Binder 2

EFFICIENCY
AND THE FUNDAMENTAL THEOREM

Gains from trade
• In a voluntary transaction, both parties become better
off: win-win situation
• Much of the value in an economy is created by trade,
no necessarily by production
Consumer and producer surplus
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The Fundamental Theorem
• Also known as Fundamental Theorem of Welfare Economics
• Exchange generates surplus:
− Sellers sell for more than marginal cost: producer surplus

− Buyers pay less than willingness to pay: consumer surplus
• If markets are competitive, then markets are efficient: total gains
from trade (surplus) are maximized
The Fundamental Theorem (cont)
• Consumers who have a valuation higher than price buy
• Producer sells units with marginal cost lower than price
• Hence, all trades such that willingness to pay is higher
than marginal cost take place
• Price indicates whether consumer should buy and
whether producer should sell: the invisible hand
• A second, less talked about, element of the theorem
• Survival of the fittest: only the best firms survive
competition
• Charles Darwin vs Adam Smith
Allocative and productive efficiency
• If q 6= q ∗ , then: allocative inefficiency (area C )
• If S 6= SL , then: productive inefficiency (area D)
• Market competition minimizes allocative and productive efficiency
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Critical assumptions underlying competitive markets assumption:
• No market power; free entry and exit; level playing field
• Well defined property rights (including externalities, IP)
• Perfect information
Efficiency, equity and regulation
• Fundamental theorem says nothing about equity
• Market regulation to improve equity
• But: can the law of S&D be “repealed”?
• Examples:
− Labor market: minimum wage, firing costs

− Housing markets: rent controls
− Currency markets: exchange rates and current
balance
− Price regulation in 1970s: gas, food, etc
Have you seen the invisible hand?
EXTERNALITIES
Tragedy of the commons
• Where can you find beer for 5 cents a bottle?
• Where has all the Newfoundland cod gone?
• Drill, baby, drill!
• Common facilities
Congestion
• Road pricing: London, Hong-Kong, etc (not NYC)
• Landing slots at LaGuardia airport
• Movie downloads, online gaming and Internet
congestion
Anti-theft systems
• The club and lojack: positive or negative externality?
• Home anti-theft systems
Collective reputations
• Keeping McDonalds restrooms clean
• Chilean wines in the US
• The liability of “Made in China”
Public goods
• National defense and neighborhood security
• Health
• Education
• Public parks
• Art
• Commodity advertising
Anti-commons
• Software patent thickets
• Patent trolls
• Litigation and innovation
Solutions to the externalities problem
• Ignore them: we live in a world of second-bests
• Self regulation
− MacDonalds; wine producers

− Raisin growers trade associations; Central Park Conservancy
• Pigouvian taxes: pay for the externality
− Gasoline tax; road tax

• Quantity regulation
− pollution caps; landing slots

• Subsidization or direct provision of public goods
• Private negotiation: Coase’s theorem
Pigouvian taxes: example
• Gasoline market (suppose supply reflects production cost)
• Each time a gallon of gasoline is burnt, a social cost c is created
(in addition to the cost of producing that one gallon of gasoline)
• As a result, socially optimal level of gasoline consumption is lower
than what the market equilibrium induces
• A properly designed gasoline tax t leads consumers to burn the
socially optimal level of gasoline
Pigouvian taxes: example
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The Coase theorem: example
• Two property owners own land on a mountainside.
Property Owner #1’s land is upstream from Owner #2
and there is significant, damaging runoff from Owner
#1’s land to Owner #2’s land. Four scenarios:
− Does #2 have a court claim over #1 or vice-versa?
− Is damage greater than cost of building wall (e.g., $100
v $50); or inversely, is cost of building the wall greater
than damage?
• In all cases, equilibrium outcome is socially optimal
• What is the role of the Courts here?
NYU Law School and the Coase Theorem
Class assignments are made by lottery. There are no waiting

lists for classes. This gives students an incentive to sign up for
the most popular classes, even if they don’t want to take them.
If they win a seat in one of the most sought-after classes, they
can work out a deal to sell their seat to another student. (The
way this is done is by the person holding the winning lottery
ticket withdrawing from the class and the other person signing
up for it a few seconds later; since there isn’t a waiting list, this
scheme will work as long as no one else happens to sign up for
the class in that few-second gap.)
In the end, the students willing to pay the most for classes are
the ones taking them, which is efficient.
— Steven Levitt, New York Times 2008

Advertising commodities
• Some advertising campaigns are directed at generic
products or commodities. Why would anyone pay to
advertise milk?
• $1 spent on advertising yields $3 to $6 of additional
revenues
• But: huge free-riding problem
• Some programs are mandatory (for all firms in industry)
• But: some producers have challenged this in court
“Advertising Commodities Can Be Tricky, but It Does Pay Off,” by Hal Varian, The New York Times, June 1, 2006.
Harry M. Kaiser, Julian M. Alston, John M. Crespi and Richard J. Sexton, The Economics of Commodity Promotion Programs (Peter Lang Publishing,
2005).
Advertising commodities
• How would you structure a campaign to provide
producers with the appropriate incentives?
• What should the Courts decide on the challenges by
individual producers?
• Are commodity marketing programs socially beneficial?
• Can you think of similar problems with similar conflicts
of interests? Do the solutions there apply in the
present context?
Regulation of gasoline consumption
• US strategy: enforce CAFE (corporate average fuel
efficiency) standards; almost no sales tax
• EU strategy: set (very) high gasoline taxes
• Pigou, 1; Coase, 0
ASYMMETRIC INFORMATION
AND MARKET FAILURE
Please accept my resignation. I don’t care to belong to any club that
will have me as a member. — Groucho Marx.
The market for lemons
• Sellers knows quality of his or her car
• Buyer only knows distribution of qualities
• For a given price, only worse cars will be offered for sale
• Buyers update beliefs and willingness to pay
• This process may unravel to the point there is no market
Adverse selection in health markets
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Adverse selection
• Consumer type: θ ∼ U[0, 1]
• Willingness to pay: θ
• Cost of serving type θ: C = c0 + c1 θ
• Price p implies q = 1 − p (types with θ > p)
• Cost of marginal type: c0 + c1 θ, where θ = p and p = 1 − q
MC = c0 + c1 (1 − q)
• Cost of average type served: average between types θ = p, θ = 1

1
AC = c0 + c1 1− q
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• Note that AC > MC

Adverse selection
• Equilibrium level of q (p = AC ):
1 − c0 − c1
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• Optimal level of q (p = MC ):
1 − c0 − c1
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• Hence q e < q o
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Solutions to adverse selection
• Pooling of health risks (employer provided insurance)
• Mandatory insurance (auto, health)
• Type inspection (cars, health risks)
• Warranties (used cars)
REGULATION: AN OVERVIEW
What is regulation?
• Government intervention in economic activity using commands,
controls, and incentives
• State-imposed limitation on the discretion that may be exercised
by individuals or organizations, which is supported by the threat of
sanction
Types of regulation
• Market regulation
• Entry regulation
• Firm regulation
• Social regulation
Examples of regulations
Controlling prices (electric power, local telephone service)
Setting price floors (crops, minimum wages)
Ensuring equal opportunity (banning discrimination in employment)
Regularizing employment practices (overtime)
Specifying qualifications (occupational licensure)
Providing for solvency (financial institutions, insurance, pension plans)
Controlling the number of market participants (broadcast licenses, taxi medallions)
Limiting ownership (media, airlines)
Requiring premarketing approval (toxic chemicals, pharmaceuticals)
Ensuring product safety (pharmaceuticals, toys, food)
Mandating product characteristics and technology (automobile safety standards)
Establishing service territories (local telephone service)
Establishing performance standards (automobile emissions standards)
Controlling toxic emissions and other pollutants (sulfur dioxide emissions trading)
Specifying industry boundaries (insurance, banking, and stock brokerage boundaries)
Allocating public resources (spectrum allocations)
Establishing technical standards (telecommunications interconnections)
Controlling unfair international trade practices (antidumping)
Mandating disclosure and restricting terms (credit cards)
Providing information (labeling)
Rationing common pool resources (fisheries)
The US regulation web
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State Regulators Constitution
Private interests : Nonmarket action

: Testimony, lobbying, petitions
: Lawsuit
Congress : Mandate, oversight, budget
President : Appointments policy
Courts : Due process, constitutionality
State regulators : Pressure
Why is there regulation?
• Normative analysis as a positive theory
• Capture theory
Normative analysis as positive theory
• In various situations, market equilibrium is not efficient.
Examples:
− Natural monopoly
− Externalities
• Responding to public demand, firms and markets are regulated
• Criticism of theory:
− Incomplete: missing link public-legislature

− Many firms lobby for regulation
− Refuting evidence: regulation with little or no rationale
− Refuting evidence: electric utility regulation has no impact on prices
Source for electric utility evidence: Stigler and Friedland (1962).

Capture theory
• Regulation is supplied in response to industry demand;
regulatory agency comes to be controlled by industry
over time.
• Related phenomenon: revolving doors. Examples:
− Meredith Attwell Baker: FCC commissioner, Comcast

− Linda J. Fisher: EPA Administrator, Monsanto
− Henry Paulson: Goldman Sachs CEO, US Treasury
Secretary
− 70% of all US generals, admirals: defense contractors
• Criticism of theory:
− Industry opposes many regulations

− Regulation frequently favors smaller firms
Special interests
• Regulatory capture is part of a more general phenomenon:
politics are biased towards measures such that benefits are
concentrated whereas costs are diffused
• Example: protection for sale (e.g., steel import tariffs)
• Example: price protection programs (e.g., peanuts)
Example: peanut program
• Since 1949, limit on number of farmers who can sell
peanuts in the US (23,046 in 1982)
• Imports also severely restricted
• Price support mechanisms
• Result: price about 50% higher than ROW
• Estimates for 1982–1987:
− Consumer to producer transfer: $255m

− Net transfer to average producer: $11,100
− Net transfer from average consumer: $1.23
Asymmetric information and regulation
• Fundamental theorem assumes perfect information
• When that is not the case, government can either
provide that information or limit actions by market
players
− FDA
− Financial services?
• Was the financial crisis the result of under-regulation?
Will the new regulatory wave (Dodd-Frank) solve the
problem?
Efficiency, equity and regulation
• Fundamental theorem says nothing about equity
• Market regulation to improve equity
− Price ceilings (rent, gas, taxi fares)

− Price floors (wages, agricultural products)
• But: can the law of S&D be “repealed”?
• Examples:
− Labor market: minimum wage, firing costs

− Housing markets: rent controls
− Currency markets: exchange rates and current balance
− Price regulation in 1970s: gas, food, etc
Foreign currency in Venezuela and empty planes

Example: gasoline prices post Sandy
• Shortages imply pressure to increase price
• Craig’s list: offer of sale of 12 gallons for $300
• NJ defines gouging as any increase > 10%
• NY prohibits “unconscionably excessive” prices
• Rationing by plate number; free gas
MONOPOLY AND REGULATION
Overview
• Context: Many markets have one seller or a seller that is
substantially bigger than its rivals.
• Concepts: market power, allocative inefficiency, regulation,
essential facility.
• Bottom line: monopoly power is bad, but the alternatives raise
problems too.
Sources of monopoly power
• Patents and copyrights (Lipitor, Lion King)
• Trade secret (Google search engine)
• Cost or product advantage (Intel)
• Network effects (Microsoft)
Spot the differences
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Solution: surplus, distribution, rent seeking; X-inefficiency.

Dominant firms
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Demand elasticity and market power
low-elasticity
demand
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INTRODUCTION TO ANTITRUST
AND COMPETITION POLICY
Spot the differences
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Plus: rent-seeking (e.g., Academy Awards).

Solution: surplus, distribution, rent seeking; X-inefficiency.
Outline
• Competition policy in the US
• Competition policy in Europe
• Main areas of competition policy
Outline
Competition policy in the US: players
• Department of Justice
• Federal Trade Commission
• Sectoral regulators (e.g. FCC, FAA)
• District Courts
• Supreme Court
Competition policy in the US: sources
• Sherman Act
− Section 1: Horizontal and vertical agreements

− Section 2: Abuse of dominant position
• Clayton Act. Following illegal if substantially lessen competition
− Section 2: Price discrimination

− Section 2: Exclusivity agreements
− Section 7: Mergers and acquisitions
• Federal Trade Commission Act
− Section 5: Unfair methods of competition are unlawful

• Regulations and guidelines:
− Merger guidelines
− Leniency program
US recent developments
• September 2008 report: “Competition and Monopoly: Single-Firm
Conduct Under Section 2 of the Sherman Act.”
• Provide greater clarity by summarizing DOJ’s views (stress on firm
efficiencies created by several practices).
• FTC disowns report the same day.
May 2009: new Assistant Attorney General Christine Varney
withdraws report effective immediately.
• August 2010: FTC and DOJ jointly publish new Horizontal
Merger Guidelines.
Outline
Competition policy in Europe: players
• DG Comp, part of the European Commission (EC)
• National competition authorities
• Court of First Instance (CFI)
• European Court of Justice (ECJ)
Competition policy in Europe: sources
• EC Treaty: Articles 101 and 102 (formerly 81,82; or 85,86)
− 101: Horizontal and vertical agreements

− 102: Abuse of dominant position
• EC Regulations, e.g.:
− Regulation 4064/1989 (mergers)

− Regulation 2790/1999 (block exemptions to Art 101)
EU recent developments
• December 08 guidance document or Art 102 (then 82).
• General principles are similar to those of US policy:
What really matters is to protect an effective competitive

process and not simply protecting competitors (pp 4–5).
• But: EU policy places greater burden on defendant than US policy.
Outline
Price fixing
• Explicit collusion is illegal (a criminal offense in US, UK, Ireland)
• Implicit collusion is not illegal
• Implicit collusion is frequently more effective
• Per se vs rule of reason
• Leniency programs
Merger policy
• US guidelines, EU regulation
• Efficiency vs market power
• Market definition
• HHI thresholds
Abuse of dominant position
• Tying
• Vertical squeeze
• Predation
• Exclusive dealing
MONOPOLY REGULATION
Natural monopoly
• In many industries, the social costs of having more than one
supplier are very high
− Water supply
− Electricity
− Telephone landlines?
− Cable?
− Airport or other infra-structures
• Typically, demand elasticities are very low (in absolute value), so
that monopoly prices would be very high
• In these situations, so form of regulation may be called for
Alternative approaches to utility regulation
• State-owned and state-run monopolies
• Cost-based price regulation
• Price-cap regulation
• Access regulation and competition
State owned enterprises
• Most European countries up until 1980s
• Still the case for various basic utilities in Europe
Cost-based regulation
• A.k.a. rate-of-return regualtion
• Most common system in the US
• Incentives: “gold plating”
• Regulators party affiliation and regulated rates
• Regulated rates and investment incentives
Price-cap regulation
• Thatcher’s privation program and Steve Littlechild
proposal
• Incentives for cost reduction
• Incentives for quality improvement
Access regulation and competition
• In many industries, there is a bottleneck — an
“essential facility” — but otherwise no natural
monopoly
• Solution: regulate access to essential facility, allow for
competition otherwise
• Problem: implementing access rules
• Biding arbitration as a solution?
PRICE DISCRIMINATION
BY INDICATORS
Overview
• Context: Frequently, firms charge different prices to different
market segments
• Concepts: market segmentation, elasticity rule
• Economic principle: If you charge different prices for the same
product, expect arbitrage
Motivation
Profit lost to buyers

who are willing to pay more than p M
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Example: laptop pricing
• Production cost is $1,200
• Three types of buyers:
Type W.T.P. ($) No. (K) Cum. No.

1 3000 10 10
2 2000 20 30
3 1000 30 60
Example (cont.)
• Strategy 1: Price at $3000
Profit = ($3000−$1200) × 10K = $18m
• Strategy 2: Price at $2000
Profit = ($2000−$1200) × 30K = $24m
• Strategy 3: Price at $3000 for Type 1
Price at $2000 for Type 2
Profit = ($3000−$1200) × 10K +
+ ($2000−$1200) × 20K = $34m
• Bottom line: If price discrimination is possible, it pays
Customer markets
• In many markets, the number of customers is relatively
small and the seller has considerable information about
buyers
• Examples: ready-mixed concrete, large commercial
aircraft, enterprise software, tug boat push services
• Although there is a list price (rack rate), each customer
receives a discount (often negotiated)
• Final price depends on customer’s ability to pay,
bargaining power
Perfect price discrimination
• Each customer is charged a different price — exactly his/her
willingness to pay (“from each, according to his/her willingness”)
• Examples: plumber, lawyer, piano teacher; customer markets
• With respect to normal pricing,
− The seller gains: revenue and profits go up

− The low-price buyer often gains
− The high-price buyer often loses
• Net effect: not clear whether this is good or bad for society as a
whole. It depends!
Practical difficulties
• Market research: group identification
• Arbitrage: resale, gray markets, harvesting
• Legal limits, US: injury to competition
• Legal limits, EU: single market
• Coming next: All approaches to PD are approximations

to PPD; we will talk about some possible strategies
Types of price discrimination
• Perfect price discrimination
• By indicators: market segment can be directly identified
− Trick: apply elasticity rule to each market segment

• By self-selection: market segment cannot be directly identified
− Trick: offer options such that each consumer will pay what they are
willing to pay
Discrimination by indicators
• Different segments can be identified directly
(i.e., it’s easy to know who’s who)
• Examples?
• Rule: different elasticities ⇒ different prices.
Specifically, higher prices in less elastic markets (elasticity rule):
pi − MC 1
=
pi −i
where
d qi pi
i ≡
d pi qi
Markups on European cars
Model Belgium France Germany Italy UK

Fiat Uno 7.6 8.7 9.8 21.7 8.7
Nissan Micra 8.1 23.1 8.9 36.1 12.5
Ford Escort 8.5 9.5 8.9 8.9 11.5
Peugeot 405 9.9 13.4 10.2 9.9 11.6
Mercedes 190 14.3 14.4 17.2 15.6 12.3
• What’s going on here?

Takeaways
• Key issues for price discrimination are:
− Identifying market segments

− Avoiding arbitrage
• With clear, separate segments: apply elasticity rule to each
separately
PRICE DISCRIMINATION
BY SELF-SELECTION
Overview
• Context: Frequently, firms cannot directly identify the di↵erent
segments
• Concepts: versioning and self-selection, two-part tari↵s, bundling;
incentive and participation constraints
• Economic principle: If you charge di↵erent prices for the same
product, expect arbitrage — unless you make the products slightly
di↵erent
Self-selection schemes
• In most cases, seller cannot directly identify consumer type,
but can still induce consumers to distinguish themselves
• Versioning: design product lines that appeal to di↵erent
consumers
• Examples?
Versioning 1.0
Willingness to Pay
Type # Not Rest Restricted Cost
Tourist 10 350 300 0
Business 10 800 200 0
• Strategy 1: Price single ticket (NR) at 350

Revenue = 350 ⇥ 20 = 7,000
• Strategy 2: Price single ticket (NR) at 800
Revenue = 800 ⇥ 10 = 8,000
• Strategy 3: Price (R,NR) at (300,800)
Revenue = 300 ⇥ 10 + 800 ⇥ 10 = 11,000
Versioning 1.1
Willingness to Pay
Type # Not Rest Restricted Cost
Tourist 10 350 300 0
Business 10 800 400 0

Revenue = 300 ⇥ 10 + 800 ⇥ 10 = 11,000
Now it won’t work: business traveller will buy restricted fare.
Revenue = 300 ⇥ 10 + 700 ⇥ 10 = 10,000
The key constraint is: 800 p NR 400 pR

Versioning summary
• A scheme to induce customers to select themselves into high and
low prices
• Key constraint (incentive): you can’t make the inexpensive version
too attractive to those willing to pay more
• Additional constraint (participation): cheap version must be
sufficiently cheap that low types are willing to purchase
• Why it works: correlation between absolute valuation and cost
(in terms of valuation) of restriction
• In practice, this is often based on years of experience of what the
market will bear
Practice: baby iMac
• Market segment H (1 million) willing to pay $1,500 for iMac,
$800 for stripped-down version
• Market segment L (2 million) willing to pay $600 for iMac,
$500 for stripped-down version
• Production cost: $300 (either version)
• What is optimal pricing policy?
Practice: baby iMac
• Candidate strategy 1: sell full version, charge $1,500
Profit: (1500 300) ⇥ 1 m = $1.2 bn
• Candidate strategy 2: sell full version, charge $600
Profit: (600 300) ⇥ 3 m = $.9 bn
• Candidate strategy 3: sell full version for $1,200,
stripped-down version for $500
Profit: (500 300) ⇥ 2 m + (1200 300) ⇥ 1 m = $1.3 bn
• Note: $1,200 = 1, 500 (800 500)
Bundling
• Examples
• Pure bundling and mixed bundling
• A form of versioning (why?)
Bundling: recitals
Willingness to Pay
Type # Mozart Cage
Classical 40 50 0
Sophisticated 40 0 50
Eclectic 20 30 30
• Strategy 1: Price at 50 per ticket

Revenue = 50 ⇥ 40 ⇥ 2 = 4,000
• Strategy 2: Price at 30 per ticket
Revenue = 30 ⇥ (40+20) ⇥ 2 = 3,600
• Strategy 3: Price at 50 per ticket or 60 for series
Revenue = 50 ⇥ 40 ⇥ 2 + 60 ⇥ 20 = 5,200
Damaged goods
• Low value version has higher production cost than
high value version
• Examples
• Clearly motivated by market segmentation
Coupons
• Examples
• A type of damaged good (why?)
• What is the correlation that makes it work?
Intertemporal discrimination
• Examples
• A type of damaged good (why?)
• The durable goods monopoly curse
Non-linear pricing
• Definition: unit price varies with quantity purchased
• Typical examples:
two-part tari↵: fixed entry fee (F), per-unit use fee (P)
quantity discounts
• What is the optimal structure? What are the main
obstacles to implementation?
Two-part tari↵s 1.0
• Suppose each consumer demands several units (minutes of calls,
hours at the gym, etc)
• Let D(p) be each consumer’s demand curve
• How can a two-part tari↵ extract more surplus from this
consumer?
p p
.......................... ..........................
.......................... ..........................
.......................... ..........................
.......................... ..........................
.......................... ..........................
.......................... ..........................
.......................... ..........................
MC
..........................
MC
I ..........................
.......................... ..........................
q q
Uniform pricing Two-part tari↵:

price per unit = MC
fixed fee = blue area
Consumer surplus
Firm profit
Practice: NPNG gym
• Monthly individual demand for hours: q = 15 2.5 p
• Marginal cost: zero
• Optimal price per hour: p = 3 (from q = 7.5)
Profit per customer: 3 ⇥ 7.5 = 22.5
• Optimal two-part tari↵: usage fee = marginal cost = 0
Fixed fee: 12 (15 ⇥ 6) = 45 (consumer surplus)
Profit per customer: 45
• Huge increase in profit (why?)
• Suppose that di↵erent consumers have di↵erent demand curves
Di (p) for each unit they consume
• How can a menu of two-part tari↵s allow seller to implement a
versioning strategy?
How are types defined?
What do di↵erent versions look like?
How does this relate to the damaged good strategy?
What are the participation and incentive constraints?
E-commerce and price discrimination
• Does it make price discrimination easier or more
difficult?
Takeaways
• If identification is a problem, you may want/need to di↵erentiate
the products and use self-selection schemes: versioning, bundling,
and so on.
• Key constraints on optimal pricing
Incentive contraint
Participation constraint
AUCTIONS
Overview
• Context: You have an object to sell; what’s the best way to do it?
• Concepts: fixed-price, auction, negotiation
• Economic principle: auctions may be the best form of price
discrimination by self-selection
Alternative selling mechanisms
• Who sets the price or prices?
− Firm: pricing
− Buyer: auctions
− Both: negotiations
• Pros and cons of auctions vis-a-vis pricing and
negotiations.
Fixed price vs auctions
• Seller owns a widget, no value for it
• Two interested buyers; valuations either $100 or $150
(equal probability)
• Perfect correlation: buyers have same valuation
• Buyers know their valuation, seller does not
• Fixed price: set p = 100 for E(π) = 100
• Ascending price auction: b = v , so E(π) = 125
• Idea: auction as ultimate strategy for price
discrimination by self-selection
Auctions
• Some common type of auctions:
− Ascending auction (a.k.a. English)

− Second-price sealed bid (a.k.a. Vickrey)
− First-price sealed bid
− First-price descending (a.k.a. Dutch)
− Multi-unit (uniform price or discriminatory)
• Some examples:
− art, wine
− eBay
− government procurement
− flowers, fish
− T-bills, IPOs
Pros and cons of each type of auction

Bidder strategy
• Trade-off similar to monopoly pricing
− Seller: margin vs quantity sold

− Bidder: margin vs winning probability
• Optimal bid results from MR = MC -type of rule
• Examples at end of chapter; more after game theory chapter
Winner’s curse
• Suppose valuations are positively correlated
• One informed bidder, one uninformed
• Uninformed bidder must beware of adverse selection
problem
• Uninformed bidder bids more conservatively, wins less
often than informed bidder
• Evidence from offshore drilling auctions
Multi-unit auctions
• Sometimes, seller has multiple, identical units
(e.g., T-bills, electricity)
• Alternative auctions
− Uniform price
− Discriminatory
• Multiple, similar objects (e.g., spectrum licenses)
• Problem: valuations are interdependent
• Common solution: simultaneously-ascending auction
Takeaways
• Different selling mechanisms trade-off
− transaction costs
− ability to extract consumer surplus
• Auctions allow for better discrimination (by self-selection)
than fixed price
• Comparison between auctions and negotiations less obvious
STRATEGY AND GAMES
Overview
• Context: You’re in an industry with a small number of
competitors. You’re concerned that if you cut your price, your
competitors will, too. How do you act? Ditto pretty much any
strategic decision: capacity, entry and exit, product positioning.
• Concepts: players, strategies, dominant and dominated strategies,
best responses, Nash equilibrium.
• Economic principle: must anticipate others’ actions and that your
actions might affect theirs.
The field of strategy
• Organizational structure and processes required to implement the
firm’s plan
• Boundaries of the firm: scale, scope, extent of outsourcing
• Formal analysis of strategic behavior: game theory
• Corporate strategy and business strategy
Game theory
• Formal analysis of strategic behaviour: relations between
inter-dependent agents
• Informally, game theory reminds us to:
− Understand our competitors: Our results depend not only on our

own decisions but on our competitors’ decisions as well
− Look into the future: Decisions taken today may have an impact
in future decisions, both by ourselves and by our competitors
− Pay attention to information: Who knows what can make a
difference
− Look for win-win opportunities: Some situations are competitive,
but others offer benefits to all
Goals
• Our goal is to create an awareness of strategic considerations in
many circumstances of business life (and, in fact, of everyday life)
• Our focus is on the play some common games: pricing, capacity,
entry and exit, product positioning
• In practice, many of the benefits come from choosing the right
games and avoiding the wrong ones. Example: when to avoid
cutting prices to gain market share
Historical notes
• John von Neuman was one of the precursors of game
theory (and many other things)
• John Nash, of a Beautiful Mind fame, was one of the
first game theorists to receive the Nobel prize
• The 1995 US spectrum auction was partly designed by
game theorist Paul Milgrom
• Game theory is now commonly used by various
consulting companies such as McKinsey
What they say
When government auctioneers need worldly advice, where can they

turn? To mathematical economists, of course . . . As for the firms . . .
their best bet is to go out . . . and hire themselves a good game
theorist.
— The Economist
Game theory, long an intellectual pastime, came into its own as a

business tool.
— Forbes
Game theory is hot. — The Wall Street Journal

What they say
I think it is instructive to use game theory analysis . . . Game theory

forces you to see a business situation over many periods from two
perspectives: yours and your competitor’s.
— Judy Lewent, CFO, Merck
At their worst, game theorists represent a throw back to the days of

such whiz kids as Robert McNamara . . . who thought that rigorous
analytical skills were the key to success. Managers have much to
learn from game theory — provided they use it to clarify their
thinking, not as a substitute for business experience.
— The Economist
Movie release game
• In 2010, Warner Bros. and Fox must decide when to
release Harry Potter andThe Chronicles of Narnia
• Two possibilities: November or December
• December is a better month, but simultaneous release
is bad for both
Harry Potter and the Deathly Hallows: Part I (released November 19, 2011)
The Chronicles of Narnia: The Voyage of the Dawn Treader (released December 10, 2011)
Game theory: concepts
• What are the elements of a game?
− Players (in previous example: Warner and Fox)

− Rules (simultaneously choose release date)
− Strategies (November, December)
− Payoffs (revenues)
• What can I do with it?
− Determine how good each of my strategies is

− Figure out what my rival is probably going to do
Movie release game
• Suppose total potential revenues (in $ millions) are
500 in November, 800 in December
• Revenues are split if more than one blockbuster in month
Fox
November December
250 800
November
250 500
Warner
500 400
December
800 400
• Coming later: how to analyze game

Class simulation
• You will be paired with a classmate. Identities will not be revealed
• You must choose A or B. Your payoff depends on your choice as
well as the other player
The other
A B
A 5 0
You
B 6 1
• Please record your choice

How to represent a game
• Matrix form (a.k.a. normal form)
− Best suited for games with simultaneous decisions

− Start by looking at dominant, dominated strategies
− If that fails, look for equilibrium given by intersection of
best-response mappings
• Game-tree form (a.k.a. extensive form)
− Best suited for games with sequential moves

− Solve game backwards, starting from endnodes
− Strategies: set of contingent decisions at each node
Solving matrix games
• Given a game (in normal form) how can we analyze it?
• What do we expect rational players to choose?
• What advice would one give to a given player?
Class simulation: prisoner’s dilemma
The other
A B
5 6
A
5 0
You
0 1
B
6 1
• Dominant strategy: B
• Payoffs (1,1) much worse than (5,5)
• Conflict between individual incentives and joint incentives
• Typical of many business situations
Dominant and dominated strategies
• Dominant strategy: payoff is greater than any other strategy
regardless of rival’s choice
− Rule 1: if there is one, choose it
• Dominated strategy: payoff is lower than some other strategy
regardless of rival’s choice
− Rule 2: do not choose dominated strategies
Elimination of “dominated” strategies
Player 2
L C R
2 0 1
T
1 1 1
0 3 0
Player 1 M
0 0 0
0 1 2
B
2 -2 2
Player 2
L C R
2 0 1
T
1 1 1
0 3 0
Player 1 M
0 0 0
0 1 2
B
2 -2 2
Player 2
L C R
2 0 1
T
1 1 1
0 3 0
Player 1 M
0 0 0
0 1 2
B
2 -2 2
Player 2
L C R
2 0 1
T
1 1 1
0 3 0
Player 1 M
0 0 0
0 1 2
B
2 -2 2
Player 2
L C R
2 0 1
T
1 1 1
0 3 0
Player 1 M
0 0 0
0 1 2
B
2 -2 2
1. Player 1 is rational
2. Player 2 is rational and believes Player 1 is rational
3. Player 1 is rational and believes that Player 2 is rational and

that Player 2 believes Player 1 is rational
that Player 1 believes that Player 2 is rational and that Player 2
believes Player 1 is rational

that Player 2 believes that Player 1 is rational and that Player 1
believes that Player 2 is rational and that Player 2 believes
Player 1 is rational
6. (You get the drift)
Class simulation
• Choose a number between 0 and 100 (inclusive)
• Let µ be the mean of all players’ choices
• Winner: player whose choice is closest to µ/2
• Please write down your number
Dubious application of dominated strategies
Player 2
L R
0 1
T
1 1
Player 1
0 1
B
-1000 2
Outcomes of games
• Sometimes a game can be “solved” just by looking at dominant
and dominated strategies (e.g., examples above)
• However, there are many games for which this isn’t enough to
produce an outcome
• Nash equilibrium: Combination of moves in which no player
would want to change her strategy unilaterally. Each chooses its
best strategy given what the others are doing (or given the beliefs
of what others are doing).
Game with no dominant, dominated strategies
Player 2
L C R
1 2 3
T
2 0 0
1 1 0
Player 1 M
1 1 1
1 0 2
B
0 2 2
Finding Nash equilibria
• A Nash equilibrium is a set of strategies, one strategy for each
player, such that: each player, given the strategies of everyone
else, is doing the best he or she can
• How do we find this? First, derive best-response mappings. For
each strategy by player B, find player A’s optimal choice. Taken
together, these form player A’s best-response mapping
• Nash equilibrium: intersection of best-response mappings, i.e.,
pair of strategy choices (sA , sB ) such that sA is optimal given sB
and sB is optimal given sA
Best responses
Player 1’s best response Player 2’s best response

Player 2’s Player 1’s Player 1’s Player 2’s
strategy best response strategy best response
L T T R
C B M {L,C }
R B B R
Player 2
L C R
T 1 2 3
2 0 0
Player 1 M 1 1 0
1 1 1
B 1 0 2
0 2 2
Best responses and Nash equilibrium
Player 2
L C R
1 2 3
T
2 0 0
1 1 0
Player 1 M
1 1 1
1 0 2
B
0 2 2
Nash equilibrium as rest point
• Suppose that, at each stage, either Player 1 or Player 2 chooses
best response to what other player was previously playing
• Will this ever stop? If yes, it will stop at a Nash equilibrium
• Example: previous game. Start at (M,R) with Player 2 moving
first. Sequence of choices would be:
(M,R)−→(M,L)−→(T,L)−→(T,R)−→(B,R)
Notes
• Each player attempts to maximize his or her payoff, not the
difference with respect to rival; if rival’s payoff is very important
(e.g., inducing exit), then this should be taken into account
directly
• What do best-response mappings look like when there are
dominant or dominated strategies?
• The meaning of simultaneous vs. sequential moves
• Nash’s theorem: for any game, there exists at least one (Nash)
equilibrium; however, this may involve randomization (mixed
strategies)
• Nash equilibrium assumes a lot about what people know (read
Adam Brandenburger’s letter to the editor of Scientific American)
Movie release game (reprise)
• What is the Nash equilibrium of this game?
• What did actually happen?
Fox
November December
250 800
November
250 500
Warner
500 400
December
800 400
Warner (Harry Potter): November 19; Fox (Narnia): December 10.

Multiple equilibria and focal points
• Schelling experiment (variant):
− You are to meet X tomorrow in Manhattan

− Must choose time and place
− X has been given same instructions as you
− No communication between you and X
− If both choose the same time and place,
both get $100; otherwise, both get 0
• What are the Nash equilibria of this game?
• What happens when game is played?
Game theory goes to Hollywood
• Watch video clip from A Beautiful Mind.
Did Ron Howard understand the concept of Nash
equilibrium?
• Watch video clip from The Princess Bride.
Does Vizini know anything about game theory?
• Watch video clip from The Simpsons.
Formalize the game played between Bart and Lisa.
Can you find the Nash equilibrium of this game?
Split or steal
• Read nyusterneconomics blog on “split or steal” (follow
the video clips links)
• Formulate the game played at the end of the show
• What is the game’s Nash equilibrium?
• How do you explain the observed behavior?
Rock, Paper and Scissors
Lisa: Look, there’s only one way to settle this.
Rock-paper-scissors.
Lisa’s brain: Poor predictable Bart. Always takes
‘rock’.
Bart’s brain: Good ol’ ‘rock’. Nuthin’ beats that!
Bart: Rock!
Lisa: Paper.
Bart: D’oh!
Takeaways
• Game theory is a formal approach to strategy
• Highlights impact of strategic interactions among firms or other
“players”
• Forces you to consider your competitors’ choices
• More coming . . .
SEQUENTIAL GAMES
The E.T. “chocolate wars”
In the movie E.T., a trail of Reese’s

Pieces, one of Hershey’s chocolate
brands, is used to lure the little
alien into the house
(Video link on book’s website)
As a result of the publicity created

by this scene, sales of Reese’s
Pieces tripled, allowing Hershey to
catch up with rival Mars
As often happens in Hollywood, the present example is inspired by true events

Chocolate wars
• Universal Studio’s original plan was to use a trail of
Mars’s M&Ms
• Mars turned down the offer
• The producers of E.T. then turned to Hershey, who
accepted the deal (for $1m), which turned out to be
very favorable to them (and unfavorable to Mars)
Chocolate wars
• Publicity from M&M product placement increases
Mars’ profits by $800 k, decreases Hershey’s by $100 k
• Publicity from Reases Pieces product placement
increases Hershey’s profits by $1.2 m, decreases Mars’
by $500 k
• No product placement: “business as usual”
Extensive form games
• Also known as tree-form games
• Best to describe games with sequential actions
• Decision nodes indicate what player is to move (rules)
• Branches denote possible choices
• End nodes indicate each player’s payoff (by order of appearance)
• Games solved by backward induction (more on this later)
Chocolate wars
don’t buy
............................................................................................
.... 0,0
.....
.....
...
......
.
.....
.....
don’t buy .......
.....
....
.....
.....
.
... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
....Hershey
.
.... .
.... .
.... .
.... .
. .....
.....
..... .....
..... .....
.
....... .....
.....
....... .....
.....
. ..
..... buy
.....
.....
............................................................................................
.
Mars
.....
.....
.....
-500, 200
.....
.....
.....
.....
.....
.....
buy
.....
...........................................................................................
-200, -100
Chocolate wars
don’t buy
............................................................................................
.... 0,0
.....
.....
...
......
.
.....
.....
don’t buy .......
.....
....
.....
.....
.
... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
....Hershey
.
.... .
.... .
.... .
.... .
. .....
.....
..... .....
..... .....
.
....... .....
.....
....... .....
.....
. ..
..... buy
.....
.....
............................................................................................
.
Mars
.....
.....
.....
-500, 200
.....
.....
.....
.....
.....
.....
buy
.....
...........................................................................................
-200, -100
• Equilibrium strategies
− H chooses “buy”
Chocolate wars
don’t buy
.....
.....
......................................................................................... 0,0
.....
.....
-500 .........
...
.....
don’t buy .......
.....
....
.....
.....
.
... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
.... .
....Hershey
.
.... .
.... .
.... .
.... .
. .....
.....
..... .....
..... .....
.
....... .....
.....
....... .....
.....
. ..
..... buy
.....
.....
............................................................................................
.
Mars
.....
.....
.....
-500, 200
.....
.....
.....
.....
.....
.....
buy
.....
...........................................................................................
-200, -100
• Equilibrium strategies
− H chooses “buy”
− Anticipating H’s move, M chooses “buy”
Chocolate wars: summary
• Think about your competitor: Mars should think about Hershey,
and vice versa
• Timing matters: Hershey had the last move; outcome would be
different if order of moves were different
• Key business insight: part of the benefit to Mars was to keep the
opportunity from Hershey: preemption
Entry game
• Firm 1 must decide whether to enter market
• If Firm 1 enters, Firm 2 (sole incumbent) must decide whether to
retaliate entry
ē
.............................................. 0, 50
...
...
...
...
.
..
...
.....
r̄ 10, 20
1 ...
... ..
...
.............................................
... ...
... .
....
... .
...
...
e
...................................................
2 ...
...
...
...
...
...
...r
.............................................
-10, 10
• Two Nash equilibria: (ē, r ) and (e, r̄ )

• Are these NE equally reasonable?
Backward induction
• If it is known that Firm 2 is a rational player, then the threat of
playing r is not credible
• By solving the game backwards, we eliminate “unreasonable” NE
such as (ē, r )
• More generally, define a subgame as the game corresponding to a
subtree
• A subgame perfect equilibrium is one such that the equilibrium
strategies form an equilibrium at each and every subgame
Commitment
• For many decisions, it’s useful to have lots of options
• In games, it’s sometimes useful to have fewer options:
to eliminate moves that lead to unattractive equilibria
• We refer to this limitation of your options as
commitment (as in, you’re committed to a particular
course of action)
Entry game (reprise)
Suppose Firm 2 has an additional early move: it can do nothing
(b̄) or choose action b that lowers its payoff should outcome (e, r̄ )
take place.
ē ......................................................... 0, 50
.....
.....
........
b̄ .....
..............................................................
.... r̄ 10, 20
...
1 ..... .....
.....
.....................................................
.. ..... ....
..
. .....
. ........
. .....
...
... e.....
.............................................................
.....
.
...
2 .....
.....
... .....
... .....
..
.....
r
.....
.....
-10, 10
2 ...
...
.....................................................
...
...
...
... ē ..................................................... 0, 50
... ....
.....
... .....
...
... . .
.. ....
b ...
.............................................................
..... r̄ 10, 0
1 .....
..... .....
.....
.....................................................
..... ....
..... ..
. .....
e
.....
..... .....
............................................................
.
2 .....
.....
.....
.....
r
.....
.........................................................
-10, 10
take place.
ē ......................................................... 0, 50
.....
.....
........
b̄ .....
..............................................................
.... r̄ 10, 20
...
1 .....
..... (10,20) .......
.....
.......................................................
..
..
. .....
. ........
. .....
...
... e.....
.............................................................
.....
.
...
2 .....
.....
... .....
... .....
..
.....
r
.....
.....
-10, 10
2 ...
...
.....................................................
...
...
...
... ē ..................................................... 0, 50
... ....
.....
... .....
...
... . .
.. ....
b ...
.............................................................
..... r̄ 10, 0
1 .....
..... (-10,10) ........
.....
......................................................
.....
..... ..
. .....
e
.....
..... .....
............................................................
.
2 .....
.....
.....
.....
r
.....
.........................................................
-10, 10
take place.
ē ....................................................... 0, 50
....
(10,20) ........
........
b̄ .....
..............................................................
.... r̄ 10, 20
...
1 .....
..... (10,20) .......
.....
.......................................................
..
..
. .....
. ........
. .....
...
... e
.....
.............................................................
.....
.
...
2 .....
.....
... .....
... .....
..
.....
r
.....
.....
-10, 10
2 ...
...
.....................................................
...
...
...
... ē ....................................................... 0, 50
... ....
... (0,50) ........
...
... . .
.. ....
b ...
.............................................................
..... r̄ 10, 0
1 .....
..... (-10,10) ........
.....
......................................................
.....
..... ..
. .....
e
.....
..... .....
............................................................
.
2 .....
.....
.....
.....
r
.....
.........................................................
-10, 10
• In equilibrium, Firm 2 chooses action b: committing to a lower
payoff under outcome (e, r̄ ) induces Firm 1 not to enter
• (e, r̄ ) does not occur along the equilibrium path (as opposed to
equilibrium)
• Value of commitment:
− Firm 2’s equilibrium payoff in first entry game: 20

− Firm 2’s equilibrium payoff in first entry game: 50
− Value of commitment: 50 − 20 = 30
Example: high-definition TV
HDTV 1: simultaneous move game
Effort by Japan
Low High
3 4
Low
4 2
Effort by US
2 1
High
3 1
HDTV 2: sequential move game
L .................................................................. 4, 3
.....
.....
.....
.........
L .....
............................................................................
Japan
...
... .....
.
... .....
.....
.
... .....
....
... H
.....
.....
.................................................................. 2, 4
.
..
....
...
...
....
US ...
...
...
...
...
... L .................................................................. 3, 2
... .....
... .....
... .....
... .........
...
H
.............................................................................
Japan .....
..
.....
.....
.....
.....
.....
H
.....
...................................................................
1, 1
HDTV summary
• With simultaneous moves, it is a dominant strategy for US to
chose L; the Nash equilibrium is (L, H), yielding the US a payoff
of 2
• If US can commit (play first), then the equilibrium is different: US
chooses H, Japan L; payoff for US is 3
• The value of commitment in this example is 3 − 2 = 1
• Comment: Two can play this game: why doesn’t Japan commit
itself, too?
Commitment
• In order for a commitment to have strategic value, it must be:
− visible to others
− credible
• Watch Dr. Strangelove video clip.
Moral: secret commitments have no strategic value.
• Read Charlie Brown’s kick-the-ball strip.
Moral: the crucial thing is what other players believe.
The doomsday machine
In the movie Dr Strangelove, directed

by Stanley Kubrik and starring Peter
Sellers (in three different roles) the US
builds a “doomsday machine”
The doomsday machine automatically

triggers nuclear war upon the first
attack by a foreign power
Commitment examples
• Polaroid v Kodak
• Intel’s second-sourcing policy
• Lowest price guarantee
• Dupont’s capacity expansion (Chapter 12)
• Can you think of others?
REPEATED GAMES
Overview
• Context: players (e.g., firms) interact with each other on an
ongoing basis
• Concepts: repeated games, grim strategies
• Economic principle: repetition helps enforcing otherwise
unenforceable agreements
Repeated games
• Repeated game ΓT : Normal-form game Γ repeated T times
• Γ (a “matrix” game) is called stage game (or one-shot game)
• Strategy in Γ: choice of row or column
• Strategy in repeated game ΓT : a contingency plan indicating
choice at time t conditional on history ht
Prisoner’s dilemma with T = 1
Player 2
A B
5 6
A
5 0
Player 1
0 1
B
6 1
• B is dominant strategy: unique NE

Prisoner’s dilemma with T = 2
Player 2
A B
5 6
A
5 0
Player 1
0 1
B
6 1
• Repetition of NE of Γ constitutes equilibrium of Γ2

• Theorem: if b
x is NE of Γ, then repetition of b
x at every period
(ignoring history) is NE of ΓT
• Are there additional equilibria?
Grim strategy in PD with T = 2
• t = 1: choose A
• t = 2:
− If (A,A) was chosen at t = 1, then A

− Otherwise, B
• Check it’s a NE:
− t = 1: deviation earns extra 6 − 5 but costs 5 − 1 next period

− t = 2: regardless of history, any rational players picks B
− Therefore, above contingent strategy cannot be an equilibrium
Infinitely repeated prisoner’s dilemma
• Note: indefinitely vs infinitely
• Are there equilibria in Γ∞ other than (B,B) every period?
• Discounted payoff: π1 + δ π2 + δ 2 π3 + ...
where πt is payoff at time t
• Proposed equilibrium strategies:
− Choose A if h = {(A, A), (A, A), ...}

− Choose B otherwise
Grim strategy equilibrium
• Equilibrium payoff
b = 5 + δ 5 + δ 2 5 + ... = 5
Π
1−δ
• Deviation payoff
δ
Π0 = 6 + δ 1 + δ 2 1 + ... = 6 +
1−δ
b ≥ Π0 ⇐⇒ δ ≥
• Π 1
5
• If δ is high enough (future important), deviation does not pay.
Self-enforcing agreements
• Repeated games as foundation for self-enforcing
agreements
• Not knowing when game ends (indefinitely repeated)
players have something to lose from deviating from
“good” action profile
• Most economic relations based on informal contracts
• International agreements (e.g. WTO, Kyoto, etc)
• Positive theories of culture and values
• Agreements are self-enforcing if they form a Nash
equilibrium of a repeated “relationship” (game)
Renegotiation
• Suppose that a player chooses B at time t
• According to the equilibrium strategies, play reverts to
B forever (payoff of 1)
• What stops players from saying “let bygones be
bygones” and return to the initial equilibrium?
• But then what stops players from deviating to B in the
first place?
• In other words, how credible (renegotiation proof) is
the equilibrium system of rewards and punishments?
Example: T = 1
Player 2
L C R
5 6 0
T
5 3 0
3 4 0
Player 1 M
6 4 0
0 0 1
B
0 0 1
• Two (Pareto ordered∗ ) Nash Equilibria: (M,C) and (B,R)
∗ Pareto ordered: both players prefer (M,C) to (B,R).

Example: T = 2
Player 2
L C R
5 6 0
T
5 3 0
3 4 0
Player 1 M
6 4 0
0 0 1
B
0 0 1
• Repetition of NE of Γ constitutes equilibrium of Γ2

• Ignoring history is always a NE of repeated game. Are there
additional equilibria?
Grim strategy
• t = 1: choose (T,L)
• t = 2:
− If (T,L) was chosen at t = 1, then (M,C)

− Otherwise, (B,R)
• Equilibrium payoff for each player: 5 + 4 > 4 + 4
• Check it’s a NE:
− t = 2: both (M,C) and (B,R) are NE of one-shot game.

− t = 1: deviation earns extra 6 − 5 but costs 4 − 1 next period
Repeated games in the lab
• Stage game:
− Nature generates potential payoff for players 1 and 2

− Sum is positive, but one is negative (e.g., 8, −3)
− Players simultaneously decide whether to accept; if either player
rejects, both get zero
• Indefinite repetition of game shows players exchange “favors”
frequently. Why?
− Altruism
− Intrinsic (backward-looking) reciprocity
− Instrumental (forward-looking) reciprocity
Cabral, L., Ozbay, E., and Schotter, A. (2014). Intrinsic and Instrumental Reciprocity: An Experimental Study. Games and Economic Behavior,
87:100–121
INFORMATION
Overview
• Context: You want to reward good performance by a subordinate,
but he has a better idea of what that performance is than you do.
What should you do?
• Concepts: principals and agents, incentives, asymmetric
information, adverse selection, moral hazard, signalling,
reputation.
• Economic principle: when people have superior information,
expect them to use it to their advantage
Games with uncertainty
• Consider an additional, non-strategic player: Nature
• If a certain variable can take several values, let Nature “decide”
which value it will be (according to underlying probabilities)
• Asymmetric information: a player who moves before Nature does
not know the value. A player who moves after Nature and
observes Nature’s move, knows the value
The E.T. “chocolate wars”
In the movie E.T., a trail of Reese’s

Pieces, one of Hershey’s chocolate
brands, is used to lure the little
alien into the house
As a result of the publicity created

by this scene, sales of Reese’s
Pieces tripled, allowing Hershey to
catch up with rival Mars
Chocolate wars
• Universal Studio’s original plan was to use a trail of Mars’s M&Ms
• Mars turned down the offer
• The producers of E.T. then turned to Hershey, who accepted the
deal (for $1m), which turned out to be very favorable to them
(and unfavorable to Mars)
Chocolate wars
• Publicity from the product placement increases Mars’ profits by
$800,000, decreases Hershey’s by $100,000
• Hershey’s increase in market share costs Mars $500,000
• Benefit to Hershey from having its brand featured is given by b
• Hershey knows the value of b. Mars knows only that
b = $1, 200, 000 or b = $700, 000 with equal probability
• No product placement by any of the two implies “business as
usual”
Chocolate wars
b = 1200 buy
......
......
...................................................................... -500, 200
(50%) . . ........
......
...
....
. ...
. ..
. ..
.. ..
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. ...
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H
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......
......
... ...... not buy
... ......
...
.....
.
.
. ....................................................................
0, 0
not buy .
...
.
.
...
... N
.....................................................................
...
...
...
.
... ...
... b = 700 buy
....... ...
...
... ......
......
................................................................... -500, -300
...
.. ... (50%) ......
. ... ......
..... ............................................................................
M ...
...
H ......
......
......
...
...
...... not buy
......
...
...
.................................................................. 0, 0
...
...
...
...
...
...buy
...
.................................................................. -200, -100
Chocolate wars
b = 1200 buy
-500
......
......
...................................................................... -500, 200
(50%) . . ........
......
...
....
. ...
. ..
. ..
.. ..
. ..
. ...
. ..
. ..
.. ..
. ..
. ..
.. ..
. ..
. ...
. ..
. ..
.. ..
. ..
. ..
H
. ......
......
......
... ...... not buy
... ......
...
.....
.
.
. ....................................................................
0, 0
not buy .
...
.
.
...
... N
.....................................................................
...
...
...
.
... ...
... b = 700 buy
....... ...
...
... ......
......
................................................................... -500, -300
...
.. ... (50%) ......
. ... ......
..... ............................................................................
M ...
...
H ......
......
......
...
...
...... not buy
......
...
... 0
.................................................................. 0, 0
...
...
...
...
...
...buy
...
.................................................................. -200, -100
Chocolate wars
b = 1200 buy
-500
......
......
...................................................................... -500, 200
(50%) . . ........
......
−500 × 50% + 0 × 50% = ...

....
. ...
. ..
. ..
.. ..
. ..
. ...
. ..
. ..
.. ..
. ..
. ..
.. ..
. ..
. ...
. ..
. ..
.. ..
. ..
. ...
H......
......
......
... ...... not buy
... ......
= −250 ....
.....
.
. ....................................................................
0, 0
not buy .
...
.
.
...
... N
.....................................................................
...
...
...
.
... ...
... b = 700 buy
....... ...
...
... ......
......
................................................................... -500, -300
...
.. ... (50%) ......
. ... ......
..... ............................................................................
M ...
...
H ......
......
......
...
...
...... not buy
......
...
... 0
.................................................................. 0, 0
...
...
...
...
...
...buy
...
.................................................................. -200, -100
Typical scenarios
• Agency problem: a principal (e.g., employer) wants to contract
with an agent, but the former cannot observe the latter’s actions
(moral hazard)
• Lemons problem (or adverse selection): one party (e.g., car
seller) has better information than the other
• Signalling problem. A player chooses its actions strategically so
as to influence others’ beliefs (e.g., reputation)
Typical scenarios
(moral hazard)
Agency and incentives
• Terminology: We refer to the payer as the principal, the payee as
the agent, and the analysis as principal-agent or agency theory.
• S. Kerr, “On the folly or rewarding A, while hoping for B.”
Performance is hard to measure. Any measurement system can be
gamed; incentives work; expect to get exactly what you pay for
• Relation to psychology theories of motivation (e.g., intrinsic v
extrinsic)
Incentives matter
• Medicare’s reimbursement’s policy: fees cover
overhead, not just marginal cost; doctor’s time vs
medical equipment
• Patent office: contrast US and EU
• Auditing firms are paid by the firms they audit;
moreover, they often make far more from consulting
relationships than auditing
Incentives matter
When [Medicare] pays a fee to a doctor who has performed a
CT scan, it is meant to cover some of the cost of buying or
leasing the scanner itself. Services using more expensive
equipment generate higher fees. ...
The cost of a CT scanner is fixed, but a doctor earns fees each
time it is used. In contrast, the doctor-patient visit, which
involves no expensive equipment, offers no significant profit
opportunity.
So the best way for a doctor to make money in his practice is
not to spend time with patients but to use equipment as much
as possible.
Paying Doctors to Ignore Patients, by Peter B Bach, in NYT, July 24, 2008.
Agency: rewarding employees
• Outcome depends on effort by employee (agent) and on other
factors beyond his control
• Employer (principal) cannot distinguish between different factors
causing observable outcome
• Incentive scheme: a system determining agent’s compensation as
a function of outcome
Other ......factors
...
...
..
...
...
.
.............................................................................................................................................................................................
Agent’s effort Outcome Agent’s reward
Agency: power incentives
• Types of incentive scheme:
− High-powered: compensation depends a great deal on

outcome (e.g., % of sales)
− Low-powered: compensation is fairly flat
• Suppose principal is risk neutral, agent risk averse.
Then high-powered incentives trade-off:
− More effort (good from the principal’s perspective)
− Greater risk on employee (compensation depends on
effort and on random events)
Agency: examples
• Salesperson compensation
• CEO compensation
• Utility regulation
Typical scenarios
(moral hazard)
The lemons problem
• When the uninformed player moves first, she must
think about how informed players will use their
information:
− Examples: product quality, insurance, credit
• General result: Tendency for low-quality products (or
high-risk customers) to flood the market
• Solutions: warranties, reputation and branding, credit
rationing, verification (medical examinations)
The market for lemons
• Sellers knows quality of his or her car
• Buyer only knows distribution of qualities
• For a given price, only worse cars will be offered for sale
• Buyers update beliefs and willingness to pay
• This process may unravel to the point there is no market
pe ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... .......
..
...
...
...
A AC
...
...
...
...
...
...
po
.
...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ......... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... .....
.. ..
.
MC
... ...
... ...
... ...
... ...
... ...
... ...
...
..
... q
e o
q q
Adverse selection
• Consumer type: θ ∼ U[0, 1]
• Willingness to pay: θ
• Cost of serving type θ: C = c0 + c1 θ
• Price p implies q = 1 − p (types with θ > p)
• Cost of marginal type: c0 + c1 θ, where θ = p and p = 1 − q
MC = c0 + c1 (1 − q)
• Cost of average type served: average between types θ = p, θ = 1

1
AC = c0 + c1 1− q
2
• Note that AC > MC

Adverse selection
• Equilibrium level of q (p = AC ):
1 − c0 − c1
qe =
1 − c21
• Optimal level of q (p = MC ):
1 − c0 − c1
qo =
1 − c1
• Hence q e < q o
pe ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... .......
..
...
...
...
A AC
...
...
...
...
...
...
po
.
...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ......... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... .....
.. ..
.
MC
... ...
... ...
... ...
... ...
... ...
... ...
...
..
... q
e o
q q
Please accept my resignation. I don’t care to belong to any club that
will have me as a member. — Groucho Marx.
Winner’s curse
• Common value auction: the object is worth the same for every
bidder, each bidder gets an unbiased signal of value
• Examples: oil field, penny jar
• Expected valuation given signal: unconditional and conditional on
being the highest bid
• Optimal strategy is to bid much less than signal estimate;
discount should be greater the greater the number of bidders or
the closer to common value is the auction
Typical scenarios
(moral hazard)
Signalling
• When the informed player moves first, she must think about the
information conveyed by her actions to uninformed players (the
signal):
− Does a low price suggest low quality?
− Advertising as a signal
− Job market signaling
− Incumbent firm’s reaction to entry
Price as a signal of quality
• One seller of stereo equipment, many buyers. Seller sets price,
buyers decide whether or not to buy (at most one unit each).
Seller knows quality of stereo, buyers do not.
• Demand:
− 80% of customers willing to pay at most $200 regardless of quality

− 20% of customers willing to pay $400 for high-quality product, only
$200 for low quality one
• High quality product costs $300; Low quality product costs $100
Price as a signal of quality
• Claim: It is an equilibrium for seller to set p = 400 if quality is
high and p = 200 if quality is low.
• In this equilibrium, price conveys information about quality:
consumers know that a high price implies high quality.
• Why wouldn’t a low-quality seller want to “masquerade” as a
high-quality seller by setting a high price? Because it loses too
much of the market. (Numbers are profit per customer.)
p = 400 ⇒ Profit = (400 − 100) × 20% = 60

p = 200 ⇒ Profit = (200 − 100) × 100% = 100
Signalling equilibria
• In the previous game, we have a separating equilibrium: different
types of seller choose different strategies.
• High quality seller chooses different strategy so as to ensure buyer
knows she’s buying from a high quality seller. In order for this to
work, it must be the case that imitation is costly.
• If imitation costs are not very high, we have a pooling equilibrium.
In this case, the “bad” type imitates the “good” type so as to
acquire a reputation for being good.
• In a multi-period situation, pooling may become attractive: the
cost of imitating early on pays off in terms of future payoffs:
reputation building.
Reputation for toughness
What is the equilibrium of the following one shot entry game?
stay out
.....
......
................................................................................................................ 0, 4
.....
.
.........
.
....
......
.....
.....
...........
..... fight entry
E .......
....... .......
.................................................................................................................... -1, -1
....... .......
....... ....
.........
....... .
enter
....... .......
.............................................................................................................................
I .......
.......
.......
.......
.......
....... accommodate entry
.......
..............................................................................................................
1, 1
• What if Monopolist faces a potential entrant in each of a series of
local markets? (Cf American Tobacco example)
• By “teaching entrant a lesson” in first markets, Monopolist might
be able to discourage entrants in other markets
• Key: Assume that there is some chance monopolist is a “Rambo,”
a monopolist whose payoff to cooperation is less than −1
• Entrants believe Monopolist is “tough” with probability α
• Suppose Monopolist fights entry even if it is not “tough”
• A second entrant still believes Monopolist is tough with
probability α; expected value from entry is
α × (−1) + (1 − α) × 1
• If α > 1/2, then entrant stays out

• For a normal Monopolist, fighting the first entrant is an
investment in reputation
• (Advanced note: in this case, equilibrium would require mixed
strategies, similar to rock-paper-scissors)
• Watch video clips from The Maltese Falcon, Casino.
• What game is being played?
• Why may it be rational to appear to be irrational?
Repetition, trust and product quality
• Previously, we saw how repetition improves cooperation between
firms
• Same is true for relation between seller and buyer when there is
asmmetric information
• Examples:
− Restaurants
− Auto repairs
Takeaways
• Think about how your rival will:
− use its information advantage

− react to your information advantage
• You will get what you reward
• Beware of the Groucho Marx problem: low-quality products or
customers flood the market (or: If this is such a good deal, why
are you offering it to me?)
• Your actions convey information and create reputations
Intrinsic and extrinsic motivation
Tom said to himself that it was not such a hollow world, after all. He
had discovered a great law of human action, without knowing
it—namely, that in order to make a man or a boy covet a thing, it is
only necessary to make the thing difficult to attain. If he had been a
great and wise philosopher, like the writer of this book, he would now
have comprehended that Work consists of whatever a body is obliged
to do, and that Play consists of whatever a body is not obliged to do.
—Mark Twain, The Adventures of Tom Sawyer (1876, Chapter 2)
Intrinsic and extrinsic motivation
• Stack Overflow: popular Q&A site for programmers (and edit)
• Qs and As are voted; participants score card
• Stack Overflow Careers: job site for programmers; CVs connected
to SO score
• Participants’ motivation
• What happens when participant gets job offer?
− Vote-generating activities drop sharply (≈ 25%)

− Non-vote-generating activities also drop, but by much less
• Extrinsic motivation accounts for a significant share of SO
voluntary contributions, but not all.
Lei Xu, Tingting Nian, Luı́s Cabral, “What Makes Geeks Tick? A Study of Stack Overflow Careers”
THE BERTRAND MODEL
Overview
• Context: You’re in an industry with one competitor. If you cut
your price to gain market share, how is she likely to respond?
What is the outcome if you get into a spiral of competitive price
cuts?
• Concepts: Bertrand model, best responses, price war
• Economic principle: the only reliable floor on price is marginal cost
Bertrand model
• Players: two firms produce identical products; each has constant
marginal cost MC
• Strategies and rules:
− Firms set prices simultaneously

− If one firm prices lower, then it gets the whole market
− If prices are the same, then firms split the market
• Total demand is Q = D(p), where p is the low price
• Referred to as Bertrand model after its inventor
Bertrand game with three price levels
Firm 2
5 4 3
7.5 12 7
5
7.5 0 0
0 6 7
Firm 1 4
12 6 0
0 0 3.5
3
7 7 3.5
• What are the best-response mappings?

• What is the Nash equilibrium?
• Excluding the strategy p = 3, does this game remind you of
another game we saw earlier?
Continuous-variable strategies
• Gas stations don’t just set price at 2, 3 or $4 per gallon
• Suppose strategy is any p ∈ IR0+
• Cannot represent game as a payoff matrix. Instead,
− represent payoffs by expressions πi (pi , pj )

− draw best-response mappings in the (p1 , p2 ) space
Continuous-variable strategies
• Best-response mapping: value or values pi∗ (pj ) such that
πi (pi , pj ) ≤ πi (pi∗ , pj ), for all pi

• Nash equilibrium: values (b
pi , b
pj ) such that
bj ) ≤ πi (b
πi (pi , p pi , p
bj ), for all pi
pi , pj ) ≤ πj (b
πj (b pi , p
bj ), for all pj
• This is equivalent to
bi ∈ pi∗ (b
p pj )
bj ∈ pj∗ (b
p pi )
Firm 1’s best-response curve
p1
45◦
p1∗ (p2 )
pM ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...
...
...
...
...
...
...
...
...
...
...
...
...
...
MC ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ..
.
...
...
...
... ...
... ...
... ...
... ...
... ... p2
M
MC p
Firm 1’s best-response mapping: optimal p1 given p2

Firm 2’s best-response curve
p1
p2∗ (p1 ) 45◦
pM ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...
...
...
...
...
...
...
...
...
...
...
...
...
...
MC ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...
...
...
...
...
...
... p2
M
MC p
Outcome of price game
p1
p2∗ (p1 ) 45◦
p1∗ (p2 )
pM ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...
...
...
...
...
...
...
...
...
...
...
...
...
...
p
b1 = MC • ...
...
...
...
...
...
... p2
M
p
b2 = MC p
Nash equilibrium: p1 = p2 = MC
The “Bertrand trap”
• Even with two firms, price is driven down to the
competitive price (marginal cost): economic profits are
zero; accounting profits could be negative if there are
sunk costs
• Note that neither higher demand nor lower costs (if
both firms have the same cost) increase profits
• Examples: airlines, fiber-optic cable, CD phone books
• Rule of thumb: Avoid this game if you can!
Ways out of the trap
• Product differentiation and branding (moderates
impact of price competition)
• Limit capacity (the capacity game is less hazardous)
• Be the cost leader
• Implicit or explicit agreement on price
(but how do you do this and stay out of jail?)
Benefits of low cost
p1
p2∗ (p1 ) 45◦
p2M ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ......
...
... p1∗ (p2 )
...
M
p1 ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...
...
...
...
... ...
... ...
... ...
... ...
... ...
... ...
b1 = MC2 −
p ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ..
.
...
• .
..
...
...
...
... ... ...
... ... ...
... ... ...
... ... ...
MC1 ...
...
...
...
...
...
... ... ...
... ... ...
... ... ...
... ... ...
... ... ... p2
M M
p2 = MC2 p1 p2
Capacity constraints
• Firm i has capacity ki ; if its demand is greater than ki , its sales
are ki , and the rest of the demand is available for firm j
• Assumption: a capacity constrained firm keeps the customers with
highest willingness to pay
• Claim: under these circumstances, if capacities are sufficiently
small, then equilibrium pricing implies
p1 = p2 = P(k1 + k2 )
where P(Q) is the market inverse demand curve

• Proof: in next graph, show that, given p1 = P(k1 + k2 ), the best
firm 2 can do is set p2 = p1
Note for aficionados: the above proof covers the essentials but is nevertheless incomplete.
Capacity constraints
...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ......
P(k1 + k2 ) ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ......
D
d1
r1 q1 , q2
k2 k1 k1 + k2
Takeaways
• Price-cutting is a dangerous game
• Price competition can be severe, even with few firms
• Avoid hazards of price competition by:
− Lowering costs
− Cooperating on price
− Limiting capacity
− Differentiating your product
THE COURNOT MODEL
Overview
• Context: You’re in an industry where capacity constraints are
important, so capacity decisions are a key strategic variable
• Concepts: Cournot model, residual demand, best responses
• Economic principle: equilibrium as a “rest point”
Cournot model
• Players: two firms produce identical products. Each has constant
marginal cost MC = c
• Strategies and rules:
− Firms set output (capacity levels) simultaneously

− Market price is a function of total output (capacity level):
p = P(q1 + q2 )
where P(·) is the inverse demand curve

• Referred to as Cournot model after its inventor
Firm 1’s optimum
P(q2 )
q2
r1 (q2 ) .................................................................................................................................................
........
..........................................................................................................................................
..........
MC
c ...
...
...
...
...
...
... ... ...
... ... ...
... ... d1 (q2 ) ...
... ... ...
... ... ... q1 , q2
q1∗ (q C ) q1∗ (q2 ) q1∗ (0) q C

q10 + q2
Best responses and equilibrium
q1
qC
.....
.... q2∗ (q1 )
....
.....
.....
.....
........
.
.....
....
.....
....
.....
.......
................
q1∗ (q2 )
qM
..
.....
.....
.....
....
.....
q
b1 ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ......
...
...
• .....
....
.....
. ...
....
... .....
....
... ..
............
... .......
....
...
...
...
...
... q2
M C
q
b2 q q
Best-response mappings
• Demand curve: P(Q) = a − b Q
• Cost function: C (q) = c q
• Firm 1’s profit function:

π1 = P q1 − C (q1 ) = a − b (q1 + q2 ) q1 − c q1
• First-order condition for profit maximization:
−b q1 + a − b (q1 + q2 ) − c = 0
• Firm 1’s best response:
a−c q2
q1∗ (q2 ) = −
2b 2
Equilibrium
• Equilibrium is determined by intersection of BR mappings:
bi = qi∗ (b
q qj )
• In the linear case

a−c q
bj
q
bi = −
2b 2
• In a symmetric equilibrium, q
b1 = q
b2 = q
b. Hence,
a−c
q
b=
3b
Convergence to Cournot equilibrium
q1
q2∗ (q1 )
......
..............
...........
.............................................
.........
..
...
.
q1∗ (q2 )
.....
.....
... ...
.......
........
..........
............................................................................................................................................................................
.
..........
.
.....
.. q2
q2◦
OLIGOPOLY MODELS AT WORK
Overview
• Context: You are an industry analyst and must predict impact of
tax rate on price and market shares. Ditto for exchange rate
devaluation, cost-reducing innovation, quality improvement,
merger, etc.
• Concepts: comparative statics, calibration, counterfactual
• Economic principle: models can help qualitatively as well as
quantitatively — but you should know how to find the right model
Long term and short term
• If players make more than one strategic choice, how to model the
sequence of moves
• Players make short term moves given their long term choices
• Even if short term moves are made simultaneously, the above
“given” suggests a sequence:
Players 1 and 2 choose Players 1 and 2 choose

........................................................................................................................................................................................................................................................................................................................................................................................
time
long term variable short term variable
• The choice between Cournot and Bertrand models depends largely

on determining what is long term, what is short term
Choosing oligopoly model
• Homogeneous product industry where firms set prices.
Which model is better: Bertrand or Cournot?
• It depends!
− Capacity constraints important: Cournot

− Capacity constraints not important: Bertrand
• More generally, the easier (the more difficult) it is to adjust
capacity levels, the better an approximation the Bertrand
(the Cournot) model provides
− Bertrand: price is the long-run choice
− Cournot: output is the long-run choice
Examples
• Consider the following products:
− banking
− cars
− cement
− computers
− insurance
− software
− steel
− wheat
• Indicate which model is more appropriate:
Bertrand or Cournot
Comparative statics / counterfactual
• What is the impact of event x on industry y ?
• Comparative statics (or counterfactual):
− Compute initial equilibrium

− Recompute equilibrium considering effect of x on model parameters
− Compare the two equilibria
• In what follows, will consider the following events x:
− Increase in input costs

− Exchange rate devaluation
− New technology adoption
Input costs and output price
• Market: flights between NY and London
• Firms: AA and BA
• Marginal cost (same for both): labor (50%), fuel (50%);
initially, marginal cost is $300 per passenger.
• Oil price up by 80%
• What is the effect of oil price hike on fares?
• Cournot duopoly with market demand p = a − b Q
• Equilibrium output per firm and total output:
a−c b =2 a−c
q
b= Q
3b 3b
• Equilibrium price:
b = a − b2 a − c = a + 2c
p = a−bQ
b
3b 3
• Therefore
db
p 2
=
dc 3
• Economics lingo: the pass-through rate is 66%
• Oil price increase of 80%; fuel is 50% cost; initial cost is $300
• Increase in marginal cost: 50% × 80% × $300 = $120
• Price increase: 2
3 120 = $80
Exchange rate fluctuations
• Two microprocessor manufacturers, one in Japan, one in US
• All customers in US
• Initially, e = 100 (exchange rate Y/$), p = 24
Moreover, c1 = Y1200, c2 = $12.
• Question: what is the impact of a 50% devaluation of the Yen
(that is, e = 150) on the Japanese firm’s market share?
Asymmetric Cournot duopoly
• Best response mappings:
a − c1 q2
q1∗ (q2 ) = −
2b 2
∗ a − c2 q1
q2 (q1 ) = −
2b 2
• Solving system qi = qi∗ (qj )
a − 2 c1 + c2
q
b1 =
3b
a − 2 c2 + c1
q
b2 =
3b
Asymmetric Cournot duopoly
• Firm 1’s market share:
q1 a − 2 c1 + c2
s1 = =
q1 + q2 2 a − c1 − c2
• In order to say more, need to know value of parameter a

Calibration
• At initial equilibrium, p = 24
• In equilibrium (when c1 = c2 = c)
a + 2c
p=
3
• Solving with respect to a
a = 3 p − 2 c = 3 × 24 − 2 × 12 = 48
• Calibration: use observable data to determine values of unknown

model parameters
Exchange rate fluctuations
• Upon devaluation, c1 = 1200/150 = 8
• Hence
48 − 2 × 8 + 12
s1 = ≈ 58%
2 × 48 − 8 − 12
b
• So, a 50% devaluation of the Yen increases the Japanese firm’s

market share to 58% from an initial 50%
New technology and profits
• Chemical industry duopoly
• Firm 1: old technology, c1 = $15
• Firm 2: new technology, c2 = $12
• Current equilibrium price: p = $20, Q = 13
• Question: How much would Firm 1 be willing to pay for the
modern technology?
• Answer: difference between equilibrium profits with new and with
old technology (comparative statics)
Equilibrium profits
• We have seen before that
a + cj − 2 ci
q
bi =
3b
a + ci + cj
p=
b
3
• Therefore firm i’s equilibrium profits are given by
bi = (p − ci ) qi
π

a + ci + cj a + cj − 2 ci
= − ci
3 3b
2
1 a + cj − 2 ci
=
b 3
Calibration
• Equilibrium equations:
2 a − c1 − c2
Q
b =qb1 + q
b2 =
3b
a + c1 + c2
p = a−bQ =
b b
3
• Solving with respect to a, b
p − c1 − c2 = 3 × 20 − 15 − 12 = 33
a = 3b
2 a − c1 − c2
b= = (2 × 33 − 15 − 12)/(3 × 13) = 1
3Qb
New technology and profits
• We have seen before that
2
1 a + cj − 2 ci
π
bi =
b 3
• Therefore
2 2
1 33 + 12 − 2 × 15 15
π
b1 = = = 25
1 3 3
2 2
1 33 + 12 − 2 × 12 21
π
b1 =
b = = 49
1 3 3
b1 − π
π
b b1 = 24
Naive (non-equilibrium) approaches
• Initial output is
a − 2 c1 + c2 33 − 2 × 15 + 12
q1 = = =5
3b 3×1
• Value from lower cost: 5 × (15 − 12) = 15 24

• Firm 2’s initial profit levels:
2 2
33 + 15 − 2 × 12 24
π
b2 = = = 64
3 3
• Difference in profit levels: 64 − 25 = 39 24

Exchange rate devaluation (again)
• French firm sole domestic producer of a given drug
• Marginal cost: e 2 per dose
• Demand in France: Q = 400 − 50 p (Q in million doses, p in e)
• Second producer, in India, marginal cost INR 150
• French regulatory system implies firms must commit to prices for
one year at a time. Production capacity can be adjusted easily
• Question: Indian rupee is devalued by 20% from INR 50/e.
Impact on the French firm’s profitability?
Exchange rate devaluation (again)
• Bertrand model seems appropriate
• Initially, c2 = 150/50 = e 3
• French firm’s profit
π1 = (400 − 50 × 3) × (3 − 2) = e 250m
• Upon devaluation, e = 50 (1 + 20%) = 60, c2 = 150/60 = e 2.5

• French firm’s profit
π1 = (400 − 50 × 2.5) × (2.5 − 2) = e 137.5m
• So, 20% devaluation implies (250 − 137.5)/250 = 45% drop in

profits
Labor negotiations
• In early 1990s, Ford substitutes robots for fraction of labor force
• In 1993, UAW initiates wage negotiations with Ford. It was
expected that similar deal would later be struck with GM, Chrysler
• Ford agreed to what was then generally considered a fairly liberal
wage and benefits package with the UAW. Why?
• Marginal cost:
− ci = z + w , i = G , C
− cF = z + (1 − α) w , α ∈ (0, 1)
Labor negotiations (cont)
• Equilibrium profit with 3 firms
2
1 a + cj + ck − 3 ci
π
bi =
b 4
• Substituting the marginal cost functions given above, we get

2
1 a − z − w (1 − 3 α)
π
bF =
b 4
• π
bF is increasing in w if and only if w (1 − 3 α) is decreasing in w ,
i.e., α > 13 : raising rivals’ costs
Takeaways
• Different models fit different industries better;
Key question: How easy can output levels be adjusted?
• Comparative statics: by comparing equilibria before and after x
estimate impact of x on price, market shares, etc.
• Calibration: Based on historical data (p, q, c, s) estimate values of
key model parameters

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EFFICIENCY

AND THE FUNDAMENTAL THEOREM

− Sellers sell for more than marginal cost: producer surplus

− Labor market: minimum wage, firing costs

− MacDonalds; wine producers

− Gasoline tax; road tax

− pollution caps; landing slots

Class assignments are made by lottery. There are no waiting

— Steven Levitt, New York Times 2008

• Cost of average type served: average between types θ = p, θ = 1

• Note that AC > MC

Private interests : Nonmarket action

− Incomplete: missing link public-legislature

Source for electric utility evidence: Stigler and Friedland (1962).

− Meredith Attwell Baker: FCC commissioner, Comcast

− Industry opposes many regulations

− Consumer to producer transfer: $255m

− Price ceilings (rent, gas, taxi fares)

− Labor market: minimum wage, firing costs

Foreign currency in Venezuela and empty planes

Solution: surplus, distribution, rent seeking; X-inefficiency.

Plus: rent-seeking (e.g., Academy Awards).

− Section 1: Horizontal and vertical agreements

− Section 2: Price discrimination

− Section 5: Unfair methods of competition are unlawful

− 101: Horizontal and vertical agreements

− Regulation 4064/1989 (mergers)

What really matters is to protect an effective competitive

Profit lost to buyers

Type W.T.P. ($) No. (K) Cum. No.

− The seller gains: revenue and profits go up

• Coming next: All approaches to PD are approximations

− Trick: apply elasticity rule to each market segment

Model Belgium France Germany Italy UK

• What’s going on here?

− Identifying market segments

• Strategy 1: Price single ticket (NR) at 350

• Strategy 3: Price (R,NR) at (300,800)

The key constraint is: 800 p NR 400 pR

• Strategy 1: Price at 50 per ticket

Uniform pricing Two-part tari↵:

− Ascending auction (a.k.a. English)

Pros and cons of each type of auction

− Seller: margin vs quantity sold

− Understand our competitors: Our results depend not only on our

When government auctioneers need worldly advice, where can they

Game theory, long an intellectual pastime, came into its own as a

Game theory is hot. — The Wall Street Journal

I think it is instructive to use game theory analysis . . . Game theory

At their worst, game theorists represent a throw back to the days of

− Players (in previous example: Warner and Fox)

− Determine how good each of my strategies is

• Coming later: how to analyze game

• Please record your choice

− Best suited for games with simultaneous decisions

− Best suited for games with sequential moves

3. Player 1 is rational and believes that Player 2 is rational and

5. Player 1 is rational and believes that Player 2 is rational and

Player 1’s best response Player 2’s best response

• Value from lower cost: 5 × (15 − 12) = 15 24

• Difference in profit levels: 64 − 25 = 39 24