University of Toronto, Department of Economics, Ajaz Hussain

Department of Economics (STG)

Ajaz Hussain

How to Solve for Applied Oligopoly Prices to Set Up a Two-Player Game in Oligopoly Prices
Overview (identical to “W24-Lecture)

 There are two “applied oligopolistic firms”.

 We’re given their demand models in the form 𝑃𝑖 = 𝑓(𝑞𝑖 , 𝑃𝑗 ) [i.e. each equation gives us firm 𝑖’s price in terms of its
output 𝑞𝑖 , and its rival’s price 𝑃𝑗 ] as well as each firm’s (constant) 𝐴𝑉𝐶𝑖 = 𝑀𝐶𝑖 .

 We’re asked to compute the numbers in this payoff matrix (and later to solve for pure and mixed strategies NE):
Matrix of Firms 1 and
2’s Gross Profits 𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒚
for each of the nine 𝑷𝟐 𝑷𝑪𝒐𝒖𝒓𝒏𝒐𝒕
𝟐 𝑷𝑩𝒆𝒓𝒕𝒓𝒂𝒏𝒅
𝟐

𝑷𝟏 , 𝑷𝟐 combinations
𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒚
𝑷𝟏 ? ? ? ? ? ?
𝑷𝑪𝒐𝒖𝒓𝒏𝒐𝒕
𝟏 ? ? ? ? ? ?
𝑷𝑩𝒆𝒓𝒕𝒓𝒂𝒏𝒅
𝟏 ? ? ? ? ? ?

Express Demand Models and 𝑴𝑪 as ..

 Take the two demand models (given to you in the form 𝑃𝑖 = 𝑓(𝑞𝑖 , 𝑃𝑗 )) and write them as follows (the table may be easier
to remember/use in the future (“own = 𝑖”; “cross = 𝑗"); make sure you line up the 𝑞’s and 𝑃’s and don’t mess with the
signs):

𝑃𝑖 = 𝑓(𝑞𝑖 , 𝑃𝑗 ) Demand Models

Intercept Own 𝒒 Cross 𝑷 Demand Model
𝑃1 = 𝑎 𝑏 𝑐 𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2
𝑃2 = 𝑑 𝑒 𝑓 𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1

 Label marginal costs as 𝑀𝐶1 and 𝑀𝐶2

 Tip: Once you have derived an expression for Firm 1, then you can derive the “corresponding” expression for Firm 2 by
“replacing” firm 1 parameters as follows: 𝑠𝑤𝑎𝑝 𝑎 → 𝑤𝑖𝑡ℎ 𝑑 , 𝑠𝑤𝑎𝑝 𝑏 → 𝑤𝑖𝑡ℎ 𝑒 , 𝑠𝑤𝑎𝑝 𝑐 → 𝑤𝑖𝑡ℎ 𝑓 , and
𝑠𝑤𝑎𝑝 𝑀𝐶1 → 𝑤𝑖𝑡ℎ 𝑀𝐶2
 The next page summarizes the price formulas, following which we “outline” the procedure expected on the final exam.

1
How to Solve for Applied Oligopoly Prices to Set Up a Two-Player Game in Oligopoly Prices
 University of Toronto, Department of Economics, Ajaz Hussain

How to Solve for the Naïve Monopoly Price (3 STEPS)

Step 1: “Derive” the Naïve Monopolist Demand Model in the form 𝑷𝒊 = 𝜶𝒊 − 𝒔𝒍𝒐𝒑𝒆𝒊 𝒒𝒊
Firm 1 Firm 2
State: 𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2 State: 𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1

Argue that Firm 1 behaves as if 𝑞2 = 0. Argue that Firm 2 behaves as if 𝑞1 = 0.

Sub 𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1 into 𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2 Sub 𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2 into 𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1

Set 𝑞2 = 0 and collect/simplify terms so that: Set 𝑞1 = 0 and collect/simplify terms so that:

𝑎 + 𝑐𝑑 𝑏 𝑑 + 𝑎𝑓 𝑒
𝑃1 = − 𝑞 𝑃2 = − 𝑞
1 − 𝑐𝑓 1 − 𝑐𝑓 1 1 − 𝑐𝑓 1 − 𝑐𝑓 2
Or: Or:
𝑃1 = 𝛼1 − 𝑠𝑙𝑜𝑝𝑒1 𝑞1 𝑃2 = 𝛼2 − 𝑠𝑙𝑜𝑝𝑒2 𝑞2
Where: Where:
𝑎 + 𝑐𝑑 𝑏 𝑑 + 𝑎𝑓 𝑒
𝛼1 = , 𝑠𝑙𝑜𝑝𝑒1 = 𝛼2 = , 𝑠𝑙𝑜𝑝𝑒2 =
1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓

Step 2: Solve for the Naïve Monopolist Profit Max Output

𝑃𝑖 = 𝛼𝑖 − 𝑠𝑙𝑜𝑝𝑒𝑖 𝑞𝑖

𝑀𝑅𝑖 = 𝛼𝑖 − 2 ∗ 𝑠𝑙𝑜𝑝𝑒𝑖 ∗ 𝑞𝑖 = 𝑀𝐶𝑖

𝛼𝑖 −𝑀𝐶𝑖
Sub 𝛼𝑖 and 𝑠𝑙𝑜𝑝𝑒𝑖 from above and re-arrange to get: 𝑞𝑖 =
2∗𝑠𝑙𝑜𝑝𝑒𝑖

Firm 1 Firm 2
𝛼1 − 𝑀𝐶1 𝑎 + 𝑐𝑑 1 − 𝑐𝑓 𝛼2 − 𝑀𝐶2 𝑑 + 𝑎𝑓 1 − 𝑐𝑓
𝑞1 = = − 𝑀𝐶1 𝑞2 = = − 𝑀𝐶2
2 ∗ 𝑠𝑙𝑜𝑝𝑒1 2𝑏 2𝑏 2 ∗ 𝑠𝑙𝑜𝑝𝑒2 2𝑒 2𝑒

Step 3: Solve for the Naïve Monopolist Profit Max Price

𝛼 −𝑀𝐶
𝑖 𝑖 𝛼𝑖 +𝑀𝐶𝑖
Sub 𝑞𝑖 = 2∗𝑠𝑙𝑜𝑝𝑒 in 𝑃𝑖 = 𝛼𝑖 − 𝑠𝑙𝑜𝑝𝑒𝑖 𝑞𝑖 to get 𝑃𝑖 = 2
𝑖

Firm 1 Firm 2
𝑚𝑜𝑛𝑜𝑝𝑜𝑙𝑦 𝛼1 + 𝑀𝐶1 𝑚𝑜𝑛𝑜𝑝𝑜𝑙𝑦 𝛼2 + 𝑀𝐶2
𝑃1 = 𝑃2 =
2 2

𝑚𝑜𝑛𝑜𝑝𝑜𝑙𝑦 1 𝑎 + 𝑐𝑑 𝑀𝐶1 𝑚𝑜𝑛𝑜𝑝𝑜𝑙𝑦 1 𝑑 + 𝑎𝑓 𝑀𝐶2

𝑃1 = ( )+ 𝑃2 = ( )+
2 1 − 𝑐𝑓 2 2 1 − 𝑐𝑓 2

2
How to Solve for Applied Oligopoly Prices to Set Up a Two-Player Game in Oligopoly Prices
 University of Toronto, Department of Economics, Ajaz Hussain

How to Solve for the Cournot Oligopoly Price (4 STEPS)

Step 1: “Derive” the Naïve Monopolist Demand Model in the form 𝑷𝒊 = 𝜶𝒊 − 𝒄𝒐𝒏𝒔𝒕𝒂𝒏𝒕𝒊𝒋 𝒒𝒋 − 𝒔𝒍𝒐𝒑𝒆𝒊 𝒒𝒊
Firm 1 Firm 2
State: 𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2 State: 𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1

Argue that Firm 1 behaves taking 𝑞2 ≥ 0 “as given”: Argue that Firm 2 behaves taking 𝑞1 ≥ 0 “as given”

Sub 𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1 into 𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2 to get: Sub 𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2 into 𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1 to get:

𝑎 + 𝑐𝑑 𝑐𝑒 𝑏
𝑃1 = − 𝑞2 − 𝑞 𝑑 + 𝑎𝑓 𝑓𝑏 𝑒
1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓 1 𝑃2 = − 𝑞1 − 𝑞
Or: 1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓 2
𝑃1 = 𝛼1 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡12 𝑞2 − 𝑠𝑙𝑜𝑝𝑒1 𝑞1 Or:
Where: 𝑃2 = 𝛼2 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡21 𝑞1 − 𝑠𝑙𝑜𝑝𝑒2 𝑞2
Where:
𝑎 + 𝑐𝑑 𝑐𝑒 𝑏 𝑑 + 𝑎𝑓 𝑓𝑏 𝑒
𝛼1 = , 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡12 = , 𝑠𝑙𝑜𝑝𝑒1 = 𝛼2 = , 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡21 = , 𝑠𝑙𝑜𝑝𝑒2 =
1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓

Step 2: Solve for Cournot Firm Profit Max Output Holding Rival’s Output constant (i.e. Reaction function)

𝑃𝑖 = 𝛼𝑖 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑖𝑗 𝑞𝑗 − 𝑠𝑙𝑜𝑝𝑒𝑖 𝑞𝑖

Holding 𝑞𝑗 constant:
𝑀𝑅𝑖 = 𝛼𝑖 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑖𝑗 𝑞𝑗 − 2 ∗ 𝑠𝑙𝑜𝑝𝑒𝑖 𝑞𝑖 = 𝑀𝐶𝑖

Sub 𝛼𝑖 , 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑖𝑗 , and 𝑠𝑙𝑜𝑝𝑒𝑖 from above and re-arrange to get Firm 𝑖’s reaction function:

𝑞𝑖 = 𝛹𝑖 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑖 𝑞𝑗

Firm 1 Firm 2
𝑞1 = 𝜓1 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡1 𝑞2 𝑞2 = 𝜓2 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡2 𝑞1

Where: Where:

𝑎 + 𝑐𝑑 − (1 − 𝑐𝑓)𝑀𝐶1 𝑐𝑒 𝑑 + 𝑎𝑓 − (1 − 𝑐𝑓)𝑀𝐶2 𝑓𝑏
𝜓1 = , 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡1 = 𝜓2 = , 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡2 =
2𝑏 2𝑏 2𝑒 2𝑒

3
How to Solve for Applied Oligopoly Prices to Set Up a Two-Player Game in Oligopoly Prices
 University of Toronto, Department of Economics, Ajaz Hussain

Step 3: Solve Cournot Reaction Functions Simultaneously to Obtain Cournot Outputs

Solve these two reaction functions (equations) simultaneously:

𝑞𝑖 = 𝜓𝑖 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑖 𝑞𝑗

𝑞𝑗 = 𝜓𝑗 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑗 𝑞𝑖

And you’ll get:

𝜓𝑖 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑖 𝜓𝑗
Optimal 𝑞𝑖 =
𝑐𝑓
1− 4

Firm 1 Firm 2
𝜓1 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡1 𝜓2 𝜓2 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡2 𝜓1
Optimal 𝑞1 = Optimal 𝑞2 =
𝑐𝑓 𝑐𝑓
1− 4 1− 4
Where: Where:

𝑎 + 𝑐𝑑 − (1 − 𝑐𝑓)𝑀𝐶1 𝑎 + 𝑐𝑑 − (1 − 𝑐𝑓)𝑀𝐶1
𝜓1 = 𝜓1 =
2𝑏 2𝑏

𝑑 + 𝑎𝑓 − (1 − 𝑐𝑓)𝑀𝐶2 𝑑 + 𝑎𝑓 − (1 − 𝑐𝑓)𝑀𝐶2
𝜓2 = , 𝜓2 = ,
2𝑒 2𝑒
𝑐𝑒 𝑓𝑏
𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡1 = 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡2 =
2𝑏 2𝑒

Step 4: Obtain Cournot Prices

𝜓𝑖 −𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑖 𝜓𝑗 𝜓𝑗 −𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑗 𝜓𝑖
Sub 𝑞𝑖 = 𝑐𝑓 and 𝑞𝑗 = 𝑐𝑓 into:
1− 1−
4 4

Optimal 𝑃𝑖 = 𝛼𝑖 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑖𝑗 𝑞𝑗 − 𝑠𝑙𝑜𝑝𝑒𝑖 𝑞𝑖

Firm 1 Firm 2
𝑃1𝐶𝑜𝑢𝑟𝑛𝑜𝑡 = 𝛼1 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡12 𝑞2 − 𝑠𝑙𝑜𝑝𝑒1 𝑞1 𝑃2𝐶𝑜𝑢𝑟𝑛𝑜𝑡 = 𝛼2 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡21 𝑞1 − 𝑠𝑙𝑜𝑝𝑒2 𝑞2

Where: Where:

𝑎 + 𝑐𝑑 𝑐𝑒 𝑏 𝑑 + 𝑎𝑓 𝑓𝑏 𝑒
𝛼1 = , 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡12 = , 𝑠𝑙𝑜𝑝𝑒1 = 𝛼2 = , 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡21 = , 𝑠𝑙𝑜𝑝𝑒2 =
1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓 1 − 𝑐𝑓

4
How to Solve for Applied Oligopoly Prices to Set Up a Two-Player Game in Oligopoly Prices
 University of Toronto, Department of Economics, Ajaz Hussain

How to Solve for the Bertrand Oligopoly Price (4 STEPS)

Step 1: Write down the Demand Models of the form 𝑷𝒊 = 𝒇(𝒒𝒊 , 𝑷𝒋 ) (we need 𝒒𝒊 for 𝑴𝑹𝒊 = 𝑴𝑪𝒊 and have 𝑷𝒋
because we’re taking that “as given”
Firm 1 Firm 2
𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2 𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1

Step 2: Solve for Bertrand Firm Profit Max Output Holding Rival’s Price constant (i.e. Reaction function)
Firm 1 Firm 2
𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2 𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1

Holding 𝑃2 constant: Holding 𝑃1 constant:

𝑀𝑅1 = 𝑎 − 2𝑏𝑞1 + 𝑐𝑃2 = 𝑀𝐶1 𝑀𝑅2 = 𝑑 − 2𝑒𝑞2 + 𝑓𝑃1

𝑎 − 𝑀𝐶1 𝑐 𝑑 − 𝑀𝐶2 𝑓
Optimal 𝑞1 = ( )+ 𝑃 Optimal 𝑞2 = ( )+ 𝑃
2𝑏 2𝑏 2 2𝑒 2𝑒 1

Step 3: Sub 𝒒𝒊 = 𝒇(𝑷𝒋 ) into 𝑷𝒊 = 𝒇(𝒒𝒊 , 𝑷𝒋 ) demand model to obtain Bertrand Reaction Functions in Prices
Firm 1 Firm 2
𝑎−𝑀𝐶1 𝑐
Sub 𝑞1 = ( ) + 2𝑏 𝑃2 into: 𝑑−𝑀𝐶2 𝑓
2𝑏 Sub 𝑞2 = ( 2𝑒
) + 2𝑒 𝑃1 into:

𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2
𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1
And you’ll get the reaction function:
And you’ll get the reaction function:
𝑎 + 𝑀𝐶1 𝑐
𝑃1 = + 𝑃2 𝑑 + 𝑀𝐶2 𝑓
2 2 𝑃2 = + 𝑃1
Or: 2 2
Or:
𝑃1 = 𝜃1 + 𝑐𝑜𝑒𝑓𝑓12 𝑃2
𝑃2 = 𝜃2 + 𝑐𝑜𝑒𝑓𝑓21 𝑃1
Where:
Where:
𝑎 + 𝑀𝐶1 𝑐
𝜃1 = , 𝑐𝑜𝑒𝑓𝑓12 = 𝑑 + 𝑀𝐶2 𝑓
2 2 𝜃2 = , 𝑐𝑜𝑒𝑓𝑓21 =
2 2

5
How to Solve for Applied Oligopoly Prices to Set Up a Two-Player Game in Oligopoly Prices
 University of Toronto, Department of Economics, Ajaz Hussain

Step 4: Solve Bertrand Reaction Functions Simultaneously to Obtain Bertrand Prices

Solve these two reaction functions (equations) simultaneously:

𝑃𝑖 = 𝜃𝑖 + 𝑐𝑜𝑒𝑓𝑓𝑖𝑗 𝑃𝑗

𝑃𝑗 = 𝜃𝑗 + 𝑐𝑜𝑒𝑓𝑓𝑗𝑖 𝑃𝑖
And you’ll get:

𝜃𝑖 + 𝑐𝑜𝑒𝑓𝑓𝑖𝑗 𝜃𝑗
Optimal 𝑃𝑖 =
𝑐𝑓
1− 4

Firm 1 Firm 2

𝜃1 + 𝑐𝑜𝑒𝑓𝑓12 𝜃2 𝜃2 + 𝑐𝑜𝑒𝑓𝑓21 𝜃1
𝑃1 = 𝑃2 =
𝑐𝑓 𝑐𝑓
1− 4 1− 4

Where: Where:
𝑎 + 𝑀𝐶1 𝑎 + 𝑀𝐶1
𝜃1 = 𝜃1 =
2 2

𝑑 + 𝑀𝐶2 𝑑 + 𝑀𝐶2
𝜃2 = 𝜃2 =
2 2
𝑐 𝑓
𝑐𝑜𝑒𝑓𝑓12 = 𝑐𝑜𝑒𝑓𝑓21 =
2 2
Sub these to get: Sub these to get:

𝑎 + 𝑀𝐶1 𝑐 𝑑 + 𝑀𝐶2 𝑑 + 𝑀𝐶2 𝑓 𝑎 + 𝑀𝐶1

2 + 2( 2 ) +2( )
𝑃1𝐵𝑒𝑟𝑡𝑟𝑎𝑛𝑑 = 𝑃2𝐵𝑒𝑟𝑡𝑟𝑎𝑛𝑑 = 2 2
𝑐𝑓 𝑐𝑓
1− 4 1−
4

6
How to Solve for Applied Oligopoly Prices to Set Up a Two-Player Game in Oligopoly Prices
 University of Toronto, Department of Economics, Ajaz Hussain

Summary of Naïve Monopoly, Cournot, and Bertrand Price Formulas

Firm 1 Firm 2

1 𝑎 + 𝑐𝑑 𝑀𝐶1 1 𝑑 + 𝑎𝑓 𝑀𝐶2
Naïve Monopoly 𝑃1𝑀 = ( )+ 𝑃2𝑀 = ( )+
2 1 − 𝑐𝑓 2 2 1 − 𝑐𝑓 2

First calculate: First calculate:

𝛹1 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡1 𝛹2 𝛹2 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡2 𝛹1
𝑞1𝐶 = 𝑞2𝐶 =
𝑐𝑓 𝑐𝑓
1− 4 1− 4
Where: Where:

𝑎 + 𝑐𝑑 − (1 − 𝑐𝑓)𝑀𝐶1 𝑑 + 𝑎𝑓 − (1 − 𝑐𝑓)𝑀𝐶2
𝛹1 = 𝛹2 =
2𝑏 2𝑒
𝑐𝑒 𝑓𝑏
𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡1 = 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡2 =
2𝑏 2𝑒
Cournot

Then compute: Then compute:

𝑃1𝐶 = 𝛼1 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡12 𝑞2𝐶 − 𝑠𝑙𝑜𝑝𝑒1 𝑞1𝐶 𝑃2𝐶 = 𝛼2 − 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡21 𝑞1𝐶 − 𝑠𝑙𝑜𝑝𝑒2 𝑞2𝑐

Where: Where:
𝑐𝑒 𝑓𝑏
𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡12 = 𝑐𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡21 =
1 − 𝑐𝑓 1 − 𝑐𝑓
𝑏 𝑒
𝑠𝑙𝑜𝑝𝑒1 = 𝑠𝑙𝑜𝑝𝑒2 =
1 − 𝑐𝑓 1 − 𝑐𝑓

𝑎 + 𝑀𝐶1 𝑐 𝑑 + 𝑀𝐶2 𝑑 + 𝑀𝐶2 𝑓 𝑎 + 𝑀𝐶1

2 + 2( 2 ) + 2( )
Bertrand 𝑃1𝐵 = 𝑃2𝐵 = 2 2
𝑐𝑓 𝑐𝑓
1− 4 1− 4

7
How to Solve for Applied Oligopoly Prices to Set Up a Two-Player Game in Oligopoly Prices
 University of Toronto, Department of Economics, Ajaz Hussain

Computing Payoff Matrix

Compute 𝑃𝐼 − 𝐴𝑉𝐶𝐼 (which is the same as 𝑃𝑖 − 𝑀𝐶𝑖 ): note how you only have to compute six #s

Matrix of 𝑷 − 𝑨𝑽𝑪 in
for 𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒚
𝑷𝟐 𝑷𝑪𝒐𝒖𝒓𝒏𝒐𝒕
𝟐 𝑷𝑩𝒆𝒓𝒕𝒓𝒂𝒏𝒅
𝟐
each of the nine 𝑷𝟏 , 𝑷𝟐
combinations
𝑷𝟏
𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒚
𝑷𝒎
𝟏 − 𝑴𝑪𝟏 𝑷𝒎
𝟐 − 𝑴𝑪𝟐 𝑷𝒎
𝟏 − 𝑴𝑪𝟏 𝑷𝑪𝟐 − 𝑴𝑪𝟐 𝑷𝒎
𝟏 − 𝑴𝑪𝟏 𝑷𝑩
𝟐 − 𝑴𝑪𝟐
𝑷𝑪𝒐𝒖𝒓𝒏𝒐𝒕
𝟏 𝑷𝑪𝟏 − 𝑴𝑪𝟏 𝑷𝒎
𝟐 − 𝑴𝑪𝟐 𝑷𝑪𝟏 − 𝑴𝑪𝟏 𝑷𝑪𝟐 − 𝑴𝑪𝟐 𝑷𝑪𝟏 − 𝑴𝑪𝟏 𝑷𝑩
𝟐 − 𝑴𝑪𝟐
𝑷𝑩𝒆𝒓𝒕𝒓𝒂𝒏𝒅
𝟏 𝑷𝑩
𝟏 − 𝑴𝑪𝟏 𝑷𝒎
𝟐 − 𝑴𝑪𝟐 𝑷𝑩
𝟏 − 𝑴𝑪𝟏 𝑷𝑪𝟐 − 𝑴𝑪𝟐 𝑷𝑩
𝟏 − 𝑴𝑪𝟏 𝑷𝑩
𝟐 − 𝑴𝑪𝟐

To compute outputs, re-arrange the basic demand models:

𝑎 − 𝑃1 + 𝑐𝑃2
𝑃1 = 𝑎 − 𝑏𝑞1 + 𝑐𝑃2 → 𝑞1 =
𝑏
𝑑 − 𝑃2 + 𝑓𝑃1
𝑃2 = 𝑑 − 𝑒𝑞2 + 𝑓𝑃1 → 𝑞2 =
𝑒
For example, Firm 1’s output if both companies charge monopoly price:

𝑎 − 𝑃1𝑚 + 𝑐𝑃2𝑚 𝑎 − 𝑃𝑚 𝑚
1 + 𝑐𝑃2
𝑞1𝑚𝑚 = =
𝑏 𝑏

Matrix of 𝒒𝟏 , 𝒒𝟐
𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒚
for each of the nine 𝑷𝟐 𝑷𝑪𝒐𝒖𝒓𝒏𝒐𝒕
𝟐 𝑷𝑩𝒆𝒓𝒕𝒓𝒂𝒏𝒅
𝟐
𝑷𝟏 , 𝑷𝟐 combinations
𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒚 𝑎 − 𝑃1𝑚 + 𝑐𝑃2𝑚 𝑑 − 𝑃2𝑀 + 𝑓𝑃1𝑀 𝑎 − 𝑃1𝑚 + 𝑐𝑃2𝑐 𝑑 − 𝑃2𝐶 + 𝑓𝑃1𝑀 𝑎 − 𝑃1𝑚 + 𝑐𝑃2𝐵 𝑑 − 𝑃2𝐵 + 𝑓𝑃1𝑀
𝑷𝟏
𝑏 𝑒 𝑏 𝑒 𝑏 𝑒
𝑎 − 𝑃1𝑐 + 𝑐𝑃2𝑚 𝑑 − 𝑃2𝑀 + 𝑓𝑃1𝐶 𝑎 − 𝑃1𝑐 + 𝑐𝑃2𝑐 𝑑 − 𝑃2𝐶 + 𝑓𝑃1𝐶 𝑎 − 𝑃1𝐶 + 𝑐𝑃2𝐵 𝑑 − 𝑃2𝐵 + 𝑓𝑃1𝐶
𝑷𝑪𝒐𝒖𝒓𝒏𝒐𝒕
𝟏
𝑏 𝑒 𝑏 𝑒 𝑏 𝑒
𝑎 − 𝑃1𝐵 + 𝑐𝑃2𝑚 𝑑 − 𝑃2𝑀 + 𝑓𝑃1𝐵 𝑎 − 𝑃1𝐵 + 𝑐𝑃2𝑐 𝑑 − 𝑃2𝐶 + 𝑓𝑃1𝐵 𝑎 − 𝑃1𝐵 + 𝑐𝑃2𝐵 𝑑 − 𝑃2𝐵 + 𝑓𝑃1𝐵
𝑷𝑩𝒆𝒓𝒕𝒓𝒂𝒏𝒅
𝟏
𝑏 𝑒 𝑏 𝑒 𝑏 𝑒

Obtain Gross Profits by multiplying each element in the 𝑃 − 𝐴𝑉𝐶 matrix with the corresponding element in the output
matrix:

Matrix of Firms 1 and

2’s Gross Profits 𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒚
for each of the nine 𝑷𝟐 𝑷𝑪𝒐𝒖𝒓𝒏𝒐𝒕
𝟐 𝑷𝑩𝒆𝒓𝒕𝒓𝒂𝒏𝒅
𝟐

𝑷𝟏 , 𝑷𝟐 combinations
𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒚
𝑷𝟏 𝜋1𝑚𝑚 𝜋2𝑚𝑚 𝜋1𝑚𝑐 𝜋2𝑚𝑐 𝜋1𝑚𝑏 𝜋2𝑚𝑏
𝑷𝑪𝒐𝒖𝒓𝒏𝒐𝒕
𝟏 𝜋1𝑐𝑚 𝜋2𝑐𝑚 𝜋1𝑐𝑐 𝜋2𝑐𝑐 𝜋1𝑐𝑏 𝜋2𝑐𝑏
𝑷𝑩𝒆𝒓𝒕𝒓𝒂𝒏𝒅
𝟏 𝜋1𝑏𝑚 𝜋2𝑏𝑚 𝜋1𝑏𝑐 𝜋2𝑏𝑐 𝜋1𝑏𝑏 𝜋2𝑏𝑏

1 𝑎+𝑐𝑑 𝑀𝐶1 𝑎−𝑃1𝑚 +𝑐𝑃2𝑚

So, for example: 𝜋1𝑚𝑚 = (𝑃1𝑚 − 𝑀𝐶1 )𝑞𝑚𝑚
1 = (2 (1−𝑐𝑓) + 2
− 𝑀𝐶1 ) (
𝑏
)

8
How to Solve for Applied Oligopoly Prices to Set Up a Two-Player Game in Oligopoly Prices
 University of Toronto, Department of Economics, Ajaz Hussain

How to Check for Mixed Strategies NE

Matrix of Firms 1 and

2’s Gross Profits 𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒚
for each of the nine 𝑷𝟐 with probability 𝒑 𝑷𝑪𝒐𝒖𝒓𝒏𝒐𝒕
𝟐 with probability 𝒒 𝑷𝑩𝒆𝒓𝒕𝒓𝒂𝒏𝒅
𝟐 with probability 𝒓
𝑷𝟏 , 𝑷𝟐 combinations
𝒎𝒐𝒏𝒐𝒑𝒐𝒍𝒚
𝑷𝟏
𝜋1𝑚𝑚 𝜋2𝑚𝑚 𝜋1𝑚𝑐 𝜋2𝑚𝑐 𝜋1𝑚𝑏 𝜋2𝑚𝑏
with probability 𝒂
𝑷𝑪𝒐𝒖𝒓𝒏𝒐𝒕 𝜋1𝑐𝑏 𝜋2𝑐𝑏
𝟏
𝜋1𝑐𝑚 𝜋2𝑐𝑚 𝜋1𝑐𝑐 𝜋2𝑐𝑐
with probability 𝒃
𝑷𝑩𝒆𝒓𝒕𝒓𝒂𝒏𝒅 𝜋1𝑏𝑏 𝜋2𝑏𝑏
𝟏
𝜋1𝑏𝑚 𝜋2𝑏𝑚 𝜋1𝑏𝑐 𝜋2𝑏𝑐
with probability 𝒄

If there is a mixed strategies NE, then:

𝐸𝑉[𝑃1𝑚 ] = 𝐸𝑉[𝑃1𝑐 ] = 𝐸𝑉[𝑃1𝐵 ] 𝑠. 𝑡. 𝑝 + 𝑞 + 𝑟 = 1 and 𝑝, 𝑞, 𝑟 ≥ 0

𝐸𝑉[𝑃2𝑚 ] = 𝐸𝑉[𝑃2𝑐 ] = 𝐸𝑉[𝑃2𝐵 ] 𝑠. 𝑡. 𝑎 + 𝑏 + 𝑐 = 1 and 𝑎, 𝑏, 𝑐 ≥ 0

You need to find 𝑎, 𝑏, 𝑐, 𝑝, 𝑞, 𝑟 satisfying the equations above (if you can’t that means there is no mixed strategies NE).

Now:

𝐸𝑉[𝑃1𝑚 ] = 𝑝 𝜋𝑚𝑚
1 + 𝑞 𝜋𝑚𝑐 𝑚𝑏
1 + 𝑟 𝜋1

𝐸𝑉[𝑃1𝑐 ] = 𝑝 𝜋𝑐𝑚 𝑐𝑐 𝑐𝑏
1 + 𝑞 𝜋1 + 𝑟 𝜋1

𝐸𝑉[𝑃1𝑐 ] = 𝑝 𝜋𝑏𝑚 𝑏𝑐 𝑏𝑏
1 + 𝑞 𝜋1 + 𝑟 𝜋1

You should practice solving these equations. If you get nonsensical probabilities  stop  there is no mixed strategies NE; otherwise
continue:

𝐸𝑉[𝑃2𝑚 ] = 𝑎 𝜋𝑚𝑚
2 + 𝑏 𝜋𝑐𝑚 𝑏𝑚
2 + 𝑐 𝜋2

𝐸𝑉[𝑃2𝑐 ] = 𝑎 𝜋𝑚𝑐 𝑐𝑐 𝑏𝑐
2 + 𝑏 𝜋2 + 𝑐 𝜋2

𝐸𝑉[𝑃2𝑏 ] = 𝑎 𝜋𝑚𝑏 𝑐𝑏 𝑏𝑏
2 + 𝑏 𝜋2 + 𝑐 𝜋2

If you get nonsensical probabilities  stop  there is no mixed strategies NE; otherwise continue.

9
How to Solve for Applied Oligopoly Prices to Set Up a Two-Player Game in Oligopoly Prices