Economics of Business &

Markets
Syllabus

Professor Fátima Barros

Fátima Barros Economics of Business and Markets 1

Who are you?

Please tell me:

(turn on your camera, please)

1. Where do you come from: country/city

2. What is your academic background: did
you study microeconomics?

Fátima Barros Economics of Business and Markets 2

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 Syllabus
Syllabus
Market Structure and Market Power
Topic 1
Cabral, Chap. 9, Besanko et al, Chap. 8
Collusion
Topic 2
Cabral, Chap. 8, Besanko et al, Chap. 8
Pricing
Topic 3
Cabral, Chap. 10, C&P, Caps 9 e 10
Product Differentiation
Topic 4 Cabral, Chap. 12
Besanko et al., Cap. 8, C&P, Cap. 7
Strategic Behavior, Entry and Exit
Topic 5
Cabral, Chap. 15, Besanko Chap. 11
Vertical Relations
Topic 6
Cabral Chap. 11, Besanko et al, Chaps. 5 and 6

Fátima Barros Economics of Business and Markets 3

Readings:

• Besanko*, D., Dranove, D. , Shanley, M. and Schaefer, S., (B&D),

Economics of Strategy, 7th edition, Wiley, 2017

• Cabral*, L., Introduction to Industrial Organization, 2nd edition,

MIT Press, 2017.

• Carlton*, D. and Perloff, J.,(C&P), Modern Industrial

Organization, 4th edition, Addison-Wesley, 2004.

* Recommended lectures.

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 Grading

WEIGHT
REQUIRED ASSIGNMENT
IN FINAL
GRADE

2 Problem Sets handed out during the term. Problem sets are
30% a team work and must be solved by groups of 4 students each.

70% Final Exam (closed book)

Office Hours: appointment by email

Fátima Barros Economics of Business and Markets 5

Policy on Problem Sets and Final Exam

• Problem sets are designed to help you to learn how to apply the
material presented in lectures. Make sure you try all exercises in the
problem sets yourself and understand the solutions in detail - the final
exam will contain problems very similar to homework problems.
• In fairness to students who complete assignments on time, late
homework sets will not be accepted…
• Final Exam: the exam is closed book and notes. A minimum grade of
8.50 in final exam is required to succeed this course .

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 Student Conduct

• Attending the Class: Each class benefits from the attendance and
participation of all students therefore your attendance is required in all
classes. You should try to sit on the same seat in every lecture and
display a legible name tag at all times.
• Arriving on Time: Late arrivals are disruptive to lectures and show
disrespect to those who are on time.
• Minimizing Disruptions: All cell phones should be turned off during
class. Laptops and tablets are allowed if and only if used to take notes or
to access slides presented in class.
• Being Prepared for Class: You should be ready to discuss any
assigned readings and to answer any assigned questions for each day's
class.

Fátima Barros Economics of Business and Markets 7

Market Structure and Market

Power

Topic 1

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 Overview

• Market Definition
• Product Market Definition
• Geographic Market Definition

• Concentration Measures
Ck and HHI
• Economies of Scale and Concentration
• Price-Cost margin and Concentration

9
Fátima Barros Economics of Business and Markets 9

MARKET DEFINITION

www.slido.com #32262

Fátima Barros Economics of Business and Markets 10

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 Market Definition: Identifying Competitors

Fátima Barros Economics of Business and Markets 11

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 Characteristics of Substitutes
• Two products tend to be close substitutes when

1. They have similar performance

characteristics
2. They have similar occasion for use and
3. They are sold in the same geographic area

Fátima Barros Economics of Business and Markets 13

1. Performance Characteristics

• Products that belong to the same type or fall under

the same SIC (Standard Industry Classification) are
not necessarily substitutes if their performance
characteristics are substantially different
• Ex: Mercedes and Fiat

Fátima Barros Economics of Business and Markets 14

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 2. Occasion for Use
• Products may share characteristics but may differ
in the way they are used
• Orange juice and Coca-Cola are soft drinks but
used in different occasions
• Another example could be hiking shoes versus
regular shoes

Fátima Barros Economics of Business and Markets 15

3. Geographic Area
• Identical products in two different geographic
markets will not be substitutes due to
“transportation costs”
• Heavy products like cement cannot be transported
over long distances to benefit from geographic
price difference
• Wood pulp…

Fátima Barros Economics of Business and Markets 16

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 Market Definition

• Market Structure: refers to the number and

characteristics of firms in a market.
• Market: set of products (and geographical áreas)
that exercise some competitive constraints to the
firm.
• high cross-price elasticity of demand

• Market: Definition of any market contains both:

• Product Dimension
• Geographic Dimension

Fátima Barros Economics of Business and Markets 17

1. Product Market Definition

• Set of suppliers producing the same product or a

set of products that are close substitutes.
• high cross-price elasticity of demand

Fátima Barros Economics of Business and Markets 18

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 How can we define those set of
products?

• The set of products that define a market must have

very high cross price-demand elasticities
among them and very low cross price-demand
elasticities vis à vis other products.

Fátima Barros Economics of Business and Markets 19

Price Elasticities of Demand for Different

Car Models

Nissan Ford Toyota BMW

Sentra Escort Lexus
745i
Nissan -6.5282 0.4544 0.0008 0.0000
Sentra
Ford 0.0778 -6.0309 0.0008 0.0000
Escort
Toyota 0.0002 0.0010 -3.0847 0.0322
Lexus
BMW 745i 0.0001 0.0005 0.0926 -3.5151

Fátima Barros Economics of Business and Markets 20

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 2. Geographic Market Definition

• Two locations should be considered as part of the

same geographic market if an increase in the
price of a product, in one geographic location,
significantly affects either the demand or supply,
and therefore the price, in another geographic
location.

Fátima Barros Economics of Business and Markets 21

Relevant Market
• The relevant market for one product includes all
products that significantly limit the price of this
product.
• The extent to which firms are able to increase
their prices above normal competition levels
depends on the possibility for consumers to buy
substitute goods. The fewer the substitute
products the less elastic the demand curve is and
the more probable is to find higher prices.
• Example: plastic bottles and glass bottles

• Very important for M&A analysis by competition

authorities
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 Relevant Market: the SSNIP Test
• The Small but Significant Non-transitory Increase in
Prices (SSNIP) was introduced with 1982 US Merger
Guidelines and is widely used by competition authorities (
including the European Commission) to define the relevant
market
• Starting with the narrowest possible market definition, if it is
profitable for a hypothetical monopolist to increase the
price of the product by 5% then there are no close
substitutes outside this market and this is a relevant market.
• Products in this market do not face significant competitive
constraints from products outside it.

Fátima Barros Economics of Business and Markets 23

Relevant Market: the SSNIP Test

• Suppose an hypothetical monopolist that is the only seller of
bananas. Would this hypothetical monopolist find it
profitable to increase the price of bananas above the current
level in a non-transitory way, say by 5-10%?
• If the answer is YES that price raise would be profitable.
This means that bananas do not face significant competitive
constraints from other products (no close substitutes).
• If the increase in price is not profitable because consumers
would substitute bananas to products outside the candidate
market, like kiwi fruits and pineapples, the market definition
should be extended to include the closest of these
substitutes

Fátima Barros Economics of Business and Markets 24

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 Relevant Market: the SSNIP Test

• We must ensure that any product exercising competitive

constraint on bananas is included in the market definition
• Products (e.g. kiwi) that are close substitutes are added to
the candidate market until the price increase is profitable
for a hypothetical monopolist that is the only seller of
bananas and kiwis in the candidate market.
• When this arises the relevant market has then been
found.

Fátima Barros Economics of Business and Markets 25

Why is it so difficult to define a Market?

• Frequently product differentiation is due to small
characteristics of the product.
• Ex: Diet Coke belongs to
✓Light cola market
✓Cola market
✓Soft drinks market
• Relevant Geographic Market:
✓Imports
✓Transportation Costs

Fátima Barros Economics of Business and Markets 26

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Fátima Barros Economics of Business and Markets 27

In: Economics of Strategy, Besanko et al., 6th ed., 2012

Fátima Barros Economics of Business and Markets 28

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 Characterization of Market Structure

• Concentration in the market

• Number of firms Concentration

• Size of firms Index

Fátima Barros Economics of Business and Markets 29

Measuring Market Structure

1. K-firm concentration ratio

k
Ck   si where si is the market share of firm i
i =1

Combined shares of the k largest firms in the

market

Ck   ,1
k
n 

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 An Oligopoly

C3=31.8+22.9+16.9=71,6

C5=31.8+22.9+16.9+6.7+6.1=84,4

Fátima Barros Economics of Business and Markets 31

Smartphones Market Share in Global Market

Average Average Average Average
2009 Market 2018 Market 2019 Market Q3’ 2020* Market
Share Share Share Share

Nokia 38,6% Samsung 20.9% Samsung 21.6% Samsung 21.1%

RIM* 19,9% Apple 14.8% Huawei 17.6% Huawei 17.5%

Apple 16,1% Huawei 14.6% Apple 13.7% Apple 12.9%

HTC 4,5% Xiaomi 8.8% Xiaomi 8.9% Xiaomi 11.3%

Samsung 3,3% OPPO 8.05% OPPO 8.3% OPPO 8.6%

Others 17,6% Others 32.9% Others 29.8% Others 31.4%

C5 82.4 C5 67.1 C5 70.1 C5 68.6

Source: Statista

Most Popular Mobile Phone Brands 1993 - 2019 - Bing

Note: RIM =Blackberry video

Fátima Barros Economics of Business and Markets 32

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 Measuring Market Structure
2. Herfindahl-Hirschman Index (HHI):
n
1 
HHI   si2 HHI   ,1
i =1 n 

• HHI index equals the sum of the squared market

shares of all firms in the market
• Conveys more information than the Ck ratio:
• Sensitive to changes in the sizes of the largest firms in
the market.

• To calculate HHI index it is usually sufficient to

consider only those firms with market shares larger
than 0,01.

Fátima Barros Economics of Business and Markets 33

Example
The UK Market of Mobile Handset Manufacturers

Firms si si2
Samsung 31.8 1011.24
Apple 22.9 524.41
Nokia 16.9 285.61
Sony 6.7 44.89
HTC 6.1 37.21
RIM 3.7 13.69
Motorola 2.4 5.76
LG 2.1 4.41
Others 7.4
HHI 1927.22

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 Measuring Market Structure

Fátima Barros Economics of Business and Markets 35

Smartphones Market Share in Global Market

Average Average Average Average
Q3’
2009 Market 2018 Market 2019 Market Market
2020*
Share Share Share Share

Nokia 38,6% Samsung 20.9% Samsung 21.6% Samsung 21.1%

RIM* 19,9% Apple 14.8% Huawei 17.6% Huawei 17.5%
Apple 16,1% Huawei 14.6% Apple 13.7% Apple 12.9%
HTC 4,5% Xiaomi 8.8% Xiaomi 8.9% Xiaomi 11.3%
Samsung 3,3% OPPO 8.05% OPPO 8.3% OPPO 8.6%
Others 17,6% Others 32.9% Others 29.8% Others 31.4%
C5 82.4 C5 67.1 C5 70.1 C5 68.6

HHI 2176.3 HHI 1010.2 HHI 1113 HHI 1058.9

Source: Statista
Most Popular Mobile Phone Brands 1993 - 2019 - Bing
Note: RIM =Blackberry video

Fátima Barros Economics of Business and Markets 36

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 A Duopoly

Fátima Barros Economics of Business and Markets 37

Example
 Consider the Energy Drinks Market (USA) market
shares of the top selling firms, in 2018.
 What is the five-firm concentration ratio?

 What is the HHI?

Fátima Barros Economics of Business and Markets 38

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 Measuring Market Structure

1
HHI = n 2 +
n

Fátima Barros Economics of Business and Markets 39

Measuring Market Structure

• If all firms have equal (identical) shares (that is, if

the market structure is completely symmetric, in
which case si = 1/n for all i) then σ2 is zero and HHI
equals 1/n.
• If the number of firms in the market is held
constant, then a higher variance due to a higher
level of asymmetry between firms' shares (that is, a
higher share dispersion) will result in a higher value
of the HHI index.

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 Ck and Herfindahl
• An example:
Firm si(%) si’(%)
1 35 45
2 25 20
3 10 6
4 7 6
5 5 5
6 5 5
7 4 4
8 4 4
9 3 3
10 2 2

Fátima Barros Economics of Business and Markets 41

Fátima Barros Economics of Business and Markets 42 42

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Fátima Barros Economics
In: Economics of Besanko,
of Strategy, BusinessD.
and Markets
et al., 6th edition, 2012 43

HHI and Mergers - USA

• In the USA the HHI is used to determine whether mergers
should be examined. According to US Merger Guidelines:
• If the post-merger HHI is lower than 1.500 (lower
concentration) the merger will be approved.
• If the post-merger is between 1.500 and 2.500 (moderate
concentration) and involve an increase in HHI of more than
100 points potentially raise significant competitive concerns
• If the post-merger HHI is higher than 2.500 (high
concentration) and involve an increase in HHI between 100
points and 200 points potentially raise significant competitive
concerns. If the HHI increases more than 200 points will be
presumed to enhance market power and is likely to be
investigated.

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 HHI and Mergers – European Union
• No concerns if:
• a post-merger HHI is below 1000
• No concerns if:
• a post-merger HHI is between 1000 and 2000 and the
increase in HHI is below 250
• a post-merger HHI is above 2000 and the increase in HHI
is below 150
• except under special circumstances
• merger involves a potential entrant or a recent entrant
with a small market share;
• one of the merging parties has a pre-merger market share
of 50% or more
• One of the merging firms is a maverick firm with a higher
likelihood of disrupting coordinated conduct.

Fátima Barros Economics of Business and Markets 45

Exercise
In 1985 United Airlines purchased Pam Am’s Pacific Division for $750 million.
The Department of Justice opposed the purchase, but it was approved by the
U.S. Department of Transportation. The percentages of total passengers
carried across the Pacific by each airline in 1984 were as follows:
1. Compute the concentration indexes that you consider adequate to assess
the level of concentration in this market before the purchase of Pan Am’s
Pacific Division by United. How do you classify the concentration level in
this market?
2. Compute the value of the concentration indexes after the purchase.
3. At the time, a Justice Department guideline called for prohibition of an
acquisition that would raise the Herfindahl Index by more than 100 points
in industries that were already highly concentrated. How would this
guideline apply to United Airlines’ proposed acquisition?
Percentage Percentage
Firm Firm
(%) (%)

Northwest 27.5 United 7.3

Japan
Airlines 21.9 China Airlines 6.8
Singapore
Pan Am 18.5 Airlines 2.9

Korean Air 9.3 Others 5.8

Fátima Barros Economics of Business and Markets 46

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 Solution with current guidelines (2010)

Fátima Barros Economics of Business and Markets 47

Limitation of Concentration Measures

• Market Definition: National, regional, or local?

• Global Market: Foreign producers excluded.
• Industry definition and product classes.

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 SIC- Standard Industry Classification
• SIC classifications in general do not correspond to the
economic market definition
• System developed to collect and analyze data on the activities
of the firms (four-digit industries). In EU we have CPA -
Classification of Products by Activity (EUROSTAT)
• Examples SIC:
• 3721- Aircraft and Aircraft Parts: includes airplanes, hang-glider,
blimps (look like a Zeppelin), helicopters
• 2834 – Pharmaceutical Preparations: includes prescriprion
drugs, over-the-counter preparations and veterinary products
• 3221 – Glass Containers; 3411 – Metal Cans

Fátima Barros Economics of Business and Markets 49

What is the price elasticity

between a hang-glider
and a F-16 fighter plane?
And between the F-16
and the blimp?

Fátima Barros Economics of Business and Markets 50

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 SIC- Standard Industry Classification

• In terms of product market the SIC market

definition can be too broad or too narrow
• If it is too broad: measured degree of
concentration is underestimated
• If it is too narrow: measured degree of
concentration is overestimated

Fátima Barros Economics of Business and Markets 51

Economies of Scale and Concentration

• Industries with large minimum efficient

scales compared to the size of the
market tend to have high concentration
• The inter-industry pattern of concentration is
replicated across countries
• When production enjoys economies of
scale, entry is difficult and hence profits are
high

Fátima Barros Economics of Business and Markets 52

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Fátima Barros Economics of Business and Markets 53

Price-Cost Margins and Concentration

• Theory would predict that price-cost

margins will be higher in industries with
greater concentration (fewer sellers)
• There could be other reasons for inter-
industry variation in price-cost margins
(regulation, concentration of buyers and so
on)

Fátima Barros Economics of Business and Markets 54

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 Price-Cost Margins and Concentration

• It is important to control for these factors if

one need to study the relation between
concentration and price-cost margin
• Most studies focus on specific industries and
compare geographically distinct markets.

Fátima Barros Economics of Business and Markets 55

Evidence on Concentration and Price

(Goldman Sachs 2014)

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 Herfindahl indices in the US manufacturing sector
Industry Group 1997 2002 Variation
Transportation equipment mfg 797.6 574.7 −229.9

Beverage and tobacco product manufacturing 777.2 709.5 −67.7

Petroleum & coal products mfg 350 543.4 193.4
Textile product mills 186.2 403 216.8
Paper mfg 173.3 259.3 86
Leather & allied product mfg 167.2 163.6 -3.6
Computer & electronic product mfg 136.6 135 -1.6

Electrical equipment, appliance, & component mfg 105.9 113.9 8

Apparel mfg 100.6 105.7 5.1
Primary metal mfg 97.4 149.6 52.2
Textile mills 94.4 105.6 11.2
Food mfg 91 118.7 27.7
Chemical mfg 76.6 99.9 23.3
Furniture & related product mfg 55.5 57.2 1.7
Machinery mfg 55.4 71.3 15.9
Wood product mfg 52.7 48.4 -4.3
Nonmetallic mineral product mfg 52.1 46.7 -5.4
Printing & related support activities 38.8 45.2 6.8
Plastics & rubber products mfg 30.2 32 1.8
Fabricated metal product mfg 8.5 10.2 1.7
Source: US Economic Census Data – Manufacturing sector

Fátima Barros Economics of Business and Markets 57

Four Classes of Market Structure

Structure Herfindahl Index Intensity of Price Competition

Perfect Usually < 0.2 Fierce
Competition
Monopolistic Usually < 0.2 Depends on the degree of
Competition product differentiation
Oligopoly 0.2 to 0.6 Depends on inter-firm rivalry
Monopoly > 0.6 Light unless there is threat of
entry

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  Market Structure
✓ Number and size of firms.
✓ Industry concentration.
✓ Technological and cost conditions.
✓ Demand conditions.
✓ Ease of entry and exit.
 Conduct
✓ Pricing.
✓ Advertising.
✓ R&D.
✓ Merger activity.
 Performance
✓ Profitability.
✓ Social welfare.

Fátima Barros Economics of Business and Markets 59

Staples Case - Questions

1. How has the office superstore market changed in the 18 years since Staples and Office Depot
originally attempted to merge? Who are the competitors? How would you classify the office
superstore industry?
2. Considering the two situations where Staples and Office Depot attempted to merge, answer
the following questions explaining what did change from 1996 to 2015:
• What is the relevant market definition in the two cases?
• Who are the customers?
• Should retailers that sell, but do not specialize in office products, be considered as part
of the market? What evidence supports this conclusion?
3. What barriers to entry help maintain the industry structure? Did they change in the two
situations?
4. How is the Herfindahl-Hirschman Index (HHI) affected by the merger? Are the HHI levels
in the case indicative of high industry concentration (consider the two situations)?

5. How might the merger lead to cost reductions for Staples? Could this be beneficial for
Staples’ customers?
6. What arguments could Staples and Office Depot make in defense of their merger?

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 ANNEX

Review of Market Structures Models

Fátima Barros Economics of Business and Markets 61

Market Structures

Perfect Competition, Monopoly and

Oligopoly Models (Cournot,
Stackelberg and Bertrand)

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 Perfect Competition

• Many buyers and sellers

• Homogeneous product
• Perfect information
• No transaction costs
• Free entry and exit

Fátima Barros Economics of Business and Markets 63

Key Implications

• Firms are “price takers” (P = MR)

• In the short-run, firms may earn profits or
losses
• Long-run profits are zero

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 Unrealistic?
• Many small businesses are “price-takers,” and decision rules
for such firms are similar to those of perfectly competitive firms
• It is a useful benchmark
• Explains why governments oppose monopolies
• Illuminates the “danger” to managers of competitive
environments
• Importance of product differentiation
• Sustainable advantage

Fátima Barros Economics of Business and Markets 65

Setting Output:

• MR = MC
• MR = P, therefore
• Set P = MC to maximize profits

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 Long Run Adjustments?

• If firms are price takers but there are

barriers to entry, profits will persist
• If the industry is perfectly competitive, firms
are not only price takers but there is free
entry
• Other firms enter the market

Fátima Barros Economics of Business and Markets 67

Effect of Entry on Price?

$ $
S
Entry S*

Pe Df
Pe* Df*

QM Qf
Market Firm
Fátima Barros Economics of Business and Markets 68

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 Effect of Entry on the Firm’s Output and
Profits?
MC
$
AC

Pe Df

Pe* Df*

QL Qf* Q

Fátima Barros Economics of Business and Markets 69

Summary of Logic
• Short run profits leads to entry
• Entry increases market supply, drives down
the market price, increases the market
quantity
• Demand for individual firm’s product shifts
down
• Firm reduces output to maximize profit
• Long run profits are zero

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 Features of Long Run Competitive
Equilibrium

• P = MC
• Socially efficient output
• P = minimum AC
• Efficient plant size
• Zero profits
Firms are earning just enough to offset their
opportunity cost

Fátima Barros Economics of Business and Markets 71

Monopoly

• Single firm serves the “relevant market”

• Most monopolies are “local” monopolies
• The demand for the firm’s product is the market
demand curve
• Firm has control over price
• But the price charged affects the quantity demanded of
the monopolist’s product

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 “Natural” Sources of
Monopoly Power

• Economies of scale
• Economies of scope

Fátima Barros Economics of Business and Markets 73

“Created” Sources of
Monopoly Power

• Patents and other legal barriers (like

licenses)
• Tying contracts
• Exclusive contracts
• Collusion

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Monopoly Profit Maximization
Produces where MR = MC.
Charge the price on the demand curve that corresponds
to that quantity.
Profit MC
$
ATC

PM

ATC
D

QM MR Q

Fátima Barros Economics of Business and Markets 75

Long Run Adjustments?

• None, unless the source of monopoly

power is eliminated.

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 Why Government Dislikes Monopoly?

• P > MC
• Too little output at a too high price

• Deadweight loss of monopoly

Fátima Barros Economics of Business and Markets 77

Deadweight Loss of Monopoly

Deadweight Loss MC
$
of Monopoly ATC

PM

D
MC

QM MR Q

Fátima Barros Economics of Business and Markets 78

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 Arguments for Monopoly

• The beneficial effects of economies of

scale, economies of scope on price and
output may outweigh the negative effects of
market power
• Encourages innovation

Fátima Barros Economics of Business and Markets 79

Oligopoly

• Relatively few firms, usually less than 10.

• Duopoly - two firms
• The products firms offer can be either differentiated
or homogeneous.

Fátima Barros Economics of Business and Markets 80

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 Role of Strategic Interaction

• What you do affects the

profits of your rivals
• What your rival does
affects your profits

Fátima Barros Economics of Business and Markets 81

Cournot Model

• A few firms produce goods that are either

perfect substitutes (homogeneous) or
imperfect substitutes (differentiated)
• Firms set output, as opposed 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 Functions
• Suppose two firms produce homogeneous
products.
• Firm 1’s reaction (or best-response) function is
a schedule summarizing the amount of Q1 firm
1 should produce in order to maximize its profits
for each quantity of Q2 produced by firm 2.
• Since the products are substitutes, an increase
in firm 2’s output leads to a decrease in the
profit-maximizing amount of firm 1’s product.

Fátima Barros Economics of Business and Markets 83

Graphically

Q2

Q2*

r1 (Firm 1’s Reaction Function)

Q1* Q1M Q1

Fátima Barros Economics of Business and Markets 84

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 Cournot Equilibrium

• Situation where each firm produces the

output that maximizes its profits, given the
the output of rival firms
• No firm can gain by unilaterally changing its
own output

Fátima Barros Economics of Business and Markets 85

Summary of Cournot Equilibrium

• The output Q1* maximizes firm 1’s profits,
given that firm 2 produces Q2*
• The output Q2* maximizes firm 2’s profits,
given that firm 1 produces Q1*
• Neither firm has an incentive to change its
output, given the output of the rival
• Beliefs are consistent:
• In equilibrium, each firm “thinks” rivals will stick
to their current output -- and they do!
Fátima Barros Economics of Business and Markets 86

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 Another Look at Cournot Equilibrium

Q2
Firm 2’s Profits
r1
Q2M Cournot Equilibrium

Q2*

Firm 1’s Profits

r2

Q1* Q 1M Q1

Fátima Barros Economics of Business and Markets 87

Stackelberg Model

• Few firms
• Producing differentiated or homogeneous products

• Barriers to entry
• Firm 1 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 leader’s output.

Fátima Barros Economics of Business and Markets 88

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 Stackelberg Summary
• Stackelberg model illustrates how
commitment can enhance profits in strategic
environments
• 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

Fátima Barros Economics of Business and Markets 89

Bertrand Model

• Few firms
• 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 MC < P1 < P2
• Firm 1 earns (P1 - 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...
• Equilibrium: Each firm charges P1 = P2 =MC

Fátima Barros Economics of Business and Markets 91

Bertrand Equilibrium

• When firms have the same cost structure,

price competition drives prices to the unit
costs level and firms make zero profit.
• Therefore, the industry equilibrium is
independent of the firms number: P=Cmg
even if there are more 2 than competitors.

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 Bertrand Paradox
• Even if there are only 2 competitors, prices
will be set at the level of marginal cost (the
perfect competition outcome).
• However, many industries look like Bertrand
model but where prices are higher than
marginal cost. This outcome might be due
to:
• Capacity constraints
• Product Differentiation
• Dynamic interaction

Fátima Barros Economics of Business and Markets 93

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

• Key Implications
• 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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