Business Strategy and

Managerial Economics
Competiti
Aditya Shrinivas
Assistant Professor, Economics

Lecture 18: Review

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2

Topic
Week 1-4 Week 5-9

Markets and Welfare Firm Dynamics

• Market equilibrium • Costs

• Consumer sensitivity • Monopoly
• Govt Intervention • Price Discrimination
• Externalities • Game Theory
• Oligopoly
• Asymmetric Info
Review
Lecture 1-3: Demand and Supply, Market Equilibrium
➢Shifters of Demand and Supply
➢Simultaneous shifts in Demand and Supply
➢Consumer and Producer surplus

Lecture 4: Elasticity
➢Elasticities: Own, Cross, Income
➢Determinants of own price elasticity

3
Individual Demand
Demand for good 𝒙 is given by

𝑫𝒙 = 𝒇(𝒑𝒙 , 𝑰, 𝒑𝒚 , 𝑻, 𝒑𝒆𝒙 )

Where
➢ 𝒑𝒙 : Price per unit of good 𝑥
➢ 𝑰 : Income
➢ 𝒑𝒚 : Price of related commodity 𝑦
➢ 𝑻 : Taste of the consumer
➢ 𝒑𝒆𝒙 : Expectations

4
 Shifts in Demand
Price ➢ An increase in price of a
substitute
➢ A decrease in price of a
complement
➢ An increase in income (and
the good is normal)
➢ An decrease in income (and
the good is inferior)
Decrease Increase in ➢ Higher expected future
in demand demand price
➢ A decrease in price of a
substitute
➢ An increase in price of a
complement
➢ A decrease in income (and
the good is normal)
➢ An increase in income (and Quantity
the good is inferior)
➢ Lower expected future price

5
Supply
Individual supply of good 𝒙 is given by
𝒔𝒙 = 𝒇(𝒑𝒙 , 𝒑𝒚 , 𝒑𝑰 , 𝑻, 𝒑𝒆𝒙 )

𝒑𝒙 : price per unit of good 𝑥

Supply shifters
𝒑𝒚 : price of a related good y
𝒑𝑰 : price of input I
𝑻 : Technology
𝒑𝒆𝒙 : Expected future price of the product

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 Shifts in Supply Curve
➢ Decrease in price of inputs
Price per
➢ Decrease in price of a substitute
unit ➢ Increase in price of a
complement
➢ Decrease in expected future
Decrease prices
in supply ➢ Better technology

Increase in
supply
➢ Increase in price of inputs
➢ Increase in price of a substitute
➢ Decrease in price of a
complement
➢ Increase in expected future prices Quantity
➢ Natural calamities, pandemic, etc.

7
Simultaneous Shifts in Supply and
Demand
Simultaneous increase in demand and decrease in supply

Price per unit S1

S0

𝑝1 B

A
𝑝0

D1

D0

𝑞0 𝑞1 Quantity

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Simultaneous Shifts in Supply and
Demand

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Producer and Consumer surplus
Consumer
Price surplus

P
P0
0

Demand
Producer
surplus

Q0 Quantity
 Price Elasticity of Demand
Own Price Elasticity (𝑬𝒑):

% age change in quantity demanded

Ep =
%age change in price
∆ Q/Q p ∆Q
= = * ,
∆ p/p Q ∆ p
where,
➢ Q is the initial quantity demanded
➢ p is the initial price
➢ ∆ Q is the change in quantity demanded
➢ ∆ p is the change in price
➢ Ep < 0 always (why?), and
➢ - ∞ < Ep < 0

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Price Elasticity of Demand
Inelastic Demand
% age change in quantity demanded < % age change in price , i.e.,
|∆ Q/Q| < |∆ p/p| → |Ep| < 1

Elastic Demand
% age change in quantity demanded > % age change in price , i.e.,
|∆ Q/Q| > |∆ p/p| → |Ep | > 1

Unitary Elastic Demand

% age change in quantity demanded = % age change in price , i.e.,
|∆ Q/Q| = |∆ p/p| → |Ep| = 1

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 Price Elasticity of Demand (Extreme)
Perfectly Inelastic Ep = 0 Perfectly elastic Ep = - ∞

Price (p) Price (p)

Quantity (Q) Quantity (Q)

A small percentage change in price A small percentage change in price
brings about no percentage change brings an infinite percentage change
in the quantity demanded. in the quantity demanded.
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 Graphical Representation

Price (p)

TR = p × 𝑄

If demand is inelastic then revenue

increases when price increases
280

250

TR = 280 × 9
= Rs. 2520 Inelastic
demand curve

9 10 Cappuccino per hour (Q)

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 Elasticity and Linear Demand Curve

𝑝
Price (p) Ep = - 2.
𝑄

➢ At prices above the mid-

point of the demand curve,
Ep = - ∞ demand is elastic.
➢ At prices below the mid-
4 point of the demand curve,
Demand curve: Q = 8 – 2.p demand is inelastic.
3 Ep = - 1

1 Ep = 0

2 4 6 8 Quantity (Q)
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Determinants of Price Elasticity

➢ Availability of direct or indirect substitutes

➢ Large number of substitutes

➢ Narrowly defined or Broadly defined market available → switching is easy
when price changes → demand
is elastic
➢ Expenditure share ▪ Example?

➢ Small number of substitutes

➢ Time Horizon available → switching is difficult
when price changes → demand
is inelastic
▪ Example?

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Determinants of Price Elasticity

➢ Availability of direct or indirect substitutes

➢ Narrowly defined or Broadly defined market

➢ Narrow market definition →

➢ Expenditure share Elastic demand
➢ Broader market definition →
Inelastic demand
➢ Time Horizon Example: Food vs pulses

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Determinants of Price Elasticity

➢ Availability of direct or indirect substitutes

➢ Narrowly defined or Broadly defined market

➢ Expenditure share
➢ Small exp. share→ Inelastic
demand
➢ Time Horizon ➢ Large exp. share → Elastic
demand

Example?

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Determinants of Price Elasticity

➢ Availability of direct or indirect substitutes

➢ Narrowly defined or Broadly defined market

➢ Consumer Preferences ➢ Immediately following a price

change, consumers may not be
able to change their
➢ Time Horizon consumption patterns →
Inelastic demand

➢ Overtime, consumers adjust

their behaviour → Elastic
demand
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Elasticity of demand
➢ Own price elasticity
% age change in quantity demanded
Ep =
%age change in price

➢ Cross price elasticity

% age change in quantity demanded of good X

EXY =
%age change in price of good Y

➢ Income elasticity

% age change in quantity demanded

EI =
%age change in income

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Income elasticity of demand
➢ If EI < 0 : It is inferior good

➢ If EI > 0 : It is a normal good

➢ If 1 > EI > 0 : It is a necessity good

➢ If EI > 1 : It is a luxury good

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Review
Lecture 5-6: Government Intervention
➢Tax causes price to rise and quantity produced / consumed
to fall
➢Taxes levied on the buyers is equivalent to taxes levied on
the sellers – economically it makes no difference
➢Burden of tax on consumer depends on how elastic
demand is relative to supply
➢Subsidy is the opposite of tax or negative tax
➢Price ceilings create excess demand
➢Price floors create excess supply

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Review
Lecture 7-8: Externalities
➢When there are external costs (negative externalities) –
there is OVERUSE. Output should be reduced to maximize
social surplus
➢Government Solutions
➢Price Mechanism : Carbon Tax
➢Quantity regulation : Command and Control [Emission Standard]
➢Quantity mechanism : Cap and Trade

➢Coase theorem provides a competitive market model to

internalize externalities

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Externalities - Review
Market Scenario Positive/Negative Type
Externality
Crop burning Negative Production

Vaccination Positive Consumption

Smoking Negative Consumption

Reclining Seat in an Consumption

Negative
Airplane

Bee-keeping Positive Production

Water pollution PGE Negative Production

De-worming pill Positive Consumption

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Externalities - Review
NEGATIVE PRODUCTION EXTERNALITY

Price /Costs

Social cost
Deadweight

P1 External cost

Supply (Private costs)

P0
OVERUSE

Demand (Private)

Q1 Q0 Quantity of
Steel

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Externalities - Review
External POSITIVE CONSUMPTION
benefit EXTERNALITY

Price /Costs
Social value

Deadweight
P1 Supply (Private costs)
P0

UNDERUSE Demand (Private benefit)

Q0 Q1 Quantity of
vaccines

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Externalities - Review
Objective is to move from
Price /Costs point A (MPC=MB)
Efficient to point B (MSC=MB).
HOW?
Social cost (Marginal
Social costs)
B
P1
Supply (Marginal Private
A costs)
P0

Demand (Private)

Q1 Q0 Quantity of
Emissions

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 Externalities - Review
Govt solutions:
1. Price Mechanism : Carbon Tax
▪ Tax on each unit of carbon produced (Pigouvian tax)

2. Quantity regulation : Command and Control [Emission Standard]

▪ Set a Legal Limit on how much pollutant a firm can emit [Pollution
control Board]

3. Quantity mechanism : Cap and Trade

▪ Set a Quantity Cap on emissions. Provide licenses to emit and let the
firms trade licenses/permits

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Externalities - Review
COASE THEOREM :

1. Provides a competitive market model to internalize

externalities

2. Two assumptions:
➢Property rights are enforceable
➢Low transaction costs

3. It won’t help with large-scale, global externalities

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Review
Lecture 9: Costs
➢Law of diminishing marginal returns
➢Shapes of short-run cost curves
➢Economies of scale

Lecture 10: Monopoly

➢Profit maximization of any firm
➢Perfectly competitive firm sets p=MC
➢Monopolist faces the entire demand curve

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Decreasing marginal returns
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒐𝒖𝒕𝒑𝒖𝒕 ∆𝒒
Marginal product of labor = =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒍𝒂𝒃𝒐𝒓 𝒊𝒏𝒑𝒖𝒕 ∆𝑳
Output.

MPL

Labor
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Shape of Marginal Cost Curve
Rs.
MC

∆𝑇𝐶 𝑤
MC = ∆𝑄
= 𝑀𝑃
𝐿

Diminishing marginal
returns to variable
input

Q
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Shape of Cost Curves
Column 1 Column2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8
Output Fixed cost Variable Total cost Average Average Average Marginal
(FC) cost (VC) (TC) fixed cost variable total cost cost
(AFC) cost (ATC) (MC)
(AVC)
0 50 0 50 - - - -
1 50 50 100 50 50 100 50
2 50 78 128 25 39 64 28
3 50 98 148 16.7 32.7 49.4 20
4 50 112 162 12.5 28 40.5 14
5 50 130 180 10 26 36 18
6 50 150 200 8.3 25 33.3 20
7 50 175 225 7.1 25 32.1 25
8 50 204 254 6.3 25.5 31.8 29
9 50 242 292 5.6 26.9 32.4 38
10 50 300 350 5 30 35 58
11 50 385 435 4.5 35 39.5 85

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 Shapes of Short-Run Cost Curves
Rs. TC = VC + FC
FC
▪ Total cost TC is the
VC
FC vertical sum of
fixed cost FC and
variable cost VC.
FC

Rs. AC AVC
MC

AFC
Q
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 Shapes of Short-Run Cost Curves
Rs. TC = VC + FC
FC
VC
FC

FC

Rs. AC AVC ▪ Average total cost AC

MC is the sum of average
variable cost AVC and
average fixed cost
AFC.
▪ The vertical distance
AFC
between AC and AVC
declines

Q
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 Average and Marginal Costs
Rs.
AC
MC
AVC

i. When MC < AVC,

then AVC is
declining
ii. When MC > AVC,
then AVC is
increasing

AFC

Q
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 Shapes of Short-Run Cost Curves
Rs. TC = VC + FC
FC
VC
FC

FC

Rs. AC AVC
MC
▪ MC intersects AC and AVC
curves at their minimum
points.
▪ The minimum point of the
ATC curve must lie above and
to the right of the minimum
point of the AVC curve.
Q

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 Economies of Scale
Rs. Rs.

LRAC

LRAC
Constant returns
to scale

Q Q
𝑄∗ 𝑄∗
Economies of Scale Diseconomies of Constant returns to Scale
Scale
Long-run average cost Long-run average cost Long-run average stays
decreases as output increases as output constant as output increases.
increases. increases.

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Monopolist
Marginal revenue for a monopolist = ??

Marginal revenue = B – C
= p2 – (p1-p2)*Q

Price per Marginal revenue = P + ∆P/∆Q * Q

unit

TR(Q) = p Q ; so MR= ?
P1
C Positive effect = B ; Negative effect = C
P2

A B

Q Q+1 Quantity

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Demand and Marginal Revenue (MR) of a
Monopolist
Price ➢ Inverse demand curve
P=6–Q

➢ TR = P.Q = (6 - Q).Q
6
➢ Marginal Revenue curve
P = 6 – 2Q
5
➢ MR curve has twice the
4 slope of the demand curve.

2
Marginal
1 Revenue Demand

0 1 2 3 4 5 6 7 Output
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How a Firm Uses Market Power to
Maximize Profits
➢ To maximize profit, produce at the output level such that:

MR = MC
➢ Same principle as that for a competitive firm.
➢ MR is not same as that for a competitive firm.
➢ A monopolist faces entire demand curve
➢ As a result, MR < Price

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Profit Maximizing Choice
Price
MC

𝑄∗ : Profit maximizing
output
𝑃∗ 𝑃∗ : Profit maximizing
price

Lost
profit
Loss
Demand
MR
𝑄′′ 𝑄∗ 𝑄′ Output
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 Cost of Monopoly

Perfect Competition Monopoly

Deadweight loss:
Price Price Value of consumer>MC
All gains
from trade
are realised
Supply MC
P∗
Pc Profit deadweight loss

Demand Demand
MR
Qc Output Q∗ Qc Output

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Profit Maximizing Choice
Price
MC

AC
𝑃∗ ➢ 𝑄∗ : Profit maximizing output
Profit ➢ 𝑃∗ : Profit maximizing price
𝐶∗ ➢ Average cost = 𝐶 ∗
➢ Profit = 𝑃∗ . 𝑄∗ - 𝐶 ∗ . 𝑄∗

Demand
MR
𝑄∗ Output
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What is Market Power?

The ability to profitably set price significantly above the marginal cost.

We say a firm has market power if it can charge a price above marginal
cost

45
 Measuring Market Power

Less Monopoly More Monopoly

power Power
Price Price

Big P∗
mark up
P∗

MC MC
Small Demand Demand
mark up MR
MR
Q∗ Output Q∗ Output

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Post-midterm Review
Lecture 12-13: Price discrimination
➢Requirements of price discrimination are: market power, heterogeneity,
and no arbitrage condition.
➢First-degree price discrimination: Based on consumer’s willingness to pay.
➢ Second-Degree Price Discrimination: Based on quantity.
➢ Third-Degree Price Discrimination: Segmenting market based on an
observable characteristic.
➢Two-part pricing: charging a fixed fee plus a per unit charge.
➢ Versioning
▪ Offer high and lower quality products targeted for different consumer
segments depending on their willingness to pay.
▪ When to version: market Segmentation is strong

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Post-midterm Review
Lecture 14 : Game Theory
➢Elements of a game : Pay-off matrix
➢Dominant Strategy
➢Nash Equilibrium
▪ Best response functions Emission Standard

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 Game theory Review
➢ Each cell corresponds to a
pair of actions, that is, to an
Players outcome of the game.

Campa ➢ In each cell, we put the two

Low Price High Price players’ payoffs for that
outcome.
Low Price 0, 0 20, -50 ➢ In each cell,
Coke ▪ first entry: payoff of
row player (Coke)
High Price - 50, 20 20, 20 ▪ second entry: payoff
of column player
(Campa)
▪ If Coke chooses low
Actions/Str price and Campa
ategies Payoffs chooses high price the
payoffs are (20, -50),
i.e., Coke gains 20 and
Campa looses 50

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 Game theory Review
Dominant Strategy
FIRM B

Advertise Don’t
Advertise

Advertise 10 , 5 15 , 0
FIRM A
Don’t
Advertise 6,8 20 , 2

Firm A : Has no dominant Strategy – Its optimal decision depends on what

Firm B does
➢If Firm B Advertises, then Firm A will Advertise
➢If Firm B Does not advertise, then Firm A will
Firm B: Dominant Strategy to Advertise (no matter what firm A does)
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 Game Theory Review
Let 𝐵𝑅1 (𝑠2 ) and 𝐵𝑅2 (𝑠1 ) be best response mappings.
A Nash equilibrium is a pair of strategies (𝑠1∗ , 𝑠2∗ ) such that

▪ 𝑠1∗ is best response to 𝑠2∗ , i.e., 𝐵𝑅1 (𝑠2∗ ) = 𝑠1∗ , and

▪ 𝑠2∗ is best response to 𝑠1∗ , i.e., 𝐵𝑅2 (𝑠1∗ ) = 𝑠2∗ ,

No player would an unilateral incentive to deviate from (𝑠1∗ , 𝑠2∗ )

In a game, there can be :

▪No Nash Equilibrium
▪One Nash Equilibrium
▪Multiple Nash Equilibria
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 Game theory Review
Best Response
If player1 expects Player 1’s
Player 2 Player 2’s strategy best
is response
L C R
L T
C B
T 2, 1 0, 2 0,3
R
B
Player 1
M 1, 1 1, 1 1, 0

If player 2 expects Player 2’s

B 0, 1 2, 0 2, 2 Player 1’s strategy best
is response
T R
M {L, C}
B R

52
Game Theory - Review
➢ Elements of a Game: Players, Actions, Timings and Payoffs.

➢ Equilibrium in Dominant Strategies: Each player will play his/her

dominant strategy regardless of what other player does.

➢ Nash Equilibrium: A pair of actions/strategies from which no player

has a unilateral incentive to deviate.

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Post-midterm Review
Lecture 15: Oligopoly I
➢Static Price competition : Bertrand Model
➢Static Quantity Competition : Cournot Model

Lecture 16 : Oligopoly II
➢Price competition with differentiated products
➢Repeated interactions : Collusion

Lecture 17 : Asymmetric Information

➢Adverse Selection
➢Solutions to Adverse Selection – Signalling

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Oligopoly - Review
➢Oligopoly : 2 or more firms (few firms)

➢Price Competition – Bertrand Model:

▪ 2 firms compete on PRICE
▪ Outcome/NE : Competitive price (p=MC) Zero Profits
▪ Bertrand Trap

➢Quantity Competition – Cournot Model

▪ 2 firms compete on Quantity
▪ Outcome/NE: Price is less than monopoly price but
greater than competitive price

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Oligopoly - Review
Bertrand Competition Cournot Competition
Two firms suffice to reach a Price is less than monopoly price but
perfectly competitive equilibrium. greater than perfect competition
price.

Monopoly Output Total Cournot Output Perfectly Competitive

and Price and price Output and price
Q = 48 Q = 32 + 32 = 64 Q = 96
P = 100 – Q = Rs.52 P = 100 – Q = Rs.36 P = MC = Rs.4

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Oligopoly - Review
Solving a Bertrand Model:

Assumptions
Players: Amazon (a) and Flipkart (f)
Identical product: Amazon and Flipkart sell identical products mostly
Strategic variable (continuous): Product price
Market demand: Q(p) = 100 – p
Constant marginal cost: Rs.4
No capacity constraints
One shot-game: Firms choose prices only once

57
Oligopoly - Review
Solving a Cournot Model:

Assumptions
Two cement manufacturers: Ultratech (u) and Ambuja (a).
Strategic variable (continuous): quantity of cement.
Identical products.
One-shot game: firms make output decisions only once and simultaneously.
Each cement manufacturer choose output level based on its expectation about
other firm's choice.

Market demand: P = 100 – Q = 100 - 𝑞𝑎 - 𝑞𝑢 ,

where
➢ P is the market price.
➢ Q is the total cement production.
➢ 𝑞𝑖 is the total cement produced by firm i, i =a, u.

Marginal cost is 𝑀𝐶𝑖 = 4

58
Oligopoly Review
Steps to Solve a Cournot Model
Calculate:
1. Residual demand
◦ P = 100 –Q = 100 - 𝑞𝑢 - 𝑞𝑎
2. MR = f(own q, and other firms q)
◦ P = 100 –Q = 100 - 2𝑞𝑢 - 𝑞𝑎
3. MR = MC (Get q* as a function of the other q)
◦ 𝑞𝑢 = 48 – (1/2) 𝑞𝑎
4. Solve the same for the other firm
◦ 𝑞𝑎 = 48 – (1/2) 𝑞𝑢
5. Solve 2 equations and 2 unknowns
◦ 𝑞𝑎 = 48 – (1/2) 𝑞𝑢

59
Oligopoly Review
➢ Price competition with differentiated products
▪ With differentiated products, each firm’s residual demand increases
in other firm’s price
▪ In equilibrium, each firm charges a price greater than the marginal
cost.

➢ Model of Repeated Interactions: collusion

▪ Each firm’s decision to collude depends on comparing profits from
cheating and profits from cooperation.
▪ Prediction: If firms value future sufficiently, then it is possible to
obtain an equilibrium in which both firms set monopoly price in each
period.

60
 Oligopoly Review
Solving a Bertrand Model with differentiated products :

➢ Two firms: AB InBev (a) and United Breweries (u)

➢ Differentiated products (say Budweiser and Kingfisher)
➢ Firms compete in prices
➢ Demand for each firm
𝑞𝑎 = 48 – 3.𝑝𝑎 + 2 𝑝𝑢
𝑞𝑢 = 80 – 4𝑝𝑢 + 3 𝑝𝑎
where,
▪ 𝑝𝑖 is price charged by firm i = a, u.
▪ 𝑞𝑖 is quantity demanded of firm i’s product, i = a, u.

➢ Marginal cost of AB InBev (𝑀𝐶𝑎 ) is Rs. 8

➢ Marginal cost of UB (𝑀𝐶𝑢 ) is Rs. 13

61
Asymmetric Info - Review
➢Asymmetric Info
▪ Some people have better information than other
➢Hidden Characteristics
▪ Characteristics that one party knows, but is unknown to the other party
▪ Leads to Adverse Selection

➢Adverse Selection :
▪ A situation resulting when products of different qualities are sold at a
single price because of asymmetric information, so that “too much”
of the “low-quality product” and “too little” of the “high-quality
product” are sold.
➢If the informed party correct the asymmetry : Signaling
▪ Education as a signal

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Managerial Economics

THANK YOU!

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