Industrial Organization

Backup Lecture Note 2:

Static Oligopoly Computations
Christian Michel
UPF

Winter 2015

Christian Michel

Static Oligopoly

Winter 2015

1 / 20

Cournot Competition

Lets start with a two-seller game:

I

Total Costs: TCi (qi ) = ci qi , i = 1, 2

F

implies constant marginal costs ci for a firm

Demand: p(Q) = a bQ where Q = q1 + q2

Christian Michel

Static Oligopoly

Winter 2015

2 / 20

Cournot Competition
Define a game:
I
I
I

Players: firms.
Action/Strategy set: production levels/quantities.
Payoff function: profits, defined:
i (q1 , q2 ) = p(q1 + q2 )qi TCi (qi )

What should be the equilibrium concept? A pair (qc1 , qc2 ) is a Cournot

equilibrium (=Nash in quantities) if:
I
I

Given q2 = qc2 , qc1 solves maxq1 1 (q1 , qc2 ).

Given q1 = qc1 , qc2 solves maxq2 2 (qc1 , q2 ).

In words, given that its rivals are playing the Cournot equilibrium strategies, no firm can increase its profit by changing its output level.
The corresponding Cournot equilibrium price is pc = a b(qc1 + qc2 ).

Christian Michel

Static Oligopoly

Winter 2015

3 / 20

Deriving profit function yields reaction function

To obtain the Cournot equilibrium, let us make a best-response analysis.
Firm 1s maximization problem:
max 1 (q1 , q2 ) = (a b(q1 + q2 ))q2 c1 q1 .
qi

Deriving the profit function with respect to q1 yields first-order condition

(for firm 1):
a bq2 2bq1 c1 = 0
Solving above equation for q1 , we get the best response of firm 1 to quantity
q2 :
a c1 1
q1 = R1 (q2 ) =
q2
2b
2
Call R1 (.) the best-response function (or reaction function) of firm 1.

Christian Michel

Static Oligopoly

Winter 2015

4 / 20

Setting reaction functions into each other to solve for

equilibrium
By symmetry, we can do the same for firm 2s profit function to obtain the
reaction function:
a c2 1
q2 = R2 (q1 ) =
q1
2b
2
ac2
multiply the last equation by 2: 2q2 = b q1 for simplicity
1
1
and set the reaction function of firm 1 , q1 = ac
2b 2 q2 , into this equation
to solve for the equilibrium quantity of firm 2:
2q2 =

a c2 a c1 1

+ q2
b
2b
2
3
a 2c2 + c1
q2 =
2
2b

a 2c2 + c1
3b
Setting this into the reaction function of firm 1 yields:
qc2 =

qc1 = R1 (qc2 ) =
Christian Michel

a c1 1 a 2c2 + c1
a 2c1 + c2

=
2b
2
3b
3b
Static Oligopoly

Winter 2015

5 / 20

Cournot Competition
Solving for qc1 = R1 (qc2 ) and qc2 = R2 (qc1 ), we get the Cournot equilibrium
output levels.

Asymmetric 2 firm Cournot equilibrium quantities

a 2c1 + c2
3b
a 2c2 + c1
qc2 =
3b
qc1 =

Equilibrium quantity supplied on the market is

Qc = qc1 + qc2 =

2a c1 c2
3b

We can also find equilibrium price.

a + c1 + c2
3
What are the pay-off functions in equilibrium?
pc = a bQc =

c1 = (pc c1 )(qc1 ) =
Christian Michel

(a 2c1 + c2 )2 c (a 2c2 + c1 )2
; 2 =
9b
9b
Static Oligopoly

Winter 2015

6 / 20

Graph Consumer Surplus and Welfare

P
P(0)

Pc (Qc )
c
0

Qc

Consumer surplus (red area): CS = 12 [P(0) P(Qc )]Qc

I

Simply compute area of the red triangle:

1
2

times length times height of triangle

Welfare: (red area + blue area): W = CS +

I
I

here constant marginal costs c for all firms

Profits look differently than on graph if marginal costs are not the same for
both firms, or if they are not constant

Christian Michel

Static Oligopoly

Winter 2015

7 / 20

Consumer Surplus and Welfare

The consumer surplus is the area of the under the demand function over
the equilibrium quantity:
This can be written as
(2a c1 c2 )2
1
1
a + c1 + c2 2a c1 c2
CS = [ (P(0) P(Qc ))Qc ] = [a
]
=
2
2
3
3b
18b
Welfare is the sum of profits and consumer surplus:
W = CS + 1 + 2 =

Christian Michel

(2a c1 c2 )2 (a 2c1 + c2 )2 (a 2c2 + c1 )2

+
+
18b
9b
9b

Static Oligopoly

Winter 2015

8 / 20

N-firm Cournot Competition

Extending this to N firms.
I

Its harder to see the reaction functions, but the story is exactly the same.

Now each firm maximizes profits according to:

i (q1 , q2 , ...qN ) = p (Q) qi TCi (qi )

The maximization problem for firm i is thus

max i (q1 , q2 , ...qN ) = (a b
qi

N
X

qj )qi ci qi

j=1

Take for example firm 1s maximization problem:

max 1 (q1 , q2 , ...qN ) = (a b
q1

N
X

qj )q1 c1 q1 = (a b[q1 + q2 + .. + qN ])q1 c1 q1

j=1

Christian Michel

Static Oligopoly

Winter 2015

9 / 20

N-firm Cournot Competition

Take for example firm 1s maximization problem:
max 1 (q1 , q2 , ...qN ) = (a b
q1

N
X

qj )q1 c1 q1 = (a b[q1 + q2 + .. + qN ])q1 c1 q1

j=1

We would derive the best response function for all N firms. For firm 1, the
first order condition of the above function yields
a b[q1 + q2 + .. + qN ] bq1 c1 = 0
Rewriting this yields the reaction function

N
a c1 1
a c1 1 X
qj
q1 = R1 (q2 , ...qN ) =
(q2 + q3 + .. + qN ) =

2b
2
2b
2
j=2

Christian Michel

Static Oligopoly

Winter 2015

10 / 20

N-firm Cournot Competition

We need N of these equations. However, if we assume that firms marginal

costs are the same (TCi (qi ) = cqi i), its a lot easier. Each firm has the same
reaction function,
I
I

qi are the quantities set by all other firms but firm i

The reaction function for any firm i in the market (before we have set i = 1)
thus yields

N
a c 1 X

qi = Ri (qi ) =
qj

2b
2
j,i

Christian Michel

Static Oligopoly

Winter 2015

11 / 20

N-firm Cournot Competition

Look at the 2-firm example:
I

When costs (c1 and c2 ) are the same, output levels of the two firms are the
same.
We guess in this case that all the output levels (q1 , ..., qN ) are going to be the
same too.
If so, denote qi = q i.

WATCH OUT!
We cannot substitute in qi = q before weve derived the best response function.
This is a common mistake.
Why is it a mistake?
I

Assuming that qi = q before we take first order conditions implies that firm i
has control over all firms output decisions (the qi s).
Here, we substitute qi = q into the already-derived best-response functions.
We do this to make the process of solving N equations for N unknowns easier.

Christian Michel

Static Oligopoly

Winter 2015

12 / 20

N-firm Cournot Competition

Back to the reaction function, for simplicity take firm 1 again (Of course, this
works also in general for firm i.)

N
a c1 1 X
qj
q1 = R1 (q2 , ...qN )

2b
2
j=2

If we now impose symmetry and say that q1 = q2 = qi = qN = q for all firms,

P
PN
using the fact that N
j=2 qj =
j=2 q = (N 1)q yields
q=

ac 1
(N 1)q
2b
2

2q =

ac
(N 1)q
b

(N + 1)q =

Christian Michel

Static Oligopoly

ac
b

Winter 2015

13 / 20

N-firm Cournot Competition

(N + 1)q =

ac
b

Thus,

N-firm Cournot equilibrium

qc =

(a c)
(N + 1)b

Qc =

N(a c)
(N + 1)b

pc = a bQc =

a + Nc
N+1

Now it is straightforward to solve for ci (profits for each firm).

Christian Michel

Static Oligopoly

Winter 2015

14 / 20

N-firm Cournot Competition

Now it is straightforward to solve for ci (profits for each firm).
ci = [pc (Qc ) c]qc = [
=[

(a c)
a + Nc
c]
N+1
(N + 1)b

(a c) (a c)
(a c)2
]
=
N + 1 (N + 1)b (N + 1)2 b

Consumer surplus (same triangle heuristics as before):

CS = [P(0) P(Qc )]Qc
CS =

1
a Nc N a c
= [a
]
2
N+1 N+1 b

a(N + 1) a Nc N a c
]
N+1
N+1 b
CS ==

Christian Michel

N2 (a c)2
2b(N + 1)2

Static Oligopoly

Winter 2015

15 / 20

Cournot Competition
Therefore consumer surplus, which is the area between the demand curve
and the market price is finally

Consumer Surplus
CSc (N) =

N2 (a c)2
2b(N + 1)2

Welfare as the sum of all N individual profits and consumer surplus can
then be written as
W = CSc (N) + Nc (N) =
W=

N2 (a c)2
(a c)2
+
N
2b(N + 1)2
(N + 1)2 b

(a c)2
(a c)2 N2 + 2N
2
[N
+
2N]
=
2b (N + 1)2
2b(N + 1)2

Welfare
(a c)2
W = CS (N) + N (N) =
2b
c

Christian Michel

Static Oligopoly

N2 + 2N
N2 + 2N + 1

Winter 2015

16 / 20

Cournot with Sequential Moves Stackelberg

Same market structure as before, except that we assume that firms move
sequentially.
Timing:
Firm 1 sets its quantity q1 .
Firm 2 sets q2 .

1
2

Payoff functions are the same as before.

What should be the equilibrium concept?
I

Its a sequential game, so we should look for subgame-perfect equilibria. Since

there is a finite number of periods, we can use backward induction.
Start with period 2, and assume that firm 1 has set quantity q1 .

Christian Michel

Static Oligopoly

Winter 2015

17 / 20

Stackelberg

Assume firm 1 has credibly committed itself to quantity q1

Firm 2s maximization problem becomes Firm 1 maximizes 1 (q1 , R2 (q1 )),
i.e.,


max 2 (q1 , q2 ) = (a b(q1 + q2 )) c q2
q2

This yields the first order condition a bq1 c = 2bq2 and the associated
reaction function
q2 = R2 (q1 ) =

Christian Michel

ac 1
q1
2b
2

Static Oligopoly

Winter 2015

18 / 20

Stackelberg
Now, consider stage 1: Firm 1 knows that, if it sets q1 , firm 2 will react by
setting R2 (q1 ).
Firm 1 maximizes 1 (q1 , R2 (q1 )), i.e.,


ac 1
q1 )) c q1
max (a b(q1 +
q1
2b
2
This leads to the first order condition a bq1
qS1 =

ac
2

c=0

ac
2b

From there it follows that

qS2 = R2 (qS1 ) =

Christian Michel

ac 1 S ac
q1 =
2b
2
4

Static Oligopoly

Winter 2015

19 / 20

Stackelberg

Implications:
I
I
I

Leader output level: qS1 = ac

= 23 qc .
2b
ac
S
Follower output level: q2 = 4b = 34 qc .
Who is making more profits?
F

First-mover advantage: leader makes more profit than follower. Leader is

better off than in Cournot.
Equilibrium price is lower than Cournot, output is larger than Cournot
Consumer surplus and social welfare are higher than Cournot.

Christian Michel

Static Oligopoly

Winter 2015

20 / 20