The Stackelberg Model 1 How would Air Lions manager act if he knows that Beta Airlines behaviour would

passively follow Air Lions reaction function? Air Lion can take advantage of this knowledge. If Air Lion knows that Beta Airlines will behave in a certain way according to Air Lions action, why shouldnt Air Lion plan act aggressively and take advantage of this information? In this case, Air Lion would decide first relying on the foreseeable reaction of Beta Airlines, which is inevitably in a passive role. This situation represents the core of the Stackelberg model, where there is a sequential interaction between the two firms: the leader attacks and the follower is passive. The Stackelberg model is useful to describe situations where a firm is clearly dominant with respect to its competitors (as IBM in the 80s and Microsoft in recent years with respect to other small software companies). Reaction curves Under the assumption of equality between marginal revenue and marginal cost, we know that the follower would behave as in the Cournot model. Its reaction curve would be equal to the previous case. Assume that Beta Airlines is the follower and that its reaction curve is given by xB*(xA). In order to define the leaders behaviour, Air Lion, we should include the information from the xB*(xA) reaction curve in the market demand curve. Air Lion knows that for every xA, Beta Airlines will react by producing xB*(xA). Therefore Air Lion can know the entire market demand. In fact, from the leaders point of view, xB is not given, but depends on xA: this is the core of the Stackelberg model. The leader knows how the follower will react to its behaviour and take advantage of this knowledge making the follower act so as to maximise its profit. As a result, the leaders demand curve totally depends on xA, i.e. on its own behaviour. With this demand curve (that includes the followers reaction curve), the leader can maximise its profit by setting marginal revenue equal to marginal cost. From reaction curves to Stackelberg equilibrium Since we now know how each firm would act given the level of output of its competitor, we can put together all the information in order to find Stackelberg equilibrium. As a matter of fact, we only have one reaction curve (of the follower Beta Airlines) and we have the aggressive behaviour of Air Lion whose aim is to maximise its profit.

Source: Katz M., Harvey R., Bollino C., Microeconomia (Versione Italiana), McGraw-Hill, 2007

Lets take again into consideration Air Lions reaction curve in figure 1 and analyze Air Lions profits in points

j,k,l and m. In m Air Lion behaves as a monopolist as it produces the maximum level of output while Beta
Airlines does not produce anything. In k Air Lions profit is lower then in l and in j is lower then in k. However in all the points, Air Lion gets the best profits given Beta Airlines levels of output xBj xBk xBl and 0. Lets start from point j : given xBj , any level of output from Air Lion higher or lower then xAj would decrease Air Lions profit. In both points j and J , profit is lower than in j given the definition of a best reaction curve. In j, Air Lions profit will definitely be higher since xAj is the same, but the competitors output is lower (hence the costs of production are the same, but the market price is higher). We can therefore infer that there exist a set of points such that Air Lions profit is equal to the profit in point j. This set of points is below the line that connects j and j, but above point j. This set of points is called isoprofit, and has a parabolic trend with a down concavity. In figure 1, isoprofits are represented by j , k and l. Lets go back to the interaction between Air Lion and Beta Airlines. In figure 2, the same reaction curves of figure 15.10 are represented (K&R English Version, p. 548), where c is the previous Cournot equilibrium.

How can Air Lion be a leader with aggressive behaviour? It can be so by simply choosing its own maximum level of profit on Beta Airlines reaction function (point z, given by the tangency between Beta Airlines reaction curve and the highest Air Lions isoprofit curve). In this point, the leaders profit is maximised, and since this point also belongs to the followers reaction curve, it is optimal for Beta as well. Since z is on Betas reaction curve, Beta does not have any reason to move from it: it is the best choice available given Air Lions behaviour.

Betas output in seats per day

Betas output in seats per day

* Air Lions reaction curve X A ( X B )

* Air Lions reaction curve X A ( X B )

XB j XB
k

J J k

XB c XB
z

k
l

z y
* Betas reaction curve X B ( X A )

XB l

l
XAj m Air Lions output in seats per day Figure 1: Isoprofit function Given Beta Airlines output, Air Lion gets the maximum possibile profit in points j,k,l. Isoprofit curves for Airlion are downward concave. XAc

w
XAy

w XAz Air Lions output in seats per day

Figure 2: Stackelberg Equilibrium In point z, Air Lions output level is higher than in point c. Point z is on Beta Airlines reaction curve.

With respect to Cournot, Stackelberg equilibrium is characterized by a higher level of output for the leader (xAz > xAc), a lower level of output for the follower (xBz < xBc), a lower market price and a higher market quantity. This is the trademark of the Stackelberg model. In z, if Air Lion behaves as a Cournot duopolist since Beta Airline produces xBz , Air Lion would consider this quantity as given and would therefore offer xAy given rise to a series of adjustments until point c is reached. Since the leaders behaviour includes the followers behaviour, it decides to offer xAz in order to avoid any possible move of the follower. What would happen if the follower would not accept its passive situation? It is possible to demonstrate that, if both try to become leaders through an aggressive expansion of the level of output produced with respect to Cournot, a possible result of a leaders war is the output of perfect competition. However, since we described Stackelberg as a model with sequential interaction, the situation in which the follower tries to emulate the leader is outside of the model and is not relevant to understand the Stackelberg model. Appendix - An analytical example of Stackelberg equilibrium In this paragraph, we are going to set a value for price, the levels of output and profit corresponding to Stackelberg equilibrium. Assume that:

1. market demand is linear: than 0

p = a bx where x = x A + x B and a and b are constants and greater

2. both firms are facing the same marginal costs.

c is the (constant) marginal cost. This assumption is

necessary to highlight the fact that the asymmetric result depends on different strategic behaviours of Air Lion and Beta Airline and not on different costs.

The levels of output produced by the two firms are

x A and x B . The total output is given by x = x A + x B .

The maximising profit condition is given by the equality between marginal revenue and marginal costs (MR=MC) for each firm. In the Stackelberg model, firms behave asymmetrically. Assume that Beta Airlines is the follower. Hence, as in Cournot, the output produced by Ail Lion is assumed as given:
* xB ( x A ) =

(a c bx A ) 2b

In order to define the leaders behaviour, we should include this information in the demand curve:

p = a b( x A + x B )
* p = a b x A + xB ( x A )

(a c bx A ) p = a b x A + 2b

From the leaders point of view,

x B is not given but depends on x A : this is the main characteristic of

Stackelberg. The leader knows how the follower will react and take advantage of this information. As a consequence, the leaders demand curve depends entirely on x A , i.e. on its own behaviour. The leaders demand curve and marginal revenue are given by:

p=

(a + c bx A ) 2
(a + c) bx A 2

MR A =

The leaders optimal level of output is given by solving

MR A = MC

MR A =

(a + c) (a c) bx A = c = MC , hence: x A = 2 2b

The followers optimal level is:

xB =

(a c bx A ) a c b(a c) (a c) = / 2b = 4b 2b 2b

The total market quantity is:

x = x A + xB =

3(a c) 4b

The price is derived from the market demand function

a + 3c 3(a c) p = a b , hence: p = 4 4b
2

The leaders profit is

(a + 3c) (a c) (a c) ( p c) x A = c = 2b 8b 4

The followers profit is

2 (a + 3c) (a c) (a c) c = ( p c) x B = 4b 16b 4

To sum up, the leaders advantage makes it double quantity and profit. Besides, the total market quantity is higher then in Cournot and the price is lower. Consumers take advantage of Stackelberg leader behaviour, who in turn gets a higher profit then the follower.