Welcome to EC 209: Managerial Economics- Group A

By: Dr. Jacqueline Khorassani

Week Ten
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Managerial EconomicsGroup A
Week Ten- Class 1
Monday, November 5

Fottrell (AM) Aplia assignment is due tomorrow before 5 PM

11:10-12:00

Chapter 9 of Baye
Basic Oligopoly Models

What are the characteristics of oligopolistic market structure?

Relatively few firms, usually less than 10.

Duopoly - two firms Triopoly - three firms

The products firms offer can be either differentiated or homogeneous.

Interdependence

Your actions affect the profits of your rivals. Your rivals actions affect your profits.

An Example

You and another firm sell differentiated products such as cars. How does the quantity demanded for your cars change when you change your price?

D2 (demand for your cars when rival matches your price change)

PH P0 PL

D1 (demand for your cars when rival holds its price constant)

QH1 QH2 Q0 QL2

QL1

Q
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What if your rivals match your price reductions but not your price increases?
P
P2

D2 (Rival matches your price change) Your demand if rivals match price reductions but not price increases Kinked Demand Curve

P0
P1

D1 D
Q2

(Rival holds its price constant) Q

Q0

Q1

Cournot Model

A few firms produce goods that are either perfect substitutes (homogeneous) or imperfect substitutes (differentiated). Firms set output, as opposed to price. The output of rivals is viewed as given or fixed. Barriers to entry exist.

Cournot Model: General Linear Case

Market demand in a homogeneous-product Cournot duopoly is

P a bQ1 Q2

Total Revenue for firm 1 is

PQ1 = aQ1 bQ12 bQ1Q2

Total Revenue for firm 2 is

PQ2 = aQ2 bQ22 bQ1Q2
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What are the marginal revenues?

TR1= PQ1 = aQ1 bQ12 bQ1Q2 TR2 = PQ2 = aQ2 bQ22 bQ1Q2

MR1 a bQ2 2bQ1

MR2 a bQ1 2bQ2

Each firms marginal revenue depends on the output produced by the other firm.
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Where do the quantities come from?

Golden rule of profit maximization says get the output from the intersection of MC and MR
MC=MR Firm 1s MC = c1 And its MR = a- bQ2 -2bQ1 c1 = a- bQ2 -2bQ1 2bQ1= -c1+a-bQ2

a c1 1 Q1 r Q2 1 Q2 2b 2
This is called Firm 1s best response function

Q1 depends on Q2

Both firms produce identical products So if Firm two produces more firm 1 must produce less
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Best-Response Function for a Cournot Duopoly

Firm 1s best-response function is

a c1 1 Q1 r1 Q2 Q2 2b 2

Similarly, Firm 2s best-response function is (c2 is firm 2s MC)

Q2 r2 Q1 a c2 1 Q1 2b 2
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Graph of Firm 1s Best-Response ac 1 Function Q r Q Q

1 1 1 2

Q2
(a-c1)/b If Q1 = 0 Q2 = (a-c1)/b

2b

Q1 = r1(Q2) = (a-c1)/2b - 0.5Q2

Q2 r1 (Firm 1s Reaction Function) Q1

(a-c1)/2b

Q1

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Cournot Equilibrium

Exist when
No firm can gain by unilaterally changing its own output to improve its profit.

A point where the two firms best-response functions intersect.

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Graph of Cournot Equilibrium

Q2 (a-c1)/b If Firm 1 produces A Firm 2 produces B If Firm 2 produces B Firm 1 produces C If Firm 1 produces C Cournot Equilibrium Firm 2 produces D

Q2M Q2* D B

r1
Q1* C A

r2 (a-c2)/b Q1
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Equilibrium Quantities are at intersection of the response curves

Managerial EconomicsGroup A

Week Ten- Class 2

Tuesday, November 6 Cairnes 15:10-16:00

Aplia assignment is due before 5PM today

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Last class we looked at Cournot Equilibrium If Firm 1 produces A

Q2 (a-c1)/b Firm 2 produces B If Firm 2 produces B Firm 1 produces C If Firm 1 produces C Cournot Equilibrium Firm 2 produces D

Q2M Q2* D B

r1
Q1* C A

r2 (a-c2)/b Q1
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Equilibrium Quantities are at intersection of the response curves

What happens if Firm 1s MC When c goes up vertical goes up? intercept of firm 1s reaction
1

Q2

(a-c1)/b

r1

curves goes down

Cournot equilibrium after firm 1s marginal cost increase

r1**

Q2**
Cournot equilibrium prior to firm 1s marginal cost increase

Q2* r2 Q1** Q1* Q1

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Firm 1s production goes down

Example of Cournot Model (See textbook page 324 for another example)

Consider a case where there are two firms: A and B. Market demand is given by Q = 339 P AC = MC = 147 The residual demand for firm A is
qA = Q qB qA = 339 P - qB , or P = 339 - qA qB

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Firm As demand is P = 339 - qA qB

Revenue for firm A

= P qA = qA (339 - qA qB) = 339 qA- qA2 - qAqB

Marginal Revenue for firm A

= 339 - 2 qA qB

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Firm As best response (or reaction function) is derived by setting its MR= MC

339 - 2 qA qB = 147 or qA = 96 1/2 qB Consider qB = 0; qA = 96 By the same reasoning qB = 96 1/2 qA

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Cournot Nash equilibrium is a combination of qA and qB so that both firms are on their reaction functions.

Firm As reaction function is

qA = 96 1/2 qB

Firm Bs reaction function is

qB = 96 1/2 qA

qA = 96 1/2 (96 1/2 qA ) Solve to find qA = 64 Similarly qB = 64

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What are the profits at equilibrium?

What is the Price? P = 339 - qA - qB P = 339 - 64 - 64 P = 211 Remember that AC = 147 Each firms profit = q (P-AC) Each firms profit = 64*(211-147) = 64 * 64 = 4096

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Could the two firms do better than this if they formed a cartel and act as a monopoly?

The monopoly outcome is found by taking the marginal revenue curve for the industry and setting it equal to MC. Recall that market demand was Q = 339 P Or P = 339-Q Revenue will be PQ = 339Q Q2 MR = 339 2Q MC = 147 339-2Q = 147 or Q = 96 & P = 243 Suppose the two firms divided the market between them so that each produced 48 units. Each would earn profits of 48 * (243-147) = 4608 4608> 4096 25

Collusion Incentives in Cournot Oligopoly

QB

rA

After Collusion
48

rB
48

QA
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But will the cartel be a stable outcome?

No Given that firm B is producing 48 units what should firm A produce? Look at Firms reaction function
qA = 96 1/2 qB qA = 96 1/2 (48) qA = 72
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Firm A has an incentive to cheat

QB

rA

48

rB
48 72

QA
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Conclusion

The numerical example makes it clear that in a duopoly firms have an incentive to restrict output to the monopoly level. However they also have an incentive to cheat on any agreement.

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Managerial EconomicsGroup A

Week Ten- Class 3

Thursday, November 8 15:10-16:00 Tyndall

Next Aplia Assignment is due before 5 PM on Tuesday, November 13

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Stackelberg Model: Characteristics

Firms produce differentiated or homogeneous products. Barriers to entry. Firm one is the leader.
The leader commits to an output before all other firms.

Remaining firms are followers.

They choose their outputs so as to maximize profits, given the leaders output.
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Stackelberg Model: General Linear Case

Two firms in the market Market demand is P = a b(Q1 + Q2) Marginal cost for firm 1 and firm 2 is c1 and c2 Firm 1 is the leader We showed earlier that Firm 2s best response (reaction) function is given by
Q2 = (a c2)/2b 1/2Q1

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What does the leader do?

The leader Firm 1 substitutes Firm 2s reaction function into market demand function.

P = a b(Q1 + (a c2)/2b 1/2Q1) This is multiplied by Q1 to get the revenue function for Firm 1. Differentiate the revenue function with respect to Q to get Firm 1s marginal revenue function. Set the MR = MC Solve for Q1. Q1 is equal to (a + c2 -2c1)/2b. Use the reaction function for Q2 to find the expression for Q2.

Where market demand function is P = a b(Q1 + Q2) And Firm2s reaction function is Q2 = (a c2)/2b 1/2Q1

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Stackelberg Equilibrium
Q2

r1

Cournot equilibrium Stackelberg Equilibrium

Q2C
Q2S

r2 Q1C Q1S Q1M Q1

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Note: Firm 1 is producing on Frim 2s reaction function (maximizes its profits given the reaction of Firm 2)

Stackelberg Summary

Leader produces more than the Cournot equilibrium output.

Larger market share, higher profits. First-mover advantage.

Follower produces less than the Cournot equilibrium output.

Smaller market share, lower profits.

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Lets use the same numerical example we used last class for Cournot model to find the Stakelberg models results

Only this time assume and Firm A is a leader Find each firms output and profit

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Example of Stackelberg Model

Note: Firm A knows Firm Bs reaction function. Market demand is given by

Q = 339 P, and AC = MC = 147

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Market demand is given by Q = 339 P

The residual demand for firm A is qA= 339 P - qB or

qA = Q qB

Remember that firm Bs reaction function is

Plug in Firm Bs reaction function into Firm As demand
P = 339 qA - 96 + 1/2 qA P = 243- 1/2 qA
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P = 339 - qA qB qB = 96 1/2 qA

Firm As demand is P = 243- 1/2 qA

Firm As revenue is PqA = 243 qA 1/2 qA2 MR = 243 qA Set this equal to MC 147 = 243- qA qA = 96 Use Bs reaction function qB = 96 1/2 qA, qB = 96 1/2 (96), qB = 48

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Profits
Remember that P = 339 - qA qB P = 339 96 48 P = 195, AC = 147 Firm As profit = 96 (195 - 147) = 4608 Firm Bs profit is 48 (195 147) = 2304
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Bertrand Model: Characteristics

1.
2.

3.
4.

5.

Few firms that sell to many consumers. Firms produce identical products at constant marginal cost. Each firm independently sets its price in order to maximize profits. Barriers to entry. Consumers enjoy
Perfect information. Zero transaction costs.
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Bertrand Equilibrium

Firms set P1 = P2 = MC! Why? Suppose not

AC= MC = 10 , P1=15 , P2= 18

How much is Firm 1s profit per unit?

P1 AC= 5

How much is Firm 2s profit per unit?

None, Firm Cant sell any

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What would Firm 2 do?

Cut the price slightly below Firm 1s (to 14) Firm 1 then has an incentive to undercut firm 2s price. (to 13) This undercutting continues... until Equilibrium: Each firm charges P1 = P2 = MC = 10.

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Contestable Markets

Key Assumptions
Producers have access to same technology. Consumers respond quickly to price changes. Existing firms cannot respond quickly to entry by lowering price. Absence of sunk costs.

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Key Implications

Strategic interaction between incumbents and potential entrants Threat of entry disciplines firms already in the market. Incumbents have no market power, even if there is only a single incumbent (a monopolist).
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Contestable Markets

Important condition for a contestable market is the absence of sunk costs.

Encourages new firms to enter You enter the industry and if things dont work out exit

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Another example

Consider a case where there are two firms 1 and 2. Market demand is given by Q = 1,000 P; AC = MC = 4. Find the Cournot, Stackelberg, Monopoly and Bertrand outcomes.

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Conclusion

Different oligopoly scenarios give rise to different optimal strategies and different outcomes. Your optimal price and output depends on
Beliefs about the reactions of rivals.

Your choice variable (P or Q) and the nature of the product market (differentiated or homogeneous products). Your ability to credibly commit prior to your rivals.

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