Price-Output Determination in Oligopolistic Market Structures

We have good models of priceoutput determination for the structural cases of pure competition and pure monopoly. Oligopoly is more problematic, and a wide range of outcomes is possible.

Cournot

1 Model

Illustrates the principle of mutual interdependence among sellers in tightly concentrated markets--even

where such interdependence is unrecognized by sellers.

Illustrates that social welfare can be improved by the entry of new sellers--even if post-entry structure is oligopolistic.
1 Augustin

Cournot. Research Into the Mathematical Principles of the Theory of Wealth, 1838

Assumptions
1. Two sellers 2. MC = $40 3. Homogeneous product 4. Q is the decision variable 5. Maximizing behavior Let the inverse demand function be given by: P = 100 Q The revenue function (R) is given by: R = P Q = (100 Q)Q = 100Q Q2 [2] [1]

Thus the marginal revenue (MR) function is given by: MR = dR/dQ = 100 2Q Let q1 denote the output of seller 1 and q2 is the output of seller 2. Now rewrite equation [1] P = 100 q1 q2 The profit () functions of sellers 1 and 2 are given by: 1 = (100 q1 q2)q1 40q1 2 = (100 q1 q2)q2 40q2 [5] [6] [4] [3]

Mutual interdependence is revealed by the profit equations. The profits of seller 1 depend on the output of seller 2and vice versa

Monopoly case
Let q2 = 0 units so that Q = q1that is, seller 1 is a monopolist. Seller 1 should set its quantity supplied at the level corresponding to the equality of MR and MC. Let MR MC = 0 100 2Q 40 = 0 2Q = 60 Q = QM = 30 units Thus

PM = 100 QM = $70
Substituting into equation [5], we find that: = $900

Finding equilibrium
Question: Suppose that seller 1 expects that seller 2 will supply 10 units. How many units should seller 1 supply based on this expectation? By equation [4], we can say: P = 100 q1 10 = 90 q1 [7] [8] [9]

The the revenue function of seller 1 is given by:

R = P q1 = (90 q1)q1 = 90q1 q12 Thus: MR = dR/dq1 = 90 2q1

Subtracting MC from MR

90 2q1 40 = 0
2q1 = 50 q1 = 25 units Thus the profit maximizing output for seller 1, given that q2 = 10 units, is 25 units. We repeat these calculations for every possible value of q2 and we find that the -maximizing output for seller 1 can be obtained from the following equation:

[10]
[11]

q1 = 30 - .5q2

[12]

Best reply function

Equation [12] is a best reply function (BRF) for seller 1. It can be used to compute the -maximizing output for seller 1 for any output selected by seller 2. 60

30 - .5q2
30

10
0 15 25 30 Output of seller 1

In similar fashion, we derive a best reply function for seller 2. It is given by:
q2 = 30 - .5q1 [13]

q2

30

q2 = 30 - .5q1

60

q1

So we have a system with 2 equations and 2 unknowns (q1 and q2) : The solutions are: q1 = 30 .5q2 q1 = 20 units q2 = 30 .5q1 q2 = 20 units
q2
60

Seller 1s BRF

Equilibrium is established when both sellers are on their best reply function

30 20

Equilibrium

Seller 2s BRF

20

30

60

q1

Cournot duopoly solution

QCOURNOT = 40 Units (20 units each) PCOURNOT = $60 1 = 2 = $400 Note that:

PCOMPETITIVE = $40 QCOMPETITIVE = 60 Units Therefore

PCOMPETITIVE < PCOURNOT < PMONOPOLY

Implications of the model

The Cournot model predicts that, holding elasticity of demand constant, price-cost margins are inversely related to the number of sellers in the market

This principle is expressed by the following equation

( P MC ) 1 P n

[14]

Where is elasticity of demand and n is the number of sellers. So as n , the price-margin approaches zero as in the purely competitive case.