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Unformatted text preview: University of Toronto, Department of Economics, ECO 204 2009 2010 S. Ajaz Hussain ECO 204 2009 2010 S. Ajaz Hussain (Draft) Chapter 6.1: Static Models of Oligopoly: Cournot, Stackelberg, and Bertrand 1 Please help improve the course by sending me an e mail about typos or suggestions for improvements Introduction In earlier chapters, we modeled a firms decisions (price, output, inputs, etc) in a ceteris paribus environment as such we didnt have to worry about other firms reactions. The ceteris paribus framework is plausible if the business is a monopoly or competes with dormant firms. In this chapter we examine strategic rivalry where the business competes with firms that are reactive 2 . From now on, decisions are intertwined. For example if a firm boosts advertising, other firms will probably react by boosting advertising; similarly, if one firm lowers price, other firms are likely to react and trigger a price war (well examine this issue further in game theory). Now whenever a firm makes a decision (say, chooses output) it has to anticipate how other firms will react, and take this into consideration when making its decision. That is, there is strategic interaction between firms with market power. In this chapter, we take the first steps for modeling decisions with strategic interaction (What I do depends on what you do, and what you do depends on what I do). The techniques in this chapter come from game theory and will, needless to say, greatly facilitate game theoretic analysis in later chapters. Throughout this chapter, we assume a static (one period) environment (well examine dynamic , multi period, models of oligopoly in the game theory chapters). Before we begin, notice that there is no strategic interaction between competitive firms (What I do does not depend on what you do, and what you do does not depend on what I do). This is because competitive firms are price takers their only decision is to choose optimal output, chosen without regard to other firms outputs. This is why there is no need for game theory in the analysis of competitive markets. In contrast, modeling rivalry between firms with market power necessarily deploys game theory. 1 For next draft, insert section on measuring market structure by HHI and CR. Also discuss Fuenstra paper on Cournot vs. Bertrand behavior in auto market. 2 Recall that market power means the firms output affects the price. In contrast, competitive firms being price takers have no market power. 1 ECO 204 (Draft) Chapter 6.1 University of Toronto, Department of Economics, ECO 204 2009 2010 S. Ajaz Hussain The economics literature contains a very large number of models of rivalry between firms with market power. There are models of firms competing on the basis of advertising, models for entry into markets, models of product differentiation, and so on. These models are collectively known as Industrial Organization if you are interested in such models take...
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