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University of St Andrews

School of Economics & Finance


EC4408/4608: Industrial Organisation and Regulation

Lectures 1 & 2: Cournot Model with Entry

1. Basic Assumptions
Consider the following model of imperfect competition in a market for a
homogeneous product.
There are m identical consumers. Each consumer has utility function
u( x , z) ( x ) z ax

b 2
x z
2

(1)

where x is the consumer's consumption of the product in this particular industry, and
z is expenditure on all other products. z is numeraire and the price of z = 1.
If p is price of x, then it is easy to see that, provided the consumer spends a positive
amount of income on both goods, the individual demand for x is given by the
equation
p.
( x ) a bx

(2)

In all that follows I assume that the consumer always spends a positive amount on
both goods and consequently the individual demand for x is given by the conventional
linear demand function (2).
Notice that the demand function given by (2) is independent of income. Thus the
compensated demand for x is identical to the Marshallian demand for x. Hence the
area under the Marshallian demand curve provides an exact measure of the consumer
benefit from consuming x units of commodity x. That is the money measure of the
benefit a consumer gets from consuming x is just

( x ) ax

b 2
x
2

(3)

We now want to move from individual demands and benefits to the aggregate demand
and benefit of all m consumers. So let X mx be the aggregate demand for x.
Then from equation (2), the (inverse) aggregate demand function is
~
b
p( X ) a bX , where b .
m

(4)

Notice that the larger the size of the market (the larger m ) the smaller is b i.e. the
flatter the aggregate demand curve.
If the aggregate consumption of x is X then the aggregate consumer benefit from
this is
X b~ X 2
b
X
CB( X ) m m a aX X 2

2
m
m 2 m

(5)

In other words the aggregate consumer benefit is just the integral under the aggregate
Marshallian demand curve.
Notice that the marginal benefit to consumers from having one additional unit of
aggregate output is just
MB( X ) CB ( X ) a bX p( X )

(6)

Having specified the consumer side of the market, let us now specify what is
happening on the production side.
Suppose now that there are n firms in the industry. For the moment n is fixed.
Each firm has cost function
where a d 0;

c( q ) dq F

(7)

F 0.

The assumption that a > d guarantees that the maximum price a consumer is willing
to pay for x is greater than the minimum marginal cost, and so ensures that in
equilibrium good x will always be produced. Marginal cost for each firm is clearly
d 0 , which is independent of output, so there is constant marginal costs. F 0
corresponds to the case where there are increasing returns to scale in production, since
average cost of production is falling with output.
Welfare
Suppose that each of these n firms produces some output q. Then the total benefit to
society from having n firms each producing output q, is just the difference between
the total benefit to consumers from having this amount produced and the total
resources (costs) used up in production. Thus

B(q, n) CB(nq) nc(q)


CB(nq) p(nq).(nq) n pnq). q c(q )

(8)

The first term on the RHS of (8) is just aggregate consumer surplus: the difference
between the aggregate benefit to consumers from consuming aggregate output nq
and the total amount they are willing to pay to consume this total output. The second

term on the RHS is the total producer surplus (profit) made by each of the firms.
Thus total welfare is just the sum of consumer surplus and producer surplus.

2.

Conventional Static Analysis: n fixed, F=0

Here we operate under conventional assumptions that there are non-increasing


returns to scale, which, in this context means assuming that F = 0. Conventional
static analysis also takes the number of firms as given. We then compare the amount
of output produced by each firm in some kind of imperfectly competitive equilibrium
to that which would be produced in the optimum.
Equilibrium
We now consider a COURNOT equilibrium. Here, each firm takes the output of all
the other firms as given, and chooses its own output to maximise profits. Thus if one
of the firms chooses output q, taking each of the other firms' output as fixed at q ,
then the firm perceives the relationship between price and its own output as being
p a b q (n 1)q ,
and therefore chooses q to
MAX q a b q ( n 1) q dq
The first-order condition for an interior solution is
MR a b(n 1)q 2 bq d MC

i.e.
q

a d n 1

q
2b
2

(9)

(10)

(10) defines this firm's reaction function - which gives the level of output chosen
by this firm as a best response to any arbitrary level of output chosen by all the other
firms. Notice this is linear and downward sloping.
Of course the level of output chosen by each other firm is not arbitrary and will be the
best-response by that firm to the level of output it perceives all other firms as
choosing. Hence, in equilibrium it must be the case that q q , and so the
equilibrium level of output chosen by each firm, must be given by

qe

ad
b(n 1)

Aggregate equilibrium output is therefore

(11)

Q e nq e

( a d )n
b(n 1)

(12)

It is then easy to see that the equilibrium price is

p e a b(nq e )

( a d ) d (n 1)
d MC
(n 1)

(13)

From the first-order condition for profit-maximisation (9), it follows that the
equilibrium profit of each firm is

b. q
e

e 2

1 ad
.

b (n 1)

(14)

Notice the following


(i)

qe 0 ;

(ii)

pe MC e .

(iii) Given our assumption in this section that F = 0, then, from (14) profits are
always positive.
Welfare Analysis
As explained in (8) the net benefit to the economy of having these n firms each
produce an output q is just the difference between the aggregate consumer benefit
and the total resource costs used up in production.
B(q, n) CB(nq ) nc (q )

Assuming the number of firms is fixed, the optimum level of output for each firm, q ,
must satisfy the condition

Bq, n
nMB(nq ) nc (q ) 0
q
i.e.

p MB(nq c (q ) MC .

That is, we get the conventional prescription that the optimum level of output is
achieved where price equals marginal cost.
Using the particular functional forms, it is easy to see that this implies
p d ,

and so
q

ad
,
bn

and

(15)
(16)

(a d )
Q nq
b

(17)

There are three points to note about this:


We have already seen that p e d p , and it follows from comparing (16)
with (11) that, as we would expect, that q q e , and so obviously Q Q e . Thus the
market failure arising from imperfect competition is that output is too small and price
too high.
1)

2)
Given the assumption that F = 0, the optimum allocation could be achieved
by perfect competition. Under perfect competition firms operate where price equals
marginal cost. But since marginal costs are constant, each firm (and hence the
industry) has a completely elastic supply function at the price p = d. So perfect
competition would certainly achieve the right equilibrium price and output.
3)
Notice that the optimum price and the optimum industry output do not in any
way depend on n. If we did have perfect competition then each firm would be
making zero profits, so the equilibrium number of firms under perfect competition is
indeterminate. Put differently, under standard conditions of constant returns and
perfect competition both the equilibrium and the optimum number of firms is
indeterminate, and so it doesnt make sense to ask whether markets get the right
number of firms.
To understand just how much of a welfare loss arises from our imperfectly
competitive equilibrium, substitute q into (8) we find that the benefit from having
the optimal level of production is

(a d ) 2
B
2b

(18)

while, by substituting q e into (8) the benefit from having the equilibrium level of
production is
Be

n(n 2)( a d ) 2
2
2b n 1

(19)

The welfare loss from having equilibrium production rather than optimal production
is therefore

(a d ) 2
2b

n(n 2) (a d ) 2
1

2b
n 1 2

1
(n 1) 2

(20)

If, following Harberger, we write this welfare loss as a percentage of the level of
welfare in the optimum then we get the Harberger welfare loss from imperfect
competition, H, which is given by

L
1

2
B (n 1)

(21)

So, for example, if we had pure monopoly (n = 1) the welfare loss would be 25% of
GNP. If we had 9 firms in the industry the loss would be 1%, and if we had 13 firms
in the industry the welfare loss would be just over 1/2 of 1% of GNP - the sort of
figure that Harberger came up with.
Now so far we have just taken number of firms as given and have looked at loss from
having the wrong level of output. Have we any reason to believe that markets
produce "right" number of firms ?
To address this question we need to consider a more dynamic analysis in which we
make the number of firms variable when considering both the equilibrium and the
optimum number of firms. To do this, let us briefly consider a fairly trivial case in
which we retain the assumption of constant returns to scale.
3.

Dynamic Analysis I: n variable, F=0.

Equilibrium Number of Firms


Conditional on n the equilibrium price, outputs and profits will still be given by (11)(14). We assume that firms will enter the market as long as it is profitable to do so,
and will carry on entering up to the point where profits are zero. But then, from ( 14),
with F = 0, it follows that the equilibrium number of firms is .
Optimum Number of Firms
Since, conditioning on n welfare in the equilibrium is still given by (19), it is easy to
(a d ) 2
B , so the market does indeed achieve
see that when n , then B e
2b
the full social optimum.
All that is happening here is that with zero fixed costs so many firms enter the market
that firms are operating essentially under conditions of perfect competition. Each
firms gets infinitesimally small relative to the size of the market and so can exercise
no market power. Thus the forces of free entry produce perfect competition and
hence the social optimum.
A much more interesting case arises when we take increasing returns to scale
seriously and allow the possibility that F > 0.
4.

Dynamic Analysis II: n variable, F > 0

Equilibrium
When firms are maximising profits it is only marginal costs that matter, so,
conditional on there being n firms in the market, the equilibrium price, output and
profit per firm are once again given by (11) - (14). The crucial difference from before

is that now profits are not always positive. If we assume that firms enter up to the
point where profits are zero, then the equilibrium number of firms is given by
(a d ) 2
1
. e
F
b
(n 1)2
i.e.

(a d ) 2
n Z 1, where Z
.
bF
e

(22)

To have a sensible outcome we obviously need to assume that Z > 4 so we get at


least one firm in the market. I am going to assume that Z > 9, so that we get at least 2
firms in the market and so have some degree of competition.
Optimum
The first point to notice now is that with positive fixed costs and constant marginal
costs then there is no competitive equilibrium. If price is at or below d then no firm
could enter the market and make a profit, and so supply would be zero. If price is
above d then every firm can anticipate making infinitely large profits by expanding
output indefinitely, so supply would be infinite. There is therefore no price at which
supply equals demand.
The important implication of this is that we can no longer use perfect competition as
a benchmark. So what benchmark can we use to determine the optimum number of
firms?
There are two possible candidates.
1)

Regulated First Best

Suppose that, whatever the number of firms that enter the market, it is always
possible to ensure that firms produce the first-best optimal output - where p = MC say by the use of regulation. Then, if there n firms in the market, the level of welfare
will now be given by
(a d ) 2
(23)
B
nF
2b
The correct criterion by which to determine the "right" number of firms is simply to
find that number which maximises B as defined by (20). Clearly the optimum is to
make n as small as possible, and so since need at least one firm, first-best optimum is
n 1.
But then the equilibrium number of firms as determined by (22) will, in general, be
greater than the optimal number of firms.

2)

Second Best

Suppose now that the government cannot regulate prices, and that, whatever
number of firms enter the industry, the equilibrium price and output will be given by
equations (11)-(13). In this case the level of welfare if n firms enter the industry is
given by
(a d ) 2
1
Be
. 1
nF
(24)
2
2b
(n 1)
Suppose, however, that the government can restrict entry - what should be the
optimal number of firms ? The optimum is now the number which maximises B e as
defined by (24). The optimum number is then defined by
(a d ) 2
1
.
F
b
(n 1)3

(25)

i.e. we increase number of firms until marginal reduction in dead-weight loss from
having one more firm equals fixed cost of entry.
This implies that the optimal number of firms is given by

n 3 Z 1

(26)

(a d ) 2
Assume that Z
8 , so that it is second-best optimal to have at least 1
bF
firm in the industry, then clearly the equilibrium number of firms as determined by
(22) will once again generally be greater than the optimum.
Hence, whichever definition of the "right" number of firms we use, markets produce
too much entry. This is the EXCESS ENTRY THEOREM and generalises way
beyond the special model used here.