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Collusion Firm 2’s profit-maximizing response to y1 = y1m is y2 = R2(y1m) y2m. Firm 2’s profit increases if it cheats on firm 1 by increasing its output level from y2m to R2(y1m). Collusion Similarly, firm 1’s profit increases if it cheats on firm 2 by increasing its output level from y1m to R1(y2m). Collusion y2 y1 y2m y1m y2 = R2(y1m) is firm 2’sbest response to firm 1 choosing y1 = y1m. R1(y2m) y1 = R1(y2), firm 1’s reaction curve y2 = R2(y1), firm 2’s reaction curve Collusion So a profit-seeking cartel in which firms cooperatively set their output levels is fundamentally unstable. E.g. OPEC’s broken agreements. The Order of Play So far it has been assumed that firms choose their output levels simultaneously. The competition between the firms is then a simultaneous play game in which the output levels are the strategic variables. The Order of Play What if firm 1 chooses its output level first and then firm 2 responds to this choice? Firm 1 is then a leader. Firm 2 is a follower. The competition is a sequential game in which the output levels are the strategic variables. The Order of Play Such games are von Stackelberg games. Is it better to be the leader? Or is it better to be the follower? Stackelberg Games Q: What is the best response that follower firm 2 can make to the choice y1 already made by the leader, firm 1? A: Choose y2 = R2(y1). Firm 1 knows this and so perfectly anticipates firm 2’s reaction to any y1 chosen by firm 1. Stackelberg Games This makes the leader’s profit function The leader chooses y1 to maximize its profit. Q: Will the leader make a profit at least as large as its Cournot-Nash equilibrium profit? Stackelberg Games A: Yes. The leader could choose its Cournot-Nash output level, knowing that the follower would then also choose its C-N output level. The leader’s profit would then be its C-N profit. But the leader does not have to do this, so its profit must be at least as large as its C-N profit. Stackelberg Games; An Example The