Managerial Economics

STRATEGIC INTERDEPENDENCE

Some More Games

MATCHING PENNIES

In this game, each player chooses heads or

tails and the two players reveal their coins
at the same time. If the coins match Player
A wins and receives a dollar from Player B.
If the coins do not match, Player B wins and
receives a dollar from Player A.
There is no Nash equilibrium in pure
strategies for this game

Player B
Tails

Heads

1, 1

1, 1

Tails

1, 1

1, 1

Player A

THE BATTLE OF THE SEXES

There are two Nash equilibria in pure

strategies for this gamethe one in which
Jim and Joan both watch mud wrestling,
and the one in which they both go to the
opera.

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Heads

Jim

Wrestling
Joan

Wrestling

Opera

2, 1

0, 0
2

Oligopoly Environment
Relatively few firms, usually less than 10.
Duopoly - two firms
Triopoly - three firms

The products firms offer can be either differentiated or

homogeneous.
Firms decisions impact one another.
Your actions affect the profits of your rivals.
Your rivals actions affect your profits.
How will rivals respond to your actions?

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Strategic Interaction
Demand curve D1 is based on the assumption
that rivals will match any price change, while D 2
is based on the assumption that they will not
match a price change.
Note that demand is more inelastic when rivals
match a price change than when they do not.
For a given price reduction, a firm will sell more if rivals
do not cut their prices (D2) than it will if they lower their
prices (D1).
In effect, a price reduction increases quantity
demanded only slightly when rivals respond by
lowering their prices.
Similarly, for a given price increase, a firm will sell more
when rivals also raise their prices (D1) than it will when
they maintain their existing prices (D2).
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Quick Check
Suppose the manager is at point B, charging a price of P 0.
If the manager believes rivals will not match price reductions but will match price increases,
what does the demand for the firms product look like?
If the manager believes rivals will match price reductions but will not match price increases,
what does the demand for the firms product look like?

Answer:
If rivals do not match price reductions, prices below P0 will induce quantities demanded along
curve D2. If rivals do match price increases, prices above P0 will generate quantities
demanded along D1. Thus, if the manager believes rivals will not match price reductions but
will match price increases, the demand curve for the firms product is given by CBD 2.
If rivals match price reductions, prices below P0 will induce quantities demanded along curve
D1. If rivals do not match price increases, prices above P0 will induce quantities demanded
along D2. Thus, if the manager believes rivals will match price reductions but will not match
price increases, the demand curve for the firms product is given by ABD 1.
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Key Insight
Each firm believes rivals will match (or follow) price reductions, but
wont match (or follow) price increases.
The effect of a price reduction on the quantity demanded of your
product depends upon whether your rivals respond by cutting their
prices too!
The effect of a price increase on the quantity demanded of your
product depends upon whether your rivals respond by raising their
prices too!
Strategic interdependence: You arent in complete control of your
own destiny!
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Cournot Duopoly
A few firms produce goods that are either perfect substitutes
(homogeneous) or imperfect substitutes (differentiated).
Firms control variable is output in contrast to price.
Each firm believes their rivals will hold output constant if it changes
its own output (The output of rivals is viewed as given or fixed).
Barriers to entry exist.

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Reaction Curves and Cournot Equilibrium

Reaction curve Relationship between a firms profitmaximizing output and the amount it thinks its competitor
will produce.
Firm 1s reaction curve shows how much it will produce
as a function of how much it thinks Firm 2 will produce.
(The xs at Q2 = 0, 50, and 75 correspond to the example)
Firm 2s reaction curve shows its output as a function of
how much it thinks Firm 1 will produce.
In Cournot equilibrium, each firm correctly assumes the
amount that its competitor will produce and thereby
maximizes its own profits. Therefore, neither firm will
move from this equilibrium.
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Cournot equilibrium
Cournot equilibrium is an example of a Nash equilibrium (and thus it is
sometimes called a Cournot-Nash equilibrium).
In a Nash equilibrium, each firm is doing the best it can given what its
competitors are doing.
As a result, no firm would individually want to change its behavior. In the
Cournot equilibrium, each firm is producing an amount that maximizes its profit
given what its competitor is producing, so neither would want to change its
output.

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Cournot Equilibrium: An Example

Two identical firms face the following market demand curve: P=30-Q
Also, MC1=MC2=0
Total revenue for firm 1: R1=PQ1, and MR=30-2Q1-Q2
Setting MR1 = 0 (the firms marginal cost) and solving for Q1, we find
Firm 1s reaction curve: Q1=15-0.5Q2
By the same calculation, Firm 2s reaction curve: Q2=15-0.5Q1
Cournot equilibrium: Q1=Q2=10
Total quantity produced: Q=Q 1+Q2=20
If the two firms collude, then the total profit-maximizing quantity is:
Total revenue for the two firms: R = PQ = (30 Q)Q = 30Q Q2, then MR1 = R/Q = 30 2Q
Setting MR = 0 (the firms marginal cost) we find that total profit is maximized at Q = 15.
Then, Q1 + Q2 = 15 is the collusion curve.
If the firms agree to share profits equally, each will produce half of the total output: Q 1=Q2=7.5
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10

Graphical
The demand curve is P = 30 Q, and
both firms have zero marginal cost.
In Cournot equilibrium, each firm
produces 10.
The collusion curve shows combinations
of Q1 and Q2 that maximize total profits.
If the firms collude and share profits
equally, each will produce 7.5.
The competitive equilibrium, in which
price equals marginal cost and profit is
zero, output produce is 15.
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11

First Mover Advantage: The Stackelberg

Model
Stackelberg model: Oligopoly model in which one firm sets its output before other firms do.
Suppose Firm 1 sets its output first and then Firm 2, after observing Firm 1s output, makes its output decision. In
setting output, Firm 1 must therefore consider how Firm 2 will react.
P = 30 Q
Also, MC1 = MC2 = 0
Firm 2s reaction curve:
Firm 1s revenue:

Setting MR1 = 0 gives Q1 = 15, and Q2 = 7.5

We conclude that Firm 1 produces twice as much as Firm 2 and makes twice as much profit.
Going first gives Firm 1 an advantage.
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12

The Bertrand Model: Price Competition

Oligopoly model in which firms produce a homogeneous good, each firm treats the price of
its competitors as fixed, and all firms decide simultaneously what price to charge.
Previous Example
P = 30 Q
MC1 = MC2 = $3
Q1 = Q2 = 9, and in Cournot equilibrium, the market price is $12, so that each firm makes a profit of $81.
Now suppose that these two duopolists compete by simultaneously choosing a price instead of a quantity.
Nash equilibrium in the Bertrand model results in both firms setting price equal to marginal cost: P 1 = P2 =
$3. Then industry output is 27 units, of which each firm produces 13.5 units, and both firms earn zero
profit.

In the Cournot model, because each firm produces only 9 units, the market price is $12.
Now the market price is $3. In the Cournot model, each firm made a profit; in the Bertrand
model, the firms price at marginal cost and make no profit.

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13

Price Competition with Differentiated

Products
Suppose each of two duopolists has fixed costs of $20 but zero variable costs, and that
they face the same demand curves:
Firm 1s demand:
Firm 2s demand:

Q1 12 2 P1 P2
Q2 12 2 P2 P1

Choosing Prices
Firm 1s profit:

2 20
1 PQ

20

12
P

2
P
1 1
1
1

Firm 1s profit maximizing price:

Firm 1s reaction curve:
Firm 2s reaction curve:
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1 / P1 12 4 P1 P2 0

P1 3 1 P2
4
P2 3 1 P1
4

The firms have the same costs, so they will charge the
same price P. Total profit is given by
T = 1 + 2 = 24P 4P2 + 2P2 40 = 24P 2P2 40.
This is maximized when T/P = 0. T/P = 24 4P, so
the joint profit-maximizing price is P = $6. Each firms profit
is therefore 1 = 2 = 12P P2 - 20 = 72 36 20 = $16
14

Competition versus Collusion: The Prisoners Dilemma

In our example, there are two firms, each of which has fixed costs of
$20 and zero variable costs. They face the same demand curves:
Q1 12 2 P1 P2
Firm 1s demand:
Firm 2s demand:

Q2 12 2 P2 P1

We found that in Nash equilibrium each firm will charge a price of $4 and earn a profit of $12, whereas if the firms
collude, they will charge a price of $6 and earn a profit of $16.
2 P2Q2 20 (4)[(12 (2)(4) 6] 20 $20
1 PQ
20 (6)[12 (2)(6) 4] 20 $4
1 1

So if Firm 1 charges $6 and Firm 2 charges only $4, Firm 2s profit will increase to $20. And it will do so at the
expense of Firm 1s profit, which will fall to $4.
PAYOFF MATRIX FOR PRICING GAME
FIRM 2

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Charge $4

CHARGE $4

CHARGE $6

$12, $12

$20, $4
15