Part II.

Market power
Chapter 3. Static imperfect competition

Slides
Industrial Organization: Markets and Strategies
Paul Belleflamme and Martin Peitz

Cambridge University Press 2009

Introduction to Part II

Oligopolies
Industries in which a few firms compete
Market power is collectively shared.
Firms cant ignore their competitors behaviour.
Strategic interaction Game theory
Oligopoly theories
Cournot (1838) quantity competition
Bertrand (1883) price competition
Not competing but complementary theories

Relevant for different industries or circumstances

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Introduction to Part II

Organization of Part II
Chapter 3

Simple settings: unique decision at single point in time

How does the nature of strategic variable (price or
quantity) affect

strategic interaction?
extent of market power?

Chapter 4

Incorporates time dimension: sequential decisions

Effects on strategic interaction?
What happens before and after strategic interaction
takes place?

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Introduction to Part II

Case.
Case. DVD-by-mail
DVD-by-mail industry
industry
Facts
Facts

<< 2004:
2004: Netflix
Netflix almost
almost only
only active
active firm
firm
2004:
2004: entry
entry by
by Wal-Mart
Wal-Mart and
and Blockbuster
Blockbuster (and
(and later
later
Amazon),
Amazon), not
not correctly
correctly foreseen
foreseen by
by Netflix
Netflix

Sequential
Sequential decisions
decisions

Leader:
Leader: Netflix
Netflix
Followers:
Followers: Wal-Mart,
Wal-Mart, Blockbuster,
Blockbuster, Amazon
Amazon

Price
Price competition
competition

Wal-Mart
Wal-Mart and
and Blockbuster
Blockbuster undercut
undercut Netflix
Netflix
Netflix
Netflix reacts
reacts by
by reducing
reducing its
its prices
prices too.
too.

Quantity
Quantity competition?
competition?

Need
Need to
to store
store more
more copies
copies of
of latest
latest movies
movies
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Chapter 3 - Objectives

Chapter
Chapter 3.
3. Learning
Learning objectives
objectives
Get
Get (re)acquainted
(re)acquainted with
with basic
basic models
models of
of
oligopoly
oligopoly theory
theory

Price
Price competition:
competition: Bertrand
Bertrand model
model
Quantity
Quantity competition:
competition: Cournot
Cournot model
model

Be
Be able
able to
to compare
compare the
the two
two models
models

Quantity
Quantity competition
competition may
may be
be mimicked
mimicked by
by aa two-stage
two-stage
model
model (capacity-then-price
(capacity-then-price competition)
competition)
Unified
Unified model
model to
to analyze
analyze price
price && quantity
quantity competition
competition

Understand
Understand the
the notions
notions of
of strategic
strategic

complements
complements and
and strategic
strategic substitutes
substitutes
See
See how
how to
to measure
measure market
market power
power empirically
empirically
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Chapter 3 - Price competition

The standard Bertrand model

2 firms

Homogeneous products
Identical constant marginal cost: c
Set price simultaneously to maximize profits

Consumers

Firm with lower price attracts all demand, Q(p)

At equal prices, market splits at and
1

Firm i faces demand

Q( pi ) if

Qi ( pi ) = iQ( pi ) if
0
if

pi < p j
pi = p j
pi > p j

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Chapter 3 - Price competition

The standard Bertrand model (contd)

Unique Nash equilibrium

Both firms set price = marginal cost: p

Proof

p2 c

For any other (p1,p2), a profitable deviation exists.

Or: unique intersection of firms best-response functions

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Chapter 3 - Price competition

The standard Bertrand model (contd)

Bertrand Paradox

Only 2 firms but perfectly competitive outcome

Message: there exist circumstances under which
duopoly competitive pressure can be very strong

Lesson: In a homogeneous product Bertrand

duopoly with identical and constant marginal
costs, the equilibrium is such that

firms set price equal to marginal costs;

firms do not enjoy any market power.

Cost asymmetries

n firms, c c
Equilibrium: any price
i

p [c1,c 2 ]

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Chapter 3 - Price competition

Bertrand competition with uncertain costs

Each firm has private information about its costs

Trade-off between margins and likelihood of winning

the competition
See particular model in the book.

Lesson: In the price competition model with

homogeneous products and private information

about marginal costs, at equilibrium,

firms set price above marginal costs;

firms make strictly positive expected profits;
more firms price-cost margins, output, profits;
Infinite number of firms competitive limit.
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Chapter 3 - Price competition

Price competition with differentiated products

Firms may avoid intense competition by offering
products that are imperfect substitutes.
Hotelling model (1929)
Disutility from
travelling

(x l1 )

(l2 x)

l1

p1
Firm 1

l2

p2

Firm 2

Mass 1 of consumers, uniformly distributed

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Chapter 3 - Price competition

Hotelling model (contd)

Suppose location at the extreme points
p2

p1 + x
p2

p1
0

Q1( p1, p2 )

Q2 ( p1, p2 )

consumer
Indifferent

Firm 1

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Firm 2

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Chapter 3 - Price competition

Hotelling model (contd)

Resolution

1 p j pi
Firms problem: max p i ( pi c)2 + 2
function:
From FOC, best-response
p =p =
c+
prices:
Equilibrium
i

pi = 12 ( p j + c + )

differentiated,
Lesson: If products are more

firms enjoy more market power.

Extensions

Localized competition with n firms: Salop (circle) model

Asymmetric competition with differentiated products
See companion slides to Chapter 3
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Chapter 3 - Quantity competition

The linear Cournot model

Model

Homogeneous product market with n firms

Firm i sets quantity q
Total output: q q q ... q
Market price given by P(q) a bq
Linear cost functions: C (q ) c q
Notation: q q q
i

-i

Residual demand

P(qi ,qi ) = (a bqi ) bqi

di (qi )

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Chapter 3 - Quantity competition

The linear Cournot model (contd)

Firms problem

conjecture rivals dont modify their quantity

Cournot conjecture:
Firm i acts as a monopolist max d (q
on its residual demand:
FOC: a
Best-response function: qi (q

qi

Nash equilibrium in the duopoly case

Assume:
Then, q

*
1

c1

q1*
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Chapter 3 - Quantity competition

The linear Cournot model (contd)

Duopoly

Lesson: In the linear Cournot model with

homogeneous products, a firms equilibrium

profits increases when the firm becomes
relatively more efficient than its rivals.
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Chapter 3 - Quantity competition

Symmetric Cournot oligopoly

Assume ci
Then

*
q (n)

If n individual quantity , total quantity , market

price , markup
If n , then markup 0

Lesson: The (symmetric linear) Cournot model

converges to perfect competition as the number

of firms increases.

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Chapter 3 - Quantity competition

Implications of Cournot competition

General demand and cost functions
Cournot pricing formula (see companion slides)
P(q)

Lesson: In the Cournot model, the markup of

firm i is larger the larger is the market share of

firm i and the less elastic is market demand.
p

If constant marginal costs

Average Lerner index

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Chapter 3 - Price vs. quantity

Price versus quantity competition

Comparison of previous results

Let Q(p)ap, c c c
Bertrand: p p c, q q (ac)/2,
Cournot: q q (ac)/3, p(a2c)/3, (ac) /9
1

Lesson: Homogeneous product case higher

price, lower quantity, higher profits under
quantity than under price competition.

To refine the comparison

Limited capacities of production

Direct comparison within a unified model
Identify characteristics of price or quantity competition
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Chapter 3 - Price vs. quantity

Limited capacity and price competition

Edgeworths critique (1897)

Bertrand model: no capacity constraint

But capacity may be limited in the short run.

Examples

Retailers order supplies well in advance

DVD-by-mail industry

Larger demand for latest movies need to hold extra stock

of copies higher costs and stock may well be insufficient

Flights more expensive around Xmas

To account for this: two-stage model

Firms precommit to capacity of production

Price competition
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Chapter 3 - Price vs. quantity

Capacity-then-price model (Kreps & Scheinkman)

Setting
1 firms set capacities
Stage 1:

qi and incur cost of

capacity, c
2 firms set prices pi; cost of production is up
Stage 2:
to capacity (and infinite beyond capacity); demand is
Q(p) a p.
equilibrium firms know that
Subgame-perfect equilibrium:
capacity choices may affect equilibrium prices

Rationing

If quantity demanded to firm i exceeds its supply...

... some consumers have to be rationed...
... and possibly buy from more expensive firm j.
question Who will be served at the low price?
Crucial question:
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Chapter 3 - Price vs. quantity

Capacity-then-price model (contd)

Efficient rationing

First served: consumers with higher willingness to pay.

Justification: queuing system, secondary markets
Consumers with unit demand, ranked
by decreasing willingness to pay
There is a positive
residual demand for
firm 2

Consumers with
highest willingness
to pay are served at
firm 1s low price
Excess demand for firm 1
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Chapter 3 - Price vs. quantity

Capacity-then-price model (contd)

Equilibrium (sketch; details in companion slides)

Stage 2. If p

< p2 and excess demand for firm 1, then

demand for 2 is: )

1

Q( p2 )

Claim: if c a (4/3)c, then

both firms set the market
clearing price: p1
Stage 1. Same reduced profit functions as in Cournot:
1 (q1 , q2 ) = (a q1 q2 )q1 cq1

Lesson: In the capacity-then-price game with

efficient consumer rationing (and with linear demand

and constant marginal costs), the chosen capacities are
equal to those in a standard Cournot market.
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Chapter 3 - Price vs. quantity

Differentiated products: Cournot vs. Bertrand

Setting

Duopoly, substitutable products (bd)

Consumers maximize linear-quadratic utility function
U(q0 , q1 , q2 )

under budget constraint y

Inverse demand functions
P1 (q1 , q2 )

Q ( p , p )

1 1 2

Demand functions

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Chapter 3 - Price vs. quantity

Differentiated products (contd)

Maximization program

Cournot:
Bertrand:

max qi (a
max pi ( pi

Cournot:

qi (q j )

Best-response functions

Downward-sloping Strategic substitutes

pi ( p j )
Bertrand:

Upward-sloping Strategic complements

Comparison of equilibria

Lesson: Price as the strategic variable gives rise to a

more competitive outcome than quantity as the
strategic variable.
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Chapter 3 - Price vs. quantity

Appropriate modelling choice: price or quantity?

Monopoly it doesnt matter.
Monopoly:
Oligopoly price and quantity competitions lead
Oligopoly:
to different residual demands

Price competition

pj fixed rival willing to serve any demand at pj

is residual demand: market demand at pi pj; zero at pi pj
So, residual demand is very sensitive to price changes.

Quantity competition

qj fixed irrespective of price obtained, rival sells qj

is residual demand: whats left (i.e., market demand qj)
So, residual demand is less sensitive to price changes.

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Chapter 3 - Price vs. quantity

Appropriate modelling choice (contd)

How do firms behave in the market place?

Stick to a price and sell any quantity at this price?

price competition
appropriate choice when

Unlimited capacity
Prices more difficult to adjust in the short run than quantities
Example: mail-order business

Stick to a quantity and sell this quantity at any price?

quantity competition
appropriate choice when

Limited capacity (even if firms are price-setters)

Quantities more difficult to adjust in the short run than prices
Example: package holiday industry

Influence of technology (e.g. Print-on-demand vs. batch printing)

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Chapter 3 - Price vs. quantity

Strategic substitutes and complements

How does a firm react to the rivals actions?
Look at the slope of reaction functions.

Upward sloping: competitor its action marginal

profitability of my own action
variables are strategic complements

Example: price competition (with substitutable products);

See Bertrand and Hotelling models

Downward sloping: competitor its action marginal

profitability of my own action
variables are strategic substitutes

Example: quantity competition (with substitutable products);

see Cournot model

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Chapter 3 - Price vs. quantity

Strategic substitutes and complements (contd)

Linear demand model of product differentiation
(with d measuring the degree of product substitutability)

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Chapter 3 - Estimating market power

Estimating market power

Setting

Symmetric firms producing homogeneous product

Demand equation: p P(q,x) (1)
q: total quantity in the market
x: vector of exogenous variables affecting demand (not cost)

Marginal costs: c(q,w)

w: vector of exogenous variables affecting (variable) costs

Approach 1. Nest various market structures in a

single model

MR(

0 competitivemarket
=1
monopoly
=1/ n
nfirmCournot
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Firms conjecture as to
how strongly price reacts
to its change in output
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Chapter 3 - Estimating market power

Estimating market power (contd)

Approach 1 (contd)

Basic model to be estimated non-parametrically:

demand equation (1) + equilibrium condition (2)
MR(

Approach 2. Be agnostic about precise game

being played

condition

(2),
Lerner
index is
From equilibrium
L

(2) is identified if single c(q,w) and single satisfy it

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Chapter 3 - Review questions

Review
Review questions
questions
How
How does
does product
product differentiation
differentiation relax
relax price
price
competition?
competition? Illustrate
Illustrate with
with examples.
examples.
How
How does
does the
the number
number of
of firms
firms in
in the
the industry
industry
affect
affect the
the equilibrium
equilibrium of
of quantity
quantity competition?
competition?
When
When firms
firms choose
choose first
first their
their capacity
capacity of
of
production
production and
and next,
next, the
the price
price of
of their
their product,
product,
this
this two-stage
two-stage competition
competition sometimes
sometimes looks
looks like
like
(one-stage)
(one-stage) Cournot
Cournot competition.
competition. Under
Under which
which
conditions?
conditions?
Using
Using aa unified
unified model
model of
of horizontal
horizontal product
product
differentiation,
differentiation, one
one comes
comes to
to the
the conclusion
conclusion that
that
price
price competition
competition is
is fiercer
fiercer than
than quantity
quantity
competition.
competition. Explain
Explain the
the intuition
intuition behind
behind this
this
result.
result.
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Chapter 3 - Review questions

Review
Review questions
questions (contd)
(contd)
Define
Define the
the concepts
concepts of
of strategic
strategic complements
complements
and
and strategic
strategic substitutes.
substitutes. Illustrate
Illustrate with
with
examples.
examples.
What
What characteristics
characteristics of
of aa specific
specific industry
industry will
will
you
you look
look for
for to
to determine
determine whether
whether this
this industry
industry is
is
better
better represented
represented by
by price
price competition
competition or
or by
by
quantity
quantity competition?
competition? Discuss.
Discuss.

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