Journal of Economic Studies 23,5/6 48

On Stackelbergs oligopoly theory

Arnold Heertje
University of Amsterdam, The Netherlands
Stackelberg from 1932 until 1946 Stackelberg dealt with the theory of oligopoly for the first time in his 1932 book (Stackelberg, 1932, pp. 87-90). Restricting himself to homogeneous duopoly in the case of quantity setting he in fact started with Cournot. On the assumption that A considers the supply of B as given, A maximizes his profit and B does the same with respect to As supply. The two resulting reaction functions determine an equilibrium point (xa , xb ). However, Stackelberg does not see in this solution a real equilibrium. In the case of complete and perfect information, A will not react according to his own reaction function, but he will determine his optimal quantity on the basis of Bs reaction function:
Da er wei, da B sein (As) Angebot als eine gegebene Gre ansieht, so wird er von allen Kombinationen, die fr B auf Grund dessen (Bs) Reaktionsfunktion in Frage kommen, diejenige aussuchen, welche fr ihn (fr A) am gnstigsten ist. Er wird dann aber im allgemeinen ein anderes Angebot realisieren, als es seiner eigenen Reaktionsfunktion entsprechen wrde. Nun sucht B ebenso zu verfahren. Das heit, jeder sucht sein Angebot dem anderen als unabnderlich aufzuoktroyieren. In einer solchen Situation ist ein Gleichgewicht unmglich (Stackelberg, 1932, p. 88).

Stackelbergs argument implies that A does influence Bs quantity and behaves accordingly. But then, in the next stage, also B realizes that he can influence As quantity, so that both suppliers do not consider each others supply as given. From the point of view of game theory one can argue that Stackelberg looks at duopoly alternatively as a one-shot game where the players have to decide simultaneously and as a multi-stage game where they act and react on the basis of observed decisions of their counterparts. The second situation may also be phrased in terms of expectations. A expects a certain supply of B on the basis of the quantity set by him. B expects a certain supply of A on the basis of the quantity set by him. Time and again the expectations do not come true. But even if they would, the emerging equilibrium would be determined by the expectations of the individual suppliers. In this sense it would be an equilibrium, based on subjective rationality and as such has to be distinguished from a Nash-Cournot equilibrium, which is based on objective rationality. This

Journal of Economic Studies Vol. 23 No. 5/6, 1996, pp. 48-57. MCB University Press, 0144-3585

The author would like to thank Dave Furth and Walter Kanning for useful conversations on this topic, which brings him back to his thesis of 1960. The author is also grateful to the anonymous referee, for his or her constructive criticism. This paper was presented at the Stackelberg Conference, Maastricht, 16 November 1995.

view is consistent with Stackelbergs observation that in the case of a Cournot On Stackelbergs duopoly, where both A and B assume that they cannot influence the supply of oligopoly the other, an equilibrium is possible. An equilibrium is also possible, according theory to Stackelberg, if A takes Bs supply as given and B makes use of As passive behaviour and under these circumstances maximizes his profit. When both A and B behave independently of each other, no equilibrium is possible. This case 49 in Stackelberg is referred to as Paretian duopoly (Pareto, 1909, pp. 595-8). Although Stackelberg added a mathematical appendix to his book of 1932, he did not provide us with a mathematical analysis of price formation in the case of duopoly. However, his Italian article on the theory of duopoly makes his position very clear (Stackelberg, 1933, pp. 275-89). If B behaves according to the Cournot hypothesis, his reaction function may be substituted in the profit equation for A, which then can be maximized with respect to xa. One might observe that his own oligopoly theory of 1934 and the subsequent discussion about his theory are contained in the few pages of his 1932 book. In particular, the tension between a static equilibrium solution and dynamic wording can already be felt at this stage. This tension is quite common not only in Stackelbergs work, but also in the work of all other scholars who at the time struggled with the formal analysis of the subjective information structure assumed with respect to the individual oligopolists. The relevance of this assumption is in particular striking in Stackelbergs oligopoly theory, as for him the question who moves first is of prime importance. It implies that the other agent can respond to an observed decision. The problems that crop up here are only dealt with in a satisfactory way in modern game theory after Nash: In his 1934 book Stackelberg introduces a concept of stability of price formation that has given rise to several interpretations in the literature:
Die Preisbildung einer bestimmten Marktform ist dann stabil, wenn sie folgenden Eigenschaften aufweist: a) Setzt man diese Preisbildungsform als Prmisse und stellt dann fr ein beliebiges Wirtschaftsindividuum die uneingeschrnkte Freiheit der Preisbildung her, so ndert sich dessen Verhalten nicht. b) Das Verhalten eines beliebigen Individuums hat nicht den Zweck, die tatschliche Preisbildungsform zu ndern (Stackelberg, 1934, p. 12).

Several interpretations of these rather vague statements have been tried (Krelle, 1993, pp. 77-8; Niehans, 1992, p. 193; Schefold, 1993, p. 42). There is confusion about the question whether Stackelberg has the stability of equilibrium in mind, the stability of prices over time or the stability of markets at large. Under the headings of dependent and independent behaviour we are confronted again with A and B being in the position of leader or follower. If both behave dependently we face Cournot duopoly and if both behave independently we face Bowley duopoly. This latter case Stackelberg used to denote Pareto duopoly, but he changed his mind for reasons not wholly clear. In Bowleys exposition there is no explicit assumption about the reaction function of A and B. His presentation is just as general as Paretos (Bowley, 1924, p. 38). Stackelberg argues that the Preisbildung ist keine stabile and die stabile Preisbildung eines echten Gleichgewichtes is lacking (Stackelberg, 1934, p. 20).

Journal of Economic Studies 23,5/6 50

The interesting case is the third one, where A aims at a position of independence and B prefers to be dependent:
Hier liegt es im Interesse eines jeden, gerade das zu tun, was der andere haben mchte. Es kommt so ein echtes Gleichgewicht zu stande, da jeder an der fr ihn grten Gewinnmglichkeit sein Verhalten unmittelbar orientiert und keiner an einer Abnderung der tatschlichen Preisbildungsform ein Interesse hat. Wir bezeichen diesen Fall des Dyopols als das asymmetrische Dyopol (Stackelberg, 1934, p. 22).

According to Stackelberg Bowleys duopoly is the rule, Cournots duopoly a special case and asymmetric duopoly the exception, if it leads to a stable equilibrium. Notwithstanding Stackelbergs judgement that the case of asymmetric duopoly is an exception, the literature took it up as the Stackelberg solution of the oligopoly problem. At the same time several interpretations were given on the basis of his verbal exposition. It goes without saying that the question of a static description of equilibrium versus a dynamic interpretation of actions and reactions or, to put it in modern terminology, of a game in a normal or extensive form plays an important role in this respect. It may even be argued that the specification of the information structure, the question of static and dynamic games of complete and incomplete information and the information being perfect or imperfect, is of relevance for the equilibrium outcome on the market. A pattern of solutions might emerge depending on the probability that market-players attach to the possibility of different sets of actions of one another. I should add here that asymmetric duopoly may be defined in terms of the behaviour of the duopolists, as Stackelberg does. Here, differences in behaviour do result from the subjective information structure. Stackelberg also refers to differences in costs and production structure as an objective cause for asymmetry. This raises the question of the relationship between the objective characteristics of the market structure and subjective behaviour. During the Second World War, Stackelberg published his Grundzge der theoretischen Volkswirtschaftslehre, nowadays a rare book in which he came back to oligopoly (Stackelberg, 1943, pp. 114-17). Stackelberg explicitly introduces the modern assumption of common knowledge:
Sind beide Dyopolisten ber die gesamte Marktlage vollkommen im Bilde, so wird jeder seine Unabhngigkeitsposition und seine Abhngigkeitsposition miteinander vergleichen und die gnstigere zu erreichen suchen. In der Regel wird fur jeden die Unabhngigkeitsposition am gnstigsten sein.

This leads to a power struggle with losses and without an equilibrium. Cournot duopoly emerges if both accept the quantity of the other as a datum but this does not represent an equilibrium in his dynamic exposition as the duopolists observe that they react to each other with their quantity. Only in the case of one producer accepting the independence-position and the other accepting the position of dependence will there be an equilibrium. Aber dieses Gleichgewicht ist labil, weil der zunchst Unterlegene jederzeit den Kampf wieder aufnehmen kann.

In his book Grundlagen der theoretischen Volkswirtschaftslehre, Stackelberg On Stackelbergs repeats his conclusion for the case of asymmetric duopoly (Stackelberg, 1948, oligopoly p. 211). Only if one of the sellers is stronger than the other, is he in the position theory to assure his own more favourable market position and to bring the other into the position of second best. Apart from this equilibrium situation the other cases are situations of struggle and competition:
Mte man da nicht annehmen da die beiden Konkurrenten bei einigermaen vernnftiger berlegung sich entschlieen mten, doch noch ihre Reaktionskurven der Abhngigkeit zu whlen, um so zum Cournotschen Dyopolpunkt zu gelangen? (Stackelberg, 1948, p. 217).

51

Stackelberg is here again at the crossroads of a static and dynamic setting. Within a static framework the answer has been in the positive, but in a dynamic setting a negative answer is possible, at least for the time being. The negative answer is implied in Stackelbergs view that when seller 1 chooses first the Cournot strategy, the other seller has an interest in choosing his position of independence. As the literature neglected Stackelbergs mathematical appendix of his 1934 book, I prefer in this paper to dwell also on his mathematical treatment. The mathematical appendix The mathematical appendix contains 31 pages. It deals with the individual equilibrium of producers and consumers, the market equilibrium under perfect competition, monopoly, and oligopoly, and bilateral monopoly and a few special cases. I shall restrict myself to his mathematical treatment of oligopoly and present it in his formulation. The total demand or sales function reads p = F(x), with total demand x and price p. In the case of duopoly, y1 being the sales of seller 1 and y2 the sales of seller 2, the profit functions read: G1 = y1 F ( y1 + y2 ) K1 ( y1 ) G2 = y2 F ( y1 + y2 ) K 2 ( y2 ) (1) (2)

with y1 + y2 = x. It comes clearly to the fore that a case of homogeneous duopoly is being considered. Seller 1 considers the supply of 2 to be given, so that he tries to maximize his profit, according to: F + y1 F' K1' = 0. (3)

Clearly, Stackelberg has to be interpreted as saying that in reality seller number 1 considers the supply of seller 2 to be given. In other words, it is not an assumption about the reaction of 2 with regard to an action of 1. This is even more clear from the following quotation:
die zweite Unternehmung hat dann die Unabhngigkeitsposition, weil y1 ber die Gleichung (3) von y2 abhngt.

Journal of Economic Studies 23,5/6 52

For seller 2 we have F + y2 F' K 2' + y2 F' . In (4) dy1 dy1 dy2 = 0. (4)

follows from (3), which, of course, gives the reaction function dy2 for seller 1, y 1 = f 1 (y 2) in implicit form. With (2) and (4) the independence position of 2 can be determined. As 1 and 2 can be interchanged, it is also possible to determine the independence position of seller 1. Now Stackelberg goes on to suggest that the case of Bowley duopoly is just a matter of solving (3) and (4) for y2 and after interchanging sellers 1 and 2 for y1. The case of Cournot duopoly emerges from solving (3) and its counterpart for seller 2. The case of asymmetric duopoly follows from solving (3) and (4) by determining both y1 and y2. By interchanging 1 and 2 we obtain the other case of asymmetric duopoly. Stackelberg also presents a numerical example. It appears that in this example, comparing the four cases, seller A gets the highest profit if seller B takes the position of independence. Stackelberg goes on:
Um die Realisierung des Unabhngigkeitspunktes von B herbeizufhren, kann A nur einen einzigen Weg einschlagen: er mu dem B die berzeugung beibringen, da er (A) sich immer nach dem Angebot von B richtet und auf jedes Angebot von B so reagiert, wie es seine (As) Reaktionsfunktion vorschreibt. Das kann er aber nur dadurch, da er einfach auf jedes Angebot y2 so reagiert, d.h. sich freiwillig in die Abhngigkeit von B begibt.

Stackelberg continues with the interesting observation:

Denn anderseits ist es tatschlich so, da, wenn A immer nach seiner Reaktionsfunktion R1 (y2) handelt, der gnstigste Punkt fr B sein Unabhngigkeitspunkt ist. Wenn also B sich mit den Abhngigkeit von A als mit einem unabnderlichen Zustand abfindet, so hat A sein Ziel erreicht.

And he concludes with the even more interesting observation:

Nun wird aber B genau ebenso denken und handeln und wird sich also seinerseits in die Abhngigkeit von A begeben. Indem nun jeden nach seiner Reaktionfunktion, R1 ( y1), bzw. R2 (y2) handelt, kommt im Eftekt das Cournotsche Dyopol zustande (Stackelberg 1934, pp. 126-30).

I have the impression that, in particular, the latter quotation has been overlooked in the literature. Stackelberg seems to imply here that in the end, that is to say after the chain of equilibria based on temporarily imperfect information converges to an overall equilibrium, the Cournot solution will emerge. It is interesting to note that in this respect the mathematical appendix deviates from his verbal text, which has given rise to the leader-follower Stackelberg solution in the literature. Now, of course, more in general, it may be noted that the exposition in plain language on the one hand suggests a much richer picture of the competitive struggle between the duopolists than is found in the mathematical model, while on the other hand the translation of the

mathematical model into plain language risks adding elements that strictly On Stackelbergs speaking are not part of the mathematics involved. Let me illustrate with a few oligopoly examples. theory In his book Stackelberg speaks of a true equilibrium in the case of asymmetric duopoly, but the mathematical appendix hints at the possibility that it is not a true equilibrium and that, in fact, only the Cournot solution 53 represents a true equilibrium. The verbal text suggests that only if costs differ substantially will the asymmetric solution emerge, but the mathematical appendix deals with asymmetric duopoly A dependent and B independent and vice versa on the basis of costs functions that in no way reflect the idea of a substantial difference. Of course, Stackelberg had in mind that a possible explanation for A being leader and B being follower is a difference in costs and production structure. As in the mathematical appendix he interchanges A and B at will, this is no longer part of the reasoning. In other words, a difference in costs functions is not a necessary condition for the possibility of an asymmetric equilibrium as we pointed out earlier. I can only but repeat that for the understanding of Stackelbergs analysis the assumption on information is very important. From the verbal text it seems clear that Stackelberg assumes complete knowledge of A and B as to their own demand and costs structure and with regard to their competitors market position. They are also aware of each others reaction function. There is in Stackelbergs words vollstndigen Markttransparanz. Stackelbergs own discussion in his mathematical expos, in particular about the question what A has to do in order to get B into the for him (A) optimal position is not compatible with the assumption of full knowledge. Finally, the mathematical appendix is completely phrased in static terms, while the verbal text suggests actions and reactions that take place over time. Stackelberg at the crossroads Assuming complete information the rules of objective rationality lead to the following reasoning about Stackelbergs contribution. Both the Bowley solution and the so-called Stackelberg equilibria are then incompatible with the reaction functions la Cournot. In other words, if seller 2 determines his maximum position in view of the reaction function of seller 1, he can do even better in view of his own reaction function, which informs him about his best response given the amount of seller 1. The same reasoning applies to seller 1. Now, within a static setting with complete (but possibly imperfect) information both will simultaneously choose the Cournot solution. The Stackelberg solution is feasible only in a dynamic context. In other words, it supposes a process of action and reaction over time, to be modelled in terms of a multi-period model. Also over time the process converges to a Cournot-equilibrium. The Bowley solution implies that both sellers are surprised as the actual quantities supplied on the market deviate from their expectations on the basis of each others reaction functions. But within a static setting and complete information there is no room for surprise. The only equilibrium point is the

Journal of Economic Studies 23,5/6 54

Cournot solution. It is a Nash equilibrium in the sense that the supply of each seller is a best response to the quantity actually put on the market by the other. Although there are clear signs that Stackelberg had an intuitive feeling that in the end the sellers tend to a Cournot solution, he did stick to the idea of the independence position. One reason seems to be that he took it for granted that one seller is a leader and the other a follower. In fact, this is an a priori that has to be explained. In game theory the comparable question is why one of the players prefers to act as a first mover. The other reason is that Stackelberg overlooked the consequence of the fact that if seller 2 as the leader chooses his maximum quantity y2s, it implies the optimal quantity y1s of seller 1 the follower. Given y1s there is according to seller 2s reaction function an optimal quantity y2, with the property that the level of profits is higher than in the case of y2s being put on the market. And, given y2 there is according to seller 1s reaction function an optimal quantity y1 with the property that the level of profits is higher than in the case of y1s being put on the market. Both sellers move till they arrive at (y1C, y2C ). This process seems to be overlooked by Stackelberg and most of the literature. Of course, in view of complete information and a static setting the process contracts to the immediate emergence of the Cournot equilibrium. Under these circumstances, Stackelbergs solution of the oligopoly problem cannot be maintained. Basically, this picture changes if incomplete information on the part of the market participants is assumed and subjective rationality enters the scene. Given a certain information structure the Stackelberg equilibrium can be justified, but depending on the specification of the change in informational content over time it still evolves into a Cournot-Nash equilibrium. The updating of probabilities by the duopolists in view of uncertainties with respect to pay-offs and the history of the game plays a role in this respect. Reaction in the literature It is interesting to note that Stackelbergs solution brought up important issues and questions. In fact, Stackelbergs approach may be viewed as an attempt to derive at least for one of the duopolists the reaction coefficient from a qualitative reasoning. Given the reaction function of the follower, the action of the leader is based on a process of maximization. This is a major step forward in the analysis of oligopoly, because it provides us with an economic explanation of the reaction coefficient. In a broader sense Stackelberg brings up the issue of differences in market position and market power of the sellers. Also, his analysis makes it even more clear and perhaps this is the most important aspect that an explicit dynamic multi-period approach (Friedman, 1982, p. 511) is needed, which in modern economics is reflected in non-co-operative dynamic games. A discussion of leadership is meaningful only within a dynamic model (Friedman, 1983, p. 109). Tinbergen, in his book on imperfect competition of 1946, did not realize the necessity of a dynamic interpretation of the Stackelberg model. In his presentation he restricted himself to one of the reaction functions (Tinbergen, 1946, p. 47). Nor did he go into a critical analysis of the Stackelberg solution in

a static context. Krelle (1976, pp. 165-71 and 1993, pp. 76-84) presented a very On Stackelbergs detailed analysis of several variants of the Stackelberg solution but did not see oligopoly that the solution in the end is dominated by the Cournot equilibrium. Even theory Friedman (1977, p. 79) seems to overlook this logical necessity. However, he clearly realized that a game theoretic approach is needed. A further application of Stackelbergs reasoning can be found in the well55 known book by Jean Tirole, The Theory of Industrial Organization (Tirole, 1989, pp. 306-32) who applies Stackelbergs approach to the choice of a capital level of an entrant after the existing firm did choose a certain level of capital. Recently this has also been carried out in the book on microeconomic theory by Mas-Colell et al, 1995, p. 426). A very careful analysis can be found in Game Theory and Industrial Economics: An Introduction (Forges and Thisse, 1992, pp. 26-9). They point out that a very distinctive feature of the Stackelberg game is the asymmetry between players, which is reflected in the definition of strategies. If player 1 moves first, then a strategy for player 1 is just an action. But for player 2 a strategy then is a function that maps an action of player 1 into an action for player 2. Let me add as a final example the discussion of Stackelberg leadership by Daughety in Cournot Oligopoly (Daughety, 1988, pp. 25-8). Daughety treats Stackelberg within the Cournot structure. Stackelbergs approach has given rise to the interesting analysis of the timing of the actions of the players (Hamilton and Slutsky, 1990, pp. 29-46; Hurkens, 1995, pp. 101-20; Van Damme and Hurkens, 1995.) Being leader or follower is no longer exogenously given, but explained in terms of structure and behaviour of the firms. Looked at from a broader dynamic point of view it appears that the Stackelberg solution is one image of an extended multi-stage game which starts with answering the question when to act and subsequently describing in each stage how to act. Conclusion In the case of complete and imperfect information the Stackelberg players, one being the leader and the other being the follower, will play a one-stage game, with a Nash-Cournot equilibrium as the immediate outcome. In the case of complete and perfect information, the Stackelberg players enter a real dynamic world in which there is a sequence of moves and the final equilibrium depends on the specification of the sequential game against the background of objective rationality. If we describe the game in extensive form as a two-stage game with the leader as first mover in stage one, the Nash-Stackelberg point is a subgame perfect equilibrium. In view of daily life duopoly it is no more than an academic game to phrase the behaviour of the duopolists in terms of a two-stage game. As soon as we allow for a multi-stage game, a process sets in that leads to the Nash-Cournot equilibrium. The process consists of strategies in the form of actions by the leader and of strategies in the form of functions that map every action by the leader into an action by the follower. Within the broader framework of a sequential game with objective rationality the Stackelberg solution boils down to an incredible threat. However, if we allow for imperfect

Journal of Economic Studies 23,5/6 56

information and subjective rationality and even interpret Stackelberg as having in mind this case in particular, the Stackelberg solution has the merit of foreshadowing modern refined game theoretical solutions of complex market structures. As Niehans puts it Stackelberg won the battle for the recognition of asymmetric duopoly, but he lost the war against Cournot stability (Niehans, 1992, p. 196). The influence of the Stackelberg solution on the literature is remarkable, but understandable in view of the link that can be established between his distinction in leaders and followers in case of oligopoly and dynamic games with complete and imperfect information. It is interesting to note that looking backwards Stackelberg had a certain feeling for the information structure of the oligopolistic situation and its significance for the outcome of the dynamic market process. In this sense the Stackelberg model is a long-lasting contribution. The phase of subjective rationality, however, can be only of a temporary character. In the end it is the Cournot-Nash solution that survives as all other assumptions about behaviour and reactions of oligopolists are below the optimum of the players in the Cournot case. Ricardo comes to mind: In speaking then of the exchangeable value of commodities, I mean always that power which it would possess, if not disturbed by any temporary or accidental cause, and which is its natural price (Ricardo, 1817, p. 89). Cournot, not Stackelberg, is after all the natural equilibrium.
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Schefold, B. (1993), Heinrich von Stackelbergs Gleichgewichtsbegriff: Auf der Suche nach dem evolutionr stabilen Marktverhalten, ber H. von Stackelbergs Marktform und Gleichgewicht, Handelsblatt, Dsseldorf. Stackelberg, H. (1932), Grundlagen einer reinen Kostentheorie, Springer, Vienna. Stackelberg, H. (1933), Sulla Teoria del Duopolio e del Polipolio, Rivista Italiana di Statistica, Economia e Finanze ; reprinted in Heinrich Freiherr von Stackelberg, Gesammelte wirtschaftswissenschaftliche Abhandlungen , Vol. 1, edited by Kloten, N. and Mller, H. Regensburg, pp. 169-86. Stackelberg, H. (1934), Marktform und Gleichgewicht, Springer, Vienna. Stackelberg, H. (1943), Grundzge der theoretischen Volkswirtschaftslehre, W. Kohlhammer, Verlag, Stuttgart. Stackelberg, H. (1948), Grundlagen der theoretischen Volkswirtschaftslehre, Francke, Berlin. Tinbergen, J. (1989), Beperkte Concurrentie, Stenfert Kroese, Leiden. Tirole, J. (1989), The Theory of Industrial Organization, MIT Press, Cambridge, MA. Van Damme, E. and Hurkens, S. (1995), Endogenous Commitment and Equilibrium Selection in Some Economic Games, Tilburg University.

On Stackelbergs oligopoly theory 57