© 2011  Steven Tschantz
Duopoly
Steven Tschantz
2/8/11
Problem
Two firms sell similar products in competition, setting prices to attract consumers. Consumers don't view these products as
exactly equivalent, but if the price of one product goes up some who would buy that product instead switch to the other. The
firms do not cooperate in setting prices, they set price to do the best for themselves. What prices do they set?
Model
Economists describe this as Bertrand competition between firms selling differentiated products. The products are (partial)
substitutes. The assumption is that firms set prices independently, without cooperation or coordination, each in order to
maximize their own profits.
The competition can be thought of as a game. Each player makes a choice of strategy (price) and the result for each player is
the payoff they get (the profit they make). Players make their choices simultaneously without communicating or negotiating.
Each player will choose a strategy to maximize its payoff knowing that the other player will choose its strategy to maximize its
payoff. If player
A
were to choose strategy
a
1
say, and player
B
knows this, then player
B
might want strategy
b
2
to maximize
its payoff. But if player
A
knows
B
will choose strategy
b
2
, then
A
may want
a
3
as its strategy. Then
B
might prefer strategy
b
4
, and back and forth endlessly. What we want is a strategy
a
for
A
for which the best
B
can do is a strategy
b
and such that
the best
A
can do in response to
b
is the original
a
. A pair of strategies
H
a
,
b
L
satisfying this condition is called a Nash equilib
rium of the game and is thought of as a solution for the game.
What we assume then is that each firm takes the competition's price as a given, looks at the demand for its own product as a
function of its own price, and sets the price that maximize its own profits. As before, to determine a firm's profit maximizing
price we need to know the demand it faces and its costs. The cost of each firm can reasonably be assumed to be a function of
the quantity it produces and sells. However, the demand for each firm's product is a function of the prices of both products.
Let the firms, and their corresponding products, be denoted by 1 and 2, with prices
p
1
and
p
2
and quantities
q
1
and
q
2
.
Suppose firms face costs
C
1
H
q
1
L
and
C
2
H
q
2
L
. Assume demands are specified by functions
q
1
=
q
1
H
p
1
,
p
2
L
and
q
2
=
q
2
H
p
1
,
p
2
L
.
Then the profit for firm 1 is
P
1
H
p
1
,
p
2
L
=
p
1
q
1
H
p
1
,
p
2
L

C
1
H
q
1
H
p
1
,
p
2
LL
and similarly for the profit of 2,
P
2
H
p
1
,
p
2
L
.