Industrial Organization

Prof. Nicolas Boccard

Departament d’Economia
Universitat de Girona, Spain

2021

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Course Syllabus

1 Imperfect Competition

2 Differentiation

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 Imperfect Competition Outline

Chapter 1: Imperfect Competition

Oligopoly with Simultaneous Decisions

1 Imperfect Competition
Cournot Competition
Bertrand Competition
Stackelberg Leadership
Hotelling Competition

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 Imperfect Competition Cournot Competition

Competition via Quantities: Cournot

• Duopoly: competition between two producers

• Good of identical quality with a common marginal cost
• Market almost competitive: law of one price
• In equilibrium demand D(p) equate supply from duopolists
a°q1 °q2
• Market price: p = P(q1 + q2 ) = b
• Profit: ¶C
1 (q1 , q2 ) = q1 P(q1 + q2 ) ° cq1
• Marginal revenue: Rm,1 = P(q1 + q2 ) + q1 P 0 (q1 + q2 )
• Best reply: quantity q1 that maximizes ¶C
1 (q1 , q2 )
a°bc°q2
• Rm,1 = c ) q1 = BR1C (q2 ) ¥ 2
• Equilibrium: solution (q1C , q2C ) to q1 = BR1C (q2 ) and q2 = BR2C (q1 )

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 Imperfect Competition Cournot Competition

Cournot Web

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 Imperfect Competition Cournot Competition

Equilibrium comparative statics

a°bc a+2bc
• Quantities: q1C = q2C = qC ¥ 3 , Price: pC ¥ P(q1C + q2C ) = 3b
a°bc pC °c a°bc
• Profit margin: pC ° c = 3b , Lerner index: L= pC
= a+2bc >0
2
(a°bc)
• Equilibrium profit: ¶C C C C
1 = ¶2 = q (p ° c) = 9b

• Welfare: W M < W C < W § (with A = W § ° W C and B = W C ° W M )

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 Imperfect Competition Cournot Competition

Extensions

• Duopoly with Asymmetric cost: c1 < c2

a°b(2c1 °c2 )
• Equilibrium: q1C = 3 > q2C
1 C 2 1 C 2
• Comparative advantage: ºC 1 = b (q1 ) > ºC
2 = b (q2 )
• Applications: cost edge, trade policy, switching cost

• Oligopoly: n firms
P
• Market demand: Q = q1 + q2 = qi + Q°i where Q°i ¥ j6=i qj
a°bci °Q°i
• Best reply: qi = BRiC (Q°i ) = 2
• Symmetric cost ) symmetric equilibrium: qi = q for i = 1, .., n
a°bc°(n°1)q a°bc
• Individual quantity solves q = 2 , qC ¥ n+1
n 1 (a°bc)2
• Demand: QC = n+1 (a ° bc), Profit: ¶C ¥ (n+1)2 b

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 Imperfect Competition Bertrand Competition

Competition via Prices: Bertrand

• Pure Competition: Homogeneous Goods

• Online markets: software, music, movies, computers, books
• Demand 1 ° p goes to lowest price, ties lead to equal sharing
• Let ≤ be the small unit of money and p the opponent’s price
• º(p + ≤) = 0 < º(p) = 12 (p ° c)(1 ° p) < º(p ° ≤) = (p ° ≤ ° c)(1 ° p + ≤)
• Best reply against p is p ° ≤ meanwhile greater than c
• “Cut-throat” competition pushes the price downward
• Bertrand Paradox: in equilibrium, firms name their marginal cost
as if they were competitive price-takers!!
• Asymmetric cost c1 < c2 : equilibrium p = c2 ° ≤
• Expensive firm excluded from market by cheap one

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 Imperfect Competition Bertrand Competition

Edgeworth Critique
• Constant marginal cost c valid for a small range of production
• With capacity k and extra cost c, undercutting story changes
• At equal price, demand is shared. A price cut doubles demand
• BUT cheap firm rations 100 ° k customers if c < p < c + ±
• Consumers turn back to expensive firm who enjoys market power
• Incentive to respond by another price cut not clear.

+δ

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 Imperfect Competition Bertrand Competition

Examples
• Mineral spring waters
• Danone’s Evian vs. Nestlé’s Vittel
• Geological conditions imply limited production ) Cournot
• Purified tap water: no production limit ) Bertrand
• Mixed case in Europe due to quality attribute
• Firms sell 6= spring waters under same brand name
• Procurement auction for standardized items
• Paper Pulp for Newspaper
• Hotel rooms for Airline
• Game Consoles
Console 12/01 1/02 5/02 1 day 1 week 5/03 1 day 9/03 3/04
Sony 299 299 199 199 199 179 179 179 179
Nintendo 350 199 199 199 149 149 149 99 99
Microsoft 400 299 299 199 199 199 179 179 149

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 Imperfect Competition Bertrand Competition

Bertrand vs. Cournot

• Homogeneous goods or services

• Theory shows that competition via quantities
• Synthesis of sequential competition
• ¨ Choice of technologies (capacities)
• ≠ Competition via prices
• If building capacity is costly, then Cournot is adequate
• Otherwise, Bertrand is the right model
• In between ? Differentiation

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 Imperfect Competition Stackelberg Leadership

Stackelberg Leadership

• Intuition: a firm moves first (leader), other follow

• Firm 1 commits to sell q̄1 (public announcement)
• Firm 2 later responds and cannot ignore this information
• Firm 2 rational ) must play BR2C (q̄1 ) (no credibility for acting 6=)
• Strategic subst.: q̄1 %) q2 & i.e., 1 can free ride on 2 to sell more
• At Cournot eq., marginal revenue = marginal cost
• With commitment, marginal revenue % since price effect smaller
@q @q
• R̄m,1 = P + P 0 q̄1 + P 0 @q̄21 = Rm,1 + P 0 @q̄21 > Rm,1
• Incentive to flood the market, yet price falls (imperfect substitution)
• Equilibrium: total supply %, price &, CS %, welfare %

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 Imperfect Competition Stackelberg Leadership

Formal Analysis

• Choice q̄1 forces q2 = BR2C (q̄1 )

a°q̄ °BRC (q̄ )
1 1 a+bc°q̄
• Price p = b
2
= 2b 1
° ¢ ° ¢
• ¶1 q̄1 , BR2C (q̄1 ) = q̄1 (p ° c) = 12 q̄1 a ° bc ° q̄1
a°bc a°bc
• Optimum q1S = C
2 > q1 = 3
• Eq. Response q2S = BR2C (q1S ) = a°bc C a°bc
4 < q2 = 3
• Output q1S + q2S > q1C + q2C ) Price & ) Welfare %
• Profits ¶S2 < ¶C C S S S C
2 = ¶1 < ¶1 and ¶1 + ¶2 < ¶1 + ¶2
C

• Flooding market shrinks overall profits but increases share for leader

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 Imperfect Competition Stackelberg Leadership

Value of Commitment

• Time Consistency pb.: #1 wish to reneg on commitment

• If #2 plays q2S then best reply is BR1 (q2S ) < q1S since q1S > q1C
• Need to enforce commitment with threat of punishment

• Legal system necessary, but seldom used!

• Weak law makes business commitments difficult

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 Imperfect Competition Hotelling Competition

Price competition with Differentiation: Hotelling

• People buy from many different shops charging different prices, why ?
• If a seller increases his price, he loses some customers, but not all
• Customers lost by the seller, buy elsewhere or refrain altogether ?
• Depends on own-price and cross-price elasticities of demand
• Hotelling’s Model
• Linear city, unit length
• Transportation cost t to go through city
• Shops A and B located at the outskirts
• Population distributed uniformly by address x 2 [0; 1]
• Consumer homogeneous in willingness to pay p̄ for one unit
• Consumer heterogeneous in address, thus in transportation cost
• Utility of x from shop A: uA (x) = p̄ ° pA ° tx
• Utility of x from shop B: uB (x) = p̄ ° pB ° t(1 ° x)
• Third alternative: refrain from consuming ) u0 = 0
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 Imperfect Competition Hotelling Competition

Hotelling Equilibrium

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 Differentiation Outline

Chapter 2: Differentiation

2 Differentiation
Introduction
Horizontal Differentiation
Location and Variety
Quality: vertical differentiation

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 Differentiation Introduction

Genesis

• Perfect competition: discrepancies between

• Empirical observations
• Theoretical predictions
• Ascribed by Marshall to exogenous frictions
• Theory of imperfect competition: endogenous frictions
• Firms try to differentiate themselves from rivals, why?
• To escape deleterious Bertrand competition
• To avoid antitrust prosecution (disloyal rivalry)
• Root of differentiation: homogeneity of goods
• Classification of differentiated products
• Horizontal: characteristics, divergent opinions
• Vertical: quality, convergent opinions

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 Differentiation Horizontal Differentiation

Differentiation Principles

• Hotelling: Maximum Differentiation Principle

• Firms maximally differentiate in order to relax price competition
• Caveat: true along their most importance characteristic
• Otherwise choose the same attributes
• Example: shopping street
• focus on single product (apparel, books)
• Initial success ) free-riders sit next door
• Attraction point for consumers ) market expands
• Virtuous circle ) new entry but Bertrand competition looms
• Differentiated entry, possible because heterogeneous tastes
• Geographical agglomeration driven by demand expansion

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 Differentiation Horizontal Differentiation

Competition for Location

• Location issue: which is better among

• move away from one’s competitor to relax competition
• come nearby to capture his clientele
• Hotelling model
• First stage: shops locate within city, not necessarily outermost
• Second stage: price competition
• Equilibrium found by backward induction

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 Differentiation Location and Variety

Variety and Opportunity Cost

• Original theory of horizontal differentiation: geographical dispersion

• Variety: new interpretation of horizontal differentiation
• Within a market segment: Interbrand Competition
• Firms develop brands & image to distinguish themselves
• Choosing attributes & characteristics ) varieties
• Appeal differently to subjective heterogeneous tastes of consumers
• Consumer characterized by ideal combination of attributes
• Existing supply: imperfect substitute
• Opportunity Cost: of consuming one instead of the other

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 Differentiation Location and Variety

Space of Products Characteristics

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 Differentiation Location and Variety

Space of Products Characteristics

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 Differentiation Location and Variety

Space of Products Characteristics

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