(B) Oligopoly Theory

The main solution concept for this course is game

theory; We will apply it a lot.
Plan
1. Cournot
2. Bertrand
3. A Simple Auction Game
4. Multi-Stage (Period) Games
5. Stackelberg
6. Collusion, innitely repeated games
7. Sequential Bargaining
Duopoly Models
Assumptions
1. Two rms with constant marginal cost c
2. Identical products
3. Inverse market demand
1(Q) = o bQ
Q = q
1
+ q
2
Consider two strategy spaces: quantity and price
(i) Quantity: Cournot Equilibrium
(ii) Price: Bertrand Equilibrium
1. Cournot Equilibrium: (Cournot NE)
1. (a) Pure strategy: q
1
for rm 1, q
2
for rm 2.
(b) Payos:

i
= [o b(q
1
+ q
2
) c] q
i
for i = 1, 2
How to nd a NE?
FOC
0
1
0q
1
= o 2bq
1
bq
2
c = 0
or expressed as a reaction function
q
1
1
(q
2
) =
o c bq
2
2b
Similarly for rm 2
q
1
2
(q
1
) =
o c bq
1
2b
Two equations in two unknowns q
1
= q
2
=
oc
3b
Result: Cournot NE
q
1
= q
2
=
o c
3b
Illustration using reaction functions
(a-c)/2b
q
2
C-N
q
2
(a-c)/3b
(a-c)/3b (a-c)/2b
q
1
R
q
2
R
M
. rm Cournot Model
Payo

i
= [o b(q
1
+ . . . + q
.
) c] q
i
for i = 1, 2, . . . , .
How to solve for the reaction functions?
FOC
0
1
0q
1
= o b(q
1
+ . . . + q
.
) bq
1
c = 0
reaction function
q
1
i
=
o c b

),=i
q
)
2b
Suppose a symmetric solution exists:
q
1
= q
2
= . . . = q
.
Result: Cournot Equilibrium
q
+
i
=
o c
b(. + 1)
Comments
1. SOC satised
2. Q =
oc
b

.
.+1
and 1 =
o+.c
.+1
3. As . o, 1 c
converge to competitive equilibrium
3. Bertrand equilibrium
an alternative strategy space
(a) Pure strategy: j
1
0 for rm 1, j
2
0 for rm
2
(b) Payos: Consider the demand curve
Pi
P
Q
D
Pj
If 1
)
< 1
i
, then rm ) gets all demand
If 1
)
= 1
i
, then each rm gets half the customers. (a
convention)
Notice: Payos are discontinuous
because rm specic demand is discontinuous
Implication: Cannot use the rst order condition
NE?
Result: Unique Bertrand Equilibrium
1
1
= 1
2
= c
How to show this?
1. At 1
1
= 1
2
= c
consider a deviation, no rm benets from de-
viating
2. 1
i
c, 1
)
= c cannot be a NE
Firm ) could increase it's price and make pos-
itive prot.
3. 1
1
, 1
2
c cannot be a NE
If 1
i
1
)
, then rm i can protably "under-
cut".
Comments
1. 1 = c is the unique symmetric NE for any
. 2
2. 1 = c seems extreme
Note: Most products are dierentiated
3. Constant marginal cost is extreme
with increasing marginal costs, Bertrand out-
come is closer to Cournot
Indeed: With capacity constraints the two out-
comes may coincide (Kreps and Scheinkman)
4. A Simple Auction Game
(due to Hendricks and Porter)
OCS auctions: Bidding for drilling rights
One rm has prior experience: better informed
Illustration of mixed strategies:
Shall see that uninformed rm disguises its bid
Assumptions
1. Common values: value of the object is
2. Two bidders bid b
i
0, i = 1, l
(a) bidder 1 is informed
knows [0, 1]
(b) bidder l is uninformed
does not know ,
but knows is distributed uniformly on [0, 1]
f
v 0 1
1
f(v) uniform density function
4. First Price Auction: high bidder wins
i wins if b
i
b
)
;
if there is a tie, b
i
= b
)
, then ip a coin.
Payo
If i wins, gets b
i
If i looses, gets 0
NE?
Pure strategies
Claim: There is no pure strategy equilibrium.
How to show this?
Suppose uninformed uses a pure strategy b
l
.
How would informed rm respond?
1. If b
l
?
Then b
1
= b
l
+ . with . small.
2. If b
l
?
Then submit a low bid (b
1
< b
l
)
Conclusion: Uninformed would make a loss
Uninformed bidder has to "disguise" his strategy
by using a mixed strategy
Result: NE: b
1
=

2
, b
l
uniformly distributed on
[0,
1
2
].
How to show this?
Verify
Uninformed bidder
l wins if b
l
b
1
or if < 2b
l
Expected value of the object conditional on bidder
l winning?
1[[l wins] = b
l
Why? because is distributed uniformly on [0, 1].
Expected payo for l?
1. For b
l

1
2
, make a loss
l
< 0.
2. For 0 b
l

1
2
:

l
= [1[[l wins] b
l
]
. .
Pr(b
l
b
1
)
. .
Payo if win Winning probability
= [b
l
b
l
] Pr(b
l
b
1
)
= 0 Pr(b
l
b
1
)
= 0
Hence, optimal (constant payos)
Informed bidder
1. What is the winning probability?
Pr(b
1
b
l
) =
_

_
0 if b
1
< 0
2b
1
0 b
1

1
2
1 b
1

1
2
Since b
l
uniformly distributed on [0,
1
2
].
2. Expected payo?

1
= [ b
1
]
. .
Pr(b
1
b
l
)
. .
Payo if win Winning probability
3. FOC for 0 b
1

1
2
( b
1
)2 2b
1
= 0
== b
1
=

2
4. SOC satised
Properties of Equilibrium
1. Pure strategy by informed rm
Mixed strategy by uninformed rm (to disguise)
Interpretation of mixed strategies:
Non-payo relevant types (aggressive or not)
2. Expected Prots:

l
= 0

1
=
_

2
_
0
3. Suppose there is a reserve price 1
What does it mean?
Acceptable bids must exceed 1
How does it aect behavior?
(a) Now Informed bids if 1
and does not bid if < 1
(b) Equilibrium changes
It remains that uninformed breaks even on av-
erage, 1
l
= 0,
but
1 [
l
[informed does not bid] < 0
1 [
l
[informed bids] 0
Why? Since 1
l
= 0
4. Empirical evidence
(a) Outer Continental Shelf auctions (Hendricks
and Porter)
(b) Better informed bidder because of prior expe-
rience in the area
(c) Average Payos in 1982 US$Mio (per auction)
1 [
1
[informed wins] = 6.76
(3.02)
1 [
l
[informed does not bid] = 2.69
(0.86)
1 [
l
[informed bids] = 0.78
(2.64)
5. An example of asymmetric information
Informed bidder has private information
Oligopoly Theory (continued)
So far: Static Oligopoly Games
Now: Multi Stage Games
Plan
1. Review: Subgame Perfect Equilibrium
2. Stackelberg Game
3. Review: N-player Multi Period Games
4. Repeated Oligopoly Games
5. Rubinstein's Bargaining Model
1. Review: Subgame Perfect Equilibrium
Games in extensive form (game tree)
Example: A game with two stages (subgames
U
0
2
Player 1
Player 2
D
L R
-1
-1
1
1
here there are two subgames
Payos are given at the end nodes:
_
a
j
_
where a is the payo to player 1 and j is
the payo to player 2
Recall: A Subgame perfect Nash equilibrium (SPNE)
is a NE in every subgame
NE?
U
0
2
Player 1
Player 2
D
L R
-1
-1
1
1
NE: (l, 1), (1, 1)
but (l, 1) is not subgame perfect as it is not a NE in
the subgame (not credible!)
SPNE?
(1, 1)
How to solve? Backwards Induction (start in the
last subgame and work backwards)
2. Stackelberg Game
Assumptions
1. Two rms constant marginal cost c
2. Firms choose quantities q
1
, q
2
0
3. Firm 1 moves rst and then, after observing
output q
1
rm 2 moves
4. Inverse demand curve
1 = o b (q
1
+ q
2
)
with o, b 0.
5. Prots

i
= [o b (q
1
+ q
2
) c]q
i
for i = 1, 2
How to solve a multi-stage game?
Backwards
1. Solve stage 2: for all possible quantities q
1
2. Solve stage 1: anticipating rm 2's reaction
q
1
2
(q
1
)
Stage 2: Firm 2's problem
max
q
2
0

2
= [o b (q
1
+ q
2
) c]q
2
FOC
o b (q
1
+ q
2
) c bq
2
= 0
SOC is satised as 2b < 0.
Reaction function
q
1
2
(q
1
) =
o c bq
1
2b
Stage 1: Firm 1 anticipates 2's reaction
What is rm 1's problem?
max
q
1
0

1
=
_
o b
_
q
1
+ q
1
2
(q
1
)
_
c
_
q
1
Substituting q
1
2
(q
1
) =
ocbq
1
2b
yields

1
=
_
o c
2
b
q
1
2
_
q
1
FOC
o c
2
bq
1
= 0
q
+
1
=
o c
2b
SOC is satised as b < 0
Result: The SPNE is given by
q
+
1
=
o c
2b
q
+
2
(q
1
) =
o c bq
1
2b
Note: In equilibrium q
+
2
=
oc
4b
Comments
1. Dierent outcome as under Cournot (order of
moves matters)
(a) Quantities: q
+
1
= 2q
+
2
(b) Industry output: Q
S
=
3
4

oc
b

2
3

oc
b
=
Q
C.
(c) Price: 1
S
=
oc
4
+ c <
oc
3
+ c = 1
C.
2. First Mover Advantage
(a)
S
1
=
(oc)
2
8b

(oc)
2
9b
=
C.
1
(b)
S
2
=
(oc)
2
16b
<
(oc)
2
9b
=
C.
2
(c) Intuition: depends on the slope of the reac-
tion function
downward sloping: rst mover advantage
upward sloping: rst mover disadvantage
Graphical Illustration of Stackelberg Equilib-
rium
(a-c)/2b
q
2
S
C-N
q
2
(a-c)/4b
(a-c)/4b (a-c)/2b
q
1
R
q
2
R
M
3. N Player Multi-Period Game
Notation
1. . Players: indexed by i
2. T periods: indexed by t = 1, 2, . . . , T
(where T is nite or innite)
3. Actions: o
t
=
_
o
1
t
, . . . , o
.
t
_
,
o
i
t

i
(action set) for i = 1, . . . , .
=
1
. . .
.
4. History: I
t
= (o
1
, . . . , o
t1
) 1
t
(history set), (I
t
is a node in the tree)
1
1
= 0
5. Time t payo:

i
: 1
t
T
with element
i
(o
t
, I
t
)
6. Game payo:
l
i
=
T

t=1
o
t1

i
(o
t
, I
t
)
where o is a discount factor o =
1
1+v
.
7. Behavioral strategy:
c
i
t
: 1
t

i
for all t, i
(a function from histories into actions)
Denition: SPNE (Subgame Perfect Nash Equi-
librium). (c
+
t
)
T
t=1
is a SPNE if
(i) c
i+
t
(I
t
)
i
for all I
t
1
t
, t, i (feasible);
(ii) c
i+
t
(I
t
) is optimal given
_
c
i+
t
_
T
t=t
for all I
t

1
t
, t, i (A NE in every subgame);
Applications:
1. Repeated Oligopoly Games
2. Bargaining
4. Repeated Oligopoly Games
Example: Firms may compete over time;
Gas stations, groceries, etc. may choose a new
price every week.
Assumptions
1. N rms
2. Set prices, j
i
t
0, let j
t
=
_
j
i
t
_
.
i=1
3. Constant marginal cost c 0
4. Demand 1
_
j
min
t
_
where j
min
t
= min(j
1
t
, . . . , j
.
t
)
Sales of rm i :
q
i
t
(j
t
) =
_

_
0 if j
i
t
j
min
t
1
_
j
min
t
_
I
if j
i
t
j
min
t
and
I = #i[j
i
t
= j
min
t

(equal rationing rule)
5. Discount factor o =
1
1+v
where v is the interest rate
6. Period payo

i
(j
t
) =
_
j
i
t
c
_
q
i
t
(j
t
)
7. Game payo
T

t=1
o
t1

i
(j
t
)
8. History: I
t
= (j
1
, . . . , j
t1
) 1
t
One shot: T = 1
. 2: Bertrand game:
j
t
= c
is the unique symmetric equilibrium
Monopolist:
max (j c) 1(j)
==
n
= (j
n
c) 1(j
n
)
Repeated game: T 1
Strategy: j
i
t
: 1
t
T
+
(a mapping from histories into real numbers)
SPNE? For any history, rms maximize the dis-
counted future payos from then on.
Finite T
What is the SPNE?
Result: The SPNE is given by
j
i
t
(.) = c for any t, i
How to show this?
Backwards induction
1. At T: for all histories I
T
rm i chooses j
i
T
to
maximize
i
(j
T
) given j
)
T
(I
T
).
The only symmetric NE is
j
i
T
(I
T
) = c for all I
T
.
2. At T 1: for all histories I
T1
rm i chooses
j
i
T1
to maximize
i
_
j
T1
_
+o
i
(j
T
) given
j
)
T1
(I
T1
).
Since, j
i
T
(I
T
) = c for all I
T
, implies

i
(j
T
) = 0,
we can rewrite the objective function as:
maximize
i
_
j
T1
_
given j
)
T1
(I
T1
);
Again: The only symmetric NE is
j
i
T1
(I
T1
) = c for all I
T1
.
(...)
3. Induction
At t = 1 : same argument applies
Unique symmetric SPNE is j
i
t
= c for all t, i, the
Bertrand outcome in every period.
Innite T. What are SPNE?
1. j
i
t
(I
t
) = c for all t, i is a SPNE
2. Trigger strategies
(Aumann, Shubik, Telser, Friedman)
j
i
t
(I
t
) =
_

_
j
n
if t = 1; or
if I
t
= (j
n
, . . . , j
n
)
. .
;
N (t-1) times
c otherwise.
(Intuition: a deviation triggers marginal cost
pricing.)
Result: If o o
+
(.), then trigger strategy is a
SPNE.
Proof:
Follow strategy: get discounted present value
\ =
o

t=0
o
t

n
.
=
1
.

n
1 o
(why? because it is a geometric sum).
Now, suppose rm i cheats in period t: Firm i
gets at most
n
in period t, and 0 thereafter:
\
o
=
t1

t=0
o
t

n
.
. .
+o
t

n
. .
+
o

t=t+1
o
t
0
. .
collude defect punishment
=
t1

t=0
o
t

n
.
+ o
t

n
Defect in period t if \
o
\ :

n
.
+
o

t=1
o
t

n
.
=
1
.

n
1 o
equivalently, defect if:
o < 1
1
.
So, o
+
(.) = 1
1
.
.
Result: If o o
+
(.), then any price v [c, j
n
]
is sustainable in a SPNE.
Proof?
use the trigger strategy, same argument as before.
Folk Theorems
All symmetric period payo divisions from 0 to

n
.
are sustainable in a SPNE
Illustration

m
45
o
All payoffs are sustainable for
sufficiently large discount factors
Conclusion: Many equilibria
(a negative result)
5. Rubinstein's Bargaining Model
Story: A pie of unit size.
Two players must agree on how to share the pie.
An alternating oer game.
Period 0, 2, 4, . . . :
1. Player 1 oers a sharing rule (a, 1 a) where
a is the share for player 1.
2. Player 2 accepts or rejects the oer
acceptance == the game ends
reject == the game continuous
Period 1, 3, 5, . . . :
1. Player 2 oers a sharing rule (j, 1 j) where
j is the share for player 1.
2. Player 1 accepts or rejects the oer
acceptance == the game ends
reject == the game continuous
Players discount future payos with discount fac-
tor c (0, 1)
(players have the same discount factor)
Game Payos
_
c
t
a, c
t
(1 a)
_
if (a, 1 a) is accepted at time t, and
a denotes the share of player 1.
NE?
1. Player 1 always demands a = 1, and rejects
all smaller shares.
Player 2 always oers j = 1 and accepts any
oer.
2. The same strategies as above, but with iden-
tities reversed.
Above NE are not SPNE: Why?
Because if 2 rejects 1's rst oer, and oers a
share 1 a c, then 1 should accept. Why? If
1 rejects, then at best he receives the entire pie
tomorrow which is worth c only.
Result: The SPNE is given by both players adopt-
ing the following strategy:
demand a
+
=
1
1+c
and accept any share
c
1+c
.
How to show this?
1. Proposer: Oer a
+
is the highest share for i
that will be accepted.
Suppose a a
+
; this will be rejected;
== can get at most
c
_
1
1
1 + c
_
=
c
2
1 + c
<
1
1 + c
2. Acceptance Rule: Suppose oer a
+
is rejected.
Then next period receive:
c
1
1 + c
1
1
1 + c
=
c
1 + c
Can show that SPNE is unique (omitted here)
Features of SPNE
1. unique
2. agreement is reached immediately
3. First oer advantage
4. As c 1, then rst oer advantage disap-
pears. Players split the pie equally.
What happens if the game ends after period 0?
That is:
1. Player 1 oers a sharing rule (a, 1 a) where
a is the share for player 1.
2. Player 2 accepts or rejects the oer, and the
game ends.
NE?
1. (a, 1 a) =
_
1
2
,
1
2
_
2. any share a (0, 1)
SPNE?
solve backwards
2nd stage: accept any oer such that 1 a 0
1st stage: oer (1, 0)