ECO316: Applied Game Theory

Lecture 2

Christopher R. Dobronyi

University of Toronto

July 5, 2018

© 2018 by Christopher R. Dobronyi

Based on materials by Martin J. Osborne
Table of contents

Firm Competition

Bertrand Model

Cournot Model

Comparison of Models
Firm Competition Bertrand Model Cournot Model Comparison of Models

Firm Competition

I Topic at the heart of classical economic theory

I Standard model:
I Each firm takes price as given
I Firms do not take other firms into account
I Outcome is independent of the number of firms
I This lecture introduces two alternative models
Firm Competition Bertrand Model Cournot Model Comparison of Models

Preview of the Two Alternative Models

I Bertrand model:
I Each firm chooses a price
I Customers buy from the firm with the lowest price
I Cournot model:
I Each firm chooses a level of output
I Price is determined by the output of all firms
Firm Competition Bertrand Model Cournot Model Comparison of Models

Review: Strategic Games

Game theory studies situations in which rational decision-makers

interact—a strategic game is a simple model consisting of
I a set of players
I a set of actions, for each player
I preferences over the set of action profiles, for each player

Action profile: a list of actions with one action for each player
Firm Competition Bertrand Model Cournot Model Comparison of Models

Bertrand Model

A Bertrand model is a strategic game consisting of

I a set of firms
I a set of possible prices, for each firm
I preferences in the form of a profit function, for each firm
in which
I each firm chooses a price
I consumers buy from the firm with the lowest price
I each firm produces enough output to satisfy demand
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model

I Players: two firms

I Actions: any non-negative price pi , for each firm i
I Cost: cost of producing q for firm i is Ci (q) = cq for c > 0
I Demand: D(p) = α − p for p ≤ α and α > c
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Cost and Demand

I Cost: cost of producing q for firm i is Ci (q) = cq for c > 0
I Demand: D(p) = α − p for p ≤ α and α > c

C (q) D(p)

α
c
D(c)

1 q c α p
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Profit

I Cost: cost of producing q for firm i is Ci (q) = cq for c > 0
I Demand: D(p) = α − p for p ≤ α and α > c

Profit: if pi ≤ α then firm i 6= j’s profit is

I pi < pj : πi (p1 , p2 ) = pi D(pi ) − cD(pi ) = (pi − c)(α − pi )
| {z } | {z }
revenue cost

pi D(pi ) cD(pi )
I pi = pj : πi (p1 , p2 ) = − = 21 (pi − c)(α − pi )
2 2
| {z } | {z }
revenue cost

I pi > pj : πi (p1 , p2 ) = 0
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Profit

I Profit: if pi ≤ α then firm i 6= j’s profit is


(pi − c)(α − pi ),
 if pi < pj ,
1
πi (p1 , p2 ) = 2 (pi − c)(α − pi ), if pi = pj ,

0, if pi > pj


πi (p1 , p2 ) (pi − c)(α − pi )

0
c pj m α pi
Firm Competition Bertrand Model Cournot Model Comparison of Models

Review: Nash Equilibrium

An action profile is a Nash equilibrium of a strategic game if

every player’s action is optimal, given the other players’ actions,

or, equivalently, if
no player can change her action to make herself strictly
better off, given the other players’ actions
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Optimal Actions

πi (p1 , p2 ) (pi − c)(α − pi )

pj
0
c m α pi

I If pj < c then any price pi > pj is optimal for firm i

Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Optimal Actions

πi (p1 , p2 ) (pi − c)(α − pi )

pj
0
c m α pi

I If pj < c then any price pi > pj is optimal for firm i

I If pj = c then any price pi ≥ c is optimal for firm i
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Optimal Actions

πi (p1 , p2 ) (pi − c)(α − pi )

0
c pj m α pi

I If pj < c then any price pi > pj is optimal for firm i

I If pj = c then any price pi ≥ c is optimal for firm i
I If c < pj ≤ m then there is no optimal price for firm i
I if pi ≥ pj then any price slightly less than pj is strictly better
I if pi < pj then any price slightly larger than pi is strictly better
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Optimal Actions

πi (p1 , p2 ) (pi − c)(α − pi )

0
c m pj α pi

I If pj < c then any price pi > pj is optimal for firm i

I If pj = c then any price pi ≥ c is optimal for firm i
I If c < pj ≤ m then there is no optimal price for firm i
I if pi ≥ pj then any price slightly less than pj is strictly better
I if pi < pj then any price slightly larger than pi is strictly better
I If pj > m then a price of m is optimal for firm i
Firm Competition Bertrand Model Cournot Model Comparison of Models

Review: How to Find a Nash Equilibrium

Method: We can find every Nash equilibrium of a strategic game

by checking every action profile to see if there is a player that
can change her action to make herself strictly better off, while
holding the other players’ actions constant

Tip: Group similar profiles together if there are a lot of profiles

Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Nash Equilibrium

Proof that (c, c) is a Nash equilibrium:

We must show that no firm i can obtain a profit strictly larger than
πi (c, c) = 0 when the other firm chooses a price of c such that
π1 (p1 , c) ≤ 0, for all p1 ,
π2 (c, p2 ) ≤ 0, for all p2

If firm 1 chooses a price of p1 and firm 2 chooses a price of c then

p1 < c implies π1 (p1 , c) < 0,
p1 ≥ c implies π1 (p1 , c) = 0

We can make a similar argument for firm 2

Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Unique Nash Equilibrium

Proof that (c, c) is the only Nash equilibrium:

πi (p1 , p2 ) (pi − c)(α − pi )

pj
0
c m α pi
pi

I pi < c & pi ≤ pj : Not a Nash equilibrium because firm i can

deviate to c to obtain a payoff of 0 instead of πi (p1 , p2 ) < 0
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Unique Nash Equilibrium

Proof that (c, c) is the only Nash equilibrium:

πi (p1 , p2 ) (pi − c)(α − pi )

pj
0
c m α pi
pi

I pi < c & pi ≤ pj : Not a Nash equilibrium because firm i can

deviate to c to obtain a payoff of 0 instead of πi (p1 , p2 ) < 0
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Unique Nash Equilibrium

Proof that (c, c) is the only Nash equilibrium:

πi (p1 , p2 ) (pi − c)(α − pi )

0
c pj m α pi
pi

I pi < c & pi ≤ pj : Not a Nash equilibrium because firm i can

deviate to c to obtain a payoff of 0 instead of πi (p1 , p2 ) < 0
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Unique Nash Equilibrium

Proof that (c, c) is the only Nash equilibrium:

πi (p1 , p2 ) (pi − c)(α − pi )

0
c m pj α pi
pi

I pi < c & pi ≤ pj : Not a Nash equilibrium because firm i can

deviate to c to obtain a payoff of 0 instead of πi (p1 , p2 ) < 0
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Unique Nash Equilibrium

Proof that (c, c) is the only Nash equilibrium:

πi (p1 , p2 ) (pi − c)(α − pi )

pi
0
c pj m α pi

I pi = c & pj > c: Not a Nash equilibrium because firm i can

deviate to pi < p < pj to obtain positive payoff instead of 0
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Unique Nash Equilibrium

Proof that (c, c) is the only Nash equilibrium:

πi (p1 , p2 ) (pi − c)(α − pi )

pi
0
c m pj α pi

I pi = c & pj > c: Not a Nash equilibrium because firm i can

deviate to pi < p < pj to obtain positive payoff instead of 0
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Unique Nash Equilibrium

Proof that (c, c) is the only Nash equilibrium:

πi (p1 , p2 ) (pi − c)(α − pi )

pi
0
c pj m α pi

I pi ≥ pj > c: Not a Nash equilibrium because firm i can

deviate to p slightly below pj if pj ≤ m and to m if pj > m
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Unique Nash Equilibrium

Proof that (c, c) is the only Nash equilibrium:

πi (p1 , p2 ) (pi − c)(α − pi )

pi
0
c m pj α pi

I pi ≥ pj > c: Not a Nash equilibrium because firm i can

deviate to p slightly below pj if pj ≤ m and to m if pj > m
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Bertrand Model: Summary

There is a unique Nash equilibrium at (c, c):

It only takes two firms to get the competitive outcome!

Questions:
I What happens with more than two firms?
I What about other cost functions?
I What about other demand functions?
I What if prices must be integers (e.g. 1 cent, 2 cents, etc.)?
I Is there a way for firms to collude?
I What if firms interact repeatedly?
Firm Competition Bertrand Model Cournot Model Comparison of Models

Cournot Model

A Cournot model is a strategic game consisting of

I a set of firms
I a set of possible quantities, for each firm
I preferences in the form of a profit function, for each firm
in which
I each firm chooses a quantity
I price is determined by an inverse demand function
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Cournot Model

I Players: two firms

I Actions: any non-negative quantity qi , for each firm i
I Cost: cost of producing q for firm i is Ci (q) = cq for c > 0
I Inverse demand: P(Q) = α − Q for Q ≤ α and α > c

I Note: Q denotes total output such that Q = q1 + q2

Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Cournot Model: Cost and Demand

I Cost: cost of producing q for firm i is Ci (q) = cq for c > 0
I Inverse demand: P(Q) = α − Q for Q ≤ α and α > c

C (q) P(Q)

α
c

c c

1 q α−c α Q
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Cournot Model: Profit

I Cost: cost of producing q for firm i is Ci (q) = cq for c > 0
I Inverse demand: P(Q) = α − Q for Q ≤ α and α > c

Profit: if Q ≤ α then firm i 6= j’s profit is

πi (q1 , q2 ) = P(Q)qi − cqi = (α − q1 − q2 )qi − cqi

| {z } |{z}
revenue cost
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Cournot Model: Profit

I Cost: cost of producing q for firm i is Ci (q) = cq for c > 0
I Inverse demand: P(Q) = α − Q for Q ≤ α and α > c

Profit: if Q ≤ α then firm i 6= j’s profit is

πi (q1 , q2 ) = P(Q)qi − cqi = −qi2 + (α − c − qj )qi

| {z } |{z}
revenue cost

This function is quadratic in qi

Firm Competition Bertrand Model Cournot Model Comparison of Models

Review: Quadratic Functions

Quadratic function: f (x) = ax 2 + bx + c

f (x) a<0
b>0

c x
0 −b −b
2a a
I a > 0: graph has a U-shape with one minimum
I a < 0: graph has an inverted U-shape with one maximum
I Minimum/maximum at −b 2a
Firm Competition Bertrand Model Cournot Model Comparison of Models

Review: Twice-Differentiable Functions

Twice-differentiable function: Derivatives f 0 (x) and f 00 (x) exist

f (x) f 0 (x ∗ ) = 0
f 00 (x ∗ ) = 0

x
x∗
I Critical points: values x ∗ such that f 0 (x ∗ ) = 0
I f 0 (x ∗ ) = 0 and f 00 (x ∗ ) > 0: local minimum at x ∗
I f 0 (x ∗ ) = 0 and f 00 (x ∗ ) < 0: local maximum at x ∗
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Cournot Model: Optimal Actions

Profit function:

πi (q1 , q2 ) πi (q1 , q2 ) =
−qi2 + (α − c − qj )qi

qi
0 α − c − qj α − c − qj
2

α−c−qj
Given quantity qj , firm i’s optimal quantity is 2
α−c−qj
That is, firm i’s best response function is bi (qj ) = 2
Firm Competition Bertrand Model Cournot Model Comparison of Models

How to Find a Nash Equilibrium

A best response function for player i in a strategic game is a

function bi (a−i ) that inputs the other players’ actions a−i and
outputs the set of optimal actions for player i

Method: We can find every Nash equilibrium of a strategic game

by calculating the best response function bi (a−i ) for each player
i and identifying all of the action profiles a such that

ai = bi (a−i ), for all players i

Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Cournot Model: Best Response Functions

Best response functions:
α − c − q2 α − c − q1
b1 (q2 ) = and b2 (q1 ) =
2 2

q2

α−c

b1 (q2 )
α−c
2 (q1∗ , q2∗ )

b2 (q1 )

α−c α−c q1
2
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Cournot Model: Nash Equilibrium

Best response functions:
α − c − q2 α − c − q1
b1 (q2 ) = and b2 (q1 ) =
2 2

If (q1∗ , q2∗ ) is a Nash equilibrium then it must satisfy

α − c − q2∗ α − c − q1∗
q1∗ = and q2∗ =
2 2
We can solve this system of equations using substitutiion:
α−c−qi∗
 
α−c − 2 α−c
qi∗ = implies qi∗ =
2 3
Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Cournot Model: Properties

α−c α−c


There is a unique Nash equilibrium at 3 , 3

Positive profit: Since the total output in equilibrium is

α−c α−c 2(α − c)

Q∗ = + = ,
3 3 3
the price in equilibrium is
 
∗ ∗ 2(α − c) α + 2c
P(Q ) = α − Q = α − =
3 3

which is greater than c because α > c

Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Cournot Model: Properties

α−c α−c


There is a unique Nash equilibrium at 3 , 3

Prices: The quantity q m that a monopolist would choose solves

maxq (α − q)q − cq = −q 2 + (α − c)q

| {z } |{z}
revenue cost

This is a quadratic function: we can find q m by using the

properties of a quadratic function or by taking its derivative, i.e.,
d h i α−c
(α − q)q − cq = 0 implies q m =
dq 2

Since q m < Q ∗ , we obtain: c < P(Q ∗ ) < P(q m )

Firm Competition Bertrand Model Cournot Model Comparison of Models

Example of a Cournot Model: Summary

α−c α−c


There is a unique Nash equilibrium at 3 , 3

Questions:
I What happens with more than two firms?
I What about other cost functions?
I What about other demand functions?
I What if quantities must be integers (e.g. 1 unit, 2 units, etc.)?
I Is there a way for firms to collude?
I What if firms interact repeatedly?
Firm Competition Bertrand Model Cournot Model Comparison of Models

Comparison of Models

I Bertrand model:
I Strategic variable is price
I Competitive outcome with only two firms
I No firm makes positive profit in the Nash equilibrium
I Cournot model:
I Strategic variable is quantity
I Price is higher than in the competitive outcome
I Price is lower than in the monopolistic outcome
I Firms make positive profit in the Nash equilibrium
I Homework: Show that the price in equilibrium goes to c and
that the profit goes to 0 as number of firms increases