1. Managerial Economics & Business Strategy Chapter 9 Basic Oligopoly Models

2. Stackelberg Summary Stackelberg model illustrates how commitment can enhance profits in strategic environments. Leader produces more than the Cournot equilibrium output. n Larger market share, higher profits. n First-mover advantage. Follower produces less than the Cournot equilibrium output. n Smaller market share, lower profits.

3. Let’s work through demonstration problem 9-6 (put your books away) Suppose the inverse demand function for two firms in a homogeneous-product Stackelberg oligopoly is given by P=50-(Q 1 +Q 2 ) and the cost functions for the two firms are C 1 (Q 1 )=2Q 1 and C 2 (Q 2 )=2Q 2 Firm 1 is the leader, and firm 2 is the follower n What is firm 2’s reaction function? n What is firm 1’s output? n What is firm 2’s output? n What is the market price?

4. Bertrand Model 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 n Perfect information. n Zero transaction costs.

5. Bertrand Equilibrium Firms set P 1 = P 2 = MC! Why? Suppose MC < P 1 < P 2. Firm 1 earns (P 1 - MC) on each unit sold, while firm 2 earns nothing. Firm 2 has an incentive to slightly undercut firm 1’s price to capture the entire market. Firm 1 then has an incentive to undercut firm 2’s price. This undercutting continues... PRICE WAR Equilibrium: Each firm charges P 1 = P 2 = MC.

6. Firms don’t like this... Bertrand oligopoly leads to zero economic profits Consumers like this… n Products are identical n Buy from the firm with the lowest price Ending outcome is like Perfect Competition Called the Bertrand Trap n This is why firms spend millions on advertising n “We” charge a different price BECAUSE “We” are different

7. What if firms WORK together? Collusion n Dealt with in greater detail in Chapter 10 Maximize TOTAL industry profit n Q = Q 1 + Q 2 P=1000-Q and C(Q) = 4Q Set MR=MC n 1000-2Q=4 n Q=498 n P=$502 n Profits = (498*502)-(4*498)=248004

8. Summary Cournot (oil production) n Set MR=MC for each firm and cross substitute to find Q 1 and Q 2 n Plug back into the inverse demand function to find P Stackelberg (Diamonds) n Set MR=MC for the FOLLOWER to find reaction function n Maximize the Profit of the Leader plugging in the followers reaction function in for Q 2 Plug in the reaction function BEFORE you maximize Profits n Plug back into the inverse demand function to find P Bertrand (contractors bidding for the job) n Use the inverse demand and cost functions to set P=MC n Profits always equal ZERO Collusion n Work together and maximize total industry Q n Monopoly outcome (MR=MC)

9. What are the outcomes? Output (highest to lowest) n Bertrand, Stackelberg, Cournot, Collusion Profits (highest to lowest) n Stackelberg leader and Collusion, Cournot, Stackelberg follower, Bertrand

10. Let’s work on Chapter 9 homework Numbers 2, 4, and 5