Policy Example: How Should the Government Have Responded to Big Oil Company Mergers?

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What are the strategic incentives for banks to take risks?What policy solutions present themselves from this analysis?

 

18.1 Cournot Model of Oligopoly: Quantity Setters

Learning Objective 18.1: Describe game theory and they types of situations it describes.

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18.2 Bertrand Model of Oligopoly: Price Setters

Learning Objective 18.2: Describe normal form games and identify optimal strategies and equilibrium outcomes in such games.

18.3 Stackelberg Model of Oligopoly: First Mover Advantage

Learning Objective 18.3: Describe sequential move games and explain how they are solved.

18.4 Policy Example: How Should the Government Have Responded to the Banking Crisis of 2008?

Learning Objective 18.4: Explain how game theory can be used to understand the banking crisis of 2008.

18.1 Cournot Model of Oligopoly: Quantity Setters

Learning Objective 18.1: Describe game theory and they types of situations it describes.

Oligopoly markets are markets in which only a few firms compete, where firms produce homogeneous or differentiated products and where barriers to entry exist that may be natural or constructed. There are three main models of oligopoly markets, each consider a slightly different competitive environment. The Cournot model considers firms that make an identical product and make output decisions simultaneously. The Bertrand model considers firms that make and identical product but compete on price and make their pricing decisions simultaneously. The Stackelberg model considers quantity setting firms with an identical product that make output decisions simultaneously. This module considers all three in order beginning with the Cournot model.

Table 18.1: Metrics of the Four Basic Market Structures

Number of Firms

Similarity of Goods

Barriers to Entry or Exit

Module

Perfect Competition

Many

Identical

No

13

Monopolistic Competition

Many

Distinct

No

19

Oligopoly

Few

Identical or Distinct

Yes

18

Monopoly

One

Unique

Yes

15

Oligopolists face downward sloping demand curves which means that price is a function of the total quantity produced which, in turn, implies that one firm’s output affects not only the price it receives for its output but the price its competitors receive as well. This creates a strategic environment where one firm’s profit maximizing output level is a function of their competitors’ output levels. The model we use to analyze this is one first introduced by French economist and mathematician Antoine Augustin Cournot in 1838. Interestingly, the solution to the Cournot model is the same as the more general Nash equilibrium concept introduced by John Nash in 1949 and the one used to solve for equilibrium in non-cooperative games in Module 17.

We will start by considering the simplest situation: only two companies who make an identical product and who have the same cost function. Later we will explore what happens when we relax those assumptions and allow more firms, differentiated products and different cost functions.

Let’s begin by considering a situation where there are two oil refineries located in the Denver, Colorado area who are the only two providers of gasoline for the Rocky Mountain regional wholesale market. We’ll call them Federal Gas and National Gas. The gas they produce is identical and they each decide independently, and without knowing the other’s choice, the quantity of gas to produce for the week at the beginning of each week. We will call Federal’s output choice qF and National’s output choice qN , where q represents liters of gasoline. The weekly demand for wholesale gas in the Rocky Mountain region is P=A – BQ, where Q is the total quantity of gas supplied by the two firms or, Q=qF+qN. Immediately you can see the strategic component: the price the both receive for their gas is a function of each company’s output. We will assume that each liter of gas produced costs the company c, or that c is the marginal cost of producing a liter of gas for both companies and that there are no fixed costs.

With these assumptions in place, we can express Federal’s profit function:


Note that we have now described a game complete with players, Federal and National, strategies, qF and qN, and payoffs πF and πN. Now the task is to search for equilibrium of the game. To do so we have to begin with a best response function. In this case the best response is the firm’s profit maximizing output. This will depend on both the firm’s own output and the competing firm’s output.

CALCULUS APPENDIX

If the profit function is


colorgreenpi_F=q_F(A-B(q_F+q_N)-c) , then we can find the optimal output level by solving for the stationary point, or solving:

colorgreen fracpartial pi_Fpartial q_F=0

If πF = qF ( A – B ( qF + qN ) -c ) then we can expand to find


Taking the partial derivative of this expression with respect to qF

colorgreenfracpartial pi_Fpartial q_F=A-2Bq_F-Bq_N-c=0

If we re-arrange this we can see that this is simply an expression of MR=MC.

colorgreenA-2Bq_F-Bq_N=c

The marginal revenue looks the same as a monopolist’s MR function but with one additional term, -BqN.

Solving for qF yields:

colorgreenq_F=fracA-Bq_N-c2B

or

colorgreen q^*_F=fracA-c2B-frac12qN

This is Federal Oil’s best response function, their profit maximizing output level given the output choice of their rivals. It is the same best response function as the ones in Module 17. By symmetry, National Oil has an identical best response function:

colorgreen q^*_N=fracA-c2B-frac12qF

We know from Module 15 that the monopolists marginal revenue curve when facing an inverse demand curve P=A-BQ

is MR(q)=A-2Bq. It runs out in this duopolist example that the firms’ marginal revenue curves include one extra term:


The profit-maximizing rule tells us that to find profit maximizing output we must set the marginal revenue to the marginal cost and solve. Doing so yields q^*_F=fracA-c2B-frac12qN for Federal Oil, and q^*_N=fracA-c2B-frac12qF for National Oil. These are the firms’ best response functions; their profit maximizing output levels given the output choice of their rivals.

Now that we know the best response functions solving for equilibrium in the model is relatively straightforward. We can begin by graphing the best response functions. These graphical illustrations of the best response functions are called reaction curves. A Nash equilibrium is a correspondence of best response functions which is the same as a crossing of the reaction curves.

Figure 18.1.1: Nash Equilibrium in the Cournot Duopoly Model



In Figure 18.1.1, we can see the Nash equilibrium of the Cournot duopoly model as the intersection of the reaction curves. Mathematically this intersection is found by solving the system of equations,  q^*_F=fracA-c2B-frac12q_N and q^*_F=fracA-c2B-frac12q_F

simultaneously. This is a system of two equations and two unknowns and therefore has a unique solution as long as the slopes are not equal. We can solve these by substituting one equation into the other which yields a single equation with a single unknown:

q^*_F=fracA-c2B-frac12

Solving by steps:

q^*_F=fracA-c2B-fracA-c4B+frac14q_F

frac34q^*_F=fracA-c4B

q^*_F=fracA-c3B

And by symmetry we know:

q^*_N=fracA-c3B

The Nash equilibrium is: (q^*_F,q^*_N) , or (fracA-c3B , fracA-c3B)

Let’s consider a specific example. Suppose in the above example the weekly demand curve for wholesale gas in the Rocky Mountain region is p = 1,000 – 2Q, in thousands of gallons, and both firm’s have constant marginal costs of 400. In this case A = 1,000, B = 2 and c = 400. So q^*_F=fracA-c3B=frac1,000-400(3)(2)=frac6006=100. By symmetry we know $latex q^*_N=100$ as well. So both Federal Oil and National Oil produce 100 thousand gallons of gasoline a week. Total output is the sum of the two and is 200 thousands gallons. The price is p = 1,000 – 2(200) = $600 for one thousand gallons of gas or $0.60 a gallon.

To analyze this from the beginning we can set up the total revenue function for Federal Oil:

TR(q_F)=p×q_F

=(1,000-2Q)q_F

=(1,000-2q_F-2q_N)q_F

= 1,000-2q frac2F-2q_Fq_N

The marginal revenue function that is associated with this is:

MR(q_F)=1,000-4q_F-2q_N

We know marginal cost is 400, so setting marginal revenue equal to marginal cost results in the following expression:

1,000-4q_F-2q_N=400

Solving for q_F:

q_F=frac600-2q_N4

q^*_F=150-fracq_F2

This is the best response function for Federal Oil. By symmetry we know that National Oil has the same best response function:

q^*_N=150-fracq_F2

Solving for the Nash equilibrium:

q^*_N=150-fracq_F2

q^*_F=150-75+fracq_F4

frac34q^*_F=25

q^*_F=100

We can insert the solution for q_F into q^*_N:


18.2 Bertrand Model of Oligopoly: Price Setters

Learning Objective 18.2:.

In the previous section we studied oligopolists that make an identical good and who compete by setting quantities. The example we used in that section was wholesale gasoline where the market sets a price that equates supply and demand and the strategic decision of the refiners was how much oil to refine into gasoline. In this section we turn our attention to a different situation in which the oligopolists compete on price. The example here are the retail gas stations that bought the wholesale gas from the refiners and are now ready to sell it to consumers. We still have identical goods, for consumers the gas that goes into their cars is all the same and we will assume away any other differences like cleaner stations or the presence of a mini-mart.

Lets imagine a simple situation where there two gas stations, Fast Gas and Speedy Gas on either side of a busy main street. Both stations have large signs that display the gas prices that each station is offering for the day. Consumers are assumed to be indifferent about the gas or the stations, so they will go to the station that is offering the lower price. So an individual gas station’s demand is conditional on its relative price with the other station

Formally we can express this with the following demand function for Fast Gas:

Q_F left{eginmatrix & & & \ a-bP_F,,if,,P_F P_F endmatrix ight.

Speedy Gas has an equivalent demand curve:

Q_S left{eginmatrix & & & \ a-bP_S,,if,,P_S P_F endmatrix ight.

In words, these demand curves say that if a station has a lower price than the other, they will get all of the demand at that price and the other station will get no demand. If they have the same price, then each will get one half of the demand at that price.

Let’s assume that Fast Gas and Speedy Gas both have the same constant marginal cost of c, and will assume no fixed costs to keep the analysis simple. The question we now have to answer is what are the best response functions for the two stations? Remember that best response functions are one player’s optimal strategy choice given the strategy choice of the other player. So what is one Fast Gas’s best response to the Speedy Gas’s price?

If Speedy Gas chargesPS > c , Fast Gas can set PF > PS and they will get no customers at all and make a profit of zero. They could instead set PF=PS and get ½ the demand at that price and make a positive profit. Or they could set PF = PS – $0.01 , or set their price one cent below Speedy Gas’s price and get all of the customers at a price that is one cent below the price at which they would get ½ the demand. Clearly, this third option is the one that yields the most profit. Now we just have to consider the case where PS = c. In this case, undercutting the price by one cent is not optimal because Fast Gas would get all of the demand but would lose money on every gallon of gas sold yielding negative profits. Setting PF = PS = c would give them half the demand at a break-even price and would yield exactly zero profits.

The best response function we just described for Fast Gas is the same best response function for Speedy Gas. So where is the correspondence of best response functions? As long as the prices are above c there is always an incentive for both stations to undercut each other’s price, so there is no equilibrium. But at PF = PS = c both stations are playing their best response to each other simultaneously. So the unique Nash equilibrium to this game is PF = PS = c.

What is particularly interesting about this is the fact that this is the same outcome that would have occurred if they were in a perfectly competitive market because competition would have driven prices down to marginal cost. So in a situation where competition is based on price and the good is relatively homogeneous, as few as two firms can drive the market to an efficient outcome.

18.3 Stackelberg Model of Oligopoly: First Mover Advantage

Learning Objective 18.3:

Both the Cournot model and the Bertrand model assume simultaneous move games. This makes sense when one firm has to make a strategic decision before knowing about the strategy choice of the other firm. But not all situations are like this, what happens when one firm makes its strategic decision first and the other firm chooses second? This is the situation described by the Stackelberg model where the firms are quantity setters selling homogenous goods.

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Let’s return to the example of two oil companies: Federal Gas and National Gas. The gas they produce is identical but now they decide their output levels sequentially. We will assume that Federal Gas sets its output first and then, after observing Federal’s choice, National Gas decides on the quantity of gas they are going to produce for the week. We will again call Federal’s output choice qF and National’s output choice qN , where q represents liters of gasoline. The weekly demand for wholesale gas is still P = A – BQ , where Q is the total quantity of gas supplied by the two firms or, Q=qF+qN.

We have now turned the previous Cournot game into a sequential game and the SPNE solution to a sequential game is found through backward induction. So we have to start at the second move of the game: National’s output choice. When National makes this decision, Federal’s output choices is already made and known to National so it is takes as given. Therefore, we can express Federal’s profit function as: