Harambee University College Microeconomics Theory II Department of Economics

CHAPTER ONE
MONOPOLY MARKET STRUCTURE
1.0 Aims and Objectives
1.1 Introduction
1.2 How monopoly is maintained
1.3 Demand for monopolist products
1.4 The monopolist’s marginal revenue
1.5 Profit maximization by monopoly firms
1.6 Monopoly supply
1.7 Price discrimination
1.8 Regulation of monopoly

1.0 Aims and Objectives

 Defining monopoly
 Explain the concept of monopoly.
 Show how the demand curve for a product sold by a monopolist firm.
 Show how the marginal revenue from a monopolist’s output is less than the price the
monopolist charges for its product.
 Understand how profit is maximized in monopoly market
 Understand how monopoly is regulated

1.1 Introduction
Pure monopoly is the form of market organization in which there is a single seller of a
commodity for which there are no close substitutes. Thus, it is at the opposite extreme from
perfect competition. Monopoly may be the result of: (1) increasing returns to scale; (2) control
over the supply of raw materials; (3) patents; or (4) government franchise. For example,
electrical companies, telephone companies, and other ―public utilities‖ usually have increasing
returns to scale (i.e., falling long-run average costs) over a sufficient range of outputs as to
enable a single firm to satisfy the entire market at a lower per-unit cost than two or more firms
could.

Page 1
Harambee University College Microeconomics Theory II Department of Economics

These natural monopolies usually operate under a government franchise and are subject to
government regulation. A monopoly may also arise because a firm may own a patent which
precludes other firms from producing the same commodity. Under pure monopoly, the firm is the
industry and faces the negatively sloped industry demand curve for the commodity. As a result,
if the monopolist wants to sell more of the commodity, it must lower its price. Thus, for a
monopolist, MR is less than P, and its MR curve lies below its demand curve.
A monopoly is opposite of perfect competition in every facet of its organization.

In actuality, it is rare for a national or world market to have only one seller. A firm has monopoly
power if it can influence the market price of its product by making more or less of it available to
buyers. Although pure monopoly is very rare, monopoly power is quite common.

Local monopolies are more common than national monopolies, and single sellers serve local
markets often. However, few if any products have no substitutes. A local electric power
company may be the sole seller of electricity in an area, but electricity in its multitude of uses
does have substitutes. When the price of electricity rises, there is a decline in the quantity
demanded for its use as a means of heating. Natural gases and oil furnaces are good substitutes
for electric heat. Similarly, the Ethiopian postal agency is the sole supplier of letter delivery.
However, telecommunication, including electronic transmission of messages, is a substitute for
the mail service.

1.1 How Monopoly Is Maintained: Barriers to Entry

Barrier to Entry is a constraint that prevents additional sellers from entering a monopoly firm’s
market. If there are significant barriers to entry, a firm or firms may be able to sustain above
normal profits over time because other firms are prevented from entry to capture the above
normal profits. Monopoly is the market structure that is usually associated with the greatest
market power. The monopolist produces a good with no close substitutes (increased probability
the demand is relatively inelastic) and there are barriers to entry. Complete barriers to entry
(BTE) make it impossible for competing firms to inter a market. However, in n most cases, BTE
are not complete but are relative. Firms’ entry into a market can be restricted by a variety of
factors. The major barriers to entry are as follows:

Page 2
Harambee University College Microeconomics Theory II Department of Economics

1.1.1 Government Franchises and Licenses

Some barriers to entry are the result of government policies that grant single-seller status to
firms. For example, local governments commonly give the right to install cable television
systems to a single firm. Governments typically establish monopolies for the rights to sell
transportation and communication services, electric power, water and sewer service.

1.1.2 Patents and Copyrights

Patents and copyrights are other government-supported barriers to entry. They give creator of
new products and works of literature, art, and music exclusive rights to sell or license the use of
their inventions and creators. Patents and copyrights provide monopoly protection for only a
specified number of years. After the patent expires, the barrier to entry is removed. The idea
behind patents and copyrights is to encourage firms and individuals to innovate and produce new
products. This is done by guaranteeing exclusive rights to the profits from new ideas to their
originators through establishment of monopoly supply for limited periods.

1.1.3 Ownership of the Entire Supply of a Resource

A monopoly can also be maintained as a result of ownership of the entire source of supply of a
particular input. Unique ability or knowledge can also create a monopoly. Talented singers,
artists, athletes, and the cream of the crop of any profession have monopolies on the use of their
services. Firms with secret processes or technologies have monopolies if other firms cannot
duplicate the techniques. The simplest way for a monopoly to arise is for a single firm to own a
key resource.

1.1.4 Cost Advantage of Large Scale Operations and the Emergence of

Monopoly
Monopolies might also arise naturally out of cost or technological advantages associated with
large-scale production or marketing of products. Economies of scale are cost savings that result
from large-scale production. These cost saving favor the establishment of monopolies because
bigger firms in industries for which economies of scale prevail can product at lower average cost
than smaller competitors. The costs of production make a single producer more efficient than a
large number of producers.

Page 3
Harambee University College Microeconomics Theory II Department of Economics

If firms can continually reduce average costs of production and profit by expanding in the long
run, one firm will eventually emerge as the dominant supplier. Perfect competition would require
many small firms with small market shares. If perfect competition existed initially, it would end
soon as existing firms would merge or one firm would purchase their assets and consolidate
them. To achieve lower average costs, one firm must dominate. Once it dominates, new firms
cannot enter because they would be too small initially to achieve the low average costs the
dominant firm enjoys by virtue of producing the entire market supply in very large plants.

1.1.5 Natural Monopoly

An industry is a natural monopoly when a single firm can supply a good or service to an entire
market at a smaller cost than could two or more firms. Natural monopoly caused by economies
of scale usually associated with a cost structure with a high fixed cost relative to variable costs.
A natural monopoly is the result of significant economies of scale over the relevant range of
output due to a high fixed cost. As the output increases the LRAC falls. If the market demand
intersects the LRAC as it falls (or at its minimum), a natural monopoly exists.

1.2 The Demand for a Monopolist’s Product

Because a monopoly firm is the sole producer in its market, it faces the downward-sloping
market demand curve. As a result, the monopoly has to accept a lower price if it wants to sell
more output. The competitive firm sells a product with many perfect substitutes (the products of
all the other firms in its market), the demand curve that any one firm faces is perfectly elastic. By
contrast, because a monopoly is the sole producer in its market, its demand curve is the market
demand curve. Thus, the monopolist’s demand curve slopes downward for all the usual reasons.
If the monopolist raises the price of its good, consumers buy less of it. Looked at another way, if
the monopolist reduces the quantity of output it sells, the price of its output increases.
The market demand curve provides a constraint on a monopoly’s ability to profit from its market
power. A monopolist would prefer, if it were possible, to charge a high price and sell a large
quantity at that high price. The market demand curve makes that outcome impossible. In
particular, the market demand curve describes the combinations of price and quantity that are
available to a monopoly firm.

Page 4
Harambee University College Microeconomics Theory II Department of Economics

By adjusting the quantity produced (or, equivalently, the price charged), the monopolist can
choose any point on the demand curve, but it cannot choose a point off the demand curve.

Price

Demand

Quantity of output
A Monopolist’s Demand Curve

Because there is only one seller in a pure monopoly market, there is no distinction between the
market demand curve and the demand curve for the firm’s product. The output of a pure
monopoly firm is the downward-sloping market demand curve that would be faced by an entire
competitive industry. For this reason, the monopolist’s pricing decision is inseparable from the
decision about how much to offer for sale. The higher the price it sets, the lower the quantity it
will sell.

1.3 The Monopolist’s Marginal Revenue

The monopolist's average revenue-the price it receives per unit sold-is just the market demand
curve. To choose its profit-maximizing output level, the monopolist also needs to know its
marginal revenue, that is, the change in revenue that results from a unit change in output.
When the demand curve is downward sloping, the price (average revenue) is greater than
marginal revenue because all units are sold at the same price. To increase sales by 1 unit, the
price must fall, so that all units sold, not just the additional unit, earn less revenue.

For a competitive firm, marginal revenue is the same as price. For example, if many rival firms
in a competitive market sell bread, each individual seller can sell as much as it wishes each day
without reducing price.

Page 5
Harambee University College Microeconomics Theory II Department of Economics

If the price of bread is 2Br a loaf, any one firm will take in an extra 2Br each time it sells an
additional loaf. A monopolist, on the other hand, must decrease the price of the product to sell
more. This follows from the fact that the demand curve for a monopolist’s product is downward
sloping. The marginal revenue of additional sales by a monopolist is always less than the price.
Thus, the slope of the monopolist marginal revenue curve is negative.

Price

Demand Demand

MR
0 Q

Figure 1.4.1: Monopolists demand and marginal revenue curve

1.4 Profit Maximization by Monopoly Firm

The profit-maximizing or best level of output for the monopolist is the output at which MR =
MC. Price is then read off the demand curve. Depending on the level of AC at this output, the
monopolist can have profits, break even, or minimize the short-run total losses.

Although a monopoly seller can influence the market price of its product, the principle of profit
maximization is the same for a monopolist as for a competitive firm. Maximization of profits
implies that marginal revenue must equal marginal cost at the output produced. However, the
marginal revenue of additional output for a monopolist is less than the price at which that output
is sold.

Page 6
Harambee University College Microeconomics Theory II Department of Economics

MC
P* AC

P1
E*
DD

MR
Q* Q

Figure 1.5.1: Equilibrium of the firm

Also, notice that it is not in the interest of a monopoly firm to charge the highest possible price.
The monopolist that maximizes profits realizes it loses sales by increasing price and considers
this in making its price decisions. Monopoly firms maximize profits by always setting price to
achieve the output over any period for which marginal revenue equals marginal cost.

1.5 Monopoly Supply

A monopolistic market has no supply curve. In other words, there is no one-to-one relationship
between price arid the quantity produced. The reason is that the monopolist's output decision
depends not only on marginal cost, but also on the shape of the demand curve. As a result, shifts
in demand do not trace out a series of prices and quantities as happens with a competitive supply
curve. Instead, shifts in demand can lead to changes in price with no change in output, changes in
output with no change in price, or changes in both.

Now suppose that you are the only buyer of the good. You again face a market supply curve,
which tells you how much producers are willing to sell as a function of the price you pay. Should
the quantity you purchase be at the point where your marginal value curve intersects the market
supply curve? No. If you want to maximize your net benefit from purchasing the good, you
should purchase a smaller quantity, which you will obtain at a lower price.

Page 7
Harambee University College Microeconomics Theory II Department of Economics

To determine how much to buy, set the marginal value from the last unit purchased equal to the
marginal expenditure on that unit. But note that the market supply curve is not the marginal
expenditure curve. The market supply curve shows how much you must pay per unit, as a
function of the total number of units you buy. In other words, the supply curve is the average
expenditure curve. And since this average expenditure curve is upward sloping, the marginal
expenditure curve must lie above it because the decision to buy an extra unit raises the price that
must be paid for all units, not just the extra one.

Even though a monopoly firm has an upward-sloping marginal cost curve at any point in time, it
does not necessarily increase quantity supplied when the demand for its product increases.
Sometimes a monopoly firm reacts to an increase in demand by raising the price of its product
rather than increasing quantity supplied! The change in quantity supplied by a monopoly firm
depends on the shift in its marginal revenue curve when demand increases. For example, if the
demand for a monopolist’s product increases, the monopolist might find it can increase profits
more by raising price rather than increasing the quantity supplied. In deciding how to respond to
an increase in demand, the monopolist examines the way the price elasticity of demand has
changed to figure the new marginal revenue associated with each possible output. It then adjusts
price to maximize profit given the new marginal revenue curve by choosing the price that allows
sale of the output for which under the new demand MR=MC.

1.6 Price Discrimination

A monopolist can increase TR and profits at a given level of output and TC by practicing price
discrimination. This involves charging different prices for the commodity for different quantities
purchased, to different classes of consumers, or in different markets.
For example, a telephone company may charge individuals 15 cents for each of the first 50
telephone calls made during each month, 10 cents for each of the next 100 calls, and so on.
Electrical companies usually charge less per kilowatt-hour to industrial users than to households
because industrial users have more substitutes available (such as generating their own electricity)
and thus have a more elastic demand curve than households.

Page 8
Harambee University College Microeconomics Theory II Department of Economics

Price discrimination is often practiced by public utilities, which charge higher rates to businesses
than they do to household users. Many drugstores, restaurants, and movie theatres offer discounts
to senior citizen. Airlines are notorious price discriminators, as shown by the multitude of fares
available for similar seats on a given flight.
To engage in price discrimination a seller must meet the following conditions:
1. The seller must be able to control the price of its product. A monopoly firm can engage in
price discrimination because it can control prices.
2. The product that will be sold at more than one price must not be resalable. It is not
possible to charge different prices to different buyers if the good is resalable. Individuals
who buy it at low prices could resell it to people who would pay higher prices. Eventually
such a process would lead to the establishment of a single price in the market.
3. The seller must be able to determine how willingness and ability to pay vary among
prospective buyers. Price discrimination will result in some people paying more and
some paying less than would be the case is one price were announced for the product.
The seller must be able to distinguish among buyers in a way that allow it to charge
higher prices only to buyers whose marginal benefit for the good would exceed the single
price.
Monopolists engage in price discrimination when they can increase their profit by doing so.

1.7 Regulation of Monopoly

Since a monopoly produces output where MR = MC and P > MR, the monopolist produces less
and charges a higher price than a perfect competitor with the same cost curves.

For efficiency considerations, government (federal, state, or local) often allows natural
monopolies (such as public utilities) to operate but subjects them to regulation. This usually
takes the form of setting a price that allows the monopolist to earn the ―normal or fair‖ return of
about8–10 percent on its investment. However, such regulation only partly correctsthe more
serious problem of misallocation of resources.

Page 9
Harambee University College Microeconomics Theory II Department of Economics

Summary
A monopoly is a firm that is the sole seller in its market. A monopoly arises when a single firm
owns a key resource, when the government gives a firm the exclusive right to produce a good, or
when a single firm can supply the entire market at a smaller cost than many firms could.
Because a monopoly is the sole producer in its market, it faces a downward-sloping demand
curve for its product. When a monopoly increases production by 1 unit, it causes the price of its
good to fall, which reduces the amount of revenue earned on all units produced. As a result, a
monopoly’s marginal revenue is always below the price of its good. Like a competitive firm, a
monopoly firm maximizes profit by producing the quantity at which marginal revenue equals
marginal cost. The monopoly then chooses the price at which that quantity is demanded. Unlike
a competitive firm, a monopoly firm’s price exceeds its marginal revenue, so its price exceeds
marginal cost. A monopolist’s profit-maximizing level of output is below the level that
maximizes the sum of consumer and producer surplus. That is, when the monopoly charges a
price above marginal cost, some consumers who value the good more than its cost of production
do not buy it. As a result, monopoly causes deadweight losses similar to the deadweight losses
caused by taxes. Policymakers can respond to the inefficiency of monopoly behavior in four
ways. They can use the antitrust laws to try to make the industry more competitive. They can
regulate the prices that the monopoly charges. They can turn the monopolist into a government-
run enterprise. Or, if the market failure is deemed small compared to the inevitable imperfections
of policies, they can do nothing at all. Monopolists often can raise their profits by charging
different prices for the same good based on a buyer’s willingness to pay. This practice of price
discrimination can raise economic welfare by getting the good to some consumers who otherwise
would not buy it. In the extreme case of perfect price discrimination, the deadweight losses of
monopoly are completely eliminated. More generally, when price discrimination is imperfect, it
can either raise or lower welfare compared to the outcome with a single monopoly price.

Page 10
Harambee University College Microeconomics Theory II Department of Economics

Model Examination Question

1. Define natural monopoly. What does the size of a market have to do with whether an industry
is a natural monopoly?
_________________________________________________________________________
2. Does monopoly lead to more technological progress than perfect competition? Why?
_________________________________________________________________________
3. How could monopolist maximize profit?
________________________________________________________________________
4. Why is a monopolist’s marginal revenue less than the price of its good? Can marginal revenue
ever be negative? Explain.
________________________________________________________________________
5. What is price discrimination?
________________________________________________________________________
6. Explain some of the major barrier to entry in monopoly market?
________________________________________________________________________

Page 11
Harambee University College Microeconomics Theory II Department of Economics

CHAPTER 2
MONOPOLISTIC COMPETITION
2.0 Aims and Objectives
2.1 Introduction
2.2 The making of monopolistic competition
2.3 Equilibrium of firm in the short run and long run
2.4 Profit Maximization in monopolistically competitive firms

2.0 Aims and Objectives

 Understanding Monopolistic Competition
 Explain the concept of monopolistic competition
 Profit Maximization in monopolistically competitive firms

2.1 Introduction
In the first chapters, we saw how firms with monopoly power can choose prices and output
levels to maximize profit. We also saw that monopoly power does not require a firm to be a pure
monopolist. In many industries several firms compete, but each firm has at least some monopoly
power-it has control over price and will charge a price that exceeds marginal cost.

In this chapter we examine market structures other than pure monopoly that can give rise to
monopoly power i.e. monopolistic competition.
A monopolistically competitive market is similar to a perfectly competitive market in that there
are many firms, and entry by new firms is not restricted.
But it differs from perfect competition in that the product is differentiated-each. Firm sells a
brand or version of the product that differs in quality, appearance, or reputation, and each firm is
the sole producer of its own brand. The amount of monopoly power the firm has depends on its
success in differentiating its product from those of other firms. Examples of monopolistically
competitive industries abound: toothpaste, laundry detergent, and packaged coffee are a few.

Page 12
Harambee University College Microeconomics Theory II Department of Economics

2.2 The making of monopolistic competition

In monopolistic competition there are many firms selling a differentiated product or service. It is
a blend of competition and monopoly. The competitive elements result from the large number of
firms and the easy entry. The monopoly element results from differentiated (i.e., similar but not
identical) products or services. Product differentiation may be real or imaginary and can be
created through advertising. However, the availability of close substitutes severely limits the
―monopoly‖ power of each firm. A monopolistically competitive market has two key
characteristics: First, films compete by selling differentiated products, which are highly
substitutable for one another but not perfect substitutes. (In other words, the cross-price
elasticity’s of demand are large but not infinite.) Second, there is free entry and exit-it is
relatively easy for new firms to enter the market with their own brands of the product and for
existing firms to leave if their products become unprofitable.
To see why free entry is an important requirement, let’s compare the markets for toothpaste and
automobiles. The toothpaste market is monopolistically competitive, but the automobile market
is better characterized as an oligopoly. It is relatively easy for other firms to introduce new
brands of toothpaste that might compete with Crest, Colgate, and so on. This limits the
profitability of producing Crest or Colgate. If the profits were large, other firms would spend the
necessary money (for development, production, advertising, and promotion) to introduce new
brands of their own, which would reduce the market shares and profitability of Crest and
Colgate. The automobile market is also characterized by product differentiation. However, the
large-scale economies involved in production make entry by new firms difficult. Hence, until the
mid-1970s when Japanese producers became important competitors, the three major U.S.
automakers had the market largely to themselves. There are many other examples of
monopolistic competition besides toothpaste. Soap, shampoo, deodorants, shaving cream, cold
remedies, and many other items found in a drugstore are sold in monopolistically competitive
markets. The markets for bicycles and other sporting goods are likewise monopolistically
competitive. Monopolistic competition is the most prevalent form of market organization in
retailing. So in most retail trade, since goods are sold in many different retail stores that compete
with one another by differentiating their services according to location, availability and expertise
of salespeople, credit terms, etc. Entry is relatively easy, so if profits are high in a neighborhood
because there are only a few stores, new stores will enter.

Page 13
Harambee University College Microeconomics Theory II Department of Economics

In a monopolistically competitive market:

1. There is relatively large number of firms, each satisfying a small but not microscopic
share of the market demand for a similar but not identical product. The market share of
each rival firm is generally larger than that which would prevail under perfect
competition. Each firm in the industry has a market share of over 1% of the total sales
over any period, but it is unlikely that any one firm satisfies more than 10% of market
demand.
2. The product of each firm selling in the market is not a perfect substitute for that sold by
competing firms. Each seller’s product has unique qualities or characteristics that cause
some buyers to prefer it to products of competing firms.
3. Firms in the industry do not consider the reaction of their rivals when choosing their
products prices or annual sales target.
4. Relative freedom of entry by new firms exists in monopolistically competitive market.
5. Neither the opportunity nor the incentive exists for firms in the industry to cooperate in
ways that decreases competition.

2.3 Equilibrium of the Firm in the short run and long run
As with monopoly, in monopolistic competition firms face downward-sloping demand curves
and therefore have monopoly power. But this does not mean that monopolistically competitive
firms are likely to earn large profits. Monopolistic competition is also similar to perfect
competition. There is free entry, so the potential to earn profits will attract new firms with
competing brands, driving profits down to zero. To make this clear, let's examine the equilibrium
price and output level for a monopolistically competitive firm in the short and long run. Because
the firm is the only producer of its brand, it faces a downward-sloping demand curve (This is the
firm's demand curve, not the market demand curve, which is more steeply sloped.) The profit
maximizing quantity is found at the intersection of the marginal revenue and marginal cost
curves. Since the corresponding price exceeds average cost, the firm earns a profit and the firm
has monopoly power. In the short run, price also exceeds average cost, and the firm earns profits.
In the long run, these profits attract new firms with competing brands into the industry. The
firm's market share falls, and its demand curve shifts downward. In long-run equilibrium, price
equals average cost, so the firm earns zero profit, even though it has monopoly power.

Page 14
Harambee University College Microeconomics Theory II Department of Economics

In the long run, above normal profits will attract the entry of firms into monopolistic
competition. Below normal profits will encourage firms to exit. As firms enter the market
demand is split among a larger number of firms which will shift the demand for each firm to the
left (decrease) and probably make it more inelastic. There are more substitutes. Exit of firms will
shift the demand for each firm’s output to the right (increase). Entry to and exit from the industry
occur until the profits for each firm are normal, i.e. the AR = AC.

The logical result of profit maximizing monopolistically competitive markets is to encourage

firms to build plants that are smaller than optimal, i.e. a larger plant can produce with fewer
inputs per unit of output (or costs per unit of output). Further inefficiency is expected since the
inefficient plant is operated at an output level that is less than the minimum point on the SRAC.
This result is due to the fact that the MR must be lower than AR when AR is negatively sloped.
Therefore MR=MC at less than the price which lies on the demand (or AR) function. Since the
demand is negatively sloped and AC is usually U-shaped, the point of tangency between AR and
LRAC (normal profits) will lie to the left of the minimum cost per unit of output. This is
sometimes called the ―excess capacity theorem:‖ firms build plants that are too small and operate
them at less than full capacity.

Assuming that you seek to maximize profits from annual sales of dresses, the short run
equilibrium output is the one for which marginal revenue equals marginal cost. This is exactly
the same way a monopolist chooses its price and output. The marginal cost curve intersects the
marginal revenue curve at an annual output of 10,000 dresses. To sell this quantity you must set
a price of Br100 per dress. Any price lower than this would result in an annual quantity
demanded greater than 10,000. Similarly, a higher price would result in a quantity demanded that
falls short of the profit-maximizing output of 10,000 dresses per year. As you can see in the
figure, the average cost of dresses when you sell 10,000-pre year is Br80. At the Br100 price.
Therefore, you earn a profit equal to Br20 per dress. Total profit from the 10,000 dresses sold per
year is Br200,000, which is represented by the shaded area in the graph. If you enjoyed a pure
monopoly in the production of these dresses, a barrier to entry in the market would prevent
additional sellers from competing with you. Under monopolistic competition, however, your
handsome profits are likely to disappear in the long run.

Page 15
 Harambee University College Microeconomics Theory II Department of Economics

To find out why, we have to show how entry of new firms as sellers in the market affects
demand for your dresses.

P
The firm maximizes profit by
selecting the output for which
MC
P* marginal revenue equals marginal
AC
cost. i.e. at Q*

DD
MR

0 Q∗ Q∗∗ Q

Figure 2.3.1: Equilibrium of the firm under monopolistically competitive market

MR

2.4 Profit Maximization

The monopolistic competitor faces a demand curve which is negatively sloped (because of
product differentiation) but highly elastic (because of the availability of close substitutes). The
monopolistic competitor’s profit- maximizing or best level of output is the output at which MR =
MC, provided P > AVC. At that output, the firm can make a profit, break even, or minimize
losses in the short run. In the long run, firms are either attracted into an industry by short-run
profits or leave it if faced with losses until the demand curve (d) facing remaining firms is
tangent to its AC curve, and the firm breaks even (P = AC). Example
Panel A of Figure 2.4.1 shows a monopolistic competitor producing 550 units of output (where
MR = MC), selling it at $10.50 (on d), and making a profit of $3.50 per unit and $1925 in total.
These profits attract more firms into the industry. This causes a downward (leftward) shift in this
firm’s demand curve to d (in Panel B), at which the firm sells 400 units at $8 and breaks even.
Since P > MR where MR = MC, the MC curve above AVC does not represent the firm’s supply
curve.
Page 16
Harambee University College Microeconomics Theory II Department of Economics

Figure 2.4.1

Page 17
Harambee University College Microeconomics Theory II Department of Economics

Summary

A monopolistically competitive market is characterized by three attributes: many firms,

differentiated products, and free entry. The equilibrium in a monopolistically competitive market
differs from that in a perfectly competitive market in two related ways. First, each firm has
excess capacity. That is, it operates on the downward-sloping portion of the average-total-cost
curve. Second, each firm charges a price above marginal cost. Monopolistic competition does not
have all the desirable properties of perfect competition. There is the standard deadweight loss of
monopoly caused by the markup of price over marginal cost. In addition, the number of firms
(and thus the variety of products) can be too large or too small. In practice, the ability of
policymakers to correct these inefficiencies is limited. The product differentiation inherent in
monopolistic competition leads to the use of advertising and brand names. Critics of advertising
and brand names argue that firms use them to take advantage of consumer irrationality and to
reduce competition. Defenders of advertising and brand names argue that firms use them to
inform consumers and to compete more vigorously on price and product quality.

In a monopolistically competitive market, firms compete by selling differentiated products,

which are highly substitutable. New firms can enter or exit easily. Firms have only a small
amount of monopoly power. In the long run, entry will occur until profits are driven to zero.
Firms then produce with excess capacity (i.e., at output levels below those that minimize average
cost).

Page 18
Harambee University College Microeconomics Theory II Department of Economics

Model Examination Question

1. Why does the demand curve of a monopolistic competitor shift down when more firms start
production?
2. What is the monopoly power of monopolistic competitor?
3. What are the characteristics of monopolistically competitive market?
4. Justify the profit maximizing level of output in monopolistically competitive firm
5. Describe the equilibrium of monopolistically competitive firm in short run and long run
6. Define the term monopolistic competition

Page 19
Harambee University College Microeconomics Theory II Department of Economics

CHAPTER 3
OLIGOPOLY MARKET STRUCTURE

3.0 Aims and Objectives

3.1 Introduction
3.2 Non-collusive oligopoly
3.2.1 The kinked demand curve model
3.2.2 Cournot model
3.2.2.1 Reaction curve approach
3.2.2.2 Mathematical version of cournot duopoly model
3.2.3 The Bertrand duopoly model
3.2.4 Stackelberg model
3.3 Collusive Oligopoly
3.3.1 Cartel
3.3.1.1 Cartel aiming at joint profit maximization
3.3.1.2 Market sharing cartel
3.3.2 Price leadership
3.3.2.1 Low cost price leadership
3.3.2.2 Dominant firm price leadership
3.3.2.3 Barometric price leadership

3.0 Aims and Objectives

 Define oligopoly market structure
 Describe non-collusive oligopoly
 Describe collusive oligopoly
 Explain the rigidity of price under oligopoly
 Describe the firm’ decision on how much to produce and at what price
 Differentiate explicit collusion and tacit collusion
 Describe pricing decision by firm’s

Page 20
Harambee University College Microeconomics Theory II Department of Economics

3.1 Introduction

Oligopoly is the form of market organization in which there are few sellers of a product. If the
product is homogenous, there is a pure oligopoly. If the product is differentiated, there is a
differentiated oligopoly. Since there are only a few sellers of a product, the actions of each seller
affect others. That is, the firms are mutually interdependent.
Pure oligopoly is found in the production of cement, aluminum, and many other industrial
products which are virtually standardized. Examples of differentiated oligopolies are industries
producing automobiles, cigarettes, PCs, and most electrical appliances, where three or four large
firms dominate the market. Because of mutual interdependence, if one firm lowered its price, it
could take most of the sales away from the other firms. Other firms are then likely to retaliate
and possibly start a price war. As a result, there is a strong compulsion for oligopolists not to
change prices but, rather, to compete on the basis of quality, product design, customer service,
and advertising.

Managing an oligopolistic firm is complicated because pricing, output, advertising, and

investment decisions involve important strategic considerations. Because only a few firms are
competing, each firm must carefully consider how its actions will affect its rivals, and how its
rivals are likely to react.

A market structure characterized by competition among a small number of large firms that have
market power, but that must take their rivals’ actions into consideration when developing their
competitive strategies.Oligopoly requires strategic thinking, unlike perfect competition,
monopoly, and monopolistic competition. Under perfect competition, monopoly, and
monopolistic competition, a seller faces a well-defined demand curve for its output, and should
choose the quantity where MR=MC. The seller does not worry about how other sellers will react,
because either the seller is negligibly small, or already a monopoly. Under oligopoly, a seller is
big enough to affect the market. You must respond to your rivals’ choices, but your rivals are
responding to your choices.

Page 21
Harambee University College Microeconomics Theory II Department of Economics

In an oligopolistic market, the product may or may not be differentiated. What matters is that
only a few firms account for most or all of total production. In some oligopolistic markets, some
or all of the firms earn substantial profits over the long run because barriers to entry make it
difficult or impossible for new firms to enter the market.

Characteristics of Oligopolistic Markets

 Only a few firms supply the entire market with a product that may be standardized or
differentiated.
 At least some of the firms in the oligopolistic industry have large market shares and thus
can influence the price of the product.
 Firms in the industry are aware of their interdependence and always consider the reaction
of their rivals when selecting prices, output goals, advertising budgets, and any other
business policy.

Monopolies are quiet rare, in part due to regulatory efforts to discourage them. However, there
are many markets that are dominated by a relatively few firms, known as oligopolies. The term
oligopoly comes from two Greek words: oligoi meaning ―few" and poleein meaning ―to sell".
Examples of oligopolies include:
1.Airliner Manufacturing: Boeing and Airbus
2.Food Processing: Kraft Food, PepsiCo and Nestle
3.US Beer Production: Anheuser-Busch and Miller Coors
4.US Film Industry: Disney, Paramount, Warners, Columbia, 20th Century Fox and
Universal
5.US Music Industry: Universal Music Group, Sony Music Entertainment, Warner
Music Group, and EMI Group
6.Academic Publishing: Elsevier, Kluwer
7.US Airline Industry: Delta/NWA, United, American
Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent
in these markets for investment and product development. There are legal restrictions on such
collusion in most countries.

Page 22
Harambee University College Microeconomics Theory II Department of Economics

There does not have to be a formal agreement for collusion to take place (although for the act to
be illegal there must be actual communication between companies)–for example, in some
industries there may be an acknowledged market leader which informally sets prices to which
other producers respond, known as price leadership.

Duopoly
Duopoly is a form of oligopoly. In its purest form two firms control all of the market, but in
reality the term duopoly is used to describe any market where two firms dominate with a
significant market share.

3.2 Non-collusive Oligopoly

Assumes that firms pursue profit maximizing strategies based on assumptions about rivals’
behavior and the impact of this behavior on the given firm’s strategies
1. Kinked demand curve model
2. Game theory models
3. Strategic entry deterrence

3.2.1 the kinked demand curve model

The kinked demand curve theory of oligopoly has a distinguished lineage.this theory sought to
explain the rigidity of prices under oligopoly. It was argued that given an existing price in an
oligopoly, if a single firm raises its price, its rivals will not respond, while if it cuts its price,
other firms will cut their prices too. Thus, the demand curve faced by an individual firm will
have a kink at the existing level of price and as a consequence, this price will not change for
small changes in cost and demand.

The kinked demand curve model shows that firms in an industry converge upon a stable price,
above which they face dramatic falls in sales and below which the increase in sales is negligible.
Considering price competition under duopoly, they have shown that in equilibrium, both firms
charge a sufficiently high common price; this collusive outcome is sustained by the use of the
kinked demand strategy on off-the-equilibrium-path. Neither of these theories, however, predicts
price rigidity—a phenomenon that the original theory of kinked demand sought to explain.

Page 23
Harambee University College Microeconomics Theory II Department of Economics

 It assumes that a firm is faced with two demand curves, assuming that other firms will
not match price increases but will match price decreases.
 If the firm considers raising the price above P1, its quantity demanded will depend upon
the behavior of rival firms.
 Assumes that managers will inflict maximum damage on other firms.
 Implies oligopoly prices tend to be ―sticky‖ and not change as they would in other market
structures
 Does not explain why price P1 exists initially

Fig. 2.2.1.1

Price Rigidity

Because implicit collusion tends to be fragile, oligopolistic firms often have a strong desire for
stability, particularly with respect to price. This is why price rigidity can be a characteristic of
oligopolistic industries. Even if costs or demand change, firms are reluctant to change price. If
costs fall or market demand declines, firms are reluctant to lower price because that might send
the wrong message to their competitors, and thereby set off a round of price warfare.

And if costs or demand rises, firms are reluctant to raise price because they are afraid that their
competitors might not also raise their prices.

This price rigidity is the basis of the well-known "kinked demand curve" model of oligopoly.
According to this model, each firm faces a demand curve kinked at the currently prevailing price
P*. (See Figure 2.2.1.2) At prices above P*, the demand curve is very elastic.

Page 24
Harambee University College Microeconomics Theory II Department of Economics

The reason is that the firm believes that if it raises its price above P*, other firms will not follow
suit, and it will therefore lose sales and much of its market share. On the other hand, the firm
believes that if it lowers its price below P*, other firms will follow suit because they will not
want to lose their shares of the market, so that sales will expand only to the extent that a lower
market price increases total market demand.

Because the firm's demand curve is kinked, its marginal revenue curve is discontinuous. (The
bottom part of the marginal revenue curve corresponds to the less elastic part of the demand
curve, as shown by the solid portions of each curve.) As a result, the firm's costs can change
without resulting in a change in price. As shown in the figure, marginal cost could increase, but it
would still equal marginal revenue at the same output level, so that price stays the same.

The kinked demand curve model is attractively simple, but it does not really explain oligopolistic
pricing. It says nothing about how firms arrived at price P* in the first place, and why they didn't
arrive at some different price. It is useful mainly as a description of price rigidity, rather than an
explanation of it. The explanation for price rigidity comes from the Prisoners' Dilemma and from
firms' desires to avoid mutually destructive price competition.

Fig. 2.2.1.2 The Kinked Demand Curve. Each firm believes that if it raises its price
above the current price P*, none of its competitors will follow suit, so it will lose most of
its sales. Each firm also believes that if it lowers price, everyone will follow suit, and its
sales will increase only to the extent that market demand increases. As a result, the firm's
demand curve D is kinked at price P*, and its marginal revenue curve is discontinuous at
that point. If marginal cost increases from MC to MC', the firm will still produce the
same output level Q* and charge the same price P*.

Page 25
Harambee University College Microeconomics Theory II Department of Economics

Nature of the Kinked Demand Curve

1. We draw a kinked demand curve which assumes that the oligopoly firm matches
price decreases but not price increases.
2. We start with a price of Po and a quantity of Qo which are stable economic levels
thatprompts the assumption that rivals will not react with a price change since they
are already there.

3. If rivals do not
change their price, the firm will face demand curve d1d1 with a marginalrevenue
curve of MR1.
4. But if the assumption is they will react, it will face demand curve d2d2 and MR2
curvebecause more competition lowers their demand and MR.
5. If the firm lowers its price it will assume that rivals will lower prices to match them
and avoidlosing market share.
6. The firm that initially lowers its price will not greatly increase its quantity demanded
because itscompetitor will follow suit quickly, before the market can react
dramatically to the price decrease.
7. So, when it lowers its price it will expect to face demand curve d2d2

Page 26
Harambee University College Microeconomics Theory II Department of Economics

8. but if it increases prices past Po its rivals will probably not follow.
9. As a result, a higher price than Po will cause quantity demanded to decrease rapidly.
10. The demand schedule to the left of and above point E will be elastic as shown by
d1d1. Remember, elastic range is the position above equilibrium.
11. At prices above Po the relevant demand curve is d1d1, which allows for a rapid
decline in QD with a price increase, but below Po it would be d2d2, which allows for
a gradual QD increase because the competition will keep it from being rapid.
12. As a result, at point E there will be a kink in the demand curve, rotates down because
the QD will be low for an inelastic OLI because others will lower their price too.
They also do not have as much leverage to differentiate their product as in
monopolistic and perfect competition markets.
13. This is shown in panel B as d1d2. The marginal revenue curve is MR1MR2, shows a
discontinuous portion or gap.
14. The MR will stay the same for a while because Demand is inelastic, response is low.
15. The kinked demand curve explains why price changes are rare in oligopolies. If price
goes up, demand falls, if prices go down, competition follows and profits go down if
elasticity is below 1.
16. A larger demand will increase output and production costs will go up.
17. The theoretical reason for the price inflexibility under the kinked demand curve has to
do with the discontinuous portion of the MR curve in Panel B.
18. The marginal cost is represented by MC & the profit maximizing output is qo, sold at
Po. If the MC shifts up to MC’, nothing will happen to the price or quantity….stays
the same.
19. Remember, the profit maximizing rate is still where MC=MR. The shift in the MC to
MC’ does not change the profit maximizing rate of output because MC’ still cuts the
MR curve in the discontinuous portion.
20. The result is when firms in an Oligopolist industry have cost increase & decreases,
price will not change as long as MC=MR.
21. Prices are therefore rigid as long as Oligopolist’s react the way we assume they will.

Page 27
Harambee University College Microeconomics Theory II Department of Economics

Criticisms of the Kinked Demand Curve

1. We don’t know how the Po price came to be.
2. If all Oligopolist firms faced a kinked demand curve it would not pay to change prices.
3. The kinked demand curve does not show us how demand & supply originally determine the
going price of an Oligopolist product.
4. Evidence is shaky, Oligopolist prices do not appear to be as rigid as the kinked demand theory
implies.

3.2.2 Cournt Model

Suppose the firms produce a homogeneous good and know the market demand curve firm must
decide how much to produce, and the two firms make their decisions at the same time. When
making its production decision, each firm takes its competitor into account. It knows that its
competitor is also deciding how much to produce, and the price it receives will depend on the
total output of both firms.

The essence of the Cournot model is that each-firm treats the output level of its competitor as
fixed, and then decides how much to produce.

Cournot oligopoly is an economic model used to describe industry structure. It has the following
features:

 There is more than one firm and all firms produce a homogeneous product;
 Firms do not cooperate;
 Firms have market power;
 The number of firms is fixed;
 Firms compete in quantities, and choose quantities simultaneously;
 There is strategic behavior by the firms.

An essential assumption of this model is that each firm aims to maximize profits, based on the ex
pectation that its own output decision will not have an effect on the decisions of its rivals. Price i
s a commonly known decreasing function of total output.

Page 28
Harambee University College Microeconomics Theory II Department of Economics

All firms know N, the total number of firms in the market, and take the output of the others as gi
ven. Each firm has a cost function ci(qi). Normally the cost functions are treated as common kno
wledge. The cost functions may be the same or different among firms. The market price is set at
a level such that demand equals the total quantity produced by all firms. Each firm takes the quan
tity set by its competitors as a given, evaluates its residual demand, and then behaves as a monop
oly.

To see how this works/ let's consider the output decision of Firm 1. Suppose Firm 1 thinks that
Firm 2 will produce nothing. Then Firm I's demand curve is the market demand curve. In Figure
2.2.2.1 this is shown D1(O), which means the demand curve for Firm 1, assuming Firm 2
produces zero. Figure 2.2.2.2 also shows the corresponding marginal revenue curve MR1(0). We
have assumed that Firm I's marginal cost MC1 is constant. As shown in the figure. Firm I's
profit-maximizing output is 50 units, the point where MR1(0) intersects MC1. So if Firm 2
produces zero. Firm 1 should produce 50.

Fig. 2.2.2.1 firm 1’s output decision

Fig. 2.2.2.1 Firm 1's Output Decision. Firm I's profit-maximizing output depends on how
111uc11 it thinks Firm 2 will produce. If it thinks Firm 2 will produce nothing, its demand curve,
labeled Di(O), is the market demand curve.

Page 29
Harambee University College Microeconomics Theory II Department of Economics

The corresponding marginal revenue curve, labeled MRi(O), intersects Firm I's marginal cost
curve MCi at an output of 50 units. If Firm 1 thinks Firm 2 will produce 50 units, its demand
curve, Di(50), is shifted to the left by this amount. Profit maximization now implies an output of
25 units. Finally, if Firm 1 thinks Firm 2 will produce 75 units. Firm 1 will produce only 12.5
units.

The point where MR1(50) = MC1. Now, suppose Firm 1 thinks Firm 2 will produce 75 units.
Then Firm I's demand curve is the market demand curve shifted to the left by 75. It is labeled
D1(75) in Figure 2.2.2.1, and the corresponding marginal revenue curve is labeled MR1 (75).
Firm I's profit-maximizing output is now 125 units, the point where MR1 (75) = MC1. Finally,
suppose Firm 1 thinks Firm 2 will produce 100 units.

Then Firm 1's demand and marginal revenue curves (not shown in the figure) would intersect its
marginal cost curve on the vertical axis; if Firm 1 thinks that Firm 2 will produce 100 units or
more, it should produce nothing.

To summarize: If Firm 1 thinks Firm 2 will produce nothing, it will produce 50; if it thinks Firm
2 will produce 50, it will produce 25; if it thinks Firm 2 will produce 75, it will produce 125; and
if it thinks Firm 2 will produce 100, then it will produce nothing. Firm 1's profit-maximizing
output is thus a decreasing schedule of how much it thinks Firm 2 will produce.

3.2.2.1 Reaction curve approach

Firm I's 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 examples shown in Figure
2.2.2.1) Firm 2's reaction curve shows its output as a function of how much it thinks Firm 1 will
produce. In Cournot equilibrium, each firm correctly assumes how much its competitor will
produce, and thereby maximizes its own profits. Therefore, neither firm will move from this
equilibrium.

Page 30
Harambee University College Microeconomics Theory II Department of Economics

Fig. 2.2.2.2.1 Reaction Curves and Cournot Equilibrium

We can go through the same kind of analysis for Firm 2 (i.e., determine Firm 2's profit-
maximizing quantity given various assumptions about how much Firm 1 will produce). The
result will be a reaction curve for Firm 2, i.e., a schedule Q*2(Q1) that relates its output to the
output it thinks Firm 1 will produce.

If Firm 2's marginal cost curve is different from that of Firm 1, its reaction curve will also differ
in form from that of Firm 1. For example. Firm 2's reaction curve might look like the one drawn
in Figure 2.2.2.2.1.

How much will each firm produce? Each firm's reaction curve tells it how much to produce,
given the output of its competitor. In equilibrium, each firm sets output according to its own
reaction curve, so the equilibrium output levels are found at the intersection of the two reaction
curves. We call the resulting setof output levels a Cournot equilibrium. In this equilibrium, each
firm correctlyassumes how much its competitor will produce, and it maximizes its
profitaccordingly.

Note that this Cournot equilibrium is an example of a Nash equilibrium. Remember that in a
Nash equilibrium, each firm is doing the best it can givenwhat its competitors are doing. As a
result, no firm has any incentive to changeits behavior.

Page 31
Harambee University College Microeconomics Theory II Department of Economics

In the Cournot equilibrium, each duopolist is producing anamount that maximizes its profit given
what its competitor is producing, so neitherduopolist has any incentive to change its output.

Suppose the firms are initially producing output levels that differ fromthe Cournot equilibrium.-
Will they adjust their outputs until the Cournotequilibrium is reached? Unfortunately, the
Cournot model says nothing aboutthe dynamics of the adjustment process. In fact, during any
adjustmentprocess, the model's central assumption that each firm can assume that itscompetitor's
output is .fixed would not hold. Neither firm's output would befixed, because both firms would
be adjusting their outputs.

When is it rational for each firm to assume that its competitor's output isfixed? It is rational if the
two firms are choosing their outputs only once becausethen their outputs cannot change. It is also
rational once they are in the Cournotequilibrium because then neither firm would have any
incentive to change itsoutput.
When using the Cournot model, we must therefore confine ourselvesto the behavior of firms in
equilibrium.

Example: A Linear Demand Curve

Let's work through an example-two identical firm facing a linear market demand curve. This will
help clarify the meaning of a Cournot equilibrium and let us compare it with the competitive
equilibrium and the equilibrium that results if the firms collude and choose their output levels
cooperatively.

Suppose our duopolists face the following market demand curve:

P = 30-Q
Where Q is the total production of both firms (i.e., Q = Q1 + Q2). Also, suppose both firms have
zero marginal cost:
MC1 = MC2 = 0

Page 32
Harambee University College Microeconomics Theory II Department of Economics

Then we can determine the reaction curve for Firm 1 as follows. To maximize profit, the firm
sets marginal revenue equal to marginal cost. Firm 1's total revenue R1 is given by
R1 = PQ1= (30-Q)Q1
= 30Q1- (Q1+Q2)Q1
= 30Q1-Q12-Q2Q1
The firm's marginal revenue MR1 is just the incremental revenue AR, resulting from an
incremental change in output AQ,:

Now, setting MRI equal to zero (the firm's marginal cost), and solving for Q1, we find:

Eq.1---- -

The same calculation applies to Firm 2:

Eq.2-----
The equilibrium output levels are the values for Q1 and Q2 that are at the intersection of the two
reaction curves, i.e., that are the solution to equations (Eq.1) and (Eq.2). By replacing Q2 in
equation (Eq.1) with the expression on the right-hand side of (Eq.2), you can verify that the
equilibrium output levels are
Cournot Equilibrium: Q1= Q2 = 10

The total quantity produced is therefore Q = Q1+Q2=20, so the equilibrium market price is P
= 30 - Q = 10.

Figure 2.2.2.2.2 shows the Cournot reaction curves andCournot equilibrium.

Note that Firm 1's reaction curve shows its output Q1 in terms of Firm 2's output Q. Similarly,
Firm 2's reaction curve shows Q2 in terms of Q1. (Since the firms are identical, the two reaction
curves have the same form. They look different because one gives Q1 in terms of Q2, and the
other gives Q2 in terms of Q1.) The Cournot equilibrium is at the intersection of the two curves.
At this point each firm is maximizing its own profit, given its competitor's output.

Page 33
Harambee University College Microeconomics Theory II Department of Economics

We have assumed that the two firms compete with each other. Suppose, instead, that the antitrust
laws were relaxed and the two firms could collude.

Fig. 2.2.2.2.2Duopoly Example. The demand curve is P = 30 - Q, and both firms have zero
marginal cost In Coumot equilibrium, each firm produces 10. The contract curve shows
combinations of Qi and Q2 that maximize total profits. If the firms collude and share profits
equally, they will each produce 7.5. Also shown is the competitive equilibrium, in which price
equals marginal cost, and profit is zero.
They would set their outputs to maximize total profit, and presumably they would split that profit
evenly. Total profit is maximized by choosing total output Q so that marginal revenue equals
marginal cost, which in this example is zero. Total revenue for the two firms is

R = PQ = (30-Q)Q = 30Q-Q2

So marginal revenue is
MR = ∆R/∆Q = 30 - 2Q
Setting MR equal to zero, we see that total profit is maximized when Q = 15. Any combination
of outputs Qi and Q2 that add up to 15 maximizes total profit. The curve Q1 + Q2 = 15, called
the contract curve, is therefore all pairs of outputs Q1 and Q2 that maximize total profit. This
curve is also shown inFigure 125. If the firms agree to share the profits equally, they will each
producehalf of the total output:
Q1 = Q2 = 7.5

Page 34
Harambee University College Microeconomics Theory II Department of Economics

As you would expect, both firms now produce 1ess;tnd earn higher profits- than in the Cournot
equilibrium. Figure 2.2.2.2.2 shows this collusive equilibrium and the competitive output levels
found by setting price equal to marginal cost. (You can verify that they are Q1 = Q 2 = 15, which
implies that each firm makes zero profit.) Note that the Cournot outcome is much better (for the
firms) than perfect competition, but not as good as the outcome from collusion.

3.2.2.2 Mathematical version of cournot duopoly model

The market price, P is determined by (inverse) market demand:

P=a-bQ if a>bQ, P=0 otherwise. Each firm decides on the quantity to sell (market share):
q1 and q2. Q= q1+q2 total market demand; Both firms seek to maximize profits.

Best response of Firm 1

Suppose firm 2 produces q2
Firm 1’s profits, if it produces q1 are:
π1 = (P-c1)q1 = [a-b(q1+q2)]q1 - c1q1
= (Residual) revenue - Cost
How to choose q1 to maximize π1?
First note that π1 is concave: d2π1/dq12 = -2b <0
First order conditions (FOC):
dπ1/dq1= a - 2bq1 - bq2 - c1
= Residual marginal revenue - Marginal cost
= 0 → q1= (a-c1)/2b - q2/2= R1(q2)

Best response of Firm 2

Suppose firm 1 produces q1
Firm 2’s profits, if it produces q2 are:
π2 = (P-c2)q2 = [a-b(q1+q2)]q2 - c2q2
= (Residual) revenue - Cost
First order conditions:
dπ2/dq2= a - 2bq2 - bq1- c2 =
= RMR - MC = 0 → q2 =(a-c2)/2b - q1/2= R2(q1)

Page 35
Harambee University College Microeconomics Theory II Department of Economics

Example: Cournot Competition

P = 130-(q1+q2), so a=130, b=1
c1 = c2 = c = 10
Suppose Firm 2 thinks that Firm 1 will set q1=40
Residual demand of Firm 2: P= 90-q2
Residual revenue of Firm 2: RR=[90-q2]q2
Residual marginal revenue (RMR):
RMR=90-2q2
Setting RMR=MC=10
90-2q2=10 → q2=40

Graphical solution

Cournot Equilibrium
q1=(a-c1)/2b – q2/2
q2=(a-c2)/2b – q1/2
Solving together for q1 and q2 :
qC1=(a-2c1+c2)/3b qC2=(a-2c2+c1)/3b
Market demand and price:
QC = qC1+ qC2= (2a- c1- c2)/3b
P = a - bQC = (a+c1+c2)/3

Page 36
Harambee University College Microeconomics Theory II Department of Economics

Example2: Cournot Competition

P = 130-(q1+q2), so a=130, b=1
c1 = c2 = c = 10

The firms best response functions:

q1=(a-bq2-c)/2b = (130-q2-10)/2=60-q2/2
q2=(a-bq1-c)/2b = (130-q1-10)/2=60-q1/2
Solving for q1 and q2 :
q1 = q2 = 40 Q=80 P = 50
Firms’ profits:
π1 = π2 = (50-10)40 = 1600
Graphical solution
q1= R1(q2)= 60-q2/2 q2 = R2(q1)= 60-q1/2

Cournot Equilibrium with N firms

Page 37
Harambee University College Microeconomics Theory II Department of Economics

3.2.3 The Bertrand duopoly model

Bertrand oligopoly is a model of price competition between duopoly firms which results in each
charging the price that would becharged under perfect competition, known as marginal cost prici
ng.

The model has the following assumptions:

 There are at least two firms producing homogeneous products;
 Firms do not cooperate;
 Firms have the same marginal cost (MC);
 Marginal cost is constant;
 Demand is linear;
 Firms compete in price, and choose their respective prices simultaneously;
 There is strategic behavior by both firms;
 Both firms compete solely on price and then supply the quantity demanded;
 Consumers buy everything from the cheaper firm or half at each, if the price is equal.
Competing in price means that firms can easily change the quantity they supply, but once they ha
ve chosen a certain price, it is very hard, if not impossible, to change it. Some examples of firms
that might operate in this way are bars, shops or other companies that publish non‐negotiable pric
es.

Bertrand model is 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.

The Bertrand model was developed in 1883 by another French economist, Joseph Bertrand. As
with the Cournot model, firms produce a homogeneous good. Now, however, they choose prices
instead of quantities. As we will see, this can dramatically affect the outcome. Let's return to the
duopoly example of the last section, in which the market demand curve is P=30- Q. where Q =
Ql + Q2 is again total production of a homogeneous good. This time, we will assume that both
firms have a marginal cost of $3:
MC1 = MC2 = 3

Page 38
Harambee University College Microeconomics Theory II Department of Economics

As an exercise, you can show that the Cournot equilibrium for this duopoly, which results when
both firms choose output simultaneously, is Q1 = Q1 = 9. You can also check that in this
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. What price will each firm choose, and how much profit will each earn? To answer this,
note that because the good is homogeneous, consumers will only purchase from the lowest-price
seller. Hence, if the two firms charge different prices, the lower-priced firm will supply the entire
market, and the higher-priced firm will sell nothing. If both firms charge the same price,
consumers would be indifferent as to which firm they buy from/ so we can assume that each film
would then supply half the market.
What is the Nash equilibrium in this case? If you think about this a little, you will see that
because of the incentive to cut prices, the Nash equilibrium is the competitive outcome; i.e., both
firms set price equal to marginal cost: P1 = P2 = $3. Then industry output is 27 units, of which
each firm produces 135 units. And since price equals marginal cost, both firms earn zero profit.

To check that this is a Nash equilibrium, ask whether either firm would have any incentive to
change its price. Suppose Firm 1 raised its price. It would then lose all of its sales to Firm 2 and
would therefore be no better off. If instead it lowered its price, it would capture the entire market,
but would lose money on every unit it produced, and so would be worse off. Hence, Firm 1 (and
likewise Firm 2) has no incentive to deviate-it is doing the best it can, given what its competitor
is doing.

Why couldn't there be a Nash equilibrium in which the firms charged the same price, but a
higher one (say $5), so that each made some profit? Because in this case, if either firm lowered
its price just a little, it could capture the entire market and nearly double its profit. Thus, each
firm would want to undercut its competitor. This undercutting would continue until the price
dropped to $3.

Page 39
Harambee University College Microeconomics Theory II Department of Economics

By changing the strategic choice variable from output to price, we get a dramatically different
outcome. In the Cournot model, each firm produces only 9 units, so that the market price is $12.
Now the market price is $3.

The Bertrand model has been criticized on several counts. First, when firms produce a
homogeneous good, it is more natural to compete by setting quantities rather than prices. Second,
even if the firms do set prices and choose the same price (as the model predicts), what share of
total sales will go to each one? We assumed that sales would be divided equally among the firms,
but there is no reason why this has to be the case. But despite these shortcomings, the Bertrand
model is useful because it shows how the equilibrium outcome in an oligopoly can depend
crucially on the firms' choice of strategic variable.

Price Competition with Differentiated Products

Oligopolistic markets often have at least some degree of product differentiation? Market shares
are determined not just by prices, but also by differences in the design, performance, and
durability of each firm's product. Then it is natural for firms to compete by choosing prices rather
than quantities. To see how price competition with differentiated products can work, let's go
through the following simple example. Suppose each of two duopolists has fixed costs of $20 but
zero variable costs, and that they face the same demand curves:

Firm 1’s Demand: Q1 = 12 - 2P1 + P2 …………………………….(2.2.3a)

Firm 2’s Demand: Q2 = 12 - 2P2 + P1………………………………(2.2.3b)

Where P1 and P2 are the prices that Firms 1 and 2 charge, respectively, and Ql and Q2 are the
resulting quantities that they sell. Note that the quantity each firm can sell decreases when the
firm raises its own price, but increases when its competitor charges a higher price.

If both firms set their prices at the same time, we can use the Cournot model to determine the
resulting equilibrium. Each firm will choose its own price, taking its competitor's price as fixed.

Now consider. Firm 1. Its profit, is its revenue PlQ1 less its fixed cost of $20. Substituting for Q1
from the demand curve of equation (2.2.3a), we have

Page 40
Harambee University College Microeconomics Theory II Department of Economics

At what price Pi is this profit maximized? The answer depends on P2, which Firm 1 assumes is
fixed. However, whatever price Firm 2 is charging. Firm 1's profit is maximized when the
incremental profit from a very small increase in its own price is just zero. Taking P2 as fixed.
Firm 1's profit-maximizing price is therefore given by

This can be rewritten to give the following pricing rule, or reaction curve, for Firm 1:

This tells Firm 1 what price to set, given the price P2 that Firm 2 is setting. We can similarly find
the following pricing rule for Firm 2:

Fig. 2.2.3.1 Nash Equilibrium in Prices. Here two firms sell a differentiated product, and each film's
demand depends on its own price and its competitor's price. The two firms choose their prices at the same
time, and each takes its competitor's price as given. Firm 1's reaction curve gives its profit-maximizing price as
a function of the price that Firm 2 sets, and similarly for Firm 2. The Nash equilibrium is at the intersection of
the two reaction curves; when each firm charges a price of $4, it is doing the best it can given its competitor's
price, and it has no incentive to change price. Also shown is the collusive equilibrium. If the firms
cooperatively set price, they would choose $6.

Page 41
Harambee University College Microeconomics Theory II Department of Economics

3.2.4 Stackelberg Model

Heinrich Freiherr von Stackelberg (October 31, 1905 - October 12, 1946) was a German
economist who contributed to game theory and industrial organization and is known for the
Stackelberg leadership model.

The Stackelberg leadership model is a strategic game in economics in which the leader firm
moves first and then the follower firms move sequentially. It is named after the German
economist Heinrich Freiherr von Stackelberg who published Market Structure and Equilibrium
(Marktform und Gleichgewicht) in 1934 which described the model.

In game theory terms, the players of this game are a leader and a follower and they compete on
quantity. The Stackelberg leader is sometimes referred to as the Market Leader.

Stackelberg's Model of Duopoly also has to do with companies trying to decide how much of a
homogeneous good to produce. The principal difference between the Cournot model and the
Stackelberg model is that instead of moving simultaneously (as in the Cournot model) the firms
now move sequentially. Firm 1 moves first and then firm two moves second.

There are some further constraints upon the sustaining of a Stackelberg equilibrium. The leader
must know ex ante that the follower observes his action. The follower must have no means of
committing to a future non-Stackelberg follower action and the leader must know this. Indeed, if
the 'follower' could commit to a Stackelberg leader action and the 'leader' knew this, the leader's
best response would be to play a Stackelberg follower action.

Firms may engage in Stackelberg competition if one has some sort of advantage enabling it to
move first. More generally, the leader must have commitment power. Moving observably first is
the most obvious means of commitment: once the leader has made its move, it cannot undo it - it
is committed to that action. Moving first may be possible if the leader was the incumbent
monopoly of the industry and the follower is a new entrant. Holding excess capacity is another
means of commitment.

Page 42
Harambee University College Microeconomics Theory II Department of Economics

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 1's output, makes its
output decision. In setting output, Firm 1 must therefore consider how Firm 2 will react.
P = 30 - Q (Q = Q1 + Q2

MC1 = MC2 = 0
Firm 2's reaction curve: Q2 = 15 – 1/2Q1
Firm 1's revenue: R1 = PQ1 = 30Q1 - Q21 - Q1Q2 = 15Q1 – 1/2Q21
And MR1 = ∆R1/∆Q1= 15 - Q1
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.

3.3 Collusive Oligopoly

Collusion – rival firms enter into an agreement in mutual interest on various accounts such as
price, market share etc.
Explicit collusion - when a number of firm enter into such agreement formally.Most commonly
found form of explicit collusion is known as cartels.The aim of such collusion is to reduce
competition and increase profits of individual members.Governments do not encourage
collusions because it creates like monopoly.
Tacit Collusion – collusion which is not avert. It is the achievement of collusive results without
actual agreements. This type of collusion is not necessarily illegal in the U.S.Price leadership is a
type of tacit collusion. It is a set of industry practices or customs in which firms throughout the
industry follow the prices changes made by a firm recognized as the ―price leader.‖

3.3.1 Cartel

A cartel is an agreement among several producers to obey output restrictions in order to increase
their joint profit. Essentially, the cartel acts like a monopolist and simply divides the market
among members of the cartel. Essentially, the cartel acts like a monopolist and simply divides
the market among members of the cartel.

Page 43
Harambee University College Microeconomics Theory II Department of Economics

A cartel is generally perceived as a specific market form of oligopoly where cartel subjects
accede to a discreet agreement between formally legally independent economic subjects which
together enter into a contract with an aim of reaching a more favorable position on relevant
market and thus eliminate the mechanism of competition.
Cartels which, based on the agreed market strategies, may follow common price strategy, set
their production quotes or divide the market are forbidden in the European Union countries as
well as in many countries outside the EU.

Producers in a cartel explicitly agree to cooperate in setting prices and output levels. Not all the
producers in an industry need to join the cartel, and most cartels involve only a subset of
producers. But if enough producers adhere to the cartel's agreements, and if market demand is
sufficiently inelastic, the cartel may drive prices well above competitive levels.

A cartel is a specific case of oligopoly with an unspecified number of buyers but only a small
number of sellers. The upper limit of the number of the sellers in the market structure for it to be
defined as oligopoly is not explicitly defined. Pepall shows, that the key issue is not the number
of the sellers but the way they communicate with each other, how they react to their individual
intentions and how they jointly address the conditions and attributes of the oligopoly market
equilibrium, that is how they resolve the question of market price of their products, how they set
the total supply of the sector and how they agree on the individual contribution of the oligopoly
subjects to the creation of total oligopoly supply on the relevant market.

It should be noted that each action of a particular firm in an oligopoly affects the behavior of
other firms on the market. Price lowering of one firm will likely decrease a market share of other
firms on the production of a sector. In other words, responses of the competitors in oligopoly
may have a significant effect on a result of managerial decision making on an oligopoly market.
It is therefore clear that a decision making about optimal price and supply in an oligopoly is far
more complicated than in other market structures.

Page 44
Harambee University College Microeconomics Theory II Department of Economics

The most famous example of this is the Organization of Petroleum Exporting Countries (OPEC).
OPEC was formed in 1960's in response to quotas instituted by President Eisenhower and
enforced on Venezuela and Persian Gulf Countries. The success of OPEC has varied over time
with conditions in the market and geo-political relations among its members and customers.
Cartels are typically illegal within countries, but in the case of OPEC, the cartel is made up of
countries.

Fig. 2.3.1.1 The OPEC Oil Cartel. TD is the total world demand curve for oil, and Sc is the
competitive (non-OPEC) supply curve. OPEC's demand DOPEC is the difference between the
two. Because both total demand and competitive supply are inelastic, OPEC's demand is
inelastic. OPEC's profit-maximizing quantity Q OPEC is found at the intersection of its marginal
revenue and marginal cost curves; at ths quantity, OPEC charges price P*. If OPEC producers
had not cartelized, price would be PC, where OPEC's demand and marginal cost curves intersect.

3.3.1.1 Cartel aiming at joint profit maximization

The profit-maximizing firms in oligopolistic markets have strong incentives to restrict

competition by creating cartels. They recognize that coordination of output or pricing
strategies could help them increase profits. In the most extreme case when all companies in
the industry form a cartel, they can duplicate the monopoly outcome, and share the largest
pool of profits that can be generated.

Page 45
Harambee University College Microeconomics Theory II Department of Economics

The increased profit is achieved at the expense of consumers, and usually leads to a reduction
in total welfare. Therefore, cartels are illegal and antitrust authorities actively engage in
fighting them. Even though there have been many success stories of governmental activities
leading to detection and punishment of firms forming cartels, there is no doubt that it is not
an easy task, and additional tools of analysis should be developed to help eliminate illegal
cooperation.

Joint profit maximization is strategy that maximizes profits for a cartel but may create
incentives for individual members to cheat.

Allocation Rule for Joint Profit Maximization

MC1 = MC2 = MC3

Where

MC1 = Firm #1’s marginal cost

MC2 = Firm #2’s marginal cost
MCc = Cartel’s marginal cost

When a Cartel is Successful

 It can raise market price without inducing significant competition from non-cartel members
 The expected punishment from forming the cartel is low relative to the expected gains
 The costs of establishing and enforcing agreement are low relative to the gains

Cartel implies direct agreement among competing Oligopolist with the aim of reducing
uncertainty. The aim of cartel is the maximization of joint profit.
The firms appoint a central agency, to whom they delegate authority to decide not only the total
quantity and the price but also the allocation of production among the members of the cartel and
the distribution of joint profits among them. The central agency has full information about the
cost function of the firms. It is assumed that all members produce identical products.

Page 46
Harambee University College Microeconomics Theory II Department of Economics

Centralized Cartel
 Cartel aiming at joint profit maximization – it is one in which cartelization is perfect.
 It is an arrangement by all members, with the objective of maximizing joint profits.
 In such type of arrangement the product is essentially homogeneous and centralized
body decides on the pricing of the product.
 Price is decided by association on the basis of summation of all firms’ cost and demand
function – individual firm is price taker.
 However when there is large number of firms and size of market is small, it is difficult
to sustain the cartel and there is every possibility that some firms may deviate from
cartel price and thus cheat other members.
 Mistakes may arise in the estimation of the market demand
 Mistake may also arise in the estimation of MC.
 Existence of high cost firm sometimes set an obstacle towards joint profit
maximization. If the cost curve of the firm lies wholly above the equilibrium MC, profit
maximization requires that high cost firm should close down which is not possible.
 A cartel may not also maximize for fear of government intervention or fear of entry.
 To maintain good image, they may not maximize profit.

2.3.1.2 Market sharing cartel

This form of collusion is more common in practice because it is more popular. The firms agree to
share the market, but keep a considerable degree of freedom concerning the style of their output,
their selling activities and other decisions.

Non-Price competition agreement

 In this form of ―loose‖ cartel, the member firms agree on a common price, at which each
of them can sell any quantity demanded.
 The price is set by bargaining, with the low cost firm pressing for a low price and high
cost firm for high price.
 The agreed price must be such as to allow some profits to all members.

Page 47
Harambee University College Microeconomics Theory II Department of Economics

 The firms agree not to sell at a price below the cartel price, but they are free to vary the
style of their product and their selling activities.
 Firms compete on a non-price basis.
 By keeping their freedom regarding the quality and appearance of their product, as well
as advertising and other selling policies, each firm hopes that it can attain a higher share
of market.

Sharing of the market by agreement on Quotas

 Sharing of the market is the agreement on quotas, that is, agreement on the quantity that
each member may sell at the agreed price.
 If the firms have identical costs, the monopoly solution will emerge with the market
being shared equally among member firms.
 However, if costs are different, the quotas and shares of the market will differ.
 Allocation of quota-share on the basis of costs is again unstable.
 Shares in case of cost differential are decided by bargaining.
 The final quota of each firm depends on the level of its cost as well as on its bargaining
skill.
 Quotas are decided on the basis of past level of sales and productive capacity.

The main problem with this type of collusion is the assumption that all firms face the same cost
functions; therefore, sustainability of such a cartel is very unstable.

Factors – Formation and sustainability of Cartel

 Number of firms in the industry
 Nature of product
 Cost Structure
 Characteristics of Sales

OPEC Cartel
 Oil producing countries
 Negotiate production quotas
 Incentive to deviate from quota and produce more.

Page 48
Harambee University College Microeconomics Theory II Department of Economics

 Overproduction causes prices to drop. All OPEC members suffer from low prices
 Punishment for overproduction: one country-typically Saudi Arabia- temporarily
increases production and causes priced to drop even more. Every members suffers from
lower profits, but original deviator is punished

3.3.2 Price leadership

Price leadership describes the situation in which a single enterprise regularly initiates market
price changes by changing its own price because all the other enterprises in the market
follow and adopt those price changes. The enterprise that initiates those price changes is
called the price leader and the enterprises that followed are called price followers. Therefore
the questions which need to be answered is how does a enterprise attain the position of price
leadership and how does it command allegiance to its price. These two questions will be
answered by considering three situations - the first will be the archetype price leadership
situation in which a dominant enterprise 'controls' the market price; the third will consider
the situation in which price leadership has failed and enterprises have engaged in collusion
to set the market price; and the second situation considered will deal with large enterprise
price leadership as exercised through a trade association.

In this form one firm sets price and other firms follow it because it is advantageous to them
or because they prefer to avoid uncertainty.
 If the product is homogenous and if there are no transport costs, the same price will
be charged by all firms.
 However if the product is differentiated, prices will differ but the direction of their
change will be the same and the same price differential will be more or less
maintained.
Types
 Price leadership by a low cost firm
 Price leadership by a large (Dominant firm)
 Barometric Price leadership

Page 49
Harambee University College Microeconomics Theory II Department of Economics

3.3.2.1 Low cost price leadership

This model assumes that there are two firms in the industry producing homogenous product at
different cost. One firm produce at low cost compared to its competitor. Moreover, firms may
have equal or unequal market share. Given firms with the stated features, low cost firm becomes
the leader and set price, which maximizes its profit. Follower firm by scarifying some of its
profit take the price set by the leader. This is to avoid the price war, which would eliminate the
firm from the industry if price set lower then its LAC.

However, the price set by the leader firm using marginal principle (MC=MR) would remain at
the stated position through maintaining output constant. Deviation of output from the point
where MR=MC due to over or under supply of output by follower firm will change the price and
then the profit of the leader will not maximized. This implies that the follower must supply a
quantity sufficient to maintain the price set by the leader. So at the optimal price level, the firms
must also enter agreement on the share of the market formally or informally. Otherwise even
though the follower adopt the leaders price, producing higher or lower level of output required to
maintain the price (set by the leader) in the market push the leader to non-profit maximizing
position. In this respect, the follower is not completely passive; it can affect the market price and
then the profit of the leader unless they enter into formal or informal agreement to supply certain
proportion of the total output.

Numerical Illustration
Market demand: P = 60-2(Y1+Y2)
Cost C (Y1) =Y12 C (Y2) = 4Y2

When we see their cost structure, firm two is a low cost firm so that it can be taken as the leader.
So, it is the one who set price using the marginal principle but the two firms go into agreement
about the share of the market at leader’s profit maximizing level of price. Let assume they agree
to share equally. With this assumption, the demand curve relevant to leader’s decision would be
modified as:

Page 50
Harambee University College Microeconomics Theory II Department of Economics

P = 60-2 (Y1+Y2), Y1=Y2

P = 60-2 (Y1+Y2) = P=60-4Y2
∏2 = PY2 – C2
∏2 = (60 – 4Y2) – 4Y2 = 56Y2 – 4Y22

Take F.C.O d∏2= 0 to determine equilibrium level of output that maximizes leader’s profit.
dY2

d∏2= d(56Y2 – 4Y22) = 0

dY2 dY2

56 – 8Y2 = 0 Y2 = Y1 = 7

P = 60 – 4Y2
= 60 – 4(7) = 60 – 28 = 32
P* = 32
However, P = 32 and output level Y1 = 7 would not maximizes the profit of the follower firm.
The price that maximizes the profit of the follower firm can be determined through maximizing
its profit function as follows’

∏1 = R1 – C1 = (60 – 4Y1)Y1 – Y2
∏1 = 60Y1 – 5Y12
Take F.O.C d∏1 = 60 – 10Y1 = 0 Y1 = 6
dY1
P = 60 – 4Y1
P = 60 – 4(6) = 60 – 24 =36
P* = 36
The output level which maximizes the profit of firm one (follower) would be Y 1 = 6 units and
charge a price P* = 36 if it did not recognizes the leader ness of firm two.

Page 51
Harambee University College Microeconomics Theory II Department of Economics

2.3.2.2 Dominant firm price leadership

Price-leadership is a form of oligopoly in which one dominant firm sets prices and all the smaller
firms in the industry follow its pricing policy.
 Oligopoly market is dominated by few firms among which one may be the largest player.
o Example : Google, Intel, Nokia, IBM, Maruti, Godrej etc.
 The other firms acknowledge the leadership of the largest firm for price determination.
 A dominant firm is a leader in term of market share or presence in all segments, or just
being the pioneer in particular product category.
 Leader is very large in size and earns economies of scale, produces optimum output at
which it is able to maximize returns.
 This dominant firm may be either a benevolent or an exploitative firms.
 A benevolent firm allows other firm to exist by fixing a price at which small firms may
also sell.
 Creation of Benevolent Firm:
-It lets other exist so that it does not have to face allegation of monopoly creation.
-It earns sufficient margin at this price an still retains market leadership.
-Success of this type of leadership depends on the assumptions that others will follow the
leader.
 An exploitative leader fixes a price at which small inefficient players may not survive and
thus it gains a large share of the market.

In some oligopolistic markets, one" large firm has a major share of total sales, and a group of
smaller firms supplies the remainder of the market. The large firm might then act as a dominant
firm, setting a price that maximizes its own profits. The other firms, which individually could
have little influence over price anyway, would then act as perfect competitors; they take the price
set by the dominant firm as given and produce accordingly. But what price should the dominant
firm set? To maximize profit, it must take into account how the output of the other firms depends
on the price it sets.

Page 52
Harambee University College Microeconomics Theory II Department of Economics

Figure 2.3.2.2.1 shows how a dominant firm sets its price. Here, D is the market demand curve,
and SF is the supply curve (i.e., the aggregate marginal cost curve of the smaller fringe firms).
The dominant firm must determine its demand curve DD. As the figure shows, this is just the
difference between market demand and the supply of fringe firms. For example, at price Pi the
supply of fringe firms is just equal to market demand, so the dominant firm can sell nothing at
this price. At a price Pz or less, fringe firms will not supply any of the good, so the dominant
firm faces the market demand curve. At prices between Pi and P2, the dominant firm faces the
demand curve DD.
Corresponding to DD is the dominant firm's marginal revenue curve MRD. MCD is the
dominant firm's marginal cost curve. To maximize its profit, the dominant firm produces
quantity QD at the intersection of MRD and MCD. From the demand curve DD, we find price
P*. At this price, fringe firms sell a quantity QF, so that the total quantity sold is QT = QD + QF.

Fig. 2.3.2.2.1 Price Setting by a Dominant Firm.The dominant firm sets price, and the other firms sell as much
as they want at that price. The dominant firm's demand curve. DD, is the difference between market demand D and
the supply of fringe firms SF. The dominant firm produces a quantity QD at the point where its marginal revenue
MRD is equal to its marginal cost MCD. The corresponding price is P*. At this price, fringe firms sell QF, so that
total sales is QT.

Page 53
Harambee University College Microeconomics Theory II Department of Economics

Price Leadership and the Dominant Enterprise

The most obvious characteristic of a dominant enterprise, especially one formed via a horizontal
merger, is that it is extremely large in comparison to the market and to the other enterprises in
the market.

Because we are primarily interested in the dominant enterprise's relationship to the other
enterprises in a particular market with respect to the determination of the market price, the only
relevant measurement of size for our purposes is sales. More specifically, because we are only
interested in the enterprise's size with respect to a single market, its size can only be defined in
terms of its specific market sales.

The size of the dominant enterprise, as discussed above, does not, by itself, permit it to dominate
the other enterprises in the market. Therefore the size of the dominant enterprise must convey
upon it a competitive advantage which the other enterprises in the market do not have. The most
important and necessary advantage the dominant enterprise must have if it is to impose its price
upon the market is a cost advantage. A second, but less important, advantage is financial.

If a dominant enterprise obtains a cost advantage from a horizontal merger, it is most likely to
occur in the area of production.

Because of its size, the dominant enterprise's financial position is much stronger than that of its
smaller competitors. That is, because of its size, the dominant enterprise has easier access to
borrowing short (or long) term working capital and at lower rates of interest than its competitors.
In addition, it has access to the capital markets, whereas the smaller enterprises are generally
frozen out of those markets.

It is generally accepted that the dominant enterprise's price is accepted as the market price by the
other enterprises in the market because of its cost and financial advantages.

Page 54
Harambee University College Microeconomics Theory II Department of Economics

A dominant firm or group has full information about market demand and industry costs can set
prices so that it earns economic profit whilst the passive fringe earns a normal rate of return.

Example:
Assume the supply curve of the competitive fringe is S = 0.2P
This is known to the dominant firm as is the market demand. D = 50 - 0.3P
The dominant firm derives its own demand curve as the difference
X = D - S at any one price
X = 50- 0.3P - 0.2P
or P =100 - 2X
Assume the dominant firm’s costs are
C = 2X
and it maximizes its profits
Π =R - C = PX - X
Π = (100-2X) X – 2X = 98X – 2X2
∂ Π = 98 – 4X = 0
∂X
X = 24.5

The leader will set price: P = 100 - 2X = 100 - 2(24.5) = 51. At this price the market is in
equilibrium when: D = 50 - 0.3 P = 34.7
As the leader produces 24.5 the fringe supplies S = 0.2P = 0.2(51) = 10.2

2.3.2.3 Barometric price leadership

Some markets may be such that no single player is so large to emerge as leader, but there may be
one firm which has better understanding of the markets. This firm acts like a barometer for the
market. A barometric has better industry intelligence and can preempt and interpret its external
environment in an effective manner.
Barometric Price – where one firm acts as a barometer for the industry and others follow.

Page 55
Harambee University College Microeconomics Theory II Department of Economics

This version postulates that the price leader is a firm that responds more quickly than its rivals to
changing cost and demand onditions, but does not in itself have significant market power. In such
circumstances the price leader acts, in effect, as a barometer of market conditions for the rest of th
e industry, with its price levels set close to those that would emerge even under competition. Baro
metric price leadership may be indicated by a number of market characteristics, for example occas
ional switching between firms in the role of price leader; the occurrence of upward price leadershi
p only in response to increased industry costs or demand; occasional and sometimes substantial ti
me lags in the price response of follower firms; and occasional rejection by the rest of the market
of price changes initiated by the price leader.

Page 56
Harambee University College Microeconomics Theory II Department of Economics

Summary
In an oligopolistic market, only a few firms account for most or all of production. Barriers to
entry allow some firms to earn substantial profits, even over the long run. Economic decisions
involve strategic considerations-each firm must consider how its actions will affect its rivals, and
how they are likely to react.

In the Cournot model of oligopoly, firms make their output decisions at the same time, each
taking the other's output as fixed. In equilibrium, each firm is maximizing its profit, given the
output of its competitor, so no firm has an incentive to change its output. The firms are therefore
in a Nash equilibrium. Each firm's profit is higher than under perfect competition, but less than
what it would earn by colluding.

In the Stackelberg model, one firm sets its output first. That firm has a strategic advantage and
earns a higher profit. It knows it can choose a large output, and its competitors will have to
choose small outputs if they want to maximize profits.

Price leadership is a form of implicit collusion that sometimes gets around the Prisoners'
Dilemma. One firm sets price, and the other firms follow with the same price.

In a cartel, producers explicitly collude in setting prices and output levels. Successful cartelization
requires that the total demand not be very price elastic, and that either the cartel control most
supply or else the supply of non-cartel producers be inelastic.

Because of the difficult of forming effective cartel, oligopolists may attempt to cooperate
implicitly without making explicit agreements with one another. Such type of oligopoly is called
price leader oligopoly. There are three forms of price leadership; price leadership by a low cost
firm, price leadership by a large (dominant firm) and Barometric price leadership. In all the three
forms the leader firm set price and the follower firm take price set by the leader as given.

Page 57
Harambee University College Microeconomics Theory II Department of Economics

Model Examination Question

1. Why do oligopolies exist? List five or six oligopolists whose products you own or regularly
purchase. What distinguishes oligopoly from monopolistic competition?
2. What assumptions about a rival’s response to price changes underlie the kinked demand curve
for oligopolists? Why is there a gap in the oligopolist’s marginal-revenue curve? How does
the kinked demand curve explain price rigidity in oligopoly? What are the shortcomings of the
kinked-demand model?
3. Why might price collusion occur in oligopolistic industries? Assess the economic desirability
of collusive pricing. What are the main obstacles to collusion? Speculate as to why price
leadership is legal, whereas price fixing is not in most countries.
4. Two firms compete by choosing price. Their demand functions are
Q1=20-P1+P2
and
Q2 = 20 + P1 - P2

where P1 and P2 are the prices charged by each firm, respectively, and Q1 and Q2 are the resulting
demands. (Note that the demand for each good depends only on the difference in prices; if the
two firms colluded and set the same price, they could make that price as high as they want, and
earn infinite profits.) Marginal costs are zero.
a. Suppose the two firms set their prices at the same time. Find the resulting Nash
equilibrium.What price will each firm charge, how much willit sell, and what will its
profit be? (Hint: Maximize the profit of each firm with respect to its price.)
b. Suppose Firm 1 sets its price first, and then Firm 2 sets its price. Whatprice will each
firm charge,how much will it sell, and what will its profit be?
c. Suppose you are one of these firms, and there are three ways you could play the game:
(i) Bothfirms set price at the same time. (ii) You set price first, (iii) Your competitor
sets price first. If you could choose among these, which would you prefer? Explain
why.

Page 58
Harambee University College Microeconomics Theory II Department of Economics

Answer

1. Oligopolies exist for several reasons, the most common probably being economies of scale. If
these are substantial, as they are in the automobile industry, for example, only very large firms
can produce at minimum average cost. This makes it virtually impossible for new firms to
enter the industry. A small firm could not produce at minimum cost and would soon be
competed out of the business; yet to start at the required very large scale would take far more
money than an unestablished firm is likely to be able to raise before proving it will be
profitable. Other barriers to entry include ownership of patents by the oligopolists and,
possibly, massive advertising that gives would-be newcomers no chance to establish a
presence in the public’s mind. Finally, there is the urge to merge. Mergers have the clear
advantage of reducing competition—of giving the emerging oligopolists more monopoly
power. Also, they may result in more economies of scale and thereby increase that barrier to
new entry. Oligopolies with which we deal include manufacturers of automobiles, ovens,
refrigerators, personal computers, gasoline, and courier services. Oligopoly is distinguished
from monopolistic competition by being composed of few firms (not many); by being
mutually interdependent with regard to price (instead of control within narrow limits); by
having differentiated or homogeneous products (not all differentiated); and by having
significant obstacles to entry (not easy entry). Both engage in much non price competition.

2. Assumptions: (1) Rivals will match price cuts: (2) Rivals will ignore price increases. The gap
in the MR curve results from the abrupt change in the slope of the demand curve at the going
price. Firms will not change their price because they fear that if they do their total revenue and
profits will fall. Shortcomings of the model: (1) It does not explain how the going price
evolved in the first place; (2) it does not allow for price leadership and other forms of
collusion.
3. Price wars are a form of competition that can benefit the consumer but can be highly
detrimental to producers. As a result, oligopolists are naturally drawn to the idea of price-
fixing among themselves, i.e., colluding with regard to price. In a recession, it is nice to know
whether one’s rivals will cut prices or quantity, so that a mutually satisfactory solution can be
reached. It is also convenient to be able to agree on what price to set to bankrupt any would-be
interloper in the industry.

Page 59
Harambee University College Microeconomics Theory II Department of Economics

From the viewpoint of society, collusive pricing is not economically desirable. From the
oligopoly’s viewpoint it is highly desirable since, when entirely successful, it allows the
oligopoly to set price and quantity as would a profit-maximizing monopolist.

The main obstacles to collusion are demand and cost differences (which result in different points
of equality of MR and MC); the number of firms (the more firms, the lower the possibility of
getting together and reaching sustainable agreement); cheating (it pays to cheat by selling more
below the agreed-on price—provided the other colluders do not find out); recession (when
demand slumps, the urge to shave prices—to cheat—becomes much greater); potential entry (the
above-equilibrium price that is the reason for collusion may entice new firms into this profitable
industry—and it may be hard to get new entrants into the combine, quite apart from the
unfortunate increase in supply they will cause); legal obstacles (for a century, antitrust laws have
made collusion illegal).

Price leadership is legal because although the firms may follow the dominant firm’s price, they
are not compelled to. Also, the tacit agreement on price does not also include an agreement to
control quantity and to divide up the market.

4.

a. To determine the Cournot equilibrium we calculate the reaction function for each-firm,
then simultaneously solve for price. Assuming marginal cost is zero, profit for Firm 1 is
P1Ql = P1(20 – P1 + P2) = 20P1 – P12+ P2P1. MR1 = 20 - 2P1 + P2. At the profit-
maximizing price, MR1 = 0. So, P1 = (20 + P2)/2. Because Firm 2 is symmetric to Firm 1,
its profit-maximizing price is P2 = (20 + P1)/2. We substitute Firm 2's reaction function
into that of Firm 1: P1 = [20 + (20 + P1)/2]/2= l5 + P1/4. P1 =20. By symmetry P2 = 20.
Then Q1 = 20, and by symmetry Q2 = 20. Profit for Firm 1 is P1Q1 = 400, and profit for
Firm 2 is also 400.

Page 60
Harambee University College Microeconomics Theory II Department of Economics

b. If firm 1 sets its price first, it takes Firm 2's reaction function into account. Film 1 profit
is πi = P1[20 – P1 + (20 + P1/2]. Then, dπ/dP= 20 -2P1 + 10+ P1. Setting this expression
equal to zero. P1 = 30. We substitute for Pi in Firm 2's reaction function. P2 =25. At these
prices, Q1 = 20 - 30 + 25 = 15 and Q2 = 20 + 30 - 25 = 25. Profit is πl = 30.15 = 450 and
π2 = 25-25 = 625.

c. Your first choice should be (iii), and your second choice should be (ii). Setting prices
above theCournot equilibrium values is optional for bothfirms when Stackelberg
strategies are followed. From the reaction functions, we know that the price leader
provokes a price increase in the follower. But the follower increases price less than the
price leader, and hence undercuts the leader. Both firms enjoy increased profits, but the
follower does best, and both do better than they would in the Cournot equilibrium.

Page 61
Harambee University College Microeconomics Theory II Department of Economics

CHAPTER 4
GAME THEORY

4.0 Aims and Objectives

4.1 Introduction
4.2 Game theory and Strategic Behavior basic concepts
4.3 Dominant Strategy and Nash Equilibrium
4.3.1 Elimination of Dominated Strategies
4.4 The prisoners’ Dilemma
4.5 Mixed Strategies Nash Equilibrium
4.6 Repeated Game
4.7 Sequential Game

4.0 Aims and Objectives

 Define game and game theory

 Describe dominant strategy in a game and Nash equilibrium
 Steps to be followed to determine dominant strategy in a game and Nash equilibrium
 Explain how dominated strategies are eliminated
 Explain the prisoner’s dilemma game
 Differentiate mixed and pure strategy
 Determining mixed strategies Nash equilibrium
 Describing the impact of finitely and infinitely repeating the game
 Describe a tit-for-tat strategy
 Explaining the effects of sequential game

4.1 Introduction

Game theory is the study of how people behave in strategic situations. By ―strategic‖ we mean a
situation in which each person, when deciding what actions to take, must consider how others
might respond to that action.

Page 62
Harambee University College Microeconomics Theory II Department of Economics

Because the number of firms in an oligopolistic market is small, each firm must act strategically.
Each firm knows that its profit depends not only on how much it produces but also on how much
the other firms produce. In making its production decision, each firm in an oligopoly should
consider how its decision might affect the production decisions of all the other firms.

There are two major tasks involved when using game theory to analyze an economic situation.
The first is to distill the situation into a simple game. Because the analysis involved in strategic
settings quickly grows more complicated than in simple decision problems, it is important to
simplify the setting as much as possible by retaining only a few essential elements.
There is a certain art to distilling games from situations that is hard to teach. The examples in the
text and problems in this chapter can serve as models that may help in approaching new
situations.
The second task is to ―solve‖ the given game, which results in a prediction about what will
happen. To solve a game, one takes an equilibrium concept (Nash equilibrium, for example) and
runs through the calculations required to apply it to the given game. Much of the chapter will be
devoted to learning the most widely used equilibrium concepts (including Nash equilibrium) and
to practicing the calculations necessary to apply them to particular games.

A game is an abstract model of a strategic situation. Even the most basic games have three
essential elements: players, strategies, and payoffs. In complicated settings, it is sometimes also
necessary to specify additional elements such as the sequence of moves and the information that
players have when they move (who knows what when) to describe the game fully.

Game theory is not necessary for understanding competitive or monopoly markets. In a

competitive market, each firm is so small compared to the market that strategic interactions with
other firms are not important. In a monopolized market, strategic interactions are absent because
the market has only one firm. But, as we will see, game theory is quite useful for understanding
the behavior of oligopolies.

Page 63
Harambee University College Microeconomics Theory II Department of Economics

A payoff is a number, also called utility that reflects the desirability of an outcome to a player,
for whatever reason. When the outcome is random, payoffs are usually weighted with their
probabilities. The expected payoff incorporates the player’s attitude towards risk.

A game is said to be zero-sum if for any outcome, the sum of the payoffs to all players is zero. In
a two-player zero-sum game, one player’s gain is the other player’s loss, so their interests are
diametrically opposed.

4.2 Game theory and Strategic Behavior basic concepts

A game is a formal description of a strategic situation.A player is an agent who makes decisions
in a game. A game in strategic form, also called normal form, is a compact representation of a
game in which players simultaneously choose their strategies. The resulting payoffs are
presented in a table with a cell for each strategy combination.

Game theory is the formal study of conflict and cooperation. Game theoretic concepts apply
whenever the actions of several agents are interdependent. These agents may be individuals,
groups, firms, or any combination of these. The concepts of game theory provide a language to
formulate, structure, analyze, and understand strategic scenarios.

Unlike a pure monopoly or a perfectly competitive firm, most firms must consider the likely
responses of competitors when they make strategic decisions about price, advertising
expenditure, investment in new capital, and other variables. Although we began to explore some
of these strategic decisions in the last chapter, there are many questions about market structure
and firm behavior that we have not yet addressed. For example, why do firms tend to collude in
some markets and compete aggressively in others'? How do some firms manage to deter entry by
potential competitors? And how should firms intake pricing decisions when demand or cost
conditions are changing, or new competitors are entering the market?

First, we should clarify what gaming and strategic decision making are all about. In essence, we
are concerned with the following question: If I believe that my competitors are rational and act to
maximize their own profits, how should I take their behavior into account when making my own
profit-maximizing decisions?

Page 64
Harambee University College Microeconomics Theory II Department of Economics

As we will see, this question can be difficult to answer, even under conditions of complete
symmetry and perfect information (i.e., my competitors and I have the same cost structure and
are fully informed about each other’s' costs, about demand, etc.). Moreover, we will be
concerned with more complex situations in which firms have different costs, different types of
information, and various degrees and forms of competitive "advantage" and "disadvantage."

Non-cooperative versus Cooperative Games

The economic games that firms play can be either cooperative or non-cooperative. A game is
cooperative if the players can negotiate binding contracts that allow them to plan joint strategies.
A game is non-cooperative if negotiation and enforcement of a binding contract are not possible.

An example of a cooperative game is the bargaining between a buyer and a seller over the price
of a rug. If the rug costs $100 to produce and the buyer values the rug at $200, a cooperative
solution to the game is possible because an agreement to sell the rug at any price between $101
and $199 will maximize the gum of the buyer's consumer surplus and the seller's profit, while
making both parties better off. Another cooperative game would involve two firms in an
industry, which negotiate a joint investment to develop a new technology (where neither firm
would have enough know-how to succeed on its own). If the firms can sign a binding contract to
divide the profits from their joint investment, a cooperative outcome that makes both parties
better off is possible. An example of a non-cooperative game is a situation in which two
competing firms take each other's likely behavior into account and independently determine a
pricing or advertising strategy to win market share.

Note that the fundamental difference between cooperative and non-cooperative games lies in the
contracting possibilities. In cooperative games binding contracts are possible; in non-cooperative
games they are not.

We will be concerned mostly with non-cooperative games. In any game, however, the most
important aspect of strategy design is understanding your opponent's point of view, and
(assuming your opponent is rational) deducing how he or she is likely to respond to your actions.
This may seem obvious-of course, one must understand an opponent's point of view.

Page 65
Harambee University College Microeconomics Theory II Department of Economics

Yet even in simple gaming situations, people often ignore or misjudge their opponents' positions
and the rational responses those positions imply.

The study of how people behave in strategic situations. Such as, card games, board games like
chess or Monopoly and betting on sports teams. Corporate or government decisions that have
significant impact, taxes, war, mergers.
A. When there are few firms in an industry, they react to each other’s price, product, quality,
and distribution policies…..they have an interdependence.
B. Since oligopolistic firms are interdependent, they must have strategies, usually models to
predict how prices and outputs are determined.
C. Economists have developed game theory models to describe firms’ rational interactions.

4.3 Dominant Strategy and Nash Equilibrium

4.3.1 Dominant Strategy

A strategy is a dominant strategy for a player if it yields the best payoff (for that player) no
matter what strategies the other players choose. It is a strategy that outperforms any other, no
matter what strategy a rival chooses. A strategy is a decision rule that indicates what action a
player will take when confronted with a decision. A strategy profile represents the collection of
strategies adopted by a player. A payoff represents the gain or loss to each player in a game.
A strictly dominant strategy results in the largest payoff to a player regardless of the strategy
adopted by any other player.

If all players have a dominant strategy, then it is natural for them to choose the dominant
strategies and we reach a dominant strategy equilibrium.

A strategy dominates another strategy of a player if it always gives a better payoff to that player,
regardless of what the other players are doing. It weakly dominates the other strategy if it is
always at least as good.

A game consists of players, strategies, and payoffs.

Now assume that in a game, there are two players, firm A and firm B; their strategies are whether
to advertise or not; consequently, their payoffs can be written as

Page 66
Harambee University College Microeconomics Theory II Department of Economics

πA(A0s strategy, B0s strategy)

and
πB (A0s strategy, B0s strategy)
respectively. Now let’s represent the game with a matrix (see Table 1). The first row is the
situation that A advertises, and the second row is the situation that A does not advertise; the first
column is the situation that B advertises, and the second column is the situation that B does not
advertise. The cells provide the payoffs under each situation. The first number in a cell is firm
A’s payoff, and the second number is firm B’s payoff.

Dominant strategy is the optimal strategy no matter what the opponent does. If we change the
element (20, 2) to (10, 2), no matter what the other firm does, advertising is always better for
firm A (and firm B). Therefore, both firms have a dominant strategy.

When all players play dominant strategies, we call it equilibrium in dominant strategy. Now back
to original case, B has dominant strategy, but A does not, because
• if B advertises, A had better advertise;
• if B does not advertise, A had better not advertise.
So we see that not all games have dominant strategy. However, since B has dominant strategy
and would always advertise, A would choose to advertise in this case.

Now consider another example. Two firms, firm 1 and firm 2, can produce crispy or sweet. If
they both produce crispy or sweet, the payoffs are (−5, −5); if one of them produces crispy while
the other produces sweet, the payoffs are (10, 10).

Page 67
Harambee University College Microeconomics Theory II Department of Economics

There is no dominant strategy for both firms. We define another equilibrium concept – Nash
equilibrium.
Nash equilibrium is a set of strategies such that each player is doing the best given the actions of
its opponents.
In this case, there are two Nash equilibriums, (sweet,crispy) and (crispy,sweet).

Identifying Dominant Strategies

 Sometimes in a matrix game, a player will have a strategy that, given all of the resulting
outcomes, would not be worth playing.
 Such a strategy would not be worth playing if it is never better and sometimes worse than
some other strategy, regardless of the strategies of other players.
 For a given player, strategies that are never better and sometimes worse than other
strategies are called dominated strategies. (We can think of this as equal or worse than all
of the other strategies.)
 On the other hand, a dominant strategy is one that is sometimes better and never worse
than all other strategies, regardless of the strategies of the other players. (We can think of
this as equal or better than all of the other strategies.)

Step by step guide on how to find a dominant strategy or strategies

Step 1. Look at the payoff matrix and figure out whose payoff’s are whose:

Page 68
Harambee University College Microeconomics Theory II Department of Economics

Prisoner 2 (P.2)

Confess Deny
Confess -10 (P.1), -10 (P.2) -1 (P.1), -25 (P.2)

Prisoner 1 (P.1) -25 (P.1), -1 (P.2) -3 (P.1), -3 (P.2)

Deny

Step 2. Figure out Prisoner 1’s best response to all of prisoner 2’s actions

Hence, prisoner 1’s dominant strategy is confess,

Step 3. Figure out Player B’s best response to all of player A’s actions

Hence, prisoner 2’s dominant strategy is confess,

Confess is a dominant strategy for both players and therefore (Confess, Confess) is a dominant
strategy equilibrium yielding the payoff vector (-10,-10).

Page 69
Harambee University College Microeconomics Theory II Department of Economics

Example (Time vs. Newsweek):

The AIDS story is a dominant strategy for both Time and Newsweek. Therefore (AIDS,AIDS) is
a dominant strategy equilibrium yielding both magazines a market share of 35 percent.

4.3.2 Nash Equilibrium

Nash equilibrium occurs in a non-cooperative game when each player adopts a strategy that is
the best response to what is believed to be the strategy adopted by the other players.When a
game is in Nash equilibrium, neither player can improve the payoff by unilaterally changing
strategies. Nash equilibrium, also called strategic equilibrium, is a list of strategies, one for each
player, which has the property that no player can unilaterally change his strategy and get a better
payoff.

Strategies for which all players are choosing their best strategy, given actions of other players.
Proves useful when there is only one unique equilibrium in the game. There may be multiple
Nash equilibrium.

Equilibrium in oligopoly markets means that each firm will want to do the best it can given what
its competitors are doing, and these competitors will do the best they can given what firm is
doing. When a market is in equilibrium, firms are doing the best they can and have no reason to
change their price or output.

Page 70
Harambee University College Microeconomics Theory II Department of Economics

There is only one Nash equilibrium of this game; in the equilibrium both firms decide to deviate
from the cartel agreement i.e. (Defect, Defect). Even though, it is Pareto dominant for the firms
to cooperate, there is lack of internal stability of the cartel due to the strong incentives for the
individual members to defect (to cheat).

Step by step guide on how to find a Nash Equilibrium or Equilibria

Step 1. Look at the payoff matrix and figure out whose payoff’s are whose:

Step 2. Figure out Player A’s best response to all of player B’s actions

Step 3. Figure out Player B’s best response to all of player A’s actions

Page 71
Harambee University College Microeconomics Theory II Department of Economics

Step 4.A Nash equilibrium exists where Player B’s best response is the same as Player
A’s best response

Therefore, the Nash equilibrium is (Not cooperate, Not Cooperate)

Find the Nash equilibrium or Nash equilibria

Page 72
Harambee University College Microeconomics Theory II Department of Economics

4.3.3 Elimination of Dominated Strategies

1. Strict Dominance in Pure Strategies

In some games, a player’s strategy is superior to all other strategies regardless of what the
other players do. This strategy then strictly dominates the other strategies. Consider the
Prisoner’s Dilemma game in Fig. 1 (p. 2). Choosing D strictly dominates choosing C
because it yields a better payoff regardless of what the other player chooses to do. If one
player is going to play D, then the other is better off by playing D as well. Also, if one
player is going to play C, then the other is better off by playing D again. For each prisoner,
choosing D is always better than C regardless of what the other prisoner does. We say that
D strictly dominates C.

In the PD game, D strictly dominates C, and C is strictly dominated by D. Observe that we

are using expected utilities even for the pure-strategy profiles because they may involve
chance moves.

Rational players never play strictly dominated strategies, because such strategies can never
be best responses to any strategies of the other players. There is no belief that a rational
player can have about the behavior of other players such that it would be optimal to choose
a strictly dominated strategy. Thus, in PD a rational player would never choose C. We can
use this concept to find solutions to some simple games. For example, since neither player
will ever choose C in PD, we can eliminate this strategy from the strategy space, which
means that now both players only have one strategy left to them: D. The solution is now
trivial: It follows that the only possible rational outcome is (D,D).

Because players would never choose strictly dominated strategies, eliminating them from
consideration should not affect the analysis of the game because this fact should be evident
to all players in the game. In the PD example, eliminating strictly dominated strategies
resulted in a unique prediction for how the game is going to be played.

Page 73
Harambee University College Microeconomics Theory II Department of Economics

The concept is more general, however, because even in games with more strategies,
eliminating a strictly dominated one may result in other strategies becoming strictly
dominated in the game that remains.

Consider the abstract game depicted in Fig. 2 below. Player 1 does not have a strategy that
is strictly dominated by another: playing U is better than M unless player 2 chooses C, in
which case M is better. Playing D is better than playing U unless player 2 chooses R, in
which case U is better. Finally, playing D instead of M is better unless player 2 chooses R,
in which case M is better.

For player 2, on the other hand, strategy C is strictly dominated by strategy R. Notice that
whatever player 1 chooses, player 2 is better off playing R than playing C: she gets 2 > 1 if
player 1 chooses U; she gets 6 > 4 if player 1 chooses M; and she gets 8 > 6 if player 1
chooses D. Thus, a rational player 2 would never choose to play C when R is available.
(Note here that R neither dominates, nor is dominated by, L.) If player 1 knows that player
2 is rational, then player 1 would play the game as if it were the game depicted in Fig. 3
below.

Page 74
Harambee University College Microeconomics Theory II Department of Economics

We examine player 1’s strategies again. We now see that U strictly dominates M because
player 1 gets 4 > 2 if player 2 chooses L, and 6 > 3 if player 2 chooses R. Thus, a rational
player 1 would never choose M given that he knows player 2 is rational as well and
consequently will never play C. (Note that U neither dominates, nor is dominated by, D.)
If player 2 knows that player 1 is rational and knows that player 1 knows that she is also
rational, then player 2 would play the game as if it were the game depicted in Fig. 4 below.

We examine player 2’s strategies again and notice that L now strictly dominates R because
player 2 would get 3 > 2 if player 1 chooses U, and 9 > 8 if player 1 chooses D. Thus, a
rational player 2 would never choose R given that she knows that player 1 is rational, etc.
If player 1 knows that player 2 is rational, etc., then he would play the game as if it were
the game depicted in Fig. 5 below.

But now, U is strictly dominated by D, so player 1 would never play U. Therefore, player
1’s rational choice here is to play D. This means the outcome of this game will be (D, L),
which yields player 1 a payoff of 5 and player 2 a payoff of 9.

The process described above is called iterated elimination of strictly dominated strategies.
The solution of G is the equilibrium D, L, and is sometimes called iterated-dominance
equilibrium, or iterated-dominant strategy equilibrium. The game G is sometimes called
dominance-solvable.

Page 75
Harambee University College Microeconomics Theory II Department of Economics

Although the process is intuitively appealing (after all, rational players would never play
strictly dominated strategies), each step of elimination requires a further assumption about
the other player’s rationality. Recall that we started by assuming that player 1 knows that
player 2 is rational and so she would not play C. This allowed the elimination of M. Next,
we had to assume that player 2 knows that player 1 is rational and that she also knows that
player 1 knows that she herself is rational as well. This allowed the elimination of R.
Finally, we had to assume that player 1 knows that player 2 is rational and that he also
knows that player 2 knows that player 1 is rational and that player 2 also knows that player
1 knows that player 2 is rational.

More generally, we want to be able to make this assumption for as many iterations as might
be needed. That is, we must be able to assume not only that all players are rational, but also
that all players know that all the players are rational, and that all the players know that all
the players know that all players are rational, and so on, ad infinitum. This assumption is
called common knowledge and is usually made in game theory.

2. Weak Dominance
Rational players would never play strictly dominated strategies, so eliminating these should
not affect our analysis. There may be circumstances, however, where a strategy is ―not
worse‖ than another instead of being ―always better‖ (as a strictly dominant one would be).
To define this concept, we introduce the idea of weakly dominated strategy.

While iterated elimination of strictly dominated strategies seems to rest on rather firm
foundation (except for the common knowledge requirement that might be a problem with
more complicated situations), eliminating weakly dominated strategies is more
controversial because it is harder to argue that it should not affect analysis. The reason is
that by definition, a weakly dominated strategy can be a best response for the player.
Furthermore, there are technical difficulties with eliminating weakly dominated strategies:
the order of elimination can matter for the result!

Page 76
Harambee University College Microeconomics Theory II Department of Economics

Consider the game in Fig. 7 Strategy D is strictly dominated by U, so if we remove it first,

we are left with a game, in which L weakly dominates R. Eliminating R in turn results in a
game where U strictly dominates M, so the prediction is (U, L). However, note that M is
strictly dominated by U in the original game as well. If we begin by eliminating M, then R
weakly dominates L in the resulting game. Eliminating L in turn results in a game where U
strictly dominates D, so the prediction is (U, R). If we begin by eliminating M and D at the
same time, then we are left with a game where neither of the strategies for player 2 weakly
dominates the other. Thus, the order in which we eliminate the strictly dominated strategies
for player 1 determines which of player 2’s weakly dominated strategies will get eliminated
in the iterative process.

This dependence on the order of elimination does not arise if we only eliminated strictly
dominated strategies. If we perform the iterative process until no strictly dominated
strategies remain, the resulting game will be the same regardless of the order in which we
perform the elimination. Eliminating strategies for other players can never cause a strictly
dominated strategy to cease to be dominated but it can cause a weakly dominated strategy
to cease being dominated.

3. Strict Dominance and Mixed Strategies

We now generalize the idea of dominance to mixed strategies. All that we have to do to
decide whether a pure strategy is dominated is to check whether there exists some mixed-
strategythat is a better response to all pure strategies of the opponents.

As an example of iterated elimination of strictly dominated strategies that can involve

mixed strategies, consider the game in Fig. 8. Obviously, we cannot eliminate any of the
pure strategies for player 1 with a mixed strategy (because it would have to include both
pure strategies in its support).

Page 77
Harambee University College Microeconomics Theory II Department of Economics

Also, no pure strategy for player 1 strictly dominates the other: whereas U does better than
D against L and C, it does worse against R. Furthermore, none of the pure strategies strictly
dominates any other strategy for player 2: L does better than C (or R) against U but worse
against D; similarly, R does better than C against U but worse against D.

Figure 8: Another Game from Myerson.

4.4 The prisoners’ Dilemma

The Prisoners’ Dilemma is a two-person, simultaneous-move, non-cooperative, one-shot game in

which each player adopts the strategy that yields the largest payoff, regardless of the strategy
adopted by the other player.

A particularly important ―game‖ is called the prisoners’ dilemma. This game provides insight
into the difficulty of maintaining cooperation. Many times in life, people fail to cooperate with
one another even when cooperation would make them all better off. An oligopoly is just one
example. The story of the prisoners’ dilemma contains a general lesson that applies to any group
trying to maintain cooperation among its members.

The prisoners’ dilemma is a story about two criminals who have been captured by the police.
Let’s call them Bonnie and Clyde. The police have enough evidence to convict Bonnie and
Clyde of the minor crime of carrying an unregistered gun, so that each would spend a year in jail.
The police also suspect that the two criminals have committed a bank robbery together, but they
lack hard evidence to convict them of this major crime. The police question Bonnie and Clyde in
separate rooms, and they offer each of them the following deal:

―Right now, we can lock you up for 1 year. If you confess to the bank robbery and implicate
your partner, however, we’ll give you immunity and you can go free.

Page 78
Harambee University College Microeconomics Theory II Department of Economics

Your partner will get 20 years in jail. But if you both confess to the crime, wewon’t need your
testimony and we can avoid the cost of a trial, so you will eachget an intermediate sentence of 8
years.‖

If Bonnie and Clyde, heartless bank robbers that they are, care only about their own sentences,
what would you expect them to do? Would they confess or remain silent? Figure 16-2 shows
their choices. Each prisoner has two strategies: confess or remain silent. The sentence each
prisoner gets depends on the strategy he or she chooses and the strategy chosen by his or her
partner in crime.

Consider first Bonnie’s decision. She reasons as follows: ―I don’t know what Clyde is going to
do. If he remains silent, my best strategy is to confess, since then I’ll go free rather than spending
a year in jail. If he confesses, my best strategy is still to confess, since then I’ll spend 8 years in
jail rather than 20. So, regardless of what Clyde does, I am better off confessing.‖

Fig. 3.4.1 the prisoners’ dialemma. In this game between two criminals suspected of committing
a crime, the sentence that each receives depends both on his or her decision whether to confess or
remain silent and on the decision made by the other.

The best strategy for a player to follow regardless of the strategies pursued by other players. In
this case, confessing is a dominant strategy for Bonnie. She spends less time in jail if she
confesses, regardless of whether Clyde confesses or remains silent.

Page 79
Harambee University College Microeconomics Theory II Department of Economics

Now consider Clyde’s decision. He faces exactly the same choices as Bonnie, and he reasons in
much the same way. Regardless of what Bonnie does, Clyde can reduce his time in jail by
confessing. In other words, confessing is also a dominant strategy for Clyde.

In the end, both Bonnie and Clyde confess, and both spend 8 years in jail. Yet, from their
standpoint, this is a terrible outcome. If they had both remained silent, both of them would have
been better off, spending only 1 year in jail on the gun charge. By each pursuing his or her own
interests, the two prisoners together reach an outcome that is worse for each of them.

Oligopolies as a Prisoners’ Dilemma

What does the prisoners’ dilemma have to do with markets and imperfect competition? It turns
out that the game oligopolists play in trying to reach the monopoly outcome is similar to the
game that the two prisoners play in the prisoners’ dilemma.

Consider an oligopoly with two members, called Iran and Iraq. Both countries sell crude oil.
After prolonged negotiation, the countries agree to keep oil production low in order to keep the
world price of oil high. After they agree on production levels, each country must decide whether
to cooperate and live up to this agreement or to ignore it and produce at a higher level.

Suppose you are the president of Iraq. You might reason as follows: ―I could keep production
low as we agreed, or I could raise my production and sell more oil on world markets. If Iran lives
up to the agreement and keeps its production low, then my country earns profit of $60 billion
with high production and $50 billion with low production. In this case, Iraq is better off with
high production. If Iran fails to live up to the agreement and produces at a high level, then my
country earns $40 billion with high production and $30 billion with low production. Once again,
Iraq is better off with high production. So, regardless of what Iran chooses to do, my country is
better off reneging on our agreement and producing at a high level.‖

Producing at a high level is a dominant strategy for Iraq. Of course, Iran reasons in exactly the
same way, and so both countries produce at a high level.
The result is the inferior outcome (from Iran and Iraq’s standpoint) with low profits for each
country.

Page 80
Harambee University College Microeconomics Theory II Department of Economics

This example illustrates why oligopolies have trouble maintaining monopoly profits. The
monopoly outcome is jointly rational for the oligopoly, but each oligopolist has an incentive to
cheat. Just as self-interest drives the prisoners in the prisoners’ dilemma to confess, self-interest
makes it difficult for the oligopoly to maintain the cooperative outcome with low production,
high prices, and monopoly profits.

Other Examples of the Prisoners’ Dilemma

We have seen how the prisoners’ dilemma can be used to understand the problem facing
oligopolies. The same logic applies to many other situations as well. Here we consider three
examples in which self-interest prevents cooperation and leads to an inferior outcome for the
parties involved.

Arms Races: An arms race is much like the prisoners’ dilemma. To see this, consider the
decisions of two countries—the United States and the Soviet Union— about whether to build
new weapons or to disarm. Each country prefers to have more arms than the other because a
larger arsenal gives it more influence in world affairs. But each country also prefers to live in a
world safe from the other country’s weapons.

Fig. 3.4.2 shows the deadly game. If the Soviet Union chooses to arm, the United States is better
off doing the same to prevent the loss of power. If the Soviet Union chooses to disarm, the
United States is better off arming because doing so would make it more powerful. For each
country, arming is a dominant strategy. Thus, each country chooses to continue the arms race,
resulting in the inferior outcome in which both countries are at risk.

Fig. 3.4.2

Page 81
Harambee University College Microeconomics Theory II Department of Economics

Throughout the era of the Cold War, the United States and the Soviet Union attempted to solve
this problem through negotiation and agreements over arms control. The problems that the two
countries faced were similar to those that oligopolists encounter in trying to maintain a cartel.
Just as oligopolists argue over production levels, the United States and the Soviet Union argued
over the amount of arms that each country would be allowed. And just as cartels have trouble
enforcing production levels, the United States and the Soviet Union each feared that the other
country would cheat on any agreement. In both arms races and oligopolies, the relentless logic of
self-interest drives the participants toward a non-cooperative outcome that is worse for each
party.

Advertising: When two firms advertise to attract the same customers, they face a problem
similar to the prisoners’ dilemma. For example, consider the decisions facing two cigarette
companies, Marlboro and Camel. If neither company advertises, the two companies split the
market. If both advertise, they again split the market, but profits are lower, since each company
must bear the cost of advertising. Yet if one company advertises while the other does not, the one
that advertises attracts customers from the other.

Figure 3.4.3 shows how the profits of the two companies depend on their actions. You can see
that advertising is a dominant strategy for each firm. Thus, both firms choose to advertise, even
though both firms would be better off if neither firm advertised.

Common Resources: Imagine that two oil companies—Exxon and Arco—own adjacent oil
fields. Under the fields is a common pool of oil worth $12 million.

Page 82
Harambee University College Microeconomics Theory II Department of Economics

Drilling a well to recover the oil costs $1 million. If each company drills one well, each will get
half of the oil and earn a $5 million profit ($6 million in revenue minus $1 million in costs).

Because the pool of oil is a common resource, the companies will not use it efficiently. Suppose
that either company could drill a second well. If one company has two of the three wells, that
company gets two-thirds of the oil, which yields a profit of $6 million. Yet if each company
drills a second well, the two companies again split the oil. In this case, each bears the cost of a
second well, so profit is only $4 million for each company.

Figure 3.4.4 shows the game. Drilling two wells is a dominant strategy for each company. Once
again, the self-interest of the two players leads them to an inferior outcome.

1.2 Mixed Strategies Nash Equilibrium

A mixed strategy is an active randomization, with given probabilities that determine the player’s
decision. As a special case, a mixed strategy can be the deterministic choice of one of the given
pure strategies.A mixed strategy is a probability distribution over the set of actions.

A game in strategic form does not always have a Nash equilibrium in which each player
deterministically chooses one of his strategies. However, players may instead randomly select
from among these pure strategies with certain probabilities. Randomizing one’s own choice in
this way is called a mixed strategy. Nash showed in 1951 that any finite strategic-form game has
an equilibrium if mixed strategies are allowed.

Page 83
Harambee University College Microeconomics Theory II Department of Economics

As before, an equilibrium is defined by a (possibly mixed) strategy for each player where no
player can gain on average by unilateral deviation. Average (that is, expected) payoffs must be
considered because the outcome of the game may be random.

In repeated games, some game G is played multiple times by the same set of agents
 G is called the stage game
 Each occurrence of G is called an iteration or a round
 Usually each agent knows what all the agents did in the previous iterations, but
not what they’re doing in the current iteration
Although there is no Nash equilibrium in pure strategies, there is a Nash equilibrium in mixed
strategies. A mixed strategy is a strategy in which the player nukes a random choice among two
or more possible actions, based on a set of chosen probabilities.

Table 3.5.1
In this game, for example. Player A might simply flip the coin, thereby playing heads with
probability '1'2 and playing tails with probability 1 /2. In fact, if Player A follows this strategy
and Player B does the same, we will have a Nash equilibrium; both players will be doing the best
they can given what the opponent is doing. Note that the outcome of the game is random, but the
expected payoff is 0 for each player.

It may seem strange to play a game by choosing actions randomly But put yourself in the
position of Player A and think what would happen if you followed a strategy other than just
flipping the coin. Suppose, for example, you decided to play heads. If Player B knows this, she
would play tails, and you would lose. Even if Player B didn't know your strategy, if the game
were played over and over again, she could eventually discern your pattern of play and choose a
strategy that countered it.

Page 84
Harambee University College Microeconomics Theory II Department of Economics

Of course, you would then want to change your strategy-which is why this would not be a Nash
equilibrium. Only if you and your opponent both choose heads or tails randomly with Probability
V2, would neither of you have any incentive to change strategies.

One reason to consider mixed strategies is that some games (such as "MatchingPennies") do not
have any Nash equilibria in pure strategies. It can beshown, however, that every game has at
least one Nash equilibrium, once weallow for mixed strategies. Hence, mixed strategies provide
solutions to gameswhen pure strategies fail. Of course, whether solutions involving mixed
strategiesare reasonable will depend on the particular game and players. Mixedstrategies are
likely to be very reasonable for "Matching Pennies," poker, andother such games. A firm, on the
other hand, might not find it reasonable tobelieve that its competitor will set its price randomly.

Some games have Nash equilibria both in pure strategies and in mixed strategies. An example is
"The Battle of the Sexes," a game that you might find familiar.

Table 3.5.2 the Battle of Sexes

It goes like this. Jim and Joan would like to spend Saturday night together, but have different
tastes in entertainment. Joan would like to go to the opera, but Jim prefers mud wrestling. (Feel
free to reverse these preferences.)
As the payoff matrix in Table 3.5.2 shows, Joan would most prefer to go to the opera with Jim,
but prefers watching mud wrestling with Jim to going to the opera alone, and similarly for Jim.

First, note that there are two Nash equilibria in pure strategies for this game the one in which Jim
and Joan both watch mud wrestling, and the one in which they both go to the opera. Jim, of
course, would prefer the first of these outconies and Joan the second, but both outcomes are
equilibria-neither Jim nor Joan would want to change his or her decision, given the decision of
the other.

Page 85
Harambee University College Microeconomics Theory II Department of Economics

This game also has an equilibrium in mixed strategies: Jim chooses wrestling; with probability
2/3 and opera with probability 1/3, and Joan chooses wrestling with probability 1/3 and opera
with probability 2/3. You can check that if Joan uses this strategy, Jim cannot do better with any
other strategy; and vice versa. The outcome is random, and Jim and Joan will each have an
expected payoff of 2/3.

Should we expect Jim and Joan to use these mixed strategies? Unless they're very risk loving or
in some other way a strange couple, probably not. By agreeing; to either form of entertainment,
each will have a payoff of at least 1, which exceeds the expected payoff of 2/3 from
randomizing. 1n this game as in many others, mixed strategies provide another solution, but not a
very realistic one. Hence for the remainder of this chapter we will focus on pure strategies.

1.3 Repeated Game

Used by game theorists, economists, social and behavioral scientists as highly simplified models
of various real-world situations.
Repeated games allow players to condition their actions on the way their opponents behave in
previous periods.
 No solution?
 You should try to be unpredictable
 Choose randomly

How does repetition change the likely outcome of the game? Suppose you are Firm 1 in the
Prisoners' Dilemma illustrated by the payoff matrix in Table 3.6.2.

Table 3.6.2 pricing problem

If you and your competitor both charge a high price, you will both make a higher profit than if
you both charged a low price.

Page 86
Harambee University College Microeconomics Theory II Department of Economics

However, you are afraid to charge a high price because if your competitor charges a low price,
you will lose money and, to add insult to injury, your competitor will get rich. But suppose this
game is repeated over and over again-for example, you and your competitor simultaneously
announce your prices on the first day of every month. Should you then play the game differently,
perhaps changing your price over time in response to your competitor's behavior?

In an interesting study, Robert Axelrod asked game theorists to come up with the best strategy
they could think of to play this game in a repeated manner. (A possible strategy might be: "I'll
start off with a high price, then lower my price, but then if my competitor lowers its price, I’ll
raise mine for a while before lowering it again, etc.") Then, in a computer simulation, Axelrod
played these strategies off against one another to see which worked best.

As you would expect, any given strategy would work better against some strategies than it would
against others. The objective, however, was to find the strategy that was most robust, i.e., would
work best on average against all, or almost all, other strategies- The result was surprising. The
strategy that worked best was extremely simple-it was a "tit-for-tat" strategy: I start out with a
high price, which I maintain so long as you continue to "cooperate" and also charge a high price.
As soon as you lower your price, however, I follow suit and lower mine. If you later decide to
cooperate and raise your price again, I’ll immediately raise my price as well.

Why does this tit-for-tat strategy work best? In particular, can I expect that using the tit-for-tat
strategy will induce my competitor to behave cooperatively (and charge a high price)?

Suppose the game is infinitely repeated. In other words, my competitor and I repeatedly set price
month after month, forever. Cooperative behavior (i.e., charging a high price) is then the rational
response to a tit-for-tat strategy. (This assumes that my competitor knows, or can figure out, that
I am using a tit-for tat strategy.) To see why, suppose that in one month my competitor sets a low
price and undercuts me. In that month it will make a large profit. But the competitor knows that
the following month I will set a low price, so that its profit will fall, and will remain low as long
as we both continue to charge a low price. Since the game is infinitely repeated, the cumulative
loss of profits that results must outweigh any short-term gain that accrued during the first month
of undercutting. Thus, it is not rational to undercut.

Page 87
Harambee University College Microeconomics Theory II Department of Economics

I’11 fact, with an infinitely repeated game, my competitor does not even have to be sure that I
am playing tit-for-tat to make cooperation the rational strategy for it to follow. Even if the
competitor believes there is only some chance that I am playing tit-for-tat, it will still be rational
for it to start by charging a high price, and maintain the high price as long as I do. The reason is
that with infinite repetition of the game, the expected gains from cooperation will outweigh those
from undercutting. This will be true even if the probability that I am playing tit-for-tat (and so
will continue cooperating) is small.

Now suppose the game is repeated a finite number of times-say N months. (N can be large as
long as it is finite.) If my competitor (Firm 2) is rational, and believes that I am rational, it would
reason as follows: "Because Firm 1 is playing tit-for-tat, I (Firm 2) cannot undercut-that is, until
the last month. I should undercut in the last month because then I can make a large profit that
month, and afterwards the game is over, so that Firm 1 cannot retaliate. Therefore," figures Firm
2,"I will charge a high price until the last month, and then I will charge a low price."

However, since I (Firm 1) have also figured this out, I also plan to charge a low price in the last
month. Of course. Firm 2 can figure this out as well, and therefore knows I will charge a low
price in the last month. But then what about the next-to-last month? Firm 2 figures that it should
undercut and charge a low price in the next-to-last month, because there will be no cooperation
anyway in the last month. But, of course, I have figured this out too, so I also plan to charge a
low price in the next-to-last month. And because the same reasoning applies to each preceding
month, the only rational outcome is for both of us to charge a low price every month.

Since most of us do not expect to live forever, the tit-for-tat strategy seems of little value; once
again we are stuck in the Prisoners' Dilemma without a way out. However, there is a way out if
my competitor as even a slight doubt about my "rationality."

Suppose my competitor thinks (it need not be certain) that I am playing tit-for-tat. It also thinks
that perhaps I am playing tit-for-tat "blindly," or with limited rationality, in the sense that I have
failed to work out the logical implications of a finite time horizon as discussed above.

Page 88
Harambee University College Microeconomics Theory II Department of Economics

My competitor thinks, for example, that perhaps I have not figured out that it will undercut me in
the last month, so that I should also charge a low price in the last month, so that it should charge
a low price in the next-to-last month, and so on. "Perhaps," thinks my competitor, "Firm 1 will
play tit-for-tat blindly, charging a high price as long as I charge a high price." Then (if the time
horizon is long enough), it is rational for my competitor to maintain a high price until the last
month (when it will undercut me).

Note that we have stressed the word "perhaps." My competitor need not be sure that I am playing
tit-for-tat "blindly," .or even that I am playing tit-for tat at all. Just the possibility of this can
make cooperative behavior a good strategy (until near the end) if the time horizon is long
enough. Although my competitor's conjecture about how I am playing the game might be wrong,
cooperative behavior is profitable in expected value terms. With a long time horizon, the sum of
current and future profits, weighted by the probability that the conjecture is correct, can exceed
the sum of profits from warfare, even if the competitor is the first to undercut.

Most managers don't know how long they and their firms will be competing with their rivals, and
this also serves to make cooperative behavior a good strategy. Although the number of months
that the firms compete is probably finite, managers are unlikely to know just what that number is.
As a result, the unravelling argument that begins with a clear expectation of undercutting in the
last month no longer applies. As with an infinitely repeated game, it will be rational to play tit-
for-tat.

Thus, in a repeated game, the Prisoners' Dilemma can have a cooperative outcome. In most
markets the game is, in fact, repeated over a long and uncertain length of time, and managers
have doubts about how "perfectly rationally" they and their competitors operate. As a result, in
some industries, particularly those in which only a few firms compete over a long period under
stable demand and cost conditions, cooperation prevails, even though no contractual
arrangements are made. (The water meter industry, discussed below, is an example of this.) In
many other industries, however, there is little or no cooperative behavior.

Sometimes cooperation breaks down or never begins because there are too many firms. More
often, the failure to cooperate is the result of rapidly shifting demand or cost conditions.
Page 89
Harambee University College Microeconomics Theory II Department of Economics

Uncertainties about demand or costs make it difficult for the firms in the industry to reach an
implicit understanding of what cooperation should entail. (Remember that an explicit
understanding, arrived at through meetings and discussions, could lead to an antitrust
conviction.) Suppose, for example, that cost differences or different beliefs about demand lead
one firm to conclude that cooperation means charging $50, but lead a second firm to think it
means charging $ 40. If the second firm charges $40, the first firm might view that as a grab for
market share and respond in tit-for-tat fashion with a $35 price. A price war could then develop.

3.7 Sequential Game

As we have seen in most of the games that we have discussed so far, both players move at the
same time and it is known as simultaneous game. In this section, we are going to consider a case
where on player move first and the other player play its strategy after observing the strategy
played by its opponent. Such type of game is called sequential game. An example of such type
of game includes the stacklederg model of oligopoly who noted-one firm (the leader) first set its
output before the other does; an advertising decision by one firm and the response of its
competitor; entry-deterring investment by an incumbent firm and the decision whether to enter
the market by a potential competitor; or a new government regulatory policy and the investment
and output response of the regulated firm. Is there any difference in the equilibrium outcome of
sequential game? We will try to give answer to such type of question in this section.

Consider a game given in table 3.7.1. in the first round, player A has a strategy to move top or
bottom. Player B after observing the optimal strategy plays a strategy left or right. The return to
each combination of strategies chosen as summarized in table 3.7.1.

Player B
Left Right
Player A Top (1, 9) (1, 9)
Bottom (0, 0) (2, 1)
table 3.7.1 the payoff matrix of a sequential game

Page 90
Harambee University College Microeconomics Theory II Department of Economics

When the game is present using a payoff matrix, it has two Nash equilibira (top, left) and
(bottom, right). However, we will show below that one of this equilibrium is not reasonable
equilibrium. The payoff matrix hides the fact that one player gets to know what the other player
has chosen before she makes her choice. As a result sequential games are easier to visualize if we
present the possible move in the form of decision tree. Such representation of a game is called
extensive form of a game. It shows how player sequential play the game one after the other. The
above game, therefore should be present is the extensive form as in figure 3.7.1 to easily identify
the equilibrium of the game.
Left – (1, 9)

Top -Player B
Right – (1, 9)
Player-A
Left – (0, 0)
Bottom –Player A

Right – (2, 1)
Figure 3.7.1 a game in extensive form

In this game, first player-A has to choose from strategy top or bottom, and player-B after
detecting the strategy chosen by player-A, choose a strategy left or right. With this basic rule of
the game, the equilibrium of the game can be determined by playing the game backward starting
from the player, which moves second. Suppose that player-A has already made her choice and
we are identify the branch that corresponds to A’s choice. For example if player-A chosen top,
then it does not matter what player B does, the payoff faced by the player is (1, 9). If player-A
choice to play bottom, then the reasonable choice for player-B I to choose right and the payoff
corresponds to the indicated combination of strategy is (2, 1).

Now think about player A’s initial choice. If she choose top, the outcome will be (1, 9) and thus
she will get a payoff of 1. But if she chooses bottom, she gets a payoff 2. So the reasonable thing
for her is to choose bottom. Thus the equilibrium outcome of the game will be (bottom, right), so
that the payoff to player A will be 2 and to player B will be 1.

Page 91
Harambee University College Microeconomics Theory II Department of Economics

The strategies (top, left) are not a reasonable equilibrium in this sequential game. That is they are
not an equilibrium given the order in which the players actually get to make their choices. It is
true that if player-A choose top, player-B could choose left but it would be silly for player-A to
ever choose top.

For plaer B’s point of view this is rather unfortunate, since she ends up with a payoff of 1 rather
than 9. What might she do about it? She can threaten to, for example, to play left if player A
plays bottom. If player B would actually carry out this threat, she would be well advised to play
top. For top gives her 1, while bottom-if player B carries out her threat will only give her 0.

Summary
A game is cooperative if the players can communicate and arrange binding contracts; otherwise
it is non-cooperative. In either kind of game, the most important aspect of strategy design is
understanding your opponent's position, and (if your opponent is rational) correctly deducing the
likely response to your actions. Misjudging an opponents position is a common mistake.

A Nash equilibrium is a set of strategies such that each player is doing the best it can, given the
strategies of the other players. An equilibrium in dominant strategies is a special case of a Nash
equilibrium; a dominant strategy is optimal no matter what the other players do. A Nash
equilibrium relies on the rationality of each player. A maximin strategy is more conservative
because it maximizes the minimum possible outcome.

Some games have no Nash equilibria in pure strategies, but have one or more equilibria in mixed
strategies. A mixed strategy is one in which the player makes a random choice among two or
more possible actions, based on a set of chosen probabilities.

Strategies that are not optimal for a one-shot game may be optimal for a repeated game.
Depending on the number of repetitions, a "tit-for-tat" strategy, in which one plays cooperatively
as long as one's competitor does the same, may be optimal for the repeated Prisoners' Dilemma.

Page 92
Harambee University College Microeconomics Theory II Department of Economics

In a sequential game, the players move in turn. In some cases, the player who moves first has an
advantage. Players may then have an incentive to try to precommit themselves to particular
actions before their competitors can do the same.

Model Examination Question

1. What is game? And what is game theory

2. What is the difference between a cooperativeand a non-cooperative game? Give an
example ofeach.
3. What is a dominant strategy?
4. Explain the meaning of a Nash equilibrium.How does it differ from an equilibrium in
dominantstrategies?
5. What is a "tit-for-tat" strategy?why is it a rational strategy for the infinitely repeated
Prisoners'Dilemma?
6. Consider a game in which the Prisoners'Dilemma is repeated 10 times, and both players
are rational and fully informed. Is a tit-for-tat strategy optimal in this case? Under what
conditions wouldsuch a strategy be optimal?
7. In many oligopolistic industries, the same firms compete over a long period of time,
setting prices and observing each other's behavior repeatedly. Given that the number of
repetitions is large, whydon't collusive outcomes typically result?
8. Two firms are in the chocolate market. Each canchoose to go for the high end of the
market (high quality) or the low end (low quality). Resulting profits are given by the
following payoff matrix:

What outcomes, if any, are Nash equilibria?

Page 93
Harambee University College Microeconomics Theory II Department of Economics

Answers
7. If games are repeated indefinitely and all players know all payoffs, rational behavior will lead
to apparently collusive outcomes. But, sometimes the payoffs of other firms can only be
known by engaging in extensive information exchanges. Perhaps the greatest problem to
maintaining a collusive outcome is exogenous changes in demand and in the prices of inputs.
When new information is not available to all players simultaneously, a rational reaction by
one firm could be interpreted as a threat by another firm.
8. There are two Nash equilibria, (100,800) and (900, 600)

Page 94
Harambee University College Microeconomics Theory II Department of Economics

References

1. Robert S.Pindyck and Daniel L.Rubinfeld; Microeconomics 3rd edition, Copyright ©1995
by Prentice-Hall, Inc.
2. Thomas J. Webster; Managerial economics, theory and practice, Copyright © 2003,
Elsevier (USA).
3. Nick Wilkinson (2005); Managerial economics, a problem solving approach. Cambridge
University Press
4. Trefor Jones (2005); Business Economics and Managerial Decision Making, Manchester
School of Management.
5. Dominick Salvatore and Eugene A. DiulioPrinciples of Economics (Second Edition),
Copyright © 2003 by The McGraw-Hill Companies.

Page 95