Stackelberg

Duopoly Model
Stackelberg duopoly
model
• An oligopoly market model
• Non-cooperative strategic game where one firm
(the “leader”) moves first and decides how
much to produce, while all other firms (the
“followers”) decide how much to produce
afterwards.
• This sequential structure is the main difference
to Cournot’s model, where firms decide
simultaneously on the quantities they produce.
Cont.,
• The leader emerge in a market because of its
size, reputation, innovative capacity, or
because it simply started operating first.
• The leader will be better known and more
recognized by customers, and is therefore
better placed to decide first which quantity to
sell.
• The follower(s) then decide(s) on their output
after observing the leader's production
choice.
• The Stackelberg leadership model was
developed in 1934 by the German economist
Heinrich Freiherr von Stackelberg in his book
“Market Structure and Equilibrium”
(Marktform und Gleichgewicht).
 Assumptio
ns
• The assumptions in Stackelberg model are same
as in the Cournot model, with the important
exception that firms make their production
quantity decisions sequentially.
• Assumptions:
• There is a fixed number of firms in the market
• Firms have market power. This means that each
firm's production-decision affects the market
price.
• All firms produce a homogenous good, and are
subject to the same demand and cost functions.
• This means that the goods produced by any firm
are completely identical in the eyes of the
consumers (they are perfect substitutes).
• Firms compete in terms of the quantities that
they produce. That is, they compete for market
share.
Cont.,
• Firms decide sequentially on output they
produce, which means we have a model
consisting of two distinct periods.
• In first period, the leader chooses its production
quantity. This decision cannot be changed after.
• In second period, the follower firm(s) choose(s)
their output after observing the quantity chosen
by the leader.
• This is the key difference when compared to
Cournot competition, in which the production
decisions by all firms are taken simultaneously.
• Each firm acts strategically on assumption that
its competitor(s) will not change their output, and
decides its own production quantity so as to
maximize its profit given its competitors’ output.

• Firms do not cooperate.

Stackelberg-Nash
Equilibrium
• To derive the Stackelberg-Nash equilibrium,
we will focus on the example of a duopoly.
• There are only two firms in the market.
• We will assume that firm 1 (leader) and firm
2 (follower) both produce the same good at
the same production cost c1 = c2 = c.
• We further assume that both firms face the
same linear demand function given by:
• p(Q) = a - bQ
• where a > 0 and b > 0.
Cont.,
• Total market quantity is sum of production by the leader (q1)
and the follower (q2), which is Q = q1 + q2.
• We can substitute this expression for Q in the following
equations.
• Firm 1's total revenue is given by the market price p(Q) times
the quantity produced:
• r1=p(Q)q1=(a−b(q1+q2))q1 (analogous for firm 2),
• Firm 1's total profits are calculated as the
difference between revenue and production costs:
• π1=p(Q)q1−cq1=(a−b(q1+q2)−c)q1(analogous
for firm 2).
• From here we will assume a > c, which is a
necessary condition such that positive profits can
be realized.
• Each firm chooses the production quantity
that maximizes its profits, taking the quantity
produced by other firms in the market into
consideration.
• To find the Nash equilibrium of this sequential
game, we need to use backward induction.
• That is, we first solve the optimization
problem for the follower in the second period,
and with this information determine the
optimal choice by the leader in the first
period.
• In the second period, Firm 2 (follower)
chooses q2, taking the quantity produced by the
leader in the first period into consideration.
• So, to derive the optimal output, we need to find
the quantity q2 that maximizes the profit
function for Firm 2, taking q1 as given. For Firm
2, the problem is thus similar to the Cournot
model:
• Given the quantity produced by the leader, q1*, we
can then calculate the output produced by the
follower:
• Thus, in the Stackelberg-Nash equilibrium, the
leader produces a larger quantity and the
follower produces a smaller quantity than the
same firms would have produced in the
Cournot-Nash equilibrium.
• The figure below illustrates the difference in
quantities produced in a Stackelberg or Cournot
oligopoly (imperfect competition)
or monopolistic market (firm 1 is the only firm in
the market), where q1S > q1C and q2S < q2C:
• Calculating the total quantity and the market price,
given q1* and q2*, we see that Stackelberg's
sequential game leads to a more competitive
equilibrium -- characterized by a larger total output
and lower price level -- than Cournot's
simultaneous game:
• The Stackelberg leader takes into account
that higher output causes the follower to
produce less, but also that higher output
depresses the price level.
• In this particular scenario, with a linear
demand function and identical costs, the two
effects happen to cancel exactly and in this
case we end up with a solution where the
Stackelberg leader produces the monopoly
quantity (although due to the depressed
price level, receives less than monopoly
profits).
• If we were to insert the production
quantities and price level into the profit
functions, we would find that the
Stackelberg leader has higher profits, and
the Stackelberg follower lower profits, than
the same firms in the Cournot model.
• This extra profit that the leader has
compared to the follower is due to them
making a production decision first, which
means the follower must accept the
leader’s output as given and produce a
smaller output for itself.
• This is called a first mover advantage.
• In the figure below, areas 1 + 2 illustrate the welfare
gain in the Stackelberg model compared to Cournot
model, while area 3 illustrates the
remaining deadweight loss compared to a situation
of perfect competition.
• Importantly, the Stackelberg equilibrium is only
more efficient than the Cournot equilibrium if firms
are symmetric; that is, if both firms have the same
production cost.
• If the leader were to have higher production costs
and thus be less efficient than the follower, then the
Cournot equilibrium would be preferable from a
welfare perspective, since the Stackelberg's
sequential model would give an advantage to the
less efficient firm with higher costs.
Example –Microsoft vs
Apple
• Actual markets may exhibit Stackelberg-type competition
when, for example, sequential market entry or R&D races
put one firm in a better market position than its
competitors.
• Let’s examine Microsoft in the 1990s as an example of this.
• Consider the market for operating systems that we use to
interact with our computers.
• Microsoft was the leader in the operating system market in
the 1990s, eventually commanding over 90% of market
share with their popular Windows OS.
• Because of this market position, software applications
generally needed to be compatible with Microsoft’s
operating system.
• Microsoft’s production decisions overshadowed any
following firms, who had to account for the massive market
share that Microsoft had (or, devise a plan to capture some
of that market share for themselves) when making
production decisions.
• Eventually Apple computers became popular as
well, and the Apple DOS took some market
share from Microsoft’s Windows operating
systems.
• Of course, in real life people generally have a
strong preference between using a Mac or a
PC.
• This is where the example differs from the
Stackelberg model we’ve talked about in this
article, since operating systems are not
identical in the eyes of consumers.
• Although the products are similar, in reality
there will almost always be some product and
price differentiation that causes market
dynamics to diverge from the stylized model.