Finance 510:

Microeconomic
Analysis
Strategic Interaction
 Recall that there is an entire spectrum of market
structures

Market Structures

Perfect Competition Monopoly

Many firms, each with zero One firm, with 100%
market share market share
P = MC P > MC
Profits = 0 (Firm’s earn a Profits > 0 (Firm’s earn
reasonable rate of return on excessive rates of return
invested capital on invested capital)
NO STRATEGIC NO STRATEGIC
INTERACTION! INTERACTION!
Most industries, however, don’t fit the assumptions of
either perfect competition or monopoly. We call these
industries oligopolies
Oligopoly
Relatively few firms, each
with positive market share
STRATEGIC INTERACTION!

Wireless (2002) US Beer (2001) Music Recording (2001)

Verizon: 30% Anheuser-Busch: 49% Universal/Polygram: 23%
Cingular: 22% Miller: 20% Sony: 15%
AT&T: 20% Coors: 11% EMI: 13%
Sprint PCS: 14% Pabst: 4% Warner: 12%
Nextel: 10% Heineken: 3% BMG: 8%
Voicestream: 6%
Further, these market shares are not constant over time!

Airlines (1992) Airlines (2002)

21
19
American American
20
17
United 15 United 15
14
Delta Delta
11
11
9
Northwest Northwest
9
7
Continental Continental
US Air SWest

While the absolute ordering didn’t change, all the airlines lost
market share to Southwest.
Another trend is consolidation

Retail Gasoline (1992) Retail Gasoline (2001)

9
Shell 24
8 Exxon/Mobil
20
Chevron 8
8 Shell 18
Texaco
7 BP/Amoco/Arco
16
Exxon 7
10
Amoco 6 Chev/Texaco
5 7
Mobil
5 Total/Fina/Elf
BP 4
Conoco/Phillips
Citgo 4
Marathon
Sun
Phillips
The key difference in oligopoly markets is that
price/sales decisions can’t be made independently
of your competitor’s decisions

Your Price (-)

Monopoly Oligopoly

Q = Q( P ) Q = Q( P, P1 ,...PN )
Your N Competitors
Prices (+)

Oligopolistic markets rely crucially on the

interactions between firms which is why we need
game theory to analyze them!
 The Airline Price Wars Suppose that American and Delta
face the given aggregate demand
p for flights to NYC and that the
unit cost for the trip is $200. If
$500 they charge the same fare, they
split the market
$220

American

60 180
Q P = $500 P = $220

P = $500 $9,000 $3,600

What will the equilibrium
$9,000 $0
Delta
be?

P = $220 $0 $1,800
$3,600 $1,800
 The Airline Price Wars

Assume that Delta has the following beliefs about American’s

Strategy

π l = Pr ( P = $500) Probabilities of

π r = Pr ( P = $220 )
choosing High or
Low price

Player A’s best response will be his own set of probabilities to

maximize expected utility

pt = Pr ( P = $500 )
pb = Pr ( P = $220 )

Max[ pt ( π l ($9000) + π r (0) ) + pb ( π l ($3600) + π r ($1800) ) ]

pt , p b
Max[ pt ( π l ($9000) + π r (0) ) + pb ( π l ($3600) + π r ($1800) ) ]
pt , p b

Subject to

pt + pb = 1 Probabilities always have to sum to one

pt ≥ 0
Both Prices have a chance of being
pb ≥ 0 chosen

( pt , pb , λ ) = $9,000 ptπ l + pb ( π l ($3600) + π r ($1800) )

+ λ (1 − pt − pb ) + µ1 pt + µ 2 pb
 ( pt , pb , λ ) = $9,000 ptπ l + pb ( π l ($3600) + π r ($1800) )
+ λ (1 − pt − pb ) + µ1 pt + µ 2 pb
First Order Necessary Conditions

9000π l − λ + µ1 = 0 pt ≥ 0 µ 2 pb = 0
( 3600π l + 1800π r ) − λ + µ 2 = 0 pb ≥ 0 µ1 pt = 0
1 − pt − pb = 0
µ 2 ≥ 0 µ1 ≥ 0

pt > 0 9000π l = λ = 3600π l + 1800π r

pb > 0 πr +πl =1
µ1 = µ 2 = 0 πl =
1
πr =
3
4 4
The Airline Price Wars

pl = 1 pr = 0 pt = 1 pb = 0 Both always charge $500

1 3 1 3 Both Randomize between

pl = pr = pt = pb = $500 and $220
4 4 4 4

pl = 0 pr = 1 pt = 0 pb = 1 Both always charge $220

Notice that prices are low most of the time!

Continuous Choice Games – Cournot Competition
p
There are two firms in an industry –
both facing an aggregate (inverse)
demand curve given by

D
Q
P = A − BQ
Aggregate
Production

Both firms have constant marginal costs equal to $C

 From firm one’s perspective, the demand curve is given by

P = A − B( q1 + q2 ) = ( A − Bq2 ) − Bq1
Treated as a constant by Firm One

Solving Firm One’s Profit Maximization…

TR = ( A − Bq2 ) q1 − Bq 1 2

MR = ( A − Bq2 ) − 2 Bq1 = c

q1 =
( A − Bq2 ) − c
2B
In Game Theory Lingo, this is Firm One’s Best Response
Function To Firm 2

 A−c  1
q2 q1 =   − q2
 A−c 
 
 2B  2
 B 
Note that this is the optimal
output for a monopolist!

q1
 A−c 
 
 2B 
Further, if Firm two produces  A−c  It drives price down to MC
 
 B 
q2
 A−c 
  P = A − BQ
 B 
 A−c 
P = A − B =c
 B 

q1
 A−c 
 
 2B 
The game is symmetric with respect to Firm two…

 A−c  1
q2 q1 =   − q2
 2B  2
 A−c 
  Firm 1  A−c  1
 B  q2 =   − q1
 2B  2
 A−c 
 
 2B 

Firm 2
q1
 A−c   A−c 
   
 2B   B 
 1 A−c  2 A−c 
q1 = q = 
* *
2  Q = q1 + q = 
* *
2 
3 B  3 B 
q2
1  A−c  2 A−c   A−c 
 <  < 
Firm 1 2 B  3 B   B 

Monopoly Competitive
Output Output

q2* There exists a unique Nash

equilibrium

Firm 2
*
q1
q1
 A numerical example…

Suppose that the market demand for computer chips (Q is in millions)

is given by

P = 120 − 20Q
Intel and Cyrix are both competing in the market and have a
marginal cost of $20.

1  120 − 20  5
q =q = 
*
I
*
C  = = 1.67 M
3  20  3

P = 120 − 20(3.33) = $53.33

 Had this market been serviced instead by a monopoly,

P = 120 − 20Q
MC = $20
MC
Q* = 2.5M p=
 1
P = 120 − 20(2.5) = $70 1 + 
 ε
$20
dQ P 1  70  $70 =
ε= =−   = −1.4  1 
dP Q 20  2.5  1 − 
 1.4 
 With competing duopolies

P = (120 − 20q2 ) − 20q1 = 86.6 − 20q1

MC = $20
MC
Q* = 1.67 M p=
 1
P = 86.6 − 20(1.67) = $53.33 1 + 
 ε
$20
dQ P 1  53.33  $53.33 =
ε= =−   = −1.6  1 
dP Qi 20  1.67  1 − 
 1.6 
 One more point…

Monopoly Duopoly

Q* = 2.5M Q* = 1.67 M
P = $70 P = $53.33
π = ($70 − $20)2.5 = $125 π = ($53 − 20)1.67 = $55

If both firms agreed to produce 1.25M chips (half the monopoly output),
they could split the monopoly profits ($62.5 apiece). Why don’t these
firms collude?
Suppose we increase the number of firms…
N
P = A − BQ = A − B ∑ qi
i =1
Demand facing firm i is given by (MC = c)

(
P = A − B ∑ j ≠i q j − Bqi )
Q−i

 A−c  1
q1 =   − Q−i
 2B  2
 Firm i’s best response to its N-1 competitors is given by

 A−c  1
qi =   − Q−i
 2B  2
Further, we know that all firms
produce the same level of output. Q−i = ( N − 1)qi
Solving for price and quantity, we get

qi =
A−c N ( A − c) A  N 
Q= P= + c
( N + 1) B ( N + 1) B N +1  N +1
 Expanding the number of firms in an oligopoly

qi =
A−c N ( A − c) A  N 
Q= P= + c
( N + 1) B ( N + 1) B N +1  N +1

Note that as the number of firms increases:

Output approaches the perfectly competitive
level of production
Price approaches marginal cost.

Lets go back to the previous example…

 Recall, we had an aggregate demand for computer chips and a constant
marginal cost of production.

P = 120 − 20Q
MC = $20
CS = (.5)(120 – 53)(3.33) = $112

q* = 1.67 M p
Q = 2q = 3.33
$112
P = $53.33 $53
π = $56
D
What would it be worth to consumers 3.33
Q
to add another firm to the industry?
With three firms in the market…

P = 120 − 20Q
MC = $20
CS = (.5)(120 – 45)(3.75) = $140

q* = 1.25M p
Q = 3q = 3.75
P = $45 $140
$45
π = $31
D
3.75
Q
A 25% increase in CS!!
6 Increasing Competition 80

70
5

60

4
50

3 40

30
2

20

1
10

0 0
13

17

21

25

29

33

37

45

49

53

57

61

65

69

73

77

81

89

93

97
41

85
1

Number of Firms

Firm Sales Industry Sales Price

 Increasing Competition
300

250

200

150

100

50

0
17

25

29

37

41

49

61

69

73

81

85

93
13

21

33

45

53

57

65

77

89

97
1

Number of Firms

Consumer Surplus Firm Profit Industry Profit

Now, suppose that there were annual fixed costs
equal to $10

P = 120 − 20Q
MC = $20
How many firms can this industry support?

A−c A  N 
qi = P= + c
( N + 1) B N +1  N +1

π i = ( P − $20)qi − $10 > 0 Solve for N

With a fixed cost of $10, this industry can support 7 Firms
140

130

120

110

100

90

80

70

60

50

40

30

20

10

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
The previous analysis was with identical firms.

 A−c  1
q2 q1 =   − q2
 2B  2
Firm 1  A−c  1
q2 =   − q1
 2B  2

Suppose Firm 2’s marginal costs

are greater than Firm 1’s….
q2*

Firm 2
*
q1
q
1
Suppose Firm 2’s marginal costs
are greater than Firm 1’s….
 A − c1  1
q1 =   − q2
q2  2B  2
 A − c2  1
Firm 1 q2 =   − q1
 2B  2
c2 > c1

q2* Firm 2
*
q1
q
1
Firm 2’s market share drops
  A + c2 − 2c1  As long as average industry
q1 = 
*
 costs are the same as the
 3B  identical firm case

 A + c1 − 2c2  c1 + c2
+ q2 = 
*
 =c
 3B  2
 2 A − ( c1 + c2 )  Industry output and price are
Q=  unaffected!
 3B 

Note, however, that production is undertaken in an inefficient manner!

With constant marginal costs, the firm with the lower cost
should be supplying the entire market!!
Market Concentration and Profitibility

N
P = A − B ∑ qi Industry Demand

i =1

P − ci si
= The Lerner index for Firm i is related

ε
to Firm i’s market share and the
P elasticity of industry demand

 H 
 
P − c  10,000 
The Average Lerner index for the

=
industry is related to the HHI and the
elasticity of industry demand
P ε
The previous analysis (Cournot Competition) considered quantity as the
strategic variable. Bertrand competition uses price as the strategic
variable.

p
Should it matter?

P*

D
Q*
Q

Just as before, we have an industry

demand curve and two competing
P = A − BQ duopolists – both with marginal cost
equal to c.
 P = A − BQ Q = a − bP
A 1
a= b=
B B
Cournot Case Bertrand Case

p1 p1
( A − Bq2 )
p2

D D
q1 q1
Price competition creates a discontinuity in each firm’s demand curve –
this, in turn creates a discontinuity in profits

0 if p1 > p2


  a − bp1 
π 1 ( p1 , p2 ) = ( p1 − c)  if p1 = p2
  2 

 ( p − c)(a − bp ) if p < p
 1 1 1 2

As in the cournot case, we need to find firm one’s best response

(i.e. profit maximizing response) to every possible price set by firm 2.
Firm One’s Best Response Function

Case #1: Firm 2 sets a price above the pure monopoly price:

p2 ≥ pm p1 = pm
Case #2: Firm 2 sets a price between the monopoly price and marginal cost

pm > p2 > c p1 = p2 − ε
Case #3: Firm 2 sets a price below marginal cost

c > p2 p1 > p2
Case #4: Firm 2 sets a price equal to marginal cost

c = p2 p1 = p2 = c

What’s the Nash equilibrium of this game?

Bertrand Equilibrium: It only takes two firm’s in the
market to drive prices to marginal cost and profits to
zero!

However, the Bertrand equilibrium makes some very restricting

assumptions…
Firms are producing identical products (i.e. perfect
substitutes)
Firms are not capacity constrained
An example…capacity constraints

Consider two theatres located side by side. Each theatre’s marginal

cost is constant at $10. Both face an aggregate demand for movies
equal to

Q = 6,000 − 60 P
Each theatre has the capacity to handle 2,000 customers per day.

What will the equilibrium be in this case?

 Q = 6,000 − 60 P
If both firms set a price equal to $10
(Marginal cost), then market demand is
5,400 (well above total capacity = 2,000)

Note: The Bertrand Equilibrium (P = MC) relies on each firm

having the ability to make a credible threat:

“If you set a price above marginal cost, I will

undercut you and steal all your customers!”

4,000 = 6,000 − 60 P
P = $33.33
At a price of $33, market demand is 4,000 and both firms operate at capacity
 Imperfect Substitutes
Recall our previous model that included travel time in the
purchase price of a product
Length = 1

Customer Firm 1

x
Distance to Store
~
p = p + tx Consumers places
a value V on the
product

Travel Costs
Dollar Price
 Imperfect Substitutes
Now, suppose that there are two competitors in the market –
operating at the two sides of town

Firm 2 Customer Firm 1

1− x x
The “Marginal Consumer” is indifferent between the two competitors.

~ ~
V − p1 − tx = V − p2 − t (1 − x)
We can solve for the “location” of this customer to get a demand curve
Imperfect Substitutes
p2 − p1 + t
x=
2t
Firm 2 Customer Firm 1

1− x x

 p2 − p1 + t   p1 − p2 + t 
D1 =  N D2 = (1 − x) N =  N
 2t   2t 
Both firms have a marginal cost equal to c

 p2 − p1 + t 
Π1 = ( p1 − c) N Each firm needs to choose
 2t  price to maximize profits
conditional on the other
firm’s choice of price.
 p1 − p2 + t 
Π 2 = ( p2 − c) N
 2t 

 p2 + t + c 
p1 =  
 2 

 p1 + t + c 
p2 =  
 2 
Bertrand Equilibrium with imperfect substitutes

p2
Firm 1

Firm 2
t +c

t +c
 
 2 
p1
t +c t +c
 
 2 
Cournot vs Bertrand
Suppose that Firm two‘s costs increase. What happens in each
case?

Bertrand Cournot
p2 q2
Firm 1

Firm 1
Firm 2

Firm 2
p1 q1
Cournot vs Bertrand
Suppose that Firm two‘s costs increase. What happens in each
case?

Cournot (Quantity Competition): Competition is very

aggressive
Firm One responds to firm B’s cost increases by
expanding production and increasing market share\
Best response strategies are strategic substitutes

Bertrand (Price Competition): Competition is very passive

Firm One responds to firm B’s cost increases by
increasing price and maintaining market share
Best response strategies are strategic complements
Stackelberg leadership – Quantity Competition

In the previous example, firms made price/quantity decisions

simultaneously. Suppose we relax that and allow one firm to choose
first.

P = A − BQ

Both firms have a marginal cost equal to c

Firm A chooses Firm B chooses Market Price is

its output first its output second determined
Firm B has observed Firm A’s output decision and faces
the residual demand curve:

P = ( A − Bq A ) − BqB
TR = ( A − Bq A ) qB − Bq 2
B

MR = ( A − Bq A ) − 2 BqB = c

A − c qA
qB = − = qB ( q A )
2B 2
Knowing Firm B’s response, Firm A can now maximize its
profits:

P = ( A − BqB ) − Bq A
A − c qA
qB = −
2B 2
P=
( A + c ) Bq A
−
2 2

TR =
( )
A − c qA
−
Bq 2
A

2 2
qA =
( A − c)
MR =
( A + c)
− Bq =c 2B
A
2 Monopoly Output
 =
( A − c) A−c 3( A − c )
qA qB = q A + qB =
2B 4B 4B
Essentially, Firm B acts as a monopoly
A − c qA in the “Secondary” market (i.e. after A
qB = − has chosen). Firm B earns lower
2B 2 profits!

1  A−c  2 A−c  3 A−c   A−c 

 <  <  < 
2 B  3 B  4 B   B 

Monopoly Cournot Stackelberg Competitive

Output Output Output Output
Sequential Bertrand Competition

With identical products, we get the same result as before (P =

MC). However, lets reconsider the imperfect substitute case.

We already derived each

 p1 + t + c   p2 + t + c 
p2 =   p1 =   firm’s best response
 2   2  functions

Now, suppose that Firm 1 gets to set its price first (taking into account
firm 2’s response)

 p2 − p1 + t 
Π1 = ( p1 − c) N
 2t 
 Sequential Bertrand Competition

 c − 3t − p1 
Π1 = ( p1 − c) N
Take the derivative  4t 
and set equal to
zero to maximize 3t
profits p1 = c +
2

 p1 + t + c  5t
p2 =  =c+
 2  4

Note that prices are higher than under the simultaneous move
example!!
 Sequential Bertrand Competition

3t 3 5
p1 = c + D1 = N D2 = N
2 8 8

 p1 + t + c  5t 18 25
p2 =  =c+ Π1 = Nt Π2 = Nt
 2  4 32 32

In the simultaneous move game, Firm A and B charged the

same price, split the market, and earned equal profits.
Here, there is a second mover advantage!!
Cournot vs Bertrand: Stackelberg Games

Cournot (Quantity Competition):

 Firm One has a first mover advantage – it gains
market share and earns higher profits. Firm B loses
market share and earns lower profits
 Total industry output increases (price decreases)

Bertrand (Price Competition):

Firm Two has a second mover advantage – it charges a
lower price (relative to firm one), gains market share and
increases profits.
Overall, production drops, prices rise, and both firms
increase profits.