 2by < a - by = p(y) for y > 0.
dp(y)/dy is the slope of the market inverse
demand function so dp(y)/dy < 0. Therefore
dp( y )
MR ( y ) = p( y ) + y < p( y )
dy
for y > 0.

Marginal Revenue Marginal Cost

E.g. if p(y) = a - by then Marginal cost is the rate-of-change of total
R(y) = p(y)y = ay - by2 cost as the output level y increases;
and so dc ( y )
MC( y ) = .
MR(y) = a - 2by < a - by = p(y) for y > 0. dy
E.g. if c(y) = F + y + y2 then
a p(y) = a - by
MC( y ) = + 2 y.

a/2b a/b y
MR(y) = a - 2by

$
Marginal Cost Profit-Maximization; An Example
c(y) = F + y + y2
At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and
F c(y) = F + y + y2 then
y MR ( y*) = a 2by* = + 2 y* = MC( y*)
$/output unit

MC(y) = + 2y

y

4
 Profit-Maximization; An Example Profit-Maximization; An Example
At the profit-maximizing output level y*, At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and if MR(y*) = MC(y*). So if p(y) = a - by and if
c(y) = F + y + y2 then c(y) = F + y + y2 then
MR ( y*) = a 2by* = + 2 y* = MC( y*) MR ( y*) = a 2by* = + 2 y* = MC( y*)
and the profit-maximizing output level is and the profit-maximizing output level is
a a
y* = y* =
2( b + ) 2( b + )
causing the market price to be
a
p ( y*) = a by* = a b .
2( b + )

Profit-Maximization; An Example Profit-Maximization; An Example

$/output unit $/output unit

a p(y) = a - by a p(y) = a - by

MC(y) = + 2y MC(y) = + 2y

y y* = y
a
MR(y) = a - 2by 2( b + ) MR(y) = a - 2by

Monopolistic Pricing & Own-Price

Profit-Maximization; An Example
Elasticity of Demand
$/output unit
Suppose that market demand
a p(y) = a - by
becomes less sensitive to changes in
p ( y*) = price (i.e. the own-price elasticity of
ab
a demand becomes less negative).
2( b + ) MC(y) = + 2y Does the monopolist exploit this by
causing the market price to rise?
y* = y
a
2( b + ) MR(y) = a - 2by

5
Monopolistic Pricing & Own-Price Monopolistic Pricing & Own-Price
Elasticity of Demand Elasticity of Demand
d dp( y ) d dp( y )
MR( y ) = ( p ( y ) y) = p ( y ) + y MR( y ) = ( p ( y ) y) = p ( y ) + y
dy dy dy dy
y dp( y ) y dp( y )
= p( y ) 1 + . = p( y ) 1 + .
p ( y ) dy p ( y ) dy
Own-price elasticity of demand is
p( y ) dy
=
y dp( y )

Monopolistic Pricing & Own-Price Monopolistic Pricing & Own-Price

Elasticity of Demand Elasticity of Demand
d dp( y )
MR( y ) = ( p ( y ) y) = p ( y ) + y MR ( y ) = p( y ) 1 + .
1
dy dy
y dp( y )
= p( y ) 1 + . Suppose the monopolists marginal cost of
p( y ) dy production is constant, at $k/output unit.
Own-price elasticity of demand is For a profit-maximum
MR ( y*) = p( y*) 1 + = k which is
1
so MR ( y ) = p( y ) 1 + .
p( y ) dy 1
= k
y dp( y ) p( y*) = .
1
1+

Monopolistic Pricing & Own-Price Monopolistic Pricing & Own-Price

Elasticity of Demand Elasticity of Demand
Notice that, since MR ( y*) = p( y*) 1 + = k ,
k 1
p( y*) = .
1+
1
p ( y*) 1 + > 0
1

E.g. if = -3 then p(y*) = 3k/2,
and if = -2 then p(y*) = 2k.
So as rises towards -1 the monopolist
alters its output level to make the market
price of its product to rise.

6
Monopolistic Pricing & Own-Price Monopolistic Pricing & Own-Price
Elasticity of Demand Elasticity of Demand
Notice that, since MR ( y*) = p( y*) 1 + = k , Notice that, since MR ( y*) = p( y*) 1 + = k ,
1 1

1 1 1 1
p( y*) 1 + > 0 1 + > 0 p( y*) 1 + > 0 1 + > 0

1
That is, > 1

Monopolistic Pricing & Own-Price Monopolistic Pricing & Own-Price

Elasticity of Demand Elasticity of Demand
Notice that, since MR ( y*) = p( y*) 1 + = k , Notice that, since MR ( y*) = p( y*) 1 + = k ,
1 1

1 1 1 1
p( y*) 1 + > 0 1 + > 0 p( y*) 1 + > 0 1 + > 0

1 1
That is, > 1 < 1. That is, > 1 < 1.

So a profit-maximizing monopolist always
selects an output level for which market
demand is own-price elastic.

Markup Pricing Markup Pricing

k
p ( y*) 1 + = k
1 k
p ( y*) = =
Markup pricing: Output price is the 1+
1 1+
marginal cost of production plus a
markup. is the monopolists price.
How big is a monopolists markup
and how does it change with the
own-price elasticity of demand?

7
 Markup Pricing
p ( y*) 1 + = k
1 k
p ( y*) =
1+
1 1+
is the monopolists price. The markup is
k k
p ( y*) k = k = . p ( y*) k =
1+ 1+
A Profits Tax Levied on a Monopoly
A profits tax levied at rate t reduces
profit from (y*) to (1-t)(y*).
Q: How is after-tax profit, (1-t)(y*),
maximized?
A Profits Tax Levied on a Monopoly
A profits tax levied at rate t reduces
profit from (y*) to (1-t)(y*).
Q: How is after-tax profit, (1-t)(y*),
maximized?
A: By maximizing before-tax profit, (y*).
So a profits tax has no effect on the
monopolists choices of output level,
output price, or demands for inputs.
I.e. the profits tax is a neutral tax.
Markup Pricing
k k
p ( y*) 1 + = k
1 k
= p ( y*) = =
1+
1 1+
is the monopolists price. The markup is
k k
k = .
1+ 1+
E.g. if = -3 then the markup is k/2,
and if = -2 then the markup is k.
The markup rises as the own-price
elasticity of demand rises towards -1.
A Profits Tax Levied on a Monopoly
A profits tax levied at rate t reduces
profit from (y*) to (1-t)(y*).
Q: How is after-tax profit, (1-t)(y*),
maximized?
A: By maximizing before-tax profit, (y*).
Quantity Tax Levied on a Monopolist
A quantity tax of $t/output unit raises
the marginal cost of production by $t.
So the tax reduces the profit-
maximizing output level, causes the
market price to rise, and input
demands to fall.
The quantity tax is distortionary.
8
Quantity Tax Levied on a Monopolist Quantity Tax Levied on a Monopolist
$/output unit $/output unit

p(y) p(y)
MC(y) + t
p(y*) p(y*) t
MC(y) MC(y)

y* y y* y
MR(y) MR(y)

Quantity Tax Levied on a Monopolist Quantity Tax Levied on a Monopolist

The quantity tax causes a drop
$/output unit $/output unit
in the output level, a rise in the
outputs price and a decline in
p(y) p(y) demand for inputs.
p(yt) MC(y) + t p(yt) MC(y) + t
p(y*) t p(y*) t
MC(y) MC(y)

yt y* y yt y* y
MR(y) MR(y)

The Inefficiency of Monopoly The Inefficiency of Monopoly

$/output unit The efficient output level
A market is Pareto efficient if it
ye satisfies p(y) = MC(y).
achieves the maximum possible total p(y)
gains-to-trade.
Otherwise a market is Pareto
MC(y)
inefficient. p(ye)

ye y

9
 The Inefficiency of Monopoly The Inefficiency of Monopoly
$/output unit The efficient output level $/output unit The efficient output level
ye satisfies p(y) = MC(y). ye satisfies p(y) = MC(y).
p(y) p(y)

CS CS
MC(y) MC(y)
p(ye) p(ye)
PS

ye y ye y

The Inefficiency of Monopoly The Inefficiency of Monopoly

$/output unit The efficient output level $/output unit
ye satisfies p(y) = MC(y).
p(y) Total gains-to-trade is p(y)
maximized.
CS p(y*)
MC(y) MC(y)
p(ye)
PS

ye y y* y
MR(y)

The Inefficiency of Monopoly The Inefficiency of Monopoly

$/output unit $/output unit

p(y) p(y)
CS CS
p(y*) p(y*)
MC(y) PS MC(y)

y* y y* y
MR(y) MR(y)

10
 The Inefficiency of Monopoly The Inefficiency of Monopoly
$/output unit $/output unit

p(y) p(y)
CS CS
p(y*) p(y*)
PS MC(y) PS MC(y)

y* y y* y
MR(y) MR(y)

The Inefficiency of Monopoly The Inefficiency of Monopoly

$/output unit $/output unit Deadweight loss measures
MC(y*+1) < p(y*+1) so both
seller and buyer could gain the gains-to-trade not
p(y) if the (y*+1)th unit of output p(y) achieved by the market.
CS was produced. Hence the
p(y*) p(y*)
PS MC(y) market MC(y)
DWL
is Pareto inefficient.

y* y y* y
MR(y) MR(y)

The Inefficiency of Monopoly How Should a Monopoly Price?

The monopolist produces
$/output unit
less than the efficient So far a monopoly has been thought
quantity, making the of as a firm which has to sell its
p(y)
market price exceed the product at the same price to every
p(y*) efficient market customer. This is uniform pricing.
MC(y) price.
e
p(y ) DWL Can price-discrimination earn a
monopoly higher profits?
y* ye y
MR(y)

11
 Types of Price Discrimination
1st-degree: Each output unit is sold
at a different price. Prices may differ
across buyers.
2nd-degree: The price paid by a
buyer can vary with the quantity
demanded by the buyer. But all
customers face the same price
schedule. E.g. bulk-buying
discounts.
Types of Price Discrimination
3rd-degree: Price paid by buyers in a
given group is the same for all units
purchased. But price may differ
across buyer groups.
E.g., senior citizen and student
discounts vs. no discounts for
middle-aged persons.

First-degree Price Discrimination First-degree Price Discrimination

$/output unit
Each output unit is sold at a different
Sell the y th unit for $p( y ).
price. Price may differ across buyers.
p ( y )
It requires that the monopolist can
discover the buyer with the highest
valuation of its product, the buyer with MC(y)
the next highest valuation, and so on.
p(y)
y y

First-degree Price Discrimination First-degree Price Discrimination

$/output unit $/output unit
Sell the y th unit for $p( y ). Later on Sell the y th unit for $p( y ). Later on
p ( y )
sell the y th unit for $ p( y ). p ( y )
sell the y th unit for $ p( y ). Finally
sell the y th unit for marginal
p( y ) p( y )
cost, $ p( y ).
MC(y) MC(y)
p ( y )

p(y) p(y)
y y y y y y y

12
 First-degree Price Discrimination First-degree Price Discrimination
$/output unit The gains to the monopolist $/output unit So the sum of the gains to
on these trades are: the monopolist on all
p( y ) MC( y ), p( y ) MC( y ) trades is the maximum
p ( y )
and zero. possible total gains-to-trade.
p( y )

p ( y )
MC(y) PS MC(y)

p(y) p(y)
y y y y y y
The consumers gains are zero.

First-degree Price Discrimination First-degree Price Discrimination

$/output unit The monopolist gets
the maximum possible First-degree price discrimination
gains from trade. gives a monopolist all of the possible
gains-to-trade, leaves the buyers
with zero surplus, and supplies the
PS MC(y) efficient amount of output.

p(y)
y y
First-degree price discrimination
is Pareto-efficient.

Third-degree Price Discrimination Third-degree Price Discrimination

Price paid by buyers in a given group
is the same for all units purchased.
But price may differ across buyer
groups.
A monopolist manipulates market
price by altering the quantity of
product supplied to that market.
So the question What discriminatory
prices will the monopolist set, one for
each group? is really the question
How many units of product will the
monopolist supply to each group?

13
 Third-degree Price Discrimination Third-degree Price Discrimination
Two markets, 1 and 2. For given supply levels y1 and y2 the
y1 is the quantity supplied to market 1. firms profit is
Market 1s inverse demand function is ( y1 , y 2 ) = p1 ( y1 ) y1 + p 2 ( y 2 ) y 2 c ( y1 + y 2 ).
p1(y1).
y2 is the quantity supplied to market 2. What values of y1 and y2 maximize
Market 2s inverse demand function is profit?
p2(y2).

Third-degree Price Discrimination Third-degree Price Discrimination

( y1 , y 2 ) = p1 ( y1 ) y1 + p 2 ( y 2 ) y 2 c ( y1 + y 2 ). ( y1 , y 2 ) = p1 ( y1 ) y1 + p 2 ( y 2 ) y 2 c ( y1 + y 2 ).

The profit-maximization conditions are The profit-maximization conditions are

c ( y1 + y 2 ) ( y1 + y 2 ) c ( y1 + y 2 ) ( y1 + y 2 )
= (p1 ( y1 ) y1 ) = (p1 ( y1 ) y1 )
y1 y1 ( y1 + y 2 ) y1 y1 y1 ( y1 + y 2 ) y1
=0 =0
c ( y1 + y 2 ) ( y1 + y 2 )
= (p 2 ( y 2 ) y 2 )
y2 y2 ( y1 + y 2 ) y2
=0

Third-degree Price Discrimination Third-degree Price Discrimination

( y1 + y 2 ) ( y1 + y 2 ) c ( y1 + y 2 )
= 1 and = 1 so ( p 1 ( y1 ) y 1 ) = (p 2 ( y 2 ) y 2 ) =
y1 y2 y1 y2 ( y1 + y 2 )

the profit-maximization conditions are

c ( y1 + y 2 )
(p1 ( y1 ) y1 ) =
y1 ( y1 + y 2 )
c ( y1 + y 2 )
and (p 2 ( y 2 ) y 2 ) = .
y2 ( y1 + y 2 )

14
 Third-degree Price Discrimination Third-degree Price Discrimination
c ( y1 + y 2 ) c ( y1 + y 2 )
( p 1 ( y1 ) y 1 ) = (p 2 ( y 2 ) y 2 ) = ( p 1 ( y1 ) y 1 ) = (p 2 ( y 2 ) y 2 ) =
y1 y2 ( y1 + y 2 ) y1 y2 ( y1 + y 2 )

MR1(y1) = MR2(y2) says that the allocation The marginal revenue common to both
y1, y2 maximizes the revenue from selling markets equals the marginal production
y1 + y2 output units. cost if profit is to be maximized.
E.g. if MR1(y1) > MR2(y2) then an output unit
should be moved from market 2 to market 1
to increase total revenue.

Third-degree Price Discrimination Third-degree Price Discrimination

Market 1 Market 2 Market 1 Market 2

p1(y1) p1(y1)
p2(y2) p2(y2)
p1(y1*) p1(y1*)
p2(y2*) p2(y2*)

MC MC MC MC

y1* y1 y2* y2 y1* y1 y2* y2

MR1(y1) MR2(y2) MR1(y1) MR2(y2)
MR1(y1*) = MR2(y2*) = MC MR1(y1*) = MR2(y2*) = MC and p1(y1*) p2(y2*).

Third-degree Price Discrimination Third-degree Price Discrimination

In which market will the monopolist Inwhich market will the monopolist
set the higher price? cause the higher price?
Recall that
1
MR 1 ( y1 ) = p1 ( y1 ) 1 +
1
and
1
MR 2 ( y 2 ) = p 2 ( y 2 ) 1 + .
2

15
Third-degree Price Discrimination Third-degree Price Discrimination
1 1
So p1 ( y*1 ) 1 + = p 2 ( y*2 ) 1 + .
Inwhich market will the monopolist 1 2
cause the higher price?
Recall that
1
MR 1 ( y1 ) = p1 ( y1 ) 1 +
1
and
1
MR 2 ( y 2 ) = p 2 ( y 2 ) 1 + .
2
* * * *
But, M R 1 ( y 1 ) = MR 2 ( y 2 ) = MC ( y 1 + y 2 )

Third-degree Price Discrimination Third-degree Price Discrimination

1 1 1 1
So p1 ( y*1 ) 1 + = p 2 ( y*2 ) 1 + . So p1 ( y*1 ) 1 + = p 2 ( y*2 ) 1 + .
1 2 1 2

Therefore, p1 ( y*1 ) > p 2 ( y*2 ) only if Therefore, p1 ( y*1 ) > p 2 ( y*2 ) only if
1 1 1 1
1+ < 1+ 1+ < 1+ 1 > 2 .
1 2 1 2

Third-degree Price Discrimination

1 1
So p1 ( y*1 ) 1 + = p 2 ( y*2 ) 1 + .
1 2

Therefore, p1 ( y*1 ) > p 2 ( y*2 ) only if Chapter Twenty-Seven

1 1
1+ < 1+ 1 > 2 .
1 2
Oligopoly
The monopolist sets the higher price in
the market where demand is least
own-price elastic.

16
 Oligopoly
A monopoly is an industry consisting
a single firm.
A duopoly is an industry consisting of
two firms.
An oligopoly is an industry consisting
of a few firms. Particularly, each firms
own price or output decisions affect its
competitors profits.
Quantity Competition
Assume that firms compete by
choosing output levels.
If firm 1 produces y1 units and firm 2
produces y2 units then total quantity
supplied is y1 + y2. The market price
will be p(y1+ y2).
The firms total cost functions are
c1(y1) and c2(y2).
Quantity Competition; An Example
Suppose that the market inverse
demand function is
p( yT ) = 60 yT
and that the firms total cost
functions are
c1 ( y1 ) = y12 and c 2 ( y 2 ) = 15 y 2 + y 22 .
Oligopoly
How do we analyze markets in which
the supplying industry is
oligopolistic?
Consider the duopolistic case of two
firms supplying the same product.
Quantity Competition
Suppose firm 1 takes firm 2s output
level choice y2 as given. Then firm 1
sees its profit function as
1 ( y1; y 2 ) = p( y1 + y 2 ) y1 c1 ( y1 ).
Giveny2, what output level y1
maximizes firm 1s profit?
Quantity Competition; An Example
Then, for given y2, firm 1s profit function is
( y1 ; y 2 ) = ( 60 y1 y 2 ) y1 y12 .
17
Quantity Competition; An Example Quantity Competition; An Example
Then, for given y2, firm 1s profit function is Then, for given y2, firm 1s profit function is
( y1 ; y 2 ) = ( 60 y1 y 2 ) y1 y12 . ( y1 ; y 2 ) = ( 60 y1 y 2 ) y1 y12 .
So, given y2, firm 1s profit-maximizing So, given y2, firm 1s profit-maximizing
output level solves output level solves

= 60 2y1 y 2 2y1 = 0 . = 60 2y1 y 2 2y1 = 0 .
y1 y1
I.e. firm 1s best response to y2 is
1
y1 = R 1 ( y 2 ) = 15 y 2 .
4

Quantity Competition; An Example Quantity Competition; An Example

y2 Firm 1s reaction curve Similarly, given y1, firm 2s profit function is
1
y1 = R 1 ( y 2 ) = 15 y 2 . ( y 2 ; y1 ) = ( 60 y1 y 2 ) y 2 15 y 2 y 22 .
60
4

15 y1

Quantity Competition; An Example Quantity Competition; An Example

Similarly, given y1, firm 2s profit function is Similarly, given y1, firm 2s profit function is
( y 2 ; y1 ) = ( 60 y1 y 2 ) y 2 15 y 2 y 22 . ( y 2 ; y1 ) = ( 60 y1 y 2 ) y 2 15 y 2 y 22 .
So, given y1, firm 2s profit-maximizing So, given y1, firm 2s profit-maximizing
output level solves output level solves

= 60 y1 2y 2 15 2y 2 = 0 . = 60 y1 2y 2 15 2y 2 = 0 .
y2 y2
I.e. firm 1s best response to y2 is
45 y1
y 2 = R 2 ( y1 ) = .
4

18
 Quantity Competition; An Example Quantity Competition; An Example
y2
An equilibrium is when each firms
output level is a best response to the
Firm 2s reaction curve other firms output level, for then
45 y1 neither wants to deviate from its
y 2 = R 2 ( y1 ) = .
4 output level.
A pair of output levels (y1*,y2*) is a
45/4
Cournot-Nash equilibrium if
45 y1 y*1 = R 1 ( y*2 ) and y*2 = R 2 ( y*1 ).

Quantity Competition; An Example Quantity Competition; An Example

y*1 = R 1 ( y*2 ) = 15
1 * 45 y*1 y*1 = R 1 ( y*2 ) = 15
1 * *
y 2 and y*2 = R 2 ( y*1 ) = 45 y1 .
y 2 and y*2 = R 2 ( y*1 ) = .
4 4 4 4
Substitute for y2* to get
1 45 y*1
y*1 = 15
4 4

Quantity Competition; An Example Quantity Competition; An Example

*
y*1 = R 1 ( y*2 ) = 15
1 * 45 y*1 y*1 = R 1 ( y*2 ) = 15 y 2 and y*2 = R 2 ( y*1 ) = 45 y1 .
1 *
y 2 and y*2 = R 2 ( y*1 ) = .
4 4 4 4
Substitute for y2* to get Substitute for y2* to get
1 45 y*1 1 45 y*1
y*1 = 15 y*1 = 13 y*1 = 15 y*1 = 13
4 4 4 4
45 13
Hence y*2 = = 8.
4

19
 Quantity Competition; An Example Quantity Competition; An Example
y*1 = R 1 ( y*2 ) = 15
1 * 45 y*1
y 2 and y*2 = R 2 ( y*1 ) = . y2 Firm 1s reaction curve
4 4 1
y1 = R 1 ( y 2 ) = 15 y 2 .
Substitute for y2* to get 60 4
Firm 2s reaction curve
1 45 y*1
y*1 = 15 y*1 = 13 45 y1
4 4 y 2 = R 2 ( y1 ) = .
4
45 13
Hence y*2 = = 8.
4 45/4
So the Cournot-Nash equilibrium is
( y*1 , y*2 ) = ( 13 , 8 ). 15 45 y1

Quantity Competition; An Example Quantity Competition

y2 Firm 1s reaction curve Generally, given firm 2s chosen output
1 level y2, firm 1s profit function is
y1 = R 1 ( y 2 ) = 15 y 2 .
60 4 1 ( y1 ; y 2 ) = p( y1 + y 2 ) y1 c1 ( y1 )
Firm 2s reaction curve
45 y1 and the profit-maximizing value of y1 solves
y 2 = R 2 ( y1 ) = .
1 p( y1 + y 2 )
c1 ( y1 ) = 0 .
4
Cournot-Nash equilibrium = p( y1 + y 2 ) + y1
y1 y1
8 (y*1 , y*2 ) = (13,8 ). The solution, y1 = R1(y2), is firm 1s Cournot-
13 48 y1 Nash reaction to y2.

Quantity Competition Quantity Competition

Similarly, given firm 1s chosen output y2 Firm 1s reaction curve y1 = R 1 ( y 2 ).
level y1, firm 2s profit function is Firm 1s reaction curve y 2 = R 2 ( y 1 ).
2 ( y 2 ; y 1 ) = p ( y1 + y 2 ) y 2 c 2 ( y 2 )
Cournot-Nash equilibrium
and the profit-maximizing value of y2 solves y1* = R1(y2*) and y2* = R2(y1*)
y*2
2 p( y1 + y 2 )
= p( y1 + y 2 ) + y 2 c 2 ( y 2 ) = 0 .
y2 y2
The solution, y2 = R2(y1), is firm 2s Cournot-
Nash reaction to y1. y*1 y1

20
 The Order of Play
So far it has been assumed that firms
choose their output levels
simultaneously.
The competition between the firms is
then a simultaneous play game in
which the output levels are the
strategic variables.
The Order of Play
Such games are von Stackelberg
games.
Is it better to be the leader?
Or is it better to be the follower?
Stackelberg Games
Q: What is the best response that
follower firm 2 can make to the
choice y1 already made by the leader,
firm 1?
A: Choose y2 = R2(y1).
The Order of Play
What if firm 1 chooses its output level
first and then firm 2 responds to this
choice?
Firm 1 is then a leader. Firm 2 is a
follower.
The competition is a sequential game in
which the output levels are the strategic
variables.
Stackelberg Games
Q: What is the best response that
follower firm 2 can make to the
choice y1 already made by the leader,
firm 1?
Stackelberg Games
Q: What is the best response that
follower firm 2 can make to the
choice y1 already made by the leader,
firm 1?
A: Choose y2 = R2(y1).
Firm 1 knows this and so perfectly
anticipates firm 2s reaction to any y1
chosen by firm 1.
21
 Stackelberg Games Stackelberg Games
This makes the leaders profit This makes the leaders profit
function function
1s ( y1 ) = p ( y1 + R 2 ( y1 )) y1 c1 ( y1 ). 1s ( y1 ) = p ( y1 + R 2 ( y1 )) y1 c1 ( y1 ).
Theleader then chooses y1 to
maximize its profit level.

Stackelberg Games Stackelberg Games

This makes the leaders profit A: Yes. The leader could choose its
function Cournot-Nash output level, knowing
1s ( y1 ) = p ( y1 + R 2 ( y1 )) y1 c1 ( y1 ). that the follower would then also
The leader chooses y1 to maximize its choose its C-N output level. The
profit. leaders profit would then be its C-N
Q: Will the leader make a profit at
profit. But the leader does not have
least as large as its Cournot-Nash to do this, so its profit must be at
equilibrium profit? least as large as its C-N profit.

Stackelberg Games; An Example Stackelberg Games; An Example

The leaders profit function is therefore
The market inverse demand function
is p = 60 - yT. The firms cost 1s ( y1 ) = ( 60 y1 R 2 ( y1 )) y1 y12
functions are c1(y1) = y12 and c2(y2) = 45 y1
= ( 60 y1 ) y1 y12
15y2 + y22. 4
195 7
Firm 2 is the follower. Its reaction = y y2.
function is 4 1 4 1
45 y1
y 2 = R 2 ( y1 ) = .
4

22
 Stackelberg Games; An Example Stackelberg Games; An Example
The leaders profit function is therefore Q: What is firm 2s response to the
leaders choice y 1s = 13 9 ?
1s ( y1 ) = ( 60 y1 R 2 ( y1 )) y1 y12
45 y1
= ( 60 y1 ) y1 y12
4
195 7 2
= y y .
4 1 4 1
For a profit-maximum,
195 7
= y1 y1s = 13 9 .
4 2

Stackelberg Games; An Example Stackelberg Games; An Example

Q: What is firm 2s response to the Q: What is firm 2s response to the
leaders choice y 1s = 13 9 ? leaders choice y 1s = 13 9 ?
s s 45 13 9 s s 45 13 9
A: y 2 = R 2 ( y1 ) = = 7 8. A: y 2 = R 2 ( y1 ) = = 7 8.
4 4
The C-N output levels are (y1*,y2*) = (13,8)
so the leader produces more than its
C-N output and the follower produces less
than its C-N output. This is true generally.

y2
Stackelberg Games y2
Stackelberg Games
(y1*,y2*) is the Cournot-Nash (y1*,y2*) is the Cournot-Nash
equilibrium. equilibrium.
Higher 2
Followers
reaction curve

y2*
Higher 1 y2*
Higher 1

y1* y1 y1* y1

23
 y2
Stackelberg Games y2
Stackelberg Games
(y1*,y2*) is the Cournot-Nash (y1*,y2*) is the Cournot-Nash
equilibrium. (y1S,y2S) is the equilibrium. (y1S,y2S) is the
Stackelberg equilibrium. Stackelberg equilibrium.
Followers Followers
reaction curve reaction curve
y2* Higher 1 y2*
y2S y2S

y1* y1S y1 y1* y1S y1

Price Competition Bertrand Games

What if firms compete using only
price-setting strategies, instead of
using only quantity-setting
strategies?
Games in which firms use only price
strategies and play simultaneously
are Bertrand games.
Each firms marginal production cost
is constant at c.
All firms set their prices
simultaneously.
Q: Is there a Nash equilibrium?

Bertrand Games Bertrand Games

Each firms marginal production cost Each firms marginal production cost
is constant at c. is constant at c.
All firms simultaneously set their All firms simultaneously set their
prices. prices.
Q: Is there a Nash equilibrium? Q: Is there a Nash equilibrium?
A: Yes. Exactly one. A: Yes. Exactly one. All firms set
their prices equal to the marginal
cost c. Why?

24
 Bertrand Games
Suppose one firm sets its price
higher than another firms price.
Bertrand Games
Suppose one firm sets its price
higher than another firms price.
Then the higher-priced firm would
have no customers.
Hence, at an equilibrium, all firms
must set the same price.
Bertrand Games
Suppose the common price set by all
firm is higher than marginal cost c.
Then one firm can just slightly lower
its price and sell to all the buyers,
thereby increasing its profit.
Bertrand Games
Suppose one firm sets its price
higher than another firms price.
Then the higher-priced firm would
have no customers.
Bertrand Games
Suppose the common price set by all
firm is higher than marginal cost c.
Bertrand Games
Suppose the common price set by all
firm is higher than marginal cost c.
Then one firm can just slightly lower
its price and sell to all the buyers,
thereby increasing its profit.
The only common price which
prevents undercutting is c. Hence
this is the only Nash equilibrium.
25