You are on page 1of 39

Game Theory and Industrial Organization

Manfred Stadler

Lecture in the Winter Term 2011/12

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 1

Game Theory and Industrial Organization


Contents: 1. Industrial Organization and Games 1.1 1.2 1.3 1.4 Structure of the Industrial Sector Strategic Interaction and Game Theory The Analytical Framework Basic Market Games

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 2

Game Theory and Industrial Organization


2. An Integrative Synthesis of the Basic Market Games 2.1 Intensity of Competition: On the Role of Market Heterogeneity 2.2 Finitely versus Innitely Repeated Competition: On the Role of Discounting 2.3 Price versus Quantity Competition: On the Role of Capacity Precommitment 2.4 Simultaneous versus Sequential Decisions: On the Role of Noise in the Observability of Decisions 2.5 Entry Deterrence versus Accommodation: On the Role of Barriers to Entry

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 3

Game Theory and Industrial Organization


3. Strategic Competition in Multi-Stage Games 3.1 3.2 3.3 3.4 3.5 A Taxonomy of Business Strategies Cost-reducing Investment Demand-enhancing Advertising Location and Horizontal Product Dierentiation Quality and Vertical Product Dierentiation

4. Competition in Games with Imperfect Information 4.1 4.2 4.3 4.4 4.5 Incomplete Cost Information Incomplete Demand Information Contractual Information Exchange Signalling of Information Intertemporal Transmission of Information
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 4

Game Theory and Industrial Organization


Basic Text Books: Martin, S. (2002), Advanced Industrial Economics, 2nd ed., Oxford. Tirole, J. (1988), The Theory of Industrial Organization, Cambridge MA. Vives, X. (1999), Oligopoly Pricing. Old Ideas and New Tools, Cambridge MA.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 5

Game Theory and Industrial Organization

Chapter 1: Industrial Organization and Games Structure of the Industrial Sector Strategic Interaction and Game Theory The Analytical Framework Basic Market Games

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 6

Structure of the Industrial Sector


The industrial sector of an economy, often called the secondary sector, includes mining manufacturing electricity and water supply and construction. In the ocial European statistics, these economic activities are part of the Classication of Economic Activities in the European Community. Source: Statistisches Bundesamt, Classication of Economic Activities, Edition 2008 (WZ 2008).

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 7

Structure of the Industrial Sector


Code A B C D E F G H I J Sector Primary sector: Agriculture, forestry and shing Secondary sector (= industrial sector): Mining and Quarrying Manufacturing Electricity, gas, steam and air conditioning supply Water supply and waste management Construction Tertiary sector (= service sector): Wholesale and retail trade Transportation and storage Accommodation and food service activities Information und communication
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 8

Structure of the Industrial Sector


Code K L M N O P Q R S T U Sector Financial and insurance activities Real estate activities Professional, scientic and technical activities Administrative and support service activities Public administration and defense, compulsory social security Education Human health and social work activities Arts, entertainment and recreation Other service activities Activities of households as employers Activities of extraterritorial organisations

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 9

Structure of the Industrial Sector


In order to study the competition between rival rms it is necessary to further disaggregate the industrial sector. Classication of industries at the two-digit level: Code B B B B 05 06 07 08 Industry Mining of coal and lignite Extraction of crude petroleum and natural gas Mining of metal ores (iron, copper, uranium) Quarrying of stone, sand, mining of clays, extraction of peat and salt

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 10

Structure of the Industrial Sector


Code C C C C C C C C C C C C C 10 11 12 13 14 15 16 17 18 19 20 21 22 Industry Manufacture Manufacture Manufacture Manufacture Manufacture Manufacture Manufacture Manufacture Printing and Manufacture Manufacture Manufacture Manufacture of food products of beverages of tobacco products of textiles of wearing apparel of leather products of wooden products of paper products reproduction of recorded media of coke and rened petroleum products of chemical products of pharmaceutical products of rubber and plastic products
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 11

Structure of the Industrial Sector


Code C C C C C C C C C C 23 24 25 26 27 28 29 30 31 32 Industry Manufacture of glass, refractory, and ceramic products Manufacture of basic metals Manufacture of metal products Manufacture of computer, electronic and optical products Manufacture of electrical equipment Manufacture of machinery and equipment Manufacture of motor vehicles and trailers Manufacture of other transport equipment Manufacture of furniture Manufacture of jewellery, musical instruments, sports goods, toys, and medical instruments Repair and installation of machinery and equipment
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 12

C 33

Structure of the Industrial Sector


Code D 35 E 36 E 37 E 38 E 39 F 41 F 42 F 43 Industry Electricity, gas, steam and air conditioning supply Water collection, treatment and supply Sewerage Waste collection and recovery of sorted materials Remediation and waste management services Construction of buildings Civil engineering Demolition, construction installation

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 13

Strategic Interaction and Game Theory


The structure-conduct-performance-(SCP-)paradigm of the traditional IO: Market structure determines rms conduct and conduct yields market performance: Structure: number and size of rms in the relevant market Conduct: prices, capacities, location, product dierentiation, advertising, research and development Performance: rms prot distribution, consumer surplus, welfare However: Market structure is not exogenous but instead depends on the markets basic conditions and rival rms behavior. In the short run, some basic conditions of markets such as technology, entry cost, consumers preferences, and the information structure can be considered as exogenous.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 14

Strategic Interaction and Game Theory


Basic paradigm of the modern theory of industrial organization: Firms conduct is based on some market-specic basic conditions and determines market structure as well as market performance. Standard tool for the analysis of conduct and hence strategic interaction of rms: game theory. Due to the importance of the strategic decision variables of rms, IO can be considered as applied microeconomics of product markets and provides the fundamental basis for economics as well as business administration. As strategic interaction is most intensive in case of only two rivals, the following investigations are usually restricted to duopoly markets.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 15

Strategic Interaction and Game Theory


Depending on the sequence of decisions on the one hand and on the information structure on the other hand, four basic game theoretical concepts, developed by the nobel price winners in 1994, can be distinguished: the NASH equilibrium, developed by J. NASH (1951), for static games with complete information, the subgame perfect NASH equilibrium, developed by R. S ELTEN (1965), for dynamic games with incomplete information, the BAYESian equilibrium, developed by J. H ARSANYI (1967/68), for static games with incomplete information, and the perfect BAYESian equilibrium (PBE), developed by R. S ELTEN (1975), for dynamic games with incomplete information.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 16

The Analytical Framework


To keep the analysis tractable we restrict ourselves to the case of two rival rms having linear (often normalized) demand functions and linear (often normalized) cost functions. Let us consider the quasi-linear quadratic utility function of representative consumers U(q0 , q1 , q2 ) = q0 + (q1 + q2 ) ( q2 + 2 q1 q2 + q2 )/2; 0 < , 0 , 1 2 where goods 1 and 2 are supplied by the two rivals i = 1, 2 in the market, and good 0 is the numraire with the normalized price (index) p0 = 1, consisting of the bundle of all other goods supplied in any market.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 17

The Analytical Framework


Maximizing consumers utility subject to their budget constraint I = q0 + p1 q1 + p2 q2 , where I is consumers income, leads to the inverse demand system pi = qi q j ; i, j = 1, 2, i= j, (1.1)

and, hence, to the demand system qi Di (p1 , p2 ) = a bpi + d p j ; where and a /( + ), i, j = 1, 2, i ,= j (1.2)

b /( 2 2 ),

d /( 2 2 )

a/(b d),

b/(b2 d 2 ),

d/(b2 d 2 ).

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 18

The Analytical Framework


The goods are independent if = d = 0 (two completely separate markets) substitutes if 0 < < and 0 < d < b (heterogeneous markets) perfect substitutes if = and d b (homogeneous markets). In the case of a homogeneous market ( = ) one obtains from (1.1) the inverse market demand function p = Q ; Q q1 + q2 ,

and by assuming market clearing, i.e. Q = D(p), the market demand function D(p) = ( / ) (1/ )p , which simplies for = 1 to the standardized form D(p) = p .
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 19

(1.3)

The Analytical Framework


Economic characterization of a relevant market: A market is dened as including all close substitutes where 0 < < and 0 < d < b. / [1, ) is an appropriate indicator of market heterogeneity. By dening b b d, the demand system (1.2) can be rewritten as Di (p1 , p2 ) = a b pi + d(p j pi ) , where (1/d) is an alternative indicator of market heterogeneity, especially used in models of location and product dierentiation.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 20

The Analytical Framework


The production cost depend on the rms technology whose features are captured by the production function. Production functions with constant returns to scale are dual to the linear cost functions Ci = ci qi , ci 0; i = 1, 2 ,

where the marginal costs ci are determined by the input prices and the total factor productivity.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 21

The Analytical Framework


Example (borrowed from Intermediate Microeconomics): Consider a rm i producing with the Cobb-Douglas technology qi = Ai Li Ri

0 < < 1,

where Ai denotes the technology level, Li the labor input, and Ri the raw material input. Minimizing production cost Ci = wLi + vRi , where w and v denote the input prices of labor and raw material, subject to the technology constraint, leads to the linear cost function Ci = A1 (w/ ) (r/(1 ))1 qi , i where the constant marginal cost is ci = A1 (w/ ) (r/(1 ))1 . i
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 22

Basic Market Games


Basic Market Games Monopoly and Collusion Bertrand Competition Cournot Competition Stackelberg Competition

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 23

Monopoly
Assuming the linear market demand function D(p) = p and constant marginal cost c < , maximization of the monopoly prot

M (p) = (p c)( p)
leads to the monopoly price pM = (1 + c)/2 = c + (1/2)( c) , the output qM = D(pM ) = (1/2)( c) , and the monopoly prot

M = (1/4)( c)2 .

(1.4)
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 24

Monopoly
Interpretation: The monopoly price depends positively on the market size and the marginal cost c. The monopoly prot depends positively on the market size but negatively on the marginal cost.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 25

Collusion
The optimal collusion strategy of two rms is to set the monopoly price pK = pM = c + (1/2)( c) and to equally share the output qK = qM /2 = (1/4)( c) and the total prot

K = M /2 = (1/8)( c)2 .

(1.5)

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 26

Bertrand Competition
The Bertrand (1883) model of price competition Assumptions: Homogeneous product market with two rms i = 1, 2 Constant and identical marginal costs ci = c Linear market demand function D(p) = p, where > c Prot maximization with respect to the prices pi Market clearing at D(p) = q1 + q2 .

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 27

Bertrand Competition
The prot of rm i is

i (p1 , p2 ) = (pi c)Di (p1 , p2 );

i, j = 1, 2, i = j ,

where the demand for the output of rm i is pi Di (p1 , p2 ) = ( pi )/2 0 if pi < p j if pi = p j if pi > p j .

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 28

Bertrand Competition
The unique equilibrium has the two rms charge the competition price (p , p ) = (pB , pB ) where 1 2 pB = c , implying that both rms realize zero prots, i.e. B = 0. This Bertrand-Paradox states that two rms are sucient for generating the market performance of perfect competition: Two is enough for competition.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 29

Bertrand Competition
Reaction functions in the Bertrand model p2
R1 (p2 ) R2 (p1 )

c p1
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 30

Cournot Competition
The Cournot (1838) model of quantity competition Firms set quantities instead of prices, all other assumptions continue to hold. Maximizing the prots

i (q1 , q2 ) = ( qi q j c)qi ;

i, j = 1, 2, i = j ,

with respect to the quantities qi leads to the reaction functions qi Ri (q j ) = ( q j c)/2 with the negative slopes R (q j ) = (1/2). i The symmetric Nash equilibrium in quantities (q , q ) = (qC , qC ) is given by 1 2 the intersection point of the reaction functions and is determined by qC = (1/3)( c) .
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 31

Cournot Competition
Reaction functions in the Cournot model q2

R1 (q2 )

c 2

R2 (q1 ) q1
c 2

c
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 32

Cournot Competition
Given these quantities the market price is pC = c + (1/3)( c) and the rms prots are

C = (1/9)( c)2 .

(1.6)

Interpretation: The market price depends positively on the market size and the marginal cost c. Firms prots depend positively on the market size but negatively on the marginal cost.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 33

Stackelberg Competition
The sequential decision model of Stackelberg (1934) Sequential structure of decisions: Stage 1: The Stackelberg leader i = L chooses his output qL Stage 2: The Stackelberg follower i = F chooses his output qF The derivation of the subgame perfect Nash equilibrium by backward induction: Step 1: Choice of qF conditional on qL The maximization of the followers prot function

F (qL , qF ) = ( qL qF c)qF
with respect to the outoput qF leads to qF RF (qL ) = ( qL c)/2 .
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 34

Stackelberg Competition
Step 2: Choice of qL by anticipating RF (qL ) The maximization of the leaders reduced-form prot function

L (qL , qF (qL )) = ( qL c)qL /2


with respect to qL leads to qL = (1/2)( c) and hence to qF = (1/4)( c) < qC . > qC

Given these quantities the market price is pS = c + (1/4)( c) < pC .


Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 35

Stackelberg Competition
The rms prots are

L = (1/8)( c)2

>

C C .
(1.7)

F = (1/16)( c)2 <

A comparison of the Stackelberg solution and the Cournot solution reveals the rst-mover advantage of the leader: The leader raises output inducing a smaller output of the follower, whereby the market price falls, and the leaders prot increases whereas the followers prot declines. At the end of this chapter, a remaining question is when to use which model. Are there more fundamental market conditions suggesting a special model? And if, is it possible to integrate the basic models into a more general approach of oligopoly theory? The answer is: yes!
Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 36

Basic Market Games


Interrelations between the Cournot (C), Bertrand (B), Stackelberg (S), monopoly (M), and collusive (K) outcomes M

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 37

Basic Market Games


References: Cournot, A. (1838), Recherches sur les principes mathematiques de la theorie des richesses. Paris. Bertrand, J. (1883), Review of Theorie mathematique de la richesse sociale & Recherche sur les principes mathematiques de la theorie des richesses. Journal des Savants, 499-508. Stackelberg, H. (1934), Marktform und Gleichgewicht. Vienna.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 38

Basic Market Games


References: Nash, J.F. (1951), Non-cooperative Games, Annals of Mathematics 54, 286-295. Harsanyi, J.C. (1967/68), Games with Incomplete Information Played by Bayesian Players. Part I: The Basic Model; Part II: Bayesian Equilibrium Points; Part III: The Basic Probability Distribution of the Game. Management Science 14, 159-182, 320-334, 486-502. Selten, R. (1965), Spieltheoretische Behandlung eines Oligopolmodells mit Nachfragetrgheit. Zeitschrift fr die gesamte Staatswissenschaft 121, 301-324 und 667-689. Selten, R. (1975), Reexamination of the Perfectness Concept for Equilibrium Points in Extensive Games. International Journal of Game Theory 4, 25-55.

Manfred Stadler Game Theory and Industrial Organization, Chapter 1 p. 39

You might also like