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Managerial Economics & Business Strategy

Managerial Economics & Business Strategy. Chapter 9 Basic Oligopoly Models. Stackelberg Summary. Stackelberg model illustrates how commitment can enhance profits in strategic environments. Leader produces more than the Cournot equilibrium output. Larger market share, higher profits.

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Managerial Economics & Business Strategy

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  1. Managerial Economics & Business Strategy Chapter 9 Basic Oligopoly Models

  2. Stackelberg Summary • Stackelberg model illustrates how commitment can enhance profits in strategic environments. • Leader produces more than the Cournot equilibrium output. • Larger market share, higher profits. • First-mover advantage. • Follower produces less than the Cournot equilibrium output. • Smaller market share, lower profits.

  3. Let’s work through demonstration problem 9-6 (put your books away) • Suppose the inverse demand function for two firms in a homogeneous-product Stackelberg oligopoly is given by P=50-(Q1+Q2) and the cost functions for the two firms are C1(Q1)=2Q1 and C2(Q2)=2Q2 • Firm 1 is the leader, and firm 2 is the follower • What is firm 2’s reaction function? • What is firm 1’s output? • What is firm 2’s output? • What is the market price?

  4. Bertrand Model • Few firms that sell to many consumers. • Firms produce identical products at constant marginal cost. • Each firm independently sets its price in order to maximize profits. • Barriers to entry. • Consumers enjoy • Perfect information. • Zero transaction costs.

  5. Bertrand Equilibrium • Firms set P1 = P2 = MC! Why? • Suppose MC < P1 < P2. • Firm 1 earns (P1 - MC) on each unit sold, while firm 2 earns nothing. • Firm 2 has an incentive to slightly undercut firm 1’s price to capture the entire market. • Firm 1 then has an incentive to undercut firm 2’s price. This undercutting continues... • PRICE WAR • Equilibrium: Each firm charges P1 = P2 = MC.

  6. Firms don’t like this... • Bertrand oligopoly leads to zero economic profits • Consumers like this… • Products are identical • Buy from the firm with the lowest price • Ending outcome is like Perfect Competition • Called the Bertrand Trap • This is why firms spend millions on advertising • “We” charge a different price BECAUSE “We” are different

  7. What if firms WORK together? • Collusion • Dealt with in greater detail in Chapter 10 • Maximize TOTAL industry profit • Q = Q1 + Q2 • P=1000-Q and C(Q) = 4Q • Set MR=MC • 1000-2Q=4 • Q=498 • P=$502 • Profits = (498*502)-(4*498)=248004

  8. Summary • Cournot (oil production) • Set MR=MC for each firm and cross substitute to find Q1 and Q2 • Plug back into the inverse demand function to find P • Stackelberg (Diamonds) • Set MR=MC for the FOLLOWER to find reaction function • Maximize the Profit of the Leader plugging in the followers reaction function in for Q2 • Plug in the reaction function BEFORE you maximize Profits • Plug back into the inverse demand function to find P • Bertrand (contractors bidding for the job) • Use the inverse demand and cost functions to set P=MC • Profits always equal ZERO • Collusion • Work together and maximize total industry Q • Monopoly outcome (MR=MC)

  9. What are the outcomes? • Output (highest to lowest) • Bertrand, Stackelberg, Cournot, Collusion • Profits (highest to lowest) • Stackelberg leader and Collusion, Cournot, Stackelberg follower, Bertrand

  10. Let’s work on Chapter 9 homework Numbers 2, 4, and 5

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