16/05/2023 BIE – Daniela Silvestri

COMPETITION MODELS EXTENSIONS

Exercise 1 – diverse cost function

Consider two firms (firm 1 and firm 2) facing the demand curve P = 50 - 5Q, where Q = q1 + q2.

The firms’ cost functions are:

C1(q1) = 20 + 10q1 and C2(q2) = 10 + 12q2.

a.) Find the Cournot equilibrium.

Starting from the inverse demand function P = 50 - 5(q1 + q2), firm 1 chooses the quantity q1 that maximizes
its profit function:

Max π1(q1,q2) = (50 – 5(q1 + q2))q1 – (20 + 10q1) = 50q1 – 5𝑞 21 – 5q2 q1 – 20 – 10q1 =
= 40q1 – 5𝑞 21 – 5q2 q1 – 20

From the first order condition, we get:

∂1
= 40 – 10𝑞1 – 5q2 = 0
∂𝑞1

Solving for 𝑞1 we get 40 – 5q2 = 10𝑞1 → 𝑞1 = 4 − 1/2𝑞2 Best reply function of firm 1

Similarly, firm 2 chooses the quantity q2 that maximizes its profit function:

Max π2(q1,q2) = (50 – 5(q1 + q2))q2 – (10 + 12q2) = 50q2 – 5q1 q2 – 5𝑞 2 2 – 10 – 12q2 =
= 38q2 – 5q1 q2 – 5𝑞 2 2 − 10

From the first order condition, we get firm 2’s best reply function:

∂2
= 38 − 5𝑞1 − 10𝑞2 = 0
∂𝑞2

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Solving for 𝑞2 we get 38 − 5𝑞1 = 10𝑞2 → 𝑞2 = 3.8 − 2 𝑞1 𝐵𝑒𝑠𝑡 𝑟𝑒𝑝𝑙𝑦 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑓𝑖𝑟𝑚 2

As you can see here, the game is not symmetric.

By solving the system with the two best reply functions:

1 1 1 4
𝑞1 = 4 − ∗ (3.8 − 𝑞1 ) → 𝑞1 = 4 − 1.9 + 𝑞1 → 𝑞1𝐶 = 2.1 ∗ = 2.8
2 2 4 3

Substituting in the best reply function of firm 2 we would have:

1
𝑞2𝐶 = 3.8 − (2.8) = 3.8 − 1.4 = 2.4
2

we find the Cournot equilibrium quantities: 𝑞1𝐶 = 2.8 𝑎𝑛𝑑 𝑞2𝐶 = 2.4 and the total quantity 𝑄𝑐 = 5.2
which is sold at the price 𝑝𝐶 = 50 − 5(5.2) = 24
The two firms get the profits:
πc1 = 24*2.8 – 20 – 10*2.8=19.2
πC2 = 24*2.4 – 10 – 12*2.4=18.8

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b) Suppose firm 1 sets its quantity first and then firm 2 sets its quantity. What price does each firm charge? How much
does it sell? What is its profit?

The game is solved via backward induction, that is, starting from the second stage.
In this stage, firm 2 chooses its quantity, as in the simultaneous game (Cournot), so its best reply function is:

q2= 3.8 – 1/2q1 (see the first order condition of firm 2 in point a.)

Going to the first stage of the game, we find the optimal price for firm 1 by plugging the best reply function
of firm 2 in the profit function of firm 1:
Max π1(q1,q2) = 40q1 – 5q2 1 – 5q2q1 – 20 = 21q1 – 2.5q12 – 20
From the first order condition, we get the optimal level of q1:
∂1 21
= 21 − 5𝑞1 = 0 → 5𝑞1 = 21 → 𝑞1 = = 4.2
∂𝑞1 5

from which it is possible to derive the optimal quantity for firm 2:

q2= 3.8 – 0.5*4.2 = 3.8 – 2.1=1.7
In equilibrium, the overall quantity Q = q1 + q2 = 4.2 + 1.7 = 5.9
The quantity will be sold at the price P= 50 – 5q → P = 50 - 5*5.9 = 20.5
πS1=P*q1-C1= 20.5*4.2 – 20 – 10*4.2=24.1
πS2=P*q2-C2= 20.5*1.7 – 10 – 12*1.7= 34.85 – 10 – 20.4= 4.45
thus higher profits for firm 1 (πS1 = 24.1) than for firm 2 (πS2 = 4.45).
Compared to the Cournot equilibrium, in the Stackelberg game played on quantities there is a first mover
advantage: firm 1 (in this case the leader), is better off when it is allowed to choose first, while firm 2, the
follower, would rather prefer to play a Cournot game.

q1 q2 Q P π1 Π2
Simultaneous 2.8 2.4 5.2 24 19.2 18.8
game
Sequential game 4.2 1.7 5.9 20.5 24.1 4.45

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Formula – different cost functions

From a demand function of the type P=a-bq and under the assumption that the two firms are not
symmetric and have different costs, in particular firm 1 has lower cost function for firm2 we can
derive the best reply function of the two firms:
𝑎−𝑐1 1 𝑎−𝑐2 1
𝑅1 (𝑞2 ) = − 𝑞2 and 𝑅2 (𝑞1 ) = − 𝑞1
2𝑏 2 2𝑏 2
The quantities produced by the two firms and the equilibrium price and profits are given by:

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Exercise 2 – diverse demand

Two firms (1 and 2) compete by choosing prices. Their demand functions are Q1= 20 - P1 + P2 and Q2 = 20 +
P1- P2, where P1 and P2 are the prices charged by each firm, respectively and Q1 and Q2 are the resulting
demands.
Assume that marginal costs are zero for both firms.

a) Suppose that the two firms’ products are not perfect substitute and that firms set their prices at the same
time. Find the resulting Nash equilibrium (quantities, prices, profits).

Given the price strategy of the other firm, each firm chooses the price that maximizes its profit function.
For firm 1, this means: Max π1 = 𝑝1 ∗ 𝑞1 − 0 = 𝑝1 (20 − 𝑝1 + 𝑝 2 ) = 20𝑝1 − 𝑝12 + 𝑝1 𝑝2

the first order condition implies: 𝑝1 = 10 + 1/2 𝑝2

Given the symmetry of the problem, for firm 2 it is: → 𝑝2 = 10 + 1/2 𝑝1

We have again a symmetric game since the two firms have the same marginal costs which are in this case
null.

By solving the system with the two first order conditions, we obtain:
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𝑝1 = 10 + 1/2(10 + 1/2𝑝1 ) → 𝑝1 = 15 + 1/4𝑝1 → 𝑝1 = 15 ∗ = 20
3

the optimal prices: p1*=p2*=20

Substituting p in the demand function we have:

𝑄1 = 20 − 20 + 20 = 20 𝑎𝑛𝑑 𝑄2 = 20 + 20 − 20 = 20

the two firms produce q1*=q2*=20 and gain profits

π1*=π2*= 20*20=400

b) Does a Bertrand’s paradox emerges? Explain Why. There is no Bertrand paradox because goods produced
are not homogenous.

c) Suppose now that firm 1 sets its price before firm 2. Find the resulting Nash equilibrium (quantities, prices,
profits).
The game is solved via backward induction, that is, starting from the second stage.
In this stage, firm 2 chooses its price as in the simultaneous game, so its best reply function is:

p2 = 10 + 1/2p1 (see the first order condition of firm 2 in point a.)

Going to the first stage of the game, we find the optimal price for firm 1 by plugging the best reply function
of firm 2 in the profit function of firm 1. Starting from the Max function of firm 1 we would have:
Max π1 = 𝑝1 (20 − 𝑝1 + 𝑝 2 ) → (20 − 𝑝1 + (10 + 1/2 𝑝1 ))𝑝1 =
1
20𝑝1 − 𝑝12 + 10𝑝1 + 2 =
2𝑝1
2
30𝑝1 − 1/2𝑝1
From the first order condition we get:

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From which we get the optimal level of p1 which is pS1= 30,

We can derive the optimal price for firm 2, pS2= 10 + 0.5*30 = 25

By plugging the equilibrium prices in the demand functions, we find the optimal quantities

Q1= 20 - P1 + P2 = 20-30 + 25 = 15
and Q2 = 20 + P1- P2=20 + 30 -25 = 25, which implies

profits for firm 1, πS1= p1*q1= 30* 15= 450

profits for firm 2, πS2= p2*q2=25*25=625

higher profits for firm 2 (πS2= 625) than for firm 1 (πS1= 450).

If Firm 1 set price first, Firm 2 is able to undercut Firm 1 and gain a larger market share. However,
both firms make greater profits than they did in part a, where they choose price simultaneously.
The price leader provokes a price increase in the follower. By being able to move second, however,
the follower increases price by less than the leader, and hence undercuts the leader. Both firms
enjoy increased profits, but the follower does better.

q1 q2 p1 p2 π1 Π2
Bertrand extension different 20 20 20 20 400 400
demand curves – simultaneous
game
Bertrand extension different
demand functions – sequential 15 25 30 25 450 625
game

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Exercise 3 – Cournot, collusion and deviation

In the market there are 3 firms, A, S, P that compete a la Cournot (goods are perceived as perfect substitute
by consumers) . The total cost function of these firms is

TCi (qi ) = 40qi , con i = A, S, P.

The demand function is: p (Q) = 160 - Q, where Q = qA + qS + qP is the total quantity demanded.

a) Find the optimal quantity for each firms, price and profits.
Note that the reply function of firm A, for example, is the optimal quantity, that is the quantity that max.
profits, produced by firm A as a function of the quantity produced by the rival firms qs and qp.
Also note that the firms are symmetric since they have the same cost function.

We can compute the profits which will be:

π A = p (Q) qA - TCA (qA) = [160 - (qA + qS + qP )] qA - 40qA

∂
= 160 - (qS + qP ) - 2qA - 40 = 0
∂𝑞𝐴

From which we get:

For symmetry we have that the two reply functions of firm S and P are:

Firms are symmetric therefore they produce the same quantity in equilibrium which we can indicate as:

We substitute that into and we will get that

In equilibrium the quantity will be:

And the equilibrium price will be:

The profit of each firm will be equal to:

Based on the formula discussed in the previous exercise session you could derive directly the total quantity
produced.
𝑎−𝑐 𝑛
𝑄∗ = given that costs are the same for the three firms, we can reasonably assume that the firms
𝑏 𝑛+1
will equally split the total quantities, therefore q=Q/3

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b) Let’s now suppose that the firms will collude, the profits:

As firms have the same cost function the problem of determining the quantity to produce in equilibrium is
given by

Where firms will behave as one single firm, will choose the quantity that maximize the profit as a monopolist.

Let’s also clarify that in a collusion normally firms find an agreement on prices rater then quantity but since
we started by analyzing the competition a la Cournot where the strategic variable is the quantity, let’s focus
also on the quantity when analyzing the collusion case.

Let’s take the derivative:

We get that and the price is:

For a total profit of:

Since firms are symmetric is reasonable to assume that they will share equally the profits and each one will
get a profit of 1200. So as you can see again, in a collusion firms reduce quantity and increases price in
order to realize higher profits.

c) Suppose that firm A will deviate from the collusive agreement and the other firms do not notice that
firm A is deviating. Compute the quantity that firm A will choose.
Firm A will deviate from the agreement and will choose a quantity qDev that max. its profits. Suppose that
the other firms do not realize about A deviation and will continue to produce the optimal collusion quantity
that is they will continue to produce 20 (Q/3= 60/3=20)

To find the quantity that A will choose we can substitute Qs=20 and Qp =20 in the previous function:
which give a quantity=40
Profits of firm A will be:

Therefore, if the other firms do not realize that A is deviating, then A will increase the quantity produced, with
a decrease in price, realizing in this way higher profits. So for firm A is not convenient to collude: