ICM#ABOUT

Improving managerial decision

making by using insights from
economics

Imperfectly Competitive Markets – 2022-2023

ICM#ABOUT

Market
forms?

Imperfectly Competitive Markets – 2022-2023

ICM#ABOUT

Market
Market
power?
power?

Imperfectly Competitive Markets – 2022-2023

ICM#ABOUT

Market
Market
Game
power?
power?
theory?

Imperfectly Competitive Markets – 2022-2023

ICM#ABOUT

Product differentiation?
Imperfectly Competitive Markets – 2022-2023
ICM#ABOUT

Profit
maximization?

Imperfectly Competitive Markets – 2022-2023

ICM#ABOUT

Personalized prices?

Imperfectly Competitive Markets – 2022-2023

ICM#ABOUT: Discussion & Application driven
Why are
the prices
increasing?
Market power,
good or bad?

Are big-tech firms too big? Is it fair that I need to pay

more than you?
Imperfectly Competitive Markets – 2022-2023
ICM#ABOUT
0. Firm decision making

1. Market forms and market power

1.1 Price elasticity

1.2 Market forms

1.3 Market power

1.4 Societal discussion: Market power and big-tech companies

Imperfectly Competitive Markets – 2022-2023

ICM#ABOUT
2. Strategic interaction under oligopoly

2.1 Strategic interaction: Game theory

2.1.1 The prisoner's dilemma
2.1.2 Homogeneous duopoly: Equilibrium in dominant strategies
2.1.3 Homogeneous duopoly: Nash-equilibria

2.2 Societal discussion: The benefits of cooperation, social norms, and

contracts in the pursuit of climate change reduction and societal well-being

2.3 Product differentiation and price competition

2.3.1 The paradox of Bertrand
2.3.2 Hotelling's model

Imperfectly Competitive Markets – 2022-2023

ICM#ABOUT
3. Profit maximization under monopoly power
3.1 Profit maximization: Graphical and algebraic representation
3.1.1 The cost-side of profit maximization
3.1.2 The revenue-side of profit maximization
3.1.3 Profit maximization
3.2 Profit maximization with price discrimination
3.2.1 First-degree price discrimination
3.2.2 Market segmentation
3.3 Societal discussion: The societal impact of personalized and dynamic pricing

Imperfectly Competitive Markets – 2022-2023

ICM#EVALUATION

■ Final exam (closed-book): 60%

■ Exam material:

■ ICM#INSIGHTS.pdf on ieseg-online contains all the exam material

■ Lectures, numerical applications, and PowerPoint slides facilitate the

learning of students

■ Continuous assessment via “in-class individualized MCQs”: 40%

Imperfectly Competitive Markets – 2022-2023

ICM#EVALUATION
■ Final exam (closed-book): 60%
■ Continuous assessment via “in-class individualized MCQs”: 40%
■ 3 tests in total, individualized as students can for each in-class MCQ test
choose between two levels of difficulty, with the choice of difficulty
influencing the maximum grade they can achieve out of 20:
■ BASIC: 7 basic T/F questions, 2 points per question: possible range of
grades is [0,14].
■ INTERMEDIATE: 5 intermediate MCQ questions (4 choices per
question), 4 points per question: possible range of grade is [0,20].
■ If a student can complete both tests within the time limit, the student
receives the maximum grade out of the two tests.
■ Specificities:
■ There are no negative points in case of incorrect answers.
■ Examples are included in the Exercises section of the “ICM#INSIGHTS.pdf” file. As
such, students can predict the difficulty level.
■ Questions originate from a larger question bank.

Imperfectly Competitive Markets – 2022-2023

ICM#EVALUATION
■ Why the choice between BASIC and INTERMEDIATE?
■ To align the continuous evaluation with the varying and heterogeneous
learning paths of students

Imperfectly Competitive Markets – 2022-2023

ICM#MORE
■ Supplementary material to facilitate learning (not
exam material!):

■ Readings on ieseg-online.

■ Playlist of selected Youtube videos:

“BA2 Imperfectly Competitive Markets”:
https://youtube.com/playlist?list=PLyl7tSQyBz7qKulfK-lPQd0D5ISCpPxnK

■ Playlist of selected Spotify podcasts:

“Imperfectly Competitive Markets”:
https://open.spotify.com/playlist/2311nJD6eRhI4bDqV988cj?si=2aa1e255fcd
a4a9b
Imperfectly Competitive Markets – 2022-2023
ICM#DISCUSS
Case: Anheuser-Busch InBev NV agreed to buy SABMiller Plc.
Good or bad?

Sources:

■ European Commission (2016), Case M.7881 - AB INBEV / SABMILLER (ieseg-online/ICM/ICM#DISCUSS)

■ URL: http://www.forbes.com/sites/taranurin/2016/10/10/its-final-ab-inbev-closes-on-deal-to-buy-sabmiller/#5103be6037d6 (accessible)

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
Main info:

■ “Anheuser-Busch InBev NV agreed to buy SABMiller Plc for almost 69 billion pounds
($106 billion), a record industry deal that will bring one out of every three beers sold
worldwide under a single company.

■ Together, AB InBev and SABMiller will be the world’s largest consumer-staples

company by earnings.

■ The enlarged brewer will have the number one or two positions in 24 of the
world’s 30 biggest beer markets, they estimate.

Question: Was this merger “Good or Bad”? With the limited information you have on
this merger case, list the pros and cons for consumers, firms, and society (now and in the
future).

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
European Commission (2016): Case M.7881 - AB INBEV / SABMILLER
■ Mergers lower competitive pressure, which can result in higher prices. There is a higher danger of
price increases when
■ Market shares are high and are incrementing
■ Competition between the firms is close (i.e., substitute products)
■ Switching possibilities are limited

■ Mergers imply more possibilities for coordination (see game theory!):

■ Reduction of the number of players;
■ Creation or transformation of structural links between competitors
■ Increased number of commercial interactions in other markets between the same competitors.

■ Beer market is the product market

■ National markets are the geographical markets of focus

■ The European Commission approved the merger, under some conditions (e.g. selling Peroni (sold to
Asahi), etc.)  Open question: good or bad decision??

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
0. Firm decision making

1. Market forms and market power

1.1 Price elasticity

1.2 Market forms

1.3 Market power

1.4 Societal discussion: Market power and big-tech companies

Imperfectly Competitive Markets – 2022-2023

0. Firm decision making

■ “It is not from the

benevolence of the butcher,
the brewer, or the baker
that we expect our dinner,
but from their regard to
their self-interest”

Adam Smith (1776)

Imperfectly Competitive Markets – 2022-2023
0. Firm decision making

Maximize the objective of the firm

Outpu
Input Firm
t
1. Labor (bakers) Bread
2. Capital (ovens)
3. Materials (Flour, yeast,
salt, butter, eggs, etc.)

Given: 1. Technological constraints

2. Market constraints

Imperfectly Competitive Markets – 2022-2023

0. Firm decision making
■ The « Firm » as economic concept
■ Abstract, formal definition:

■ “A production-unit that transforms inputs into

output and creates with this process added value”

■ Production decisions are made by organizations

■ Important role for management

Imperfectly Competitive Markets – 2022-2023

0. Firm decision making
■ An economic analysis of firm behavior
■ Pilar I: Define the economic objective of the firm
 Why does the firm do what it does?

■ Pilar II: Define the technology of the firm

 How does the firm do it?

■ Pilar III: Tackle the empirical challenges you are confronted

with when analyzing observed firm behavior
 How can we see what the firm does?

Imperfectly Competitive Markets – 2022-2023

0. Firm decision making
■ Three economically meaningful objectives
■ Cost minimization: minimize costs to produce a given level of output

■ Revenue maximization: maximize revenues, given the input (costs)

■ Profit maximization: Maximize profits

■ Not so meaningful in the long term: e.g. size maximization, quality

maximization, social status maximization, etc.

■ The economic objective concerns the principal, not the agent (recall:
pricipal-agent theory)

Imperfectly Competitive Markets – 2022-2023

0. Firm decision making

■ Discussion: What is profit?

■ Accounting profit
■ Historical costs
■ Legal compliance
■ Reporting requirements

■ Economic profit
■ Market value
■ Opportunity, or implicit cost
■ More useful measure for managerial decision making

Imperfectly Competitive Markets – 2022-2023

0. Firm decision making
■ Discussion: Sources of profit?
■ Innovation
■ Producing products that are better than existing products in terms of
functionality, technology, and style

■ Risk taking
■ Future outcomes and their likelihoods are unknown, as are the
reactions of rivals

■ Exploiting market inefficiencies

■ Building barriers to entry, employing sophisticated price strategies,
diversifying, and making good strategic production decisions

Imperfectly Competitive Markets – 2022-2023

0. Firm decision making
■ Discussion: Corporate Social Responsability (CSR) and/or profits?

■ Economic profits should include social/ecological costs and revenues!

(i.e., ‘internalization’ of social/ecological side-effects)

■ Even if there would be substitution between CSR and accounting

profits, most likely, CSR is in line with economic (long-term) profit
maximization

 We can consider CSR as a managerial tool to maximize (well-defined)

long-term economic profits

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
0. Firm decision making

1. Market forms and market power

1.1 Price elasticity

1.2 Market forms

1.3 Market power

1.4 Societal discussion: Market power and big-tech companies

Imperfectly Competitive Markets – 2022-2023

Price elasticity
■ Price elasticity εp
■ Measures the relative change in demand for a good when there is
a relative change in the price of the good

■ Stated differently, measures the percentage change in quantity

demanded given a small (marginal) percentage change in price

■ = (%Δqd) / (%Δp)

■ = (Δqd/qd) / (Δp/p)

■ Mostly negative but can be positive as well

Imperfectly Competitive Markets – 2022-2023
Price elasticity
■ Price elasticity εp

|εp|=0 : Completely price-inelastic demand

|εp|=∞: Perfectly price-elastic demand
|εp|<1 : Price-inelastic demand
|εp|>1 : Price-elastic demand

? ?

Imperfectly Competitive Markets – 2022-2023

Price elasticity

|εp|<1 or >1?

|εp|<1 or >1?

|εp|<1 or >1?
|εp|<1 or >1?

Allen et al. (2013)

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
Case: Taxing sugary drinks, good idea?

Sources:
■ The Economist, 2019, May 23rd, Soda Stream: How to tax sugary drinks,
ieseg-online/ICM/ICM#DISCUSS.
■ URL: https://www.economist.com/finance-and-economics/2019/05/23/how-to-tax-sugary-drinks

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
Case: August 2nd, 2021: Pfizer
and Moderna ramp up EU Covid
vaccine prices: Why?

Sources:
■ Financial Times (2021, August 2nd), ieseg-online/ICM/ICM#DISCUSS.
■ URL: https://www.ft.com/content/d415a01e-d065-44a9-bad4-f9235aa04c1a
Imperfectly Competitive Markets – 2022-2023
Price elasticity

■ Further discussion: price elasticity for medical

treatments
■ https://www.bbc.com/news/world-europe-49739845

■ https://www.statnews.com/pharmalot/2016/10/07/ariad-riases-leukemia-drug-price/

■ https://twitter.com/sensanders/status/1374078584248279042

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
0. Firm decision making

1. Market forms and market power

1.1 Price elasticity

1.2 Market forms

1.3 Market power

1.4 Societal discussion: Market power and big-tech companies

Imperfectly Competitive Markets – 2022-2023

Market forms

Monopolistic competition
Oligopoly

Perfect
Monopoly competition

Imperfectly Competitive Markets – 2022-2023

Market forms
■ Perfect competition
The following conditions need to be fulfilled simultaneously:

1. Market atomism: individual actions do not influence the market price

2. Perfect information: the consumers know the quality of the product and know
the prices of all suppliers; the producers know the willingness to pay of the
consumers

3. Homogeneity: all firms sell a product that is considered to be identical; the

goods are thus perfect substitutes for the consumers

4. Free entry and exit: each firm can start production in the sector when the firm
decides to, and each firm can exit the sector when the firm decides to do so
Imperfectly Competitive Markets – 2022-2023
Market forms
■ Perfect competition
Demand Supply

Imperfectly Competitive Markets – 2022-2023

Market forms
■ Monopoly
Demand Supply

Imperfectly Competitive Markets – 2022-2023

Market forms
■ Monopoly: Entry barriers

■ Technological barriers

■ Exclusive right of use of production factors and legal

barriers

■ Strategic behavior of the monopolist

■ Network externalities
Imperfectly Competitive Markets – 2022-2023
ICM#DISCUSS
Case: Is Meta a monopolist? Should it
be broken up?

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
Case: Is Meta a monopolist? Should it be broken up?

Sources: https://www.economist.com/business/2021/07/03/is-facebook-a-monopolist
Market forms
■ Homogeneous Duopoly
Demand Supply

Imperfectly Competitive Markets – 2022-2023

Market forms
■ Heterogeneous Duopoly
Demand Supply

Imperfectly Competitive Markets – 2022-2023

Market forms
■ Oligopoly:
■ Many consumers and some suppliers
■ Strategic interaction between suppliers
■ If firm A does action Z, then firm B will do action X, then firm A will do
action P, etc.
■ Possibly a few dominant companies, supplemented by `competitive fringe’

■ Differentiated products are possible, but not necessary

■ No independent demand curve of its own

■ Barriers to entry
■ i.e., economies of scale, reputational barriers, strategic barriers, legal barriers.

Imperfectly Competitive Markets – 2022-2023

Market forms
■ Monopolistic Competition
Demand Supply

Imperfectly Competitive Markets – 2022-2023

Market forms
■ Monopolistic competition: elements of monopoly and of perfect
competition
■ Many suppliers of a similar product, each supplier is relatively small in relation to
the total market. Consequently, there is no strategic interaction.
■ If firm A does action Z, then firm B…will not change her behavior

■ Perfect information

■ Product differentiation: can be subjective or objective

 a particular good is perceived as unique

■ each company has its own demand curve (with a finite price elasticity) and thus market
power

■ Free entry/exit  No profits in the

Imperfectly longMarkets
Competitive run – 2022-2023
Market forms
■ Monopolistic competition: free entry and exit
■ Profit  Entry and Losses  Exit
■ Entry = Additional supply of similar products
 Demand curve of the product already present:
■ will decrease: inward shift of the demand function
■ will flatten: consumers will become more price elastic because more and more
producers offer the same product

 This process continues as long as positive profit is made by the existing company.

 The market only comes to rest when no more profit is made by the producers present (and
there is therefore no more incentive to enter).

 In the long run, firms under monopolistic competition have no potential to make a profit.

■ From a managerial viewpoint, it is thus important to constantly innovate, apply

marketing, and thus pursue product differentiation under monopolistic competition, to
avoid the long-run solution of no profits.
48
Imperfectly Competitive Markets – 2022-2023
Market forms

? ?

? ?

? ?

? ?

Allen et al. (2013)

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
Case: Dry bars promote Ireland to the sober. Virgin Mary, a pub in
Dublin serves no booze of any kind. If an alcohol-free bar can work
in Dublin, it can work anywhere, says Sarah Connolly, a co-owner.
To which concept and market form does this relate?

Sources:
■ https://thevirginmarybar.com/
■ The Economist (2021, July 31), An alcohol-free Irish pub refreshes parts that others cannot reach,
ieseg-online/ICM/ICM#DISCUSS.
Imperfectly Competitive Markets – 2022-2023
Market forms
■ Question: Define the market form for these sectors

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
0. Firm decision making

1. Market forms and market power

1.1 Price elasticity

1.2 Market forms

1.3 Market power

1.4 Societal discussion: Market power and big-tech companies

Imperfectly Competitive Markets – 2022-2023

Market power
■ Market power: the ability of a firm to have a substantial influence on
market prices.

■ It thus relates to price setting behavior.

■ Market power exists when the profit-maximizing firm sets its prices
above costs.

■ Specifically, market power exists when the firm’s profit-maximizing

price p*(q*)> MC(q*).

■ Differently put, market power exists when markups μ exceed one:

■ When, μ = > 1.
Imperfectly Competitive Markets – 2022-2023
Market power
■ Market power: inverse relationship between market
power and price elasticity
( Can be shown via the so called Lerner index =[ p* - MC(q*)]/ p* = 1/|ε| )

Higher |ε| Lower |ε|

Less market power More market power

p p

P↑

q q

Imperfectly Competitive Markets – 2022-2023

Market power
■ Market power: inverse relationship between market
power and price elasticity
( Can be shown via the so called Lerner index =[ p* - MC(q*)]/ p* = 1/|ε| )

|ε|=∞ |ε|= 0
No market power Infinitly high market power

p p

q q

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
0. Firm decision making

1. Market forms and market power

1.1 Price elasticity

1.2 Market forms

1.3 Market power

1.4 Societal discussion: Market power and big-tech companies

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
Case: Companies appear to be gaining market power: good or
bad?

Sources:
■ The Economist, 2018, July 7th, From the many to the few: Companies appear to be gaining market power.
ieseg-online/ICM/ICM#DISCUSS.
■ URL:
https://www.economist.com/graphic-detail/2018/07/06/companies-appear-to-be-gaining-market-power

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS

https://www.economist.com/graphic-detail/2018/07/06/companies-appear-to-be-gaining-market-power
Imperfectly Competitive Markets – 2022-2023
ICM#DISCUSS
■ Market power, superstar firms, and the labor share

■ David Autor, The Rise of Superstar Firms and the Fall of the Labor Share,
Youtube video. URL: https://www.youtube.com/watch?v=wQM-xydsB-s

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
2. Strategic interaction under oligopoly

2.1 Strategic interaction: Game theory

2.1.1 The prisoner's dilemma
2.1.2 Homogeneous duopoly: Equilibrium in dominant strategies
2.1.3 Homogeneous duopoly: Nash-equilibria

2.2 Societal discussion: The benefits of cooperation, social norms, and

contracts in the pursuit of climate change reduction and societal well-being

2.3 Product differentiation and price competition

2.3.1 The paradox of Bertrand
2.3.2 Hotelling's model

Imperfectly Competitive Markets – 2022-2023

Characteristics of an oligopoly
■ Each oligopolist is a price setter (as the monopolist)

■ Has to take into account its (price-setting) behavior :

■ Own cost structure and market demand
■ The behavior of rival companies

■ ‘Homogeneous Duopoly’:
■ 2 suppliers
■ Homogeneous product

Imperfectly Competitive Markets – 2022-2023

Characteristics of an oligopoly
■ Main conclusion: there is mutual influence

■ In consequence, there is ‘strategic interaction’:

■ They consider the other ‘players’ actions in determining their own

optimal action.

■ It is as if oligopolists are playing a ‘game’….

Imperfectly Competitive Markets – 2022-2023

Characteristics of an oligopoly
■ It is as if oligopolists are playing a ‘game’….
■ https://www.youtube.com/watch?v=7FbkwrhW_0I (min 4 onwards)

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
Case: July 2022: Oil price rises after Joe Biden fails to secure
Saudi output increase. OPEC (+) countries are playing a game
with high stakes?

Sources:
■ URL: https://www.theguardian.com/business/2022/jul/18/oil-price-rises-joe-biden-saudi-output-petrol
-diesel-prices

Imperfectly Competitive Markets – 2022-2023

ICM#ABOUT
2.Strategic interaction under oligopoly

2.1 Strategic interaction: Game theory

2.2 Societal discussion

2.3 Product differentiation and price competition

Imperfectly Competitive Markets – 2022-2023

Strategic interaction: Game theory
■ As a manager you are confronted with strategic interaction from two
inversely related perspectives:

■ Which strategy maximizes profits, given the market conditions and

strategical interactions?
■ How to play the game?
■ « Game theory »

■ Which market conditions should I install to maximize profits?

■ How to design the game?
■ « Mechanism design »
■ e.g. auctions

Imperfectly Competitive Markets – 2022-2023

The rules of the game
■ The game:
■ A situation whereby players take into account « interdependence »
■ We consider simultaneous one-shot games

■ The players
■ The (rational) decision-makers

■ Pure strategies:
■ Possible actions of players

■ Payoff matrix:
■ The outcomes of the game for each player and each combination of
strategies 
Imperfectly Competitive Markets – 2022-2023
The rules of the game
■ Dominant strategy:
■ The strategy that delivers the best result, irrespective of the
decisions of the other player

■ Rational players
■ Rational players will always play their dominant strategy
■ Rational players will anticipate that other players play their
dominant strategy

■ Equilibrium in dominant strategies:

■ Each player plays his/her dominant strategy
■ Expected outcome under dominant strategies

Imperfectly Competitive Markets – 2022-2023

Let’s play: The prisoner’s dilemma

■ Search the equilibrium in dominant strategies

Prisoner 2
Confess Deny

Confess
(8 years; 8 years) (1 year; 10 years)
Pris
one
r1 Deny
(10 years; 1 year) (2 years; 2 years)

Imperfectly Competitive Markets – 2022-2023

Let’s play: The prisoner’s dilemma

■ Search the equilibrium in dominant strategies

Prisoner 2
Confess Deny

Confess
(8 years; 8 years) (1 year; 10 years)
Pris
one
r1 Deny
(10 years; 1 year) (2 years; 2 years)

Imperfectly Competitive Markets – 2022-2023

Let’s play: The prisoner’s dilemma
■ Prisoner’s dilemma:
https://www.youtube.com/watch?v=t9Lo2fgxWHw

71
Imperfectly Competitive Markets – 2022-2023
Let’s play: homogeneous duopoly

■ Search the equilibrium in dominant strategies

Player 2 (duopolist 2)
Maintain cartel Break cartel
agreement agreement
Pla Maintain cartel
yer agreement (4000; 4000) (2900; 4500)
1
(du Break cartel
opol agreement
(4500; 2900) (3000; 3000)
ist
1)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly

■ Search the equilibrium in dominant strategies

Player 2 (duopolist 2)
Maintain cartel Break cartel
agreement agreement
Pla Maintain cartel
yer agreement (4000; 4000) (2900; 4500)
1
(du Break cartel
opol agreement
(4500; 2900) (3000; 3000)
ist
1)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly

■ Search the equilibrium in dominant strategies

Player 2 (duopolist 2)
Maintain cartel Break cartel
agreement agreement
Pla Maintain cartel
yer agreement (4000; 4000) (2900; 3900)
1
(du Break cartel
opol agreement
(3900; 2900) (3000; 3000)
ist
1)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly

■ There is no equilibrium in dominant strategies (!)

Player 2 (duopolist 2)
Maintain cartel Break cartel
agreement agreement
Pla Maintain cartel
yer agreement (4000; 4000) (2900; 3900)
1
(du Break cartel
opol agreement
(3900; 2900) (3000; 3000)
ist
1)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly
■ Nash equilibrium

■ Combination of strategies where no player wants to change his/her

strategy, given the strategy of the other player

■ More general than equilibrium in dominant strategies

■ Each equilibrium in dominant strategies is a Nash equilibrium, but

the inverse is not true

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly
■ Nash equilibrium:
■ A situation where no player can improve given the behavior of the
other players

■ Equilibrium in dominant strategies:

■ Each player plays the strategy that gives the best outcome regardless
of the behavior of the other players

■ Mutual relationship:
■ Any equilibrium in dominant strategies is also a Nash equilibrium,
but not vice versa
■ If there is an equilibrium in dominant strategies, it is also the unique
Nash equilibrium
Imperfectly Competitive Markets – 2022-2023
Let’s play: homogeneous duopoly

■ Search the Nash equilibrium(s)

Player 2 (duopolist 2)
Maintain cartel Break cartel
agreement agreement
Pla Maintain cartel
yer agreement (4000; 4000) (2900; 3900)
1
(du Break cartel
opol agreement
(3900; 2900) (3000; 3000)
ist
1)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly

■ Search the Nash equilibrium(s)

Player 2 (duopolist 2)
Maintain cartel Break cartel
agreement agreement
Pla Maintain cartel
yer agreement (4000; 4000) (2900; 3900)
1
(du Break cartel
opol agreement
(3900; 2900) (3000; 3000)
ist
1)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly

■ Search the Nash equilibrium(s)

Player 2 (duopolist 2)
Maintain cartel Break cartel
agreement agreement
Pla Maintain cartel
yer agreement (8000 ; 8000) (1000 ; 9000)
1
(du Break cartel
opol agreement
(9000 ; 1000) (2000 ; 2000)
ist
1)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly

■ Search the Nash equilibrium(s)

Player 2 (duopolist 2)
Maintain cartel Break cartel
agreement agreement
Pla Maintain cartel
yer agreement (8000 ; 8000) (1000 ; 9000)
1
(du Break cartel
opol agreement
(9000 ; 1000) (2000 ; 2000)
ist
1)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly
■ https://www.youtube.com/watch?v=6rs_EQpxTI4

Imperfectly Competitive Markets – 2022-2023

Game theory: Let’s play more games!

Allen et al. (2013)

Imperfectly Competitive Markets – 2022-2023

Game theory: Let’s play more games!

Allen et al. (2013)

Imperfectly Competitive Markets – 2022-2023

Game theory: Let’s play more games!

Allen et al. (2013)

Imperfectly Competitive Markets – 2022-2023

Game theory: Let’s play more games!

Allen et al. (2013)

Imperfectly Competitive Markets – 2022-2023

Game theory: Let’s play more games!

Allen et al. (2013)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly

■ 4 possible output levels; search the Nash equilibrium(s)

Strategies for duopolist 2

Stra t1 t2 t3 t4
tegi
q2 = 200 q2 = 400 q2 = 600 q2 = 800
es
for s q = 200 (3000;3000) (2500;5000) (2000;6000) (1500;6000)
1 1
duo
poli s2 q1 = 400 (5000;2500) (4000;4000) (3000;4500) (2000;4000)

st 1 s3 q1 = 600 (6000;2000) (4500;3000) (3000;3000) (1500;2000)

s4 q1 = 800 (6000;1500) (4000;2000) (2000;1500) (0;0)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly

■ 4 possible output levels; search the Nash equilibrium(s)

Strategies for duopolist 2

Stra t1 t2 t3 t4
tegi
q2 = 200 q2 = 400 q2 = 600 q2 = 800
es
for s q = 200 (3000;3000) (2500;5000) (2000;6000) (1500;6000)
1 1
duo
poli s2 q1 = 400 (5000;2500) (4000;4000) (3000;4500) (2000;4000)

st 1 s3 q1 = 600 (6000;2000) (4500;3000) (3000;3000) (1500;2000)

s4 q1 = 800 (6000;1500) (4000;2000) (2000;1500) (0;0)

Imperfectly Competitive Markets – 2022-2023

Let’s play: homogeneous duopoly

■ 4 possible output levels; search the Nash equilibrium(s)

Strategies for duopolist 2

Stra t1 t2 t3 t4
tegi
q2 = 200 q2 = 400 q2 = 600 q2 = 800
es
for s q = 200 (3000;3000) (2500;5000) (2000;6000) (1500;6000)
1 1
duo
poli s2 q1 = 400 (5000;2500) (4000;4000) (3000;4500) (2000;4000)

st 1 s3 q1 = 600 (6000;2000) (4500;3000) (3000;3000) (1500;2000)

s4 q1 = 800 (6000;1500) (4000;2000) (2000;1500) (0;0)

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
2.Strategic interaction under oligopoly

2.1 Strategic interaction: Game theory

2.2 Societal discussion

2.3 Product differentiation and price competition

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
Case: Big fossil fuel groups all failing
climate goals, study shows.
Don’t hate the payer, hate the game?

A total of 125 oil and gas producers, coal miners and electricity
groups were assessed on their preparedness for a lower-carbon
economy © REUTERS

Source:
■ Financial Times, 2020, Big fossil fuel groups all failing climate goals, study shows.
ieseg-online/ICM/ICM#DISCUSS. Imperfectly Competitive Markets – 2022-2023
Societal discussion: The stereotypical Battle of the sexes

■ Search the Nash equilibrium(s)

Player 2 (Mrs.)
Football Cinema

Pla Football
yer (3 ; 1) (0 ; 0)
1
(Mr. Cinema
(0 ; 0) (1 ; 3)
)

Imperfectly Competitive Markets – 2022-2023

Societal discussion: The stereotypical Battle of the sexes

■ Search the Nash equilibrium(s)

Player 2 (Mrs.)
Football Cinema

Pla Football
yer (3 ; 1) (0 ; 0)
1
(Mr. Cinema
(0 ; 0) (1 ; 3)
)

Imperfectly Competitive Markets – 2022-2023

Societal discussion: Reducing CO2 emissions

■ Search the Nash equilibrium(s)

Player 2 (Country 2)
Reduce Not reduce

Pla Reduce
yer (8 ; 8) (1 ; 3)
1
(Co Not reduce
untr (3 ; 1) (2 ; 2)
y 1)

Imperfectly Competitive Markets – 2022-2023

Societal discussion: Reducing CO2 emissions

■ Search the Nash equilibrium(s)

Player 2 (Country 2)
Reduce Not reduce

Pla Reduce
yer (8 ; 8) (1 ; 3)
1
(Co Not reduce
untr (3 ; 1) (2 ; 2)
y 1)

Imperfectly Competitive Markets – 2022-2023

Societal discussion: Reducing CO2 emissions

■ Search the Nash equilibrium(s)

Player 2 (Country 2)
Reduce Not reduce

Pla Reduce
yer (8 ; 8) (1 ; 10)
1
(Co Not reduce
untr (10 ; 1) (2 ; 2)
y 1)

Imperfectly Competitive Markets – 2022-2023

Societal discussion: Game theory
■ Main insights

■ Blindly striving for your self-interest does not necessarily imply

you will reach your best outcome

■ Importance of coordination mechanisms to change the pay-offs in

the game to reach superior equilibria

■ Importance of social norms and government intervention

■ Imposition of cooperative outcomes can improve the outcomes for

all players

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
2.Strategic interaction under oligopoly

2.1 Strategic interaction: Game theory

2.2 Societal discussion

2.3 Product differentiation and price competition

Imperfectly Competitive Markets – 2022-2023

Product differentiation and price competition
■ « Paradox of Bertrand »
■ In a duopoly with no product differentiation (thus
« homogenous ») and competition on output prices,
profits will be zero.

■ Proof: Assume A and B sell the same hamburgers and they are the only
hamburger sellers in town. A asks 5 euros for a hamburger and B only 3
euros, while the cost of making a hamburger is 1 euro.

■ Then A will sell no hamburgers and B will sell a lot of hamburgers.

■ Thus A will set his/her price below 2 euros, as a result, B will sell no
hamburgers and A will sell many hamburgers.
■ Then B sets its price to 1,…, then A sets its price to 1 euro.
■ Thus no profit.

Imperfectly Competitive Markets – 2022-2023

Product differentiation and price competition
■ « Paradox of Bertrand »
■ In a duopoly with no product differentiation (thus
« homogenous ») and competition on output prices,
profits will be zero

■ How to escape?

 use product differentiation

■ « Heterogenous » duopoly: both price and product variety

are strategical variables
Imperfectly Competitive Markets – 2022-2023
Product differentiation and price competition
■ https://www.youtube.com/watch?v=jILgxeNBK_8&t=5s

Imperfectly Competitive Markets – 2022-2023

Product differentiation and price competition
■ Hotelling’s law

(Geographically) differentiated suppliers of ice-cream

Left cart 1 C (Center) cart 2 Right

500 m “Socially Optimal Solution” 500 m

2 km’s
Uniform distribution of potential buyers of ice-creams

Imperfectly Competitive Markets – 2022-2023

Product differentiation and price competition
■ Hotelling’s law: presume a fixed price

Left cart 1 C (Center) cart 2 Right

2 km’s
Uniform distribution of potential buyers of ice-creams

Imperfectly Competitive Markets – 2022-2023

Product differentiation and price competition
■ Hotelling’s law: presume a fixed price
■ Carts can increase their market share by moving towards
the center

Left cart 1 C Cart 2 Right

2 km’s
Uniform distribution of potential buyers of ice-creams

Imperfectly Competitive Markets – 2022-2023

Product differentiation and price competition
■ Hotelling’s law: presume a fixed price
■ Carts can increase their market share by moving towards
the center
■ Result: Minimal differentiation
cart 1 = cart 2 Tendency to cluster
Left C (Center) Right

Not “socially optimal”

2 km’s
Uniform distribution of potential buyers of ice-creams

Imperfectly Competitive Markets – 2022-2023

Product differentiation and price competition
■ Hotelling’s law: presume price competition
■ « Homogeneous duopoly with price
competition »profit=0
■ Tendency to move away from the center, to differentiate

Left C (Center) Right

Not “socially optimal”

2 km’s
Uniform distribution of potential buyers of ice-creams

Imperfectly Competitive Markets – 2022-2023

Product differentiation and price competition
■ «  Hotelling’s law»: presume price competition
■ The market share depends on:
■ Price
■ Relative differentiation and position in the market

■ Prices and differentiation are interlinked

■ More differentiation implies lower price elasticity of demand
■ Less room for price differentiation implies a tendency to larger
homogeneity

■ Less (room for) price competition implies a smaller tendency for product
differentiation

■ More (room for) price competition implies a larger tendency for product
differentiation
Imperfectly Competitive Markets – 2022-2023
Product differentiation and price competition
■ Applications of « Hotelling’s law »

■ Political parties and the « median voter »

■ Television broadcasting

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
3. Profit maximization under monopoly power
3.1 Profit maximization: Graphical and algebraic representation
3.1.1 The cost-side of profit maximization
3.1.2 The revenue-side of profit maximization
3.1.3 Profit maximization
3.2 Profit maximization with price discrimination
3.2.1 First-degree price discrimination
3.2.2 Market segmentation
3.3 Societal discussion: The societal impact of personalized and dynamic pricing

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
3. Profit maximization under monopoly power

3.1 Profit maximization: Graphical and algebraic representation

3.1.1 The cost-side of profit maximization
3.1.2 The revenue-side of profit maximization
3.1.3 Profit maximization

3.2 Profit maximization with price discrimination

3.2.1 First-degree price discrimination
3.2.2 Market segmentation

3.3 Societal discussion: The societal impact of personalized and

dynamic pricing
Imperfectly Competitive Markets – 2022-2023
Firms with monopoly power
■ Applicable to monopoly in both the SR and LR and monopolistic
competition in the SR.
■ Price setters: the market demand is the demand of the individual
monopolist
■ For the produced quantity q applies:
■ AR = p(q), whereby
■ p is the maximal market price that the monopolist can charge for
each produced quantity q
■ In result: the monopolist influences via his behavior the market
outcome (i.e., the market price and quantity); the monopolist has
‘market power’.

Imperfectly Competitive Markets – 2022-2023

Profit maximization: Graphical and algebraic representation
Profit maximization
■ ‘Optimal’ production level = ‘profit maximizing’ production level

■ Economic vs. accounting profit

■ Economic profit
■ = Revenues - (explicit + implicit costs)

■ For output level q: P(q) = TR(q) – TC(q)

■ Optimal output level q* maximizes profit, given the:

■ Technological constraints

■ Market constraints

Imperfectly Competitive Markets – 2022-2023

The cost-side of profit maximization

■ Cost function:

■ Minimal costs for a given production level q

■ Short run: some production factors are fixed (e.g., buildings,

capital)

■ Long run: all production factors are variable

Imperfectly Competitive Markets – 2022-2023

The cost-side of profit maximization
Short Run Total Cost function
■ TC(q) = ‘variable costs’ + ‘fixed costs’
= VC(q) + FC
E.g.: labor as variable and capital as fixed costs

■ Variable costs: VC(q) = pL qL(q)

■ Fixed costs: FC = pK K

■ Average Costs: AC (AVC, AFC)

■ Marginal costs: =
■ For simplicity, we assume Constant Returns to Scale
 AVC does not depend on q and AVC=MC.
Imperfectly Competitive Markets – 2022-2023
The cost-side of profit maximization

Imperfectly Competitive Markets – 2022-2023

The cost-side of profit maximization
Example: TC(q) = 63 + 20q

• FC = 63 ?

• AVC(q) = 20 ?

• MC(q) = 20 ?

• AC(q) = 63/q+20 ?

Imperfectly Competitive Markets – 2022-2023

The revenue-side of profit maximization
Revenue analysis
■ Revenues are determined by demand
■ Total revenues:
■ TR(q) = p(q) q
■ with p(q) = inverse demand function

■ So: total revenues = function of the sold quantity q:

■ (Directly) via q
■ (Indirectly) via p

■ Average Revenues = AR(q) =

■ Marginal Revenues = MR(q) =

Imperfectly Competitive Markets – 2022-2023

The revenue-side of profit maximization

Example: (Linear) demand function for books: q = 2400 – 80 p

 Determine TR(q) , AR(q), MR(q)

Imperfectly Competitive Markets – 2022-2023

The revenue-side of profit maximization

Example: (Linear) demand function for books: q = 2400 – 80 p

■ Step 1: Inverse demand function : p is a function of q, p(q) is thus positioned

on the left side of the equation:
p = 30 – 0.0125 q (= p(q))

■ Step 2: Total revenues is p(q) times q

TR(q) = p(q)q = 30q – 0.0125 q²

■ Step 3: Calculate MR(q) (and AR(q))

■ AR(q) = TR(q)/q = 30 – 0.0125 q = p(q)
 You know that AR(q) equals p(q), so if you have the inverse demand function, you do not need to do
this calculation.
■ MR(q) = dTR(q) / dq = 30 – 0.025 q
Imperfectly Competitive Markets – 2022-2023
The revenue-side of profit maximization
Revenues and the inverse demand function– graphical illustration
Price
book
(inverse) D = AR(q) = 30 – 0.0125 q
30
MR(q) = 30 – 0.025 q

TR 1200 2400 q
18000

TR(q) = 30q – 0.0125 q²

1200 2400 q
Imperfectly Competitive Markets – 2022-2023
The revenue-side of profit maximization
The relation between AR(q) and MR(q)

Imperfectly Competitive Markets – 2022-2023

Profit maximization
Profit maximization rule

2 steps:

■ Step 1: Identify the profit-maximizing production quantity q* (> 0)

■ Step 2: Decide whether to produce or not

Imperfectly Competitive Markets – 2022-2023

Profit maximization
Step 1 – optimal q*?
Profit maximization rule :
Maximal profit
Profit (q) MR = MC
MP = 0

MR > MC MR < MC
MP > 0 MP < 0

q
q*
Imperfectly Competitive Markets – 2022-2023
Profit maximization
Step 1: Optimal production quantity q*?
■ Profit maximization rule

MP(q*)=dP(q*)/dq = 0

dTR(q*)/dq - dTC(q*)/dq = MR(q*) – MC(q*) = 0

Imperfectly Competitive Markets – 2022-2023

Profit maximization
Step 2 – produce q* or not?
Distinguish between Short Run and Long Run:

■ Long run: produce q* if TR(q*) > TC(q*)

■ Short run:
produce q* if TR(q*) > VC(q*), even if TR(q*) < TC(q*) (= VC + FC)

■ not producing => profit = - FC (=> loss)

■ producing => profit = - FC + (TR - VC)

Imperfectly Competitive Markets – 2022-2023
Profit maximization
Optimal production quantity q*: a numeric example
■ Presume:

■ Total Cost function: TC(q) = 63 + 20q

■ Inverse demand function: p(q) = 30−0.0125q

■ Questions:

■ optimal q*?
■ Produce or not?

Imperfectly Competitive Markets – 2022-2023

Profit maximization

Optimal production quantity q*: a numeric example

■ Obtain TC  Ok, given
■ Obtain MR(q) and MC(q) from TR(q) en TC(q)
■ MC(q) is the derivate of TC(q)
MC(q) = 20

■ TR(q) is p(q) times q

ÞTR(q) = 30q−0.0125q2

■ MR(q) is a derivate of TR(q)

=> MR(q) = 30 – 0.025q
Imperfectly Competitive Markets – 2022-2023
Profit maximization

Optimal production quantity q*: a numeric example

■ Step 1: MR(q*) = MC(q*)

30 – 0.025q = 20 or: q* = 400

Imperfectly Competitive Markets – 2022-2023

Profit maximization

Optimal production quantity q*: a numeric example

■ Step 2: Produce q*=400 or not?
■ p(q*)=30-0.0125q*=25 and AVC(q*)=20
 Produce

■ Total profit with q* = 400?

P(q*) = TR(q*) – TC(q*)
= 30q* – 0.0125q*2 – (63+20q*)
= 10000 – 8063 = 1937
or P(q*)=q*(p*-AVC(q*))-FC=400(25-20)-63 = 1937

Imperfectly Competitive Markets – 2022-2023

Profit maximization
p
30 p(q)=AR(q) |εp|< ∞: Finite price elasticity
MR(q)  Market power:
p = 25
*
F  p*=25>MC(q*)=20; µ=1.25>1.
 Realized profits= red area – FC > 0
E MC=AVC
20

q* = 400 1200 2400 q

Imperfectly Competitive Markets – 2022-2023

ICM#INSIGHTS
3. Profit maximization under monopoly power

3.1 Profit maximization: Graphical and algebraic representation

3.1.1 The cost-side of profit maximization
3.1.2 The revenue-side of profit maximization
3.1.3 Profit maximization

3.2 Profit maximization with price discrimination

3.2.1 First-degree price discrimination
3.2.2 Market segmentation

3.3 Societal discussion: The societal impact of personalized and

dynamic pricing
Imperfectly Competitive Markets – 2022-2023
Price discrimination
Definitions:
■ The monopolist asks a different price from consumers with a
different willingness to pay

■ First-degree price discrimination:

“the monopolist asks for each additional unit exactly the
maximal willingness to pay of the respective buyer”

■ Markt segmentation:
■ The market is segmented into submarkets, with consumers with a
similar (and observed) profile (e.g., age)
■ Then, the quantity and price are determined at the segment level,
depending on the demand function of the consumers in the segment
 Price discrimination increases profits
Imperfectly Competitive Markets – 2022-2023
First degree price discrimination

p The inverse demand curve represents the

Marginal WTP willingness to pay (WTP) of each potential
Price for Elon
customer for one additional unit.
Price for Jeff
Price for Mark

Price for Bill MC=AVC

1 unit 1 unit 1 unit 1 unit q

for Elon For Jeff for Mark for Bill

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
Case: Just for you,
personalized online prices: for
the good of the consumer,
firms, and/or society?

Sources:
■ Rafi Mohammed (2017) How retailers use personalized prices to test what you’re willing to pay, Harvard Business
Review. ieseg-online/ICM/ICM#DISCUSS. URL:
https://hbr.org/2017/10/how-retailers-use-personalized-prices-to-test-what-youre-willing-to-pay
Imperfectly Competitive Markets – 2022-2023
Market segmentation

SEGMENT A SEGMENT B

Imperfectly Competitive Markets – 2022-2023

Market segmentation

Uniform price on youngster and adult market:

Price for Price for cinema

cinema ticket ticket

MC MC
MRyoungster
MRadult Dadult =ARadult
Dyoungster =ARyoungster
Cinema tickets Cinema tickets
Imperfectly Competitive Markets – 2022-2023
Market segmentation

p p

padult Dadult =ARadult

pyoungster
MC MC
Dyoungster=ARyoungster
MRadult
MRyoungster
qyoungster q qadult q

Imperfectly Competitive Markets – 2022-2023

Market segmentation
Numeric example
• Presume:
Total Cost function: TC(q) = 6q
=> MC(q) = 6 (constant)
Demand function segment 1:
q1(p1) = 20 – 2p1 More elastic
=> AR1(q1) = p1(q1) = 10 – q1/2
Demand function segment 2:
q2(p2) = 16 – p2 Less elastic
=> AR2(q2) = p2(q2) = 16 – q2
Market demand (for p1 = p2 = p) :
q(p) = q1(p) + q2(p) = 36 – 3p
=> AR(q) = p(q) = 12 – q/3

Imperfectly Competitive Markets – 2022-2023

Market segmentation
Numeric example
Maximal profit under uniform pricing
• Total en marginal revenues:
TR(q) = 12q – q²/3
MR(q) = 12 – (2/3)q
• Optimal output and price:
MC = MR(q*):
6 = 12 – (2/3)q* => q* = 9
price: p(q*) = 12 – q*/3 = 9
• Maximal profit under uniform price setting:
P(q*) = TR(q*) – TC(q*) = 81 – 54 = 27

Imperfectly Competitive Markets – 2022-2023

Market segmentation
Numeric example
Maximal profit with market segmentation
• Market 1: TR1(q1) = 10q1 – (q1)²/2
Optimal output: (MC =) 6 = 10 - q1 => q1* = 4
Price: p1 (q1*) = 10 – q1*/2 = 8 More elastic
Profit: P1 (q1*) = TR1 (q1*) – TC (q1*) = 32 – 24 = 8
• Market 2: TR2(q2) = 16q2 – (q2)²
Optimal output: (MC =) 6 = 16 – 2q2 => q2* = 5
Less elastic
Price: p2(q2*) = 16 – q2* = 11
Profit: P2(q2*) = TR2(q2*) – TC (q2*) = 55 – 30 = 25
• Maximal profit with market segmentation:
P1(q1*) + P2(q2*) = 8 + 25 = 33
(> 27, the maximal profit under uniform price setting)

Imperfectly Competitive Markets – 2022-2023

ICM#DISCUSS
Case: Spotify applies country-specific
pricing. To the benefit of Spotify,
consumers, and/or society?

Jason Leung

https://mts.io/projects/spotify-pricing/

Imperfectly Competitive Markets – 2022-2023

ICM#END
■ Don’t forget about the supplementary material to
facilitate learning on ieseg-online

Best of luck !!

Imperfectly Competitive Markets – 2022-2023