Topic 1: Cournot and Stackelberg CompetitionXxxxx
MODEL 1: COURNOT DUOPOLY AND STACKELBERG DUOPOLY
Model Characteristics
Basic model of firm level competition in an abstract market
➔ There is a duopoly
◆ However, we know in real life there are typically more than two firms serving the market
➔ Firms have one strategic variable (output choice)
➔ There is one market
➔ Game is played once
◆ Firms compete with each other just once and make their production decisions simultaneously
Oligopoly Assumptions
● A few firms dominate the industry
● Thus each oligopolist has market power → can influence market conditions faced by all rival firms
● Significant barriers to entry due to unrecoverable costs
Cournot Competition
Cournot Assumptions
● Each firm sets its output
● Market sets the price
● Firms produce homogeneous products
● Firms face identical costs
➔ There is strategic interdependence between firms → the behavior of one firm is dependant on the
behavior of other firms
◆ Creates a problem: what is the optimal level of output for firms? This decision is dependant on
the output levels of rival firms
◆ Solution: game theory
➔ It is at the intersection of both firms’ reaction functions
◆ Firm 1’s choice is optimal given firm 2’s
response to that choice
◆ Firm 2’s choice is optimal given firm 1’s
response to that choice
◆ This is known as Nash equilibrium - each
player’s choice is optimal given the responses
to that choice by the other firms in the market
1
,Stackelberg Competition
Stackelberg Equilibrium
Stackleberg competition is similar to Cournot competition in that they both agree that firms compete over
output, however unlike Cournot competition which assumes that firms choose their output simultaneously, in
Stackelberg competition output is assumed to be chosen sequentially, with the first firm to bring its goods
and services to the market being the one to experience first-mover advantage
First-mover Advantage
Advantages to the leading firm:
1. Positive reputation through the asymmetry created in the marketplace
a. A positive reputation contributes to building a positive brand for the firm, which, despite not
being recorded on the balance sheet, is a strong asset
2. Larger market share
3. Higher profits than its rivals
a. First-movers may benefit from economies of scale as they face a larger learning curve which in
turn forces them to develop more cost-efficient processes and means of production prior to
competing with rivals
Strategy
● When setting their strategy, rival firms must regard the first-mover’s strategy as fixed for the time period
that their strategy is to be set. This is because investment is non-recoverable, for instance
investments in productive capacity
● Therefore, there is a restriction of strategic flexibility for the first mover - rival firms understand that
the first mover will not respond (optimally or otherwise) to their strategic choices
Campbell vs Heinz
● Both companies sell premade soups at a low cost
● Campbell had a first-mover advantage in the US whereas Heinz had a first-mover advantage in
the UK for being the first entrants in these geographic markets. That is why Campbell is inferior in the
UK to Heinz, and Heinz is inferior to Campbell in the US
● Campbell established itself in the US by making use of heavy magazine advertising combined with
a low-price policy, also acquiring its main rival Franco-American in 1921 and reaching a market
share of over 80%
● “Its biggest competitor thereafter was Heinz which sought to establish a position on the basis of
heavy advertising linked with promotional deals and an unusually widespread and expensive
sales network. However, despite its efforts Heinz failed to significantly erode Campbell’s market
share”
2
, ● However, Heinz did experience first-mover advantages in the UK in the 1930s by establishing an
initial lead in the canned soup market there
Coca-Cola vs Pepsi
● Both companies dominate the soft drinks market globally
● Honing in on the European market specifically, there has been a prolonged asymmetry in market
share between these rivals in the cola market. The asymmetry derives from an initiative taken by
Coca-Cola during WWII where the company pledged to put a coke in the hand of every American
serviceman overseas. Together with the small size of the European market, the asymmetry
disincentivized Pepsi to mount an expensive advertising campaign in that market
3
, Topic 2: Tacit Collusion in Oligopoly and Repeated GamesXxx
MODEL 2: COLLUSION
Model Characteristics
Adaption of the basic model, wherein firms may choose to collude
➔ There is a duopoly
◆ However, we know in real life there are typically more than two firms serving the market
➔ Firms have one strategic variable (output choice)
➔ There is one market
➔ Game is repeatedly played
◆ So far in our discussions of oligopoly, we have modelled output-setting as a one-off event.
However, if we permit the output-setting game to be played over and over again, we do not
necessarily get the same equilibrium behavior as we have in the one-shot game
◆ More specifically, if all firms know that the same game will be indefinitely repeated, all may
be able to achieve higher profits than are achieved in the Cournot Nash Equilibrium
described previously
Infinitely Repeated Output-Setting
Tacit Collusion — when firms choose actions that are likely to minimize the response from another firm
without there being a formal, binding agreement
Softening of Competition
● Tacit collusion in the repeated output-setting game allows firms to achieve a softening of competition
○ This means that a lower level of output is set compared to the Cournot Nash Equilibrium,
which results in a higher price compared to the Cournot Nash Equilibrium and higher profits
■ So effectively they kind of achieve a monopoly outcome
● Firms achieve this by punishing rivals who choose to act in a strongly competitive manner
○ We assume the type of strategy to be a grim strategy. This is where if rival firm B cheats on
firm A, then the next time and every time thereafter that the two firms meet, firm A will act
aggressively towards firm B
○ Once there is defection in the model, there is no going back to collusion
○ We do not assume firms to use another punishment strategy other than the grim strategy
Hence, we observe two additional features of the repeated model that emerge….
Additional Features of the Model
1. Contingency
4
MODEL 1: COURNOT DUOPOLY AND STACKELBERG DUOPOLY
Model Characteristics
Basic model of firm level competition in an abstract market
➔ There is a duopoly
◆ However, we know in real life there are typically more than two firms serving the market
➔ Firms have one strategic variable (output choice)
➔ There is one market
➔ Game is played once
◆ Firms compete with each other just once and make their production decisions simultaneously
Oligopoly Assumptions
● A few firms dominate the industry
● Thus each oligopolist has market power → can influence market conditions faced by all rival firms
● Significant barriers to entry due to unrecoverable costs
Cournot Competition
Cournot Assumptions
● Each firm sets its output
● Market sets the price
● Firms produce homogeneous products
● Firms face identical costs
➔ There is strategic interdependence between firms → the behavior of one firm is dependant on the
behavior of other firms
◆ Creates a problem: what is the optimal level of output for firms? This decision is dependant on
the output levels of rival firms
◆ Solution: game theory
➔ It is at the intersection of both firms’ reaction functions
◆ Firm 1’s choice is optimal given firm 2’s
response to that choice
◆ Firm 2’s choice is optimal given firm 1’s
response to that choice
◆ This is known as Nash equilibrium - each
player’s choice is optimal given the responses
to that choice by the other firms in the market
1
,Stackelberg Competition
Stackelberg Equilibrium
Stackleberg competition is similar to Cournot competition in that they both agree that firms compete over
output, however unlike Cournot competition which assumes that firms choose their output simultaneously, in
Stackelberg competition output is assumed to be chosen sequentially, with the first firm to bring its goods
and services to the market being the one to experience first-mover advantage
First-mover Advantage
Advantages to the leading firm:
1. Positive reputation through the asymmetry created in the marketplace
a. A positive reputation contributes to building a positive brand for the firm, which, despite not
being recorded on the balance sheet, is a strong asset
2. Larger market share
3. Higher profits than its rivals
a. First-movers may benefit from economies of scale as they face a larger learning curve which in
turn forces them to develop more cost-efficient processes and means of production prior to
competing with rivals
Strategy
● When setting their strategy, rival firms must regard the first-mover’s strategy as fixed for the time period
that their strategy is to be set. This is because investment is non-recoverable, for instance
investments in productive capacity
● Therefore, there is a restriction of strategic flexibility for the first mover - rival firms understand that
the first mover will not respond (optimally or otherwise) to their strategic choices
Campbell vs Heinz
● Both companies sell premade soups at a low cost
● Campbell had a first-mover advantage in the US whereas Heinz had a first-mover advantage in
the UK for being the first entrants in these geographic markets. That is why Campbell is inferior in the
UK to Heinz, and Heinz is inferior to Campbell in the US
● Campbell established itself in the US by making use of heavy magazine advertising combined with
a low-price policy, also acquiring its main rival Franco-American in 1921 and reaching a market
share of over 80%
● “Its biggest competitor thereafter was Heinz which sought to establish a position on the basis of
heavy advertising linked with promotional deals and an unusually widespread and expensive
sales network. However, despite its efforts Heinz failed to significantly erode Campbell’s market
share”
2
, ● However, Heinz did experience first-mover advantages in the UK in the 1930s by establishing an
initial lead in the canned soup market there
Coca-Cola vs Pepsi
● Both companies dominate the soft drinks market globally
● Honing in on the European market specifically, there has been a prolonged asymmetry in market
share between these rivals in the cola market. The asymmetry derives from an initiative taken by
Coca-Cola during WWII where the company pledged to put a coke in the hand of every American
serviceman overseas. Together with the small size of the European market, the asymmetry
disincentivized Pepsi to mount an expensive advertising campaign in that market
3
, Topic 2: Tacit Collusion in Oligopoly and Repeated GamesXxx
MODEL 2: COLLUSION
Model Characteristics
Adaption of the basic model, wherein firms may choose to collude
➔ There is a duopoly
◆ However, we know in real life there are typically more than two firms serving the market
➔ Firms have one strategic variable (output choice)
➔ There is one market
➔ Game is repeatedly played
◆ So far in our discussions of oligopoly, we have modelled output-setting as a one-off event.
However, if we permit the output-setting game to be played over and over again, we do not
necessarily get the same equilibrium behavior as we have in the one-shot game
◆ More specifically, if all firms know that the same game will be indefinitely repeated, all may
be able to achieve higher profits than are achieved in the Cournot Nash Equilibrium
described previously
Infinitely Repeated Output-Setting
Tacit Collusion — when firms choose actions that are likely to minimize the response from another firm
without there being a formal, binding agreement
Softening of Competition
● Tacit collusion in the repeated output-setting game allows firms to achieve a softening of competition
○ This means that a lower level of output is set compared to the Cournot Nash Equilibrium,
which results in a higher price compared to the Cournot Nash Equilibrium and higher profits
■ So effectively they kind of achieve a monopoly outcome
● Firms achieve this by punishing rivals who choose to act in a strongly competitive manner
○ We assume the type of strategy to be a grim strategy. This is where if rival firm B cheats on
firm A, then the next time and every time thereafter that the two firms meet, firm A will act
aggressively towards firm B
○ Once there is defection in the model, there is no going back to collusion
○ We do not assume firms to use another punishment strategy other than the grim strategy
Hence, we observe two additional features of the repeated model that emerge….
Additional Features of the Model
1. Contingency
4
