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Final Exam Resume

Managerial Economics (McGill University)

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Managerial Economics – Chapter 6: Analysis of Cost

Opportunity Cost: Revenue manager could have received if he chose next best alternative. Need to reduce
opportunity costs.

 Opportunity Cost Doctrine: Economists believe the true costs of inputs are their values when used in the
most effective way. Therefore, input values and production costs determine economic costs of
production.
 Historical Cost: This is not the same as opportunity costs. How much was actually paid for inputs.
 Explicit Costs: Firm’s expenses (accounting)
 Implicit Costs: Include the forgone value of resources that managers did not put to their best use (i.e.,
opportunity costs)
o Excluding these implicit costs can be a serious mistake.
 Sunk Costs: Resources spent that cannot be recovered.

Cost Function: Various Relationships between input costs and output

 Short Run: Consists of fixed and variable costs. A time period when the firm cannot alter the quantities
of factories.
 Long Run: All costs are variable.

Fixed Costs: Cost that does not depend on the firm’s level of output (Q). These costs are incurred even if the firm
is producing nothing and can’t be recovered.
 If TC=0 when Q=0, there are no fixed costs.

Variable Costs: Cost that depends on the level of production chosen.

Short-Run Cost Functions:

We consider 3 short-run cost concepts: fixed, variable, and total:

1. Total Fixed Costs (TFC) are the total costs per period of time incurred by the firm on fixed inputs. Fixed
costs do not change with volume
2. Total Variable Costs (TVC) are the costs incurred by the firm for variable inputs. TVC vary with level of
output.
3. Total Costs (TC) are the sum of TFC and TVC

TC=TFC +TVC

Fig. 6.1: Fixed, Variable and Total Costs

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Average and Marginal Costs:

Average Costs:

1. Average Fixed Costs (AFC):

TFC
AFC =
Q

2. Average Variable Costs (AVC):

TVC 1
AVC = =W ×
Q AP
(Inverse of Average Product times the cost per unit of input 
when AP is maximized, AVC is minimized)

3. Average Total Costs (ATC):

ATC= AFC + AVC

Marginal Cost: The cost of producing one extra unit of output

dTC dTFC dTVC

MC= = +
dQ dQ dQ

** But! dTFC/dQ is zero because Fixed Costs cannot vary. Therefore,

dTVC 1
MC= =Wx
dQ MP
(Inverse of Marginal Product - ΔQ/ΔL - times the cost per unit of input)

 MC = ATC when ATC reaches its minimum

 MC = AVC when AVC reaches its minimum
Because MP=AP when AP is maximized

Fig. 6.2: Average and Marginal Cost Curves

Average fixed cost continually decreases as output increases.

The minimum of ATC occurs at a higher output than the minimum of AVC.
The ATC curve is the vertical sum of the AVC and AFC curves.

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Marginal Cost passes through the minimum of ATC and AVC.

Long Run Cost Functions:

In the long-run, all inputs are variable (nothing is fixed!!). In many cases, the desirability of increasing the size of
operations in the long-run is driven by a need to achieve economies of scale in production.

 Long Run Average Cost (LAC): shows the minimum long-run cost per unit of producing each output level.
Each of these minimum costs represents a different short run. If the curve is downward sloping, the firm
is experiencing economies of scale.

LTC
LAC=
Q

 Long Run Total Cost (LTC): relationship between long run total cost and output. All costs are variable
because in the long run, fixed costs (such as PPE) can also be changed.

LTC=LAC ×Q

 Long Run Marginal Cost (LMC): how varying output affects the cost of producing the last output

dLTC
LMC=
dQ

Figure 1: Long-run Average Cost and Long-run Marginal Cost curves

LAC and LMC decrease, reach a minimum, and then increase because of economies & diseconomies of scale.
LMC is less than LAC when LAC is decreasing;
LMC is equal to LAC when LAC is at a minimum;

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LMC is greater than LAC when LAC is increasing.

Managerial Use of Scale Economies:

 Economies of Scale: When the firms average unit cost decreases as output increases and all resources
are variable (as you produce more, costs start to go down).
 Diseconomies of Scale: When the firms average unit cost increases as output increases and all resources
are variable.
 Constant Economies of Scale: If unit cost is constant as the quantity of production increases.

Managerial Use of Scope Economies:

 Economies of Scope: When the cost of jointly producing two (or more) products is less than the cost of
producing each one alone.
o For example: Nike might have benefits of producing sneakers and basketballs at the same time
due to the use of similar materials.

Economies of scope are determined by the following formula:

C ( Q1 ) +C ( Q2 )−C (Q1+Q2)
S=
C(Q1 +Q 2 )

• S = degree of economies of scope

• C(q1) = cost of producing q1 units of the first product alone
• C(q2) = cost of producing q2 units of the second product alone
• C(q1 + q2) = cost of producing q1 units of the first product in combination with q 2 units of the second
product

 If there are economies of scope, S is greater than zero because the cost of producing both products together
is less than the cost of producing each alone. S measures the % of saving that results from producing them jointly
rather than individually.

Break Even Analysis:

 Break-even point (QB): The output level at which fixed costs are covered and the company begins to earn
profit. This is the intersection of the cost and revenue functions (TC=TR).
 Profit contribution (or Contribution Margin): CM = TR - TVC (on a per-unit basis)  CM = P - AVC

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TFC
QB =
P−AVC

Profit Contribution Analysis:

The output level needed to reach a certain level of profit:

¿Costs+ Profit
Output at desired Net Income=
Contribution Margin

** Exercise: Should a product be introduced or not?

 We will be making an economic profit when: AVC < Price (even if ATC > Price)
 We will incur an economic loss when: AVC > Price
 So, for any output where price exceeds AVC, managers should produce, even though the price does not
cover ATC. (see Chapter 7)

Managerial Economics – Chapter 7: Perfect Competition

Market Structure:

 Perfect Competition: many small firms that produce identical products. There are low barriers to entry
and no non-price competition (i.e., no advertising).
o Ex. Agriculture
 Monopolistic Competition: many firms that produce slightly different products from each other and
there are low barriers to entry. There is a lot of non-price competition in order to differentiate the
products (i.e. advertising and product differentiation).
o Ex. Shirt manufacturing
 Oligopoly: Market with few sellers. Identical or differentiated products. There are high barriers to entry.
There is some non-price competition in order to differentiate the products (i.e. advertising and product
differentiation).
o Ex. Automobile manufacturers
 Monopoly: markets with a single seller. Unique product. Entry is blocked and they use non-price
competition to stimulate demand (i.e. advertising). If entry occurs, the monopoly no longer exists.
o Ex. Public utilities

Key Characteristics of Perfect Competition:

1. Managers have no control over the price of their product (i.e. they are price takers: they accept the
decisions of the aggregate market). They, however, choose to produce at the profit-maximizing output
when the price is given.
 This is a key part of perfect competition and is very different from all other market structures,
because in all other markets, managers can vary both output and price.
2. Perfect competition is concerned with the aggregate demand and supply of the market.
3. Equilibrium quantity in perfect competition is found at P=MC.

Demand Curves:

 For a firm: Demand curve is horizontal (constant).

 For the entire industry: Demand curve is downward sloping.

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Figure 7.1: Determination of Price in Perfectly Competitive Market

Output Decision of a Perfectly Competitive Firm:

 Profit-maximizing quantity is given by MR=MC
 In Perfect competition, TR=PxQ  dTR/dQ = MR = P (since P is already set & constant since the demand
curve is horizontal)
 P=MC (and MC is increasing) is the profit maximizing condition in perfect competition
 At this output, the vertical distance between TR and TC curves is the largest
 The nature of competition is to grind the price down to marginal cost. The competitive pressure is
relentless!!!

In the case of negative profit:

Produce at a loss
YES
Negative Does the product’s price
Economic cover AVC, P>AVC?
Profit NO
Discontinue
Production

 It is essential to recognize that if managers shut a plant, they will still

incur Fixed Costs:
o If the loss from producing is less than the firm’s fixed costs, it is more
profitable (a smaller deficit) to produce than to discontinue
production.

Figure 7.4: Marginal Revenue and Marginal Cost of a Perfectly Competitive firm

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When output is at the profit maximizing level of four units, price (=marginal revenue) equals marginal cost.
Shutdown point: When the price (=MR) equals the minimum Average Variable Cost. The shutdown point is the
point (Z, P3) on the graph below. The manager will be indifferent at P 3.

Figure 7.5: Short-Run Average and Marginal Cost Curves

If Price > AVC  Produce; If Price < AVC  discontinue production.

Producer and Consumer Surplus in the Short-Run:

 Producer Surplus: This is the difference between the market price and the producer’s reservation price
(also known as the variable-cost profit)
o Producer surplus=TR-TVC (vs. Profit=TR-TC where TC=TVC+TFC)
 Consumer Surplus: This is the difference between the market price and the consumer’s reservation price
(the price they are willing to pay).

Market social welfare is the summation of producer and consumer surplus.

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Long-Run Equilibrium of the Firm under Perfect Competition:

 Important consideration in the perfectly competitive industry is what happens when a firm earns
economic profit. In the long run, perfect competition states that no firm earns an economic profit.
 When economic profit is earned, firms are induced to enter (P>LAC). This shifts the supply curve and
results in a lower price.
 When negative economic profit is earned (P<LAC), firms are induced to exit. This will shift the supply
curve and result in a higher price.
 This will continue to happen until economic profit=0 (i.e. P=LAC) and the industry is in the long-run
equilibrium. At that point, LAC is minimized because:
 P=LMC
 LMC=LAC
 LAC is minimized
 This all happens because of the no barriers to entry in a perfectly competitive industry.

Figure 7.8: Long-Run Equilibrium of a Perfectly Competitive Firm

In long-run equilibrium, the price (=MC) must equal the lowest value on the long-run average total cost

Managerial Economics – Chapter 8: Monopoly and Monopolistic Competition

In this chapter we expand on the studying of market structure. Last chapter we were introduced to the concept of
perfect competition. This chapter will focus on both monopoly and monopolistic competition.

Monopoly: A monopolist has immediate influence on the output and the price of that product in the market. The
monopolist has complete control of the supply curve
 They must decide both Price & Quantity (choose the optimal combination); they are no longer price takers
 They have more strategic power and are rewarded with higher economic profit

A monopoly is characterized by products that have:

1. No close substitute
2. One supplier
3. Barriers to entry

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Entry Barriers:
1. Legal: when the law does not allow a firm to enter a given market (legal system, legal patent)
2. Natural: when the technology used to produce a good/service allows one firm to meet the entire market
demand at a lower price than two or more firms could

Like many other market structures, the monopolist will produce where:

MR=MC

Since the monopolist can set the price of the product, it will sell at a price of:

MC=P 1+
[ ( )] 1
η

MC=P 1−
[ (|1η|)]
MC
P=
[ ]
1−
1
|η|

 It is also true that in a monopoly, Price must exceed Average Variable Cost if managers are to maximize
profit. If not, the monopolist is not covering variable cost and should shut the operation to reduce losses
to only fixed costs.

 To maximize profit, managers need to produce the output Q M where the MC curve intersects that of MR.
If the monopolist produces QM, she will set a price of PM. Because she is the only member of her market,
her firm’s demand curve is the industry demand curve. This is in contrast to perfect competition, where
the demand curve for a firm’s output is horizontal.

Cost-Plus Pricing: This is a very simple strategy that guarantees that the price is higher than the average cost. It
does not necessarily optimize profit. It is often adopted by small businesses that cannot determine the maximum
price.

Price=Cost ( 1+ Markup )

( Price−Cost )
Markup(%)=
Cost

Profit Margin=Price−Cost

If the owner wants to earn a 15 percent profit on their good they will simply multiply the cost by 1.15.

Target Return: This is another approach to pricing. The owner determines a certain amount of profit they would
like to earn. They then find the amount of markup needed to earn this target return.

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P=L+M + K + ( QF )+ π ( P− AC )
Where:
 P is price
 L is unit labour cost
 M is unit material cost
 K is unit marketing costs
 F is fixed (or indirect) costs
 Q is units of output
 A is total gross operating assets
 π is desired profit rate on these assets (ROR on assets)=Q(P-AC)
Cost plus pricing does not maximize profit, as it does not take supply and demand into consideration. However,
there is a way to determine a markup that will yield the max profit:

|η|
Markup=
(|η|−1 )

Multiple-Product Firm:

For firms that produce more than one product:

TR=TR X + TRY

∆ TR X ∆ TRY
MR X = +
∆ QX ∆ Q X

∆ TRY ∆TR X
MRY = +
∆ Q Y ∆Q Y

 If products X and Y are complements, this effect is positive because an increase in the quantity sold of
one product increases the total revenue from the other product

 If products X and Y are substitutes, the effect is negative because an increase in the quantity sold of one
product reduces the total revenue of the other product

Output of Joint Products: Variable Proportions

 Isocost curve (labeled TC):

Curve showing the amounts of
goods produced at the same
total cost
o Slope: dQy/dQx

 Isorevenue lines (labeled TR):

Lines showing the combinations
of output of products that yield
the same total revenue
o Slope: -Px/Py

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 Optimal combinations of goods are found where isocost and isorevenue lines are tangent.

The optimal point, which must be at a point where an isorevenue line

is tangent to an isocost curve, is at point M, where profit per day is
$7,000

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Monopsony: A monopoly is a market with a single seller. A monopsony is a market with a single buyer.

Monopolistic Competition:

This is the next step after perfect competition. Do not let the word monopolistic fool you. These industries have
low barriers to entry. One of the main distinctions between this type of market structure and perfect
competition is the fact that firms do not produce homogenous products  product differentiation. Products are
very similar as a group, but there are still variations (i.e. toothbrushes).

Conditions to classify as monopolistic competition:

1. There must be many firms in the product group.
2. When formulating their own price and output policies, firms do not explicitly concern themselves with
their rivals’ responses. If there are many firms, this condition normally is met.
3. Entry into the product group must be relatively easy, and there must be no collusion, such as price fixing
or market sharing, among managers in the product group.

In the short-run firms may earn economic profit and will produce where:

MR=MC

In the long-run the market is very much like perfect competition in the fact that no firm earns economic profit.
Otherwise entry or exit of firms will occur, and entry and exit are incompatible with long-run equilibrium.

Figure 8.10: Long-Run Equilibrium in Monopolistic Competition

The long-run equilibrium is at price P1 and output Q1. There is zero profit because LAC equals Price. Profit is maximized
because MR=MC.

Advertising Expenditure: Most important for monopolistic firms. Monopolists do not need advertising as much
since they do not need to attract consumers. We assume diminishing marginal returns to advertising
expenditures, which means that beyond some point, successive advertising outlays yield smaller increases in
sales.
MR A = price elasticity of demand=|η|

P
−η=
P−MR

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Managerial Economics – Chapter 9: Price Discrimination

Price Discrimination occurs when the same product is sold at more than one price. Even if the products are not
precisely the same, price discrimination is said to occur if similar products are sold at prices that are in different
ratios to their marginal cost.

First-Degree Price Discrimination:

Charge each customer a price equal to his/her reservation
price in order to extract all consumer surpluses. First-
degree discrimination lets managers expand sales (because
they are not constrained to a single price). The firm is
aware of each individual’s demand curve
 Small number of buyers, which allows producers to
estimate consumer’s reservation prices
 Producers maximize profit by making consumer
surplus equal to 0.
(i.e., they charge a price which is equal to
consumer’s reservation price).
 The auto dealer is an example of first-degree
The first-degree price discriminator captures all consumer
surplus J and turns it into producer surplus (variable-cost profit)

Second Degree Price Discrimination:

Charge based on consumption level (utility companies, such as gas, water, and electricity). Price per unit decreases
as consumers hit certain targets.

The company charges a different price (P0, P1, or P2) depending

on how much the consumer purchases, thus increasing its total
revenue and profit.

For instance, the company charges a high price, P0, if the

consumer purchases fewer than X units of gas per month.

Unlike first-degree price discrimination, managers leave a

consumer surplus of A+B+C, because second-degree (and third-
degree) discrimination occurs at the group level and not at the
individual level.

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Third Degree Price Discrimination:

Charge based on price elasticity in each market or market segment (e.g. student prices, airline tickets). Conditions
for this to be successful are as follows:
1. Demand must be heterogeneous.
2. Managers can identify and segregate different segments.
3. Individuals have different preferences towards the product.

Marginal revenues in both classes must be equal: MR1 = MR2 = MC

( ( )) ( ( )) ( ( ))
P 1+
1
η1
=P 1+
1
η2
=P 1+
1
η3
=…=MC

Profit Maximization requires MR in each market to be equal to MC!

When this is true (the marginal revenue in one class in equal to the marginal revenue in the other), the ratio of the
price in the first class to that in the second class equals:

[ ] (| |)
1
1−
P1 η2
=

(| |)
P2 1
1−
η1

The firm’s profit is

π =TR 1 +TR2−TC

 Students are a good example of third-degree discrimination. They have relatively limited income, so they
tend to have high price elasticities of demand - they are price sensitive. Thus many times they are sold a
good or a service at a lower price.
 If we take the example of airline tickets, one reason for these price differences is that the price elasticity of
demand for business travel is much less elastic than for vacation travel (regardless of the price of an airline
ticket, business trips are well worth making…)

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Coupons and Rebates: One way managers can implement price discrimination strategy is with coupons and
rebates.
 Segment the market and offer coupons to consumers who need more incentive to purchase a product
(e.g., they have different price elasticities or their reservation prices are lower than regular customers).
 This is a way of third degree price discrimination.
 It is discrimination since not all consumers will use the coupons.

Suppose managers sell their product in a market where they think two types of consumers exists: a more
affluent group (1) with a relatively low price elasticity, and a less affluent group (2) with a higher price elasticity
(more likely to use the coupon)

[
P 1−
(| | )]
1
η1
=( P−X ) 1−
[ (| | )]
1
η2
=MC

Where X = Coupon

Peak Load Pricing: Very often a firm will see times when there are an enormous amount of customers and other
times when there are very little. In this “high” time, firms do face higher costs in order to properly serve their
customers. Peak load pricing is therefore a way to maximize profit in both the low and high times.

The idea here is to charge one price for the very low time, and a higher price for the higher times. This will allow
the firm to properly adjust and continue to maximize profits. (Figure 9.4: Determination of Peak and Through
Prices)
 Charge Pp in peak
 Charge PT in trough
 MRT=MC
 MRP=MC
Two-Part Tariff: Often managers will implement a first-degree price discrimination strategy through a two-part
tariff:
 Consumer pay an entry fee (lump sum fee, registration fee, monthly fee, subscription fee, annual fee)
and per use fee (per unit, per minute, per game, etc.).
o Per use fee: MC=AVC
o Entry fee: consumer surplus
o So, managers must choose their use fee before pricing the entry fee!

Figure 9.5: Optimal Two-Part Tariff When All Demanders Are the Same

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The optimal two-part tariff when all demanders are clones is a use fee equal to marginal cost (P*=MC) and an entry fee
equal to the consumer surplus resulting from such a use fee (T*)

With Different Demand Curves:

 This gets very tricky when there are two (or more) types of demanders.
 Lets take a strong and weak demander. The strong demander is willing to purchase more units than the
weak at any given price.

Option 1:
 Per use fee=MC
 Entry fee=consumer surplus of the strong demander.
 This will exclude the weak demander from the market.

Option 2:
 Per use fee=MC
 Entry fee=consumer surplus of the weak demander.

Option 3:
 Per use fee>MC
 Entry fee=consumer surplus of the weak demander

The one that maximizes profit will be the one to choose. The only way to determine that is by calculating both
and comparing.

 If managers want to exclude the weak demander, they should set the use fee=MC and the entry fee
equal to the relevant consumer surplus of the strong demander.

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 If managers want to include the weak demander, they must choose the use fee P*, which maximizes the
area 2A*+2C+D+E (if P*>MC) or 2A*+2C+2D (if P*=MC), whichever is larger.
 Once P* is chosen, it determines the consumer surplus (either A* or A*+C+D)

Managerial Economics – Chapter 10: Bundling and Intrafirm Pricing

This chapter can be very confusing at first. The best way to approach any bundling question is to take it very slow
and draw it all out properly. As well, practice is key when it comes to mixed bundling, there is very little to
memorize and the only way to get better at these questions is to do as many as possible.

Bundling:
When two products are sold together: they can be complements or substitutes. The optimal solution yields the
greatest profit of the profit maximizing solutions given by separate pricing, pure bundling and mixed bundling.

Separate Price:
1. Write out reservation prices
2. Make sure to take into account costs
3. Solution must always be a reservation price

Pure Bundling:
When managers offer goods/services as one package. Consumers cannot buy separately.
1. Calculate reservation prices per consumer for the bundle
2. Make sure to take into account costs
3. Solution must always be a bundle reservation price

Mixed Bundling:
When managers offer goods/services as one package or separately. The bundle price is always less then the sum
of the individual goods
1. Easy way to start is to look for large abnormalities in prices for certain products
a. Example: Every consumer wants to buy product A at 10 but consumer 2 is willing to pay 50
b. The idea here is to exploit that by charging a bundle price and a separate price
c. The way to do this is to create incentives. The way to create incentives is by creating consumer
surplus for those abnormal customers to buy the separate price or to buy the bundle
2. Make sure to take into account costs
3. Solution does not have to be a combination of reservation prices

Perfect Negative Correlation:

Customers typically have higher reservation prices for one item than the other item in a bundle. All reservation
prices lie on slope=-1

Credibility of the Bundle:

Managers correctly anticipate which consumers will purchase the bundle/goods separately
 Extraction: when a manager extracts the entire consumer surplus from each consumer (pure
bundling=best strategy)
 Exclusion: excluding customers who desire a product at a lower price than production cost.
 Inclusion: including customers who desire a product at a higher price than its selling price.

Tying:
Managers sell products that need a complimentary product. It ensures that the product works properly and
protects brand name. (i.e. you can only download an iTunes song on an Apple product).

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Intra-Firm Pricing:
Input is produced upstream to be used in a downstream plant.

No External Market:
MRM=MCM+MCP

Transfer Price=MCP=Marginal Cost of the Production Division

Perfectly Competitive External Market:

Production:
P=MCP

Marketing:
MRM=MCM+P

Transfer Price=P=Perfectly Competitive Market Price

Managerial Economics – Chapter 11: Oligopoly

Oligopoly: Market with only a few firms. It falls somewhere between monopolistic competition and a single
monopoly. It is also given the most attention in the public. Ex. Automobile manufacturing, oil refining (very
expensive to build an automobile or an oil refinery)
Characteristics:
1. High barriers to entry
2. Economies of scale which causes few firms to survive
3. Interdependence

Cooperative Behaviour:
This market structure encourages cooperation among rival managers in order to increase profits, decrease
uncertainty and discourage new entry

Cartels: This is the classic collusive strategy. In this, each individual firm works with each other to maximize the
profits not of the firm, but of the entire cartel as a whole  Find the MC for Cartel as a whole, and determine
the amount of output where MR=MC (you want the MC of each firm to be equal)

This is done by:

MR=MC
MC here is the summation of the individual firms marginal costs.

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Breakdown of Collusive Agreements:

One major issue with the cartel is the incentive to cheat. Since the cartel is maximizing the profits of all firms
together and not necessarily each individual firm, there may be incentive to cheat.
 For example, if the price elasticity of demand is elastic, one firm can expand their sales by reducing price.
However, if this happens, the cartel ceases to exist.
This in practice happens very often, even with the most exclusive cartels. This will be expanded on in detail in
Chapter 12 about Game Theory.

Price Leadership:
This is when there is one big firm in the industry with many smaller ones. The large one finds the price to charge
and quantity with MR=MC. The smaller firms take the price as given and find profit max output.
In summary:
 Small firms: price takers (Demand curve is a summation of all demand curves by small firms)
 Large firm: price setter (Demand curve=Total demand – small firms’ demand)

Duopoly:
This is the simplest case because it is competition between only two firms. So you can choose to compete on
either price or quantity

1. Competition on Price:
This is the worst way to compete since the price will eventually be cut down to marginal costs. Here a
collusive agreement would benefit firms in order for them to not wash away all their profits.
 Collusion: qA+ qB=Q; it then behaves as a monopolist setting MC total=MR
 It restricts output but increases price
 Notice that if one firm’s Marginal Costs are always lower than the other firm’s MC, that firm will
produce all the output to maximize profits.

2. Competition on Quantity (Cournot):

This is where we introduce the reaction function. This function determines the best possible production
strategy to the other firm’s choice of output.
 Each firm sets their MR=MC. Let's say the firm A and B produce at Q A and QB respectively. They
continue to profit maximize taking the quantity that the other firm's produce as granted.
 Each firm has their MC functions: MCA and MCB.
 Each firm will also have their MR functions. To derive this, we start from the Total Revenue
function.

TRA = P(QA+QB)QA
TRB = P(QA+QB)QB

Where P(Q) is the demand function of the industry. Therefore, the marginal revenue for each
firm is just

MRA = dTRA/dQA
MRB = dTRB/dQB

Each firm then sets MR=MC

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A Cournot equilibrium occurs

where the two firm’s reaction functions intersect. This is the only output combination where both firms’ expectations of
what the other firm will produce are consistent with their own expectations of their own optimal output. In this case, both
firms produce 24 units.

Stackelberg Model (first-mover advantage):

When, in a Cournot environment, one firm moves first and optimizes production based on knowledge of its
rival’s reaction function, there is a first-mover advantage. Ex. If Firm A sets the price, we will substitute Q B in PA,
then find TRA and MRA which we will set = MCA, and find the optimal output for A.

Reaction Function:
Identifies the profit maximizing output to produce given rivals output (i.e find Q A as a function of QB and vice
versa)
 Each Duopolist will produce where the reaction functions intersect. This is because they are doing the
best possible given the action of the other firm (this is expanded on in Game Theory, Chapter 11).

Bertrand Reaction Function:

Price combination at which both firm’s expectations of how other firm will price is consistent with their own
expectations of optimal price. Differentiated product
 Assume both firms have the same MC
 Set dTR1/dP1=MC
 Set dTR1/dP2=MC
 Solve for price

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A Bertrand equilibrium occurs where the two firms’ reaction functions intersect. This is the only price combination at which
both firms’ expectations of how the other firm will price are consistent with their own expectations of their own optimal
price. In this case, both firms will price at $25.

Managerial Economics – Chapter 12: Game Theory

Game theory: Game theory is an analytical tool or guide for making decisions in situations involving
interdependence.
It provides a useful guideline on how to behave in strategic situations involving interdependence. We will discuss
how game theoretic models can help managers make better pricing and output decisions.
 Game theory is extremely helpful for making competitive sense of some of the most common strategic
situations in the business world.
 Situations where conflict interfaces with mutual dependence.
 Such games are common both within firms and in market actions between firms, for example,
o In price wars,
o New product introductions,
o Strikes,
o Negotiations and divisional relationships.
Game theory is used by economists to examine strategic interaction of markets, and is especially useful in
analyzing oligopoly markets.
 A game involves players making strategic decisions. There are 3 keys elements of the game:
1. Players are the decision-making units

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2. A strategy is an option available to a player

3. Payoffs are the outcomes

 A payoff matrix is a table that describes the outcome for each player and for each set of strategic choices.
 A dominant strategy (DS) is a strategy that produces the optimal outcome regardless of what the other
players do.
 A dominant strategy equilibrium (DSE) occurs if each player in a game chooses its dominant strategy.
 A Nash equilibrium occurs if every player’s strategy is optimal given its competitors’ strategies
o If, given the strategies of the other players, no player can improve his payoff by unilaterally
changing his own strategy, every player is doing the best he or she can given what other players
are doing.

Strategy Basics:
All game theoretic models are defined by five parameters:

1. The players: A player is an entity that makes decisions; models describe the number and identities of players.
2. The feasible strategy set: Actions with a non-zero probability of occurring comprise the feasible strategy set.
3. The outcomes or consequences: The feasible strategies of all players intersect to define an outcome matrix.
4. The payoffs: Every outcome has a defined payoff for every player. Players are assumed to be rational, that is,
to prefer a higher payoff to a lower one.
5. The order of play: Play may be simultaneous or non-simultaneous, that is, sequential.

Matrix form: Form that summarizes all possible outcomes

Extensive form: Form that provides a road map of player decisions
Game trees: Game trees are another name for extensive form games and are akin to decision trees. **We
anticipate the future actions of others and then choose actions that are rational, conditioned on our expected
behavior of others.**

Games in Economics:
Interdependence of firms’ profits, which is the distinguishing feature of oligopoly markets, arises when the
number of firms in a market is small enough that every firm’s price and output decisions affect the demand and
marginal revenue conditions of every other firm in the market.
1Game theory provides a useful guideline on how to behave in strategic situations involving interdependence. A
game is any decision-making situation in which people compete with each other for the purpose of gaining the
greatest individual payoff (rather than group payoff) from playing the game.
The game theory is divided into four sections:
1) Simultaneous decisions,
2) Sequential decisions,
3) Repeated decisions, and
4) Strategic entry deterrence.

1) Simultaneous Decisions: Simultaneous decision games occur when managers must make their individual

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decisions without knowing the decisions of their rivals.

 A dominant strategy is a strategy or action that always provides the best outcome no matter what decisions
rivals make (in a pay-off matrix, you don’t even look at the numbers of your rival! Only your numbers to see
if the “numbers” of one strategy are always higher than the “numbers” of all the other strategies). When a
dominant strategy exists, a rational decision maker always chooses to follow its own dominant strategy and
predicts that if its rivals have dominant strategies, they will also choose to follow their dominant strategies.
 A dominant strategy equilibrium exists when all decision makers have dominant strategies.
 A prisoners’ dilemma arises when all rivals possess dominant strategies, and in dominant strategy
equilibrium, they are all worse off than if they had cooperated in making their decisions. In other words,
there is a cell in the payoff table that makes every rival better off than in the dominant strategy equilibrium
cell.
o When a firm does not have a dominant strategy, but at least one of its rivals does have a dominant
strategy, the firm’s manager can predict with confidence that its rivals will follow their dominant
strategies. A manager can then choose its own best strategy, knowing the actions that will almost
certainly be taken by rivals possessing dominant strategies.
 Dominated strategies are strategies or decisions that are never the best strategy for any of the decisions
that rivals might make. Therefore, a dominated strategy would never be chosen and should be ignored or
eliminated for decision-making purposes. If, after a first round of eliminating dominated strategies, other
strategies become dominated as a result of the first-round elimination, then successive elimination of
dominated strategies should continue until no dominated strategies remain in the final payoff table.
o Strategically astute managers will search first for dominant strategies, and, if no dominant strategies
can be discovered, they next look for dominated strategies. When neither form of strategic
dominance exists, decision makers must employ a different concept for making simultaneous
decisions.
o In order for all firms in an oligopoly market to be predicting correctly each others’ decisions—
managers cannot make best decisions without making correct decisions—all firms must be choosing
individually best actions given the predicted actions of their rivals, which they can then believe are
correctly predicted. Thus, strategically astute managers look for mutually best decisions.
 A Nash equilibrium is a set of actions or decisions for which all managers are choosing their best actions
given the actions they expect their rivals to choose.
o In Nash equilibrium, no single firm can unilaterally (by itself) make a different decision and do better.
This characteristic of Nash equilibrium is called strategic stability, and it provides the fundamental
reason for believing that strategic decision makers will likely decide on a Nash pair of decisions.
o When managers face a simultaneous decision-making situation possessing a unique Nash
equilibrium set of decisions, rivals can be expected to make the decisions leading to the Nash
equilibrium. If there are multiple Nash equilibria, there is generally no way to predict the likely
outcome.
o All dominant strategy equilibria are also Nash equilibria, but Nash equilibria can occur without either
dominant or dominated strategies.
o Economists have developed a tool, called best-response curves, to analyze and explain simultaneous
decisions when decision choices are continuous rather than discrete. A firm’s best-response curve
indicates the best decision to make (usually the profit-maximizing one) based on, or accounting for,
the decision the firm expects its rival will make. A Nash equilibrium occurs at the price (or output)
pair where the firms’ best-response curves intersect.

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2) Sequential Decisions: In contrast to simultaneous decisions, the natural process of some decisions requires
one firm to make a decision, and then a rival firm, knowing the action taken by the first firm, makes its
decision. Such decisions are called sequential decisions. Even though they are made at different times,
sequential decisions nonetheless involve strategic interdependence. Sequential decisions are linked over
time: The best decision a manager can make today depends on how rivals will respond tomorrow.
 The easiest way to analyze sequential decisions is to use a game tree. A game tree is a diagram showing
firms’ decisions as decision nodes with branches extending from the nodes, one for each action that can
be taken at the node. The sequence of decisions usually proceeds from left to right along branches until
final payoffs associated with each decision path are reached.
 When firms make sequential decisions, managers make best decisions for themselves by working
backwards through the game tree using the roll-back method. The roll-back method (also known as
backward induction) results in a unique path that is also a Nash decision path: Each firm does the best
for itself given the best decisions made by its rivals.
 If letting your rivals know what you are doing by going first in a sequential decision game increases your
payoff (relative to your payoff from going second), then a first-mover advantage exists. Alternatively, if
reacting to a decision already made by a rival increases your payoff (relative to your payoff from going
first), then a second-mover advantage exists.
 2To determine whether the order of decision-making can confer an advantage when firms make
sequential decisions, the roll-back method can be applied to the game trees for each possible sequence
of decisions. If the payoff increases by being the first (second) to move, then a first-mover (second-
mover) advantage exists. If the payoffs are identical, then order of play confers no advantage.
 Managers can make strategic moves to achieve better outcomes for themselves, usually to the detriment
of their rivals. Only credible strategic moves matter; rivals ignore any commitments, threats, or promises
that will not be carried out should the opportunity to do so arise. There are three types of strategic
moves: commitments, threats, and promises:
a) 34Managers make commitments by announcing, or demonstrating to rivals in some other way,
that they will bind themselves to take a particular action or make a specific decision no matter
what action or decision is taken by its rivals.
b) 5Threats, whether they are made explicitly or tacitly, take the form of a conditional statement,
“If you take action A, I will take action B, which is undesirable or costly to you.”
c) 6Promises, like threats, are also conditional statements that must be credible to affect strategic
decisions. Promises take the conditional form, “If you take action A, then I will take action B
which is desirable or rewarding to you.”

3) Repeated Decisions: Cooperation occurs when oligopoly firms make individual decisions that make every
firm better off than they would be in a (noncooperative) Nash equilibrium.
 Making noncooperative decisions is called “cheating” by game theorists, even though “cheating” does
not imply that the firms have made any kind of agreement to cooperate.
 Cooperation is possible in every prisoner’s dilemma decision, but cooperation is not strategically stable
when the decision is made only once. In one-time prisoners’ dilemmas, there can be no future
consequences from cheating, so both firms expect the other to cheat, which in turn makes cheating the
best response for each firm.
 When decisions are repeated over and over again by the same firms, managers get a chance to punish

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cheaters. When cheating can be punished by making credible threats of punishment in later rounds of
decision-making, strategically astute managers can sometimes, but not always, achieve cooperation in
prisoners’ dilemmas.
 Cooperation increases a firm’s value when the present value of the costs of cheating exceeds the present
value of the benefits from cheating. Alternatively, cheating increases a firm’s value when the present
value of the benefits from cheating outweighs the present value of the costs of cheating. Cooperation is
achieved in an oligopoly market when all firms decide not to cheat.
 A widely studied category of punishment strategies is known in game theory as trigger strategies.
Managers implement trigger strategies by initially choosing the cooperative action and continuing to
choose the cooperative action in successive repetitions of a decision until a rival cheats. The act of
cheating then “triggers” a punishment phase in the next repetition of the game that may last one or
more repetitions depending on the nature of the trigger scheme.
 The two most commonly studied trigger strategies are tit-for-tat and grim strategies.
o In a tit-for-tat strategy, cheating triggers punishment in the next decision period, and the
punishment continues unless the cheating stops, which triggers a return to cooperation in the
following decision period. In other words, if firm B cheated in the last decision period, firm A will
cheat in this decision period. If firm B cooperated last time, then firm A will cooperate this time.
o In a grim strategy, cheating triggers punishment in the next decision period, and the
punishment continues forever, even if cheaters make cooperative decisions in subsequent
periods.
 Since cooperation usually increases profits, managers frequently adopt legal tactics, known as
facilitating practices, designed to make cooperation more likely. Four such tactics are price matching,
sale-price guarantees, public pricing, and price leadership:
 Price matching: A firm commits to a price-matching strategy by publicly announcing, usually in
an advertisement, that it will match any lower prices offered by its rivals. This largely eliminates
the benefit to other firms from cutting their prices, and so price matching discourages
noncooperative price-cutting.
 Sale-price guarantees: Your firm offers a sale-price guarantee by promising customers who buy
an item from you today that they are entitled to receive any sale price your firm might offer for
some stipulated future period. The primary purpose of this tactic is to make it costly for firms to
cut their prices.
 Public pricing: Publicly available prices, which are timely and authentic, facilitate quick detection
of noncooperative price cuts. Early detection of cheating both reduces the present value of
benefits from cheating and increases the present value of the costs of cheating, which reduces
the likelihood of noncooperative price-cutting.
 Price leadership: Sometimes one oligopoly firm (the leader) sets its price at a level it believes
will maximize total industry profit, and then the rest of the firms (the followers) cooperate by
setting the same price. This arrangement, known as price leadership, does not require an explicit
agreement among firms and is generally a lawful means of facilitating cooperative pricing.
 Cartels are the most extreme form of cooperative oligopoly. Essentially a cartel is an explicit collusive
agreement among firms to drive up prices by restricting total market output. Cartels are illegal in the
United States, Canada, Mexico, Germany, and the European Union.
o Cartels find it extremely difficult to maintain cooperatively set cartel prices because cartel pricing
schemes are usually strategically unstable. The lack of strategic stability of cartels stems from the

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incentive to cheat by lowering price. The incentive to cut price below the cartel price is great
because, when undetected (and unmatched), price cutting occurs along a very elastic single-firm
demand curve with the associated lure of much greater revenues for any one firm that cuts
price. Of course the lure is great for every firm, and eventually many cartel members begin
cutting their prices secretly. This causes price to fall sharply along a much steeper demand curve
that reflects the firm’s demand when many cartel members all lower price together.
 A far less extreme form of cooperation among oligopoly firms is tacit collusion, which occurs when
oligopoly firms cooperate without an explicit agreement or any other facilitating practices.

4) Strategic Entry Deterrence: 7Strategic entry deterrence occurs when an established firm (or firms) makes
strategic moves designed to discourage or even prevent the entry of a new firm or firms into a market. 8Two
types of strategic moves designed to manipulate the beliefs of potential entrants about the profitability of
entering are limit pricing and capacity expansion.
a) Limit Pricing: 9Under certain circumstances, an oligopolist, or possibly a monopolist, may be able to
make a credible commitment to charge forever a price lower than the profit-maximizing price in order to
discourage new firms from entering the market.
b) Capacity Expansion: 1011Sometimes an established firm can make its threat of a price cut in the event
of entry credible by irreversibly increasing its plant capacity. When increasing production capacity results
in lower marginal costs of production for an established firm, the established firm’s best response to
entry of a new firm may then be to increase its own level of production, which requires the established
firm to cut its price in order to sell the extra

Two-Person Games:
Each player may be a single person or an organization, is a decision-making unit with a certain amount of
resources.
 The rules of the game describe how these resources can be employed.
 A strategy is a complete specification of what a player will do under each contingency in playing of the
game.
For example a corporation president might tell his subordinates how he wants an R & D program to start,
and what should be done at subsequent times in response to various actions of competing firms.
 A player’s payoff varies from game to game; its win, lose or draw in checkers, and various sums of money
in poker.
 For simplicity we deal only with two person games, games with only two players.
 The relevant features of a two-person game can be shown by constructing a payoff matrix. This is shown
in Figure 11.1. Two companies Allied Company and Barkley Corporation are about to stage rival R & D
programs and that each firm has a choice of strategies. In this game, there is a dominant strategy for
each player.

Solution Concepts:
Key to the solution of game theory problems is the anticipation of the behavior of others.

Equilibrium: When no player has an incentive to unilaterally change his or her strategy
No player is able to improve his or her payoff by unilaterally changing strategy.
Simultaneous games: are games in which players make their strategy choices at the same time

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Sequential games: are games in which players make their decisions sequentially
In sequential games, the first mover may have an advantage
A cooperative game: is a game in which the players can negotiate explicit binding contracts.
A zero sum game: is a game where the sum of payouts is constant.
A variable sum game: is a game where the sum of payouts for each set of strategies varies.
A non-cooperative game: is a game in which formal negotiation and entering into a legally binding contract is
not possible.

Prisoner's dilemma: Prisoner’s dilemma is when two firms acting in their own best interest pursue a course of
action that does not result in the ideal outcome.
In Prisoner’s Dilemma, repeated play can lead to cooperative behavior in a prisoner’s dilemma game.
Trust, reputation, promises, threats, and reciprocity are relevant only if there is repeated play.
Cooperative behavior is more likely if there is an infinite time horizon than if there is a finite time horizon.
If there is a finite time horizon, then the value of cooperation, and hence its likelihood, diminishes as the time
horizon is approached. Backward induction implies that cooperation will not take place in this case.
Situations in which interaction can cause the players to select an inferior strategy.
Cigarette advertising
Dominant strategy: advertise
Even if both firms have lower profits

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