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Microeconomics | EE 311 |

Faculty of Economic, Thammasat University

Oligopoly and Game Theory


1. A monopolist can produce at constant average (marginal) cost of AC = MC = 5. It
faces a market demand curve given by Q = 53 P.
a) Calculate the profit-maximizing price and quantity for this monopolist. Also
calculate its profits.
b) Suppose the second firm enters the market. Let Q1 be the output of the first firm
and Q2 be the output of the second. Market demand is now given by
Q1 + Q2 = 53 P.
Assuming that this second firm has the same costs as the first, write the profits of
each firm as functions of Q1 and Q2.
c) Suppose (as in the Cournot model) that each firm chooses its profit-maximizing
level of output on the assumption that its competitors output is fixed. Find each
firms reaction curve.
d) Calculate the Cournot equilibrium. What are the resulting market price and
profits of each firm.
e) Find the Stackleberg equilibrium when the first firm is the leader and the new
entrant is the follower.
2. Two computer firms, A and B, are planning to market network systems for office
information management. Each firm can develop either a fast, high-quality system
(High), or a slower, low quality system (Low). Market research indicates that the
resulting profits to each firm for the alternative strategies are given by the following
payoff matrix:
Firm B
High
Low
Firm A
High 30 , 30
50 , 35
Low 40 , 60
20 , 20
a) If both firms make their decisions at the same time and follow maximin (low-risk)
strategies, what will the outcome be?
b) Suppose both firms try to maximize profits, but Firm A has a head start in
planning and can commit first. Now what will the outcome be? What will the
outcome be if Firm B has the head start in planning and can commit first?
c) Getting a head start costs money (you have to gear up a large engineering team).
Now consider the two-stage game in which first, each firm decides how much
money to spend to speed up its planning, and second, it announces which product
(H or L) it will produce. Which firm will spend more to speed up its planning?
How much will it spend? Should the other firm spend anything to speed up its
planning? Explain.

Chayun Tantivasadakarn | 28/9/15

Microeconomics | EE 311 |

Faculty of Economic, Thammasat University

3. Two firms are in the chocolate market. Each can choose 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:
Firm 2
Low
High
Firm 1
Low
-20 , -30
900 , 600
High 100 , 800
50 , 50
a) What outcomes, if any, are Nash equilibria?
b) If the managers of both firms are conservative and each follows a maximin
strategy, what is the outcome?
c) What is the cooperative outcome? Which firm benefits most from the cooperative
outcome? How much would that firm need to offer the other to persuade it to
collude?

Chayun Tantivasadakarn | 28/9/15

Microeconomics | EE 311 |

Faculty of Economic, Thammasat University

Solution:
1.a) The monopolists profits are maximized when MC = MR.
2

Since TR = 53Q Q , then MR = 53 2Q. Set this equal


to MC = 5 and solve to get QM = (53 5)/2 = 24 and PM
= 53 24 = 29. Hence the profits = (PM AC)QM = (29
5)24 = 576.
1.b) Profits of the firm i for a given output level Qj is given
by

i (Pi AC
)Qi 53
Qi Q2
Qi Q2
i QiQj 5Qi 48
i QiQj

1.c) Under Cournot competition, each firm i maximize its


profits, treating the rivals output as fixed. Differentiate i
with respect to Qi and set it to zero gives the reaction
function of i in terms of Qj:
48 2Qi Qj 0
Qi 24 Qj 2

for i, j = 1, 2.

1.d) Substitute Qi into the other firms reaction function and


solve will give: Q1 = Q2 = 16. Thus the price = 53 2(16)
= 21 and the profits will be the same and equal to (21
5)16 = 256 for each firm.

1.e) For Stackelberg model, we have to start from the


followers reaction function of firm 2 which is given by

Chayun Tantivasadakarn | 28/9/15

Microeconomics | EE 311 |

Faculty of Economic, Thammasat University

Q2 24 Q1 2.

Substitute this into the profit function of the

leader to get

1 53
Q1 Q12 Q1 24 Q1 / 2 5Q1 24Q1 Q12 / 2

Differentiate 1with respect to Q1 and set it to zero gives


Q1 = 24. Substitute this back into the reaction function of 2
yields Q2 = 12. Therefore the total output Q = 24 + 12 = 36
and the price P = 53 36 = 17. Finally, profit for each firm
is:
1 (17 5)24 288
, 2 (17 5)12 144

2. From the payoff matrix


2.a)

Using Maximin strategies the equilibrium is High,

High since:

- Firm As worse payoff for High strategy is 30 while


the worse payoff for Low strategy is 20. Thus the

maximum of the minimum is 30 and A should choose


High strategy.

- Firm Bs worse payoff for High strategy is 30 while


the worse payoff for Low strategy is 20. Thus the

maximum of the minimum is 30 and A should choose


High strategy.

Chayun Tantivasadakarn | 28/9/15

Microeconomics | EE 311 |

2.b)

Faculty of Economic, Thammasat University

This is a sequential game where Firm A moves first.

The game tree is as shown below. We use backward

induction to solve the game by starting at the second stage


of the follower. Firm B will choose Low if it knows

that Firm A chooses High since the payoff for Low is


35 which is higher than 30 of High. Similarly, Firm B
will choose High if it knows that Firm A chooses

Low since the payoff for High is 60 which is higher


than 20 of High.

At the first stage problem for the

leader, Firm A compare the two alternative and will


conclude that High will give a higher payoff (50
compared to 40), so it will choose High. The

equilibrium, therefore, will be High, Low with payoffs


= (50,35) if Firm A moves first. Similarly, if Firm B

move first, the equilibrium will be Low, High with


payoffs = (40,60).
A

Hig
h
Lo

Hi

30,30

Lo

50,35

gh
w
Hi

40,60

Lo

20,20

gh
w

Chayun Tantivasadakarn | 28/9/15

Microeconomics | EE 311 |

2.c)

Faculty of Economic, Thammasat University

The results from 2.b) suggest that Firm A will gain

= 10 (= 50 40) if it has the head start. So it will not


pay more than 10 to get the head start. Firm B, on the
other hand will gain = 25 = (60 35) which is larger.

Therefore Firm B will be willing to spend more to speed


things up. Since the information is known to both firms,
Firm B should only spend enough to discourage Firm A

which would be an amount slightly more than 10and Firm


A will not spend it.

3. From the payoff matrix


3.a)

There are two Nash equilibria: Low, High with

payoffs = (900,600) and High, Low with payoffs =


(100,800).

3.b)

The Maximin equilibrium is High, High with

payoffs = (50,50). The explanation is similar to those


given in 2, so it will not be repeated again.
3.c)

The cooperative outcome should maximize the

summation of the two firms payoffs which is = 1,500 (=


900 + 600) when Firm 1 uses Low and Firm 2 uses
High. If both firm play a non-cooperative game, the

result will be either one of the Nash equilibria given in


Chayun Tantivasadakarn | 28/9/15

Microeconomics | EE 311 |

Faculty of Economic, Thammasat University

3.a). Note that Firm 1 will gain = 800 (= 900 100) if


both firms cooperate while Firm 2 will lose

200 (=

600 800). Hence, Firm 1 needs to offer at least 200 to


persuade Firm 2 to cooperate. And since Firm 1 stands to
gain more than what it needs to pay (800 > 200),

Firm

1 will have the incentive to do so.

Chayun Tantivasadakarn | 28/9/15