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University of St Andrews

School of Economics & Finance

EC4408/4608: Industrial Organisation and Regulation

Lectures 3 & 4: Some Extensions of Basic Model

In this Lecture we will examine briefly three extensions to the basic Cournot Model discussed in
Lectures 1 &2. Some of this will be relevant for later lectures in innovation, but it is convenient to
establish the basic ideas now.

1. Bertrand Competition
Go back now to the model of previous Lecture homogeneous product, identical marginal costs and
ask how would the analysis of Lectures 1 and 2 go through if, instead of Cournot competition there
had been Bertrand competition.
In the short run (static) case where there was a fixed number of firms, then, if n > 2, we know that
Bertrand competition results in prices being driven down to marginal cost, whereas, as we saw, under
Cournot competition the equilibrium price is above marginal cost. So, in the short-run (static) case
Bertrand competition is more competitive than Cournot.
But what about the long-run where the number of firms is variable and there are fixed costs F > 0?
Under Cournot competition we saw that there would be an equilibrium number of firms


a c

which, as long as fixed costs are not too large relative to the size of the market, will be greater than
However under Bertrand competition, if there are ever 2 or more firms in the industry they will drive
price down to marginal cost and, with F > 0, all firms will make losses and so firms will leave the
industry. So the only long-run equilibrium under Bertrand competition is pure monopoly n e 1 . So
the important message to take away is that the greater the intensity of (price) competition in the
short run the lower will be the degree of competition in the long-run.

2. Distribution of Consumer and Producer Surplus

The model presented in Lectures 1 & 2 implicitly assumed that we were dealing with a closed
economy this is true of most of the literature on imperfect competition.

To see how the closed economy assumption shows up in the analysis, notice that the increased
INDUSTRY profits, 0 , arising from having imperfect competition (e.g. Cournot competition)
in a particular industry rather than perfect competition, would flow to the shareholders and owners
of capital of the firms in that industry . But, in a closed economy, these shareholders and owners of
capital are also consumers in that economy (remember the national income accounting identities).
Moreover it is the consumers in that economy who would suffer from the loss of consumer surplus
CS 0 arising from the higher prices/lower output under imperfect competition. Moreover we
showed that CS .
In addition we explicitly assumed that for all consumers and households the marginal utility of
income was constant and equal to 1 again an assumption that is common in most of the literature
in imperfect competition. This implies that the reduction in consumer surplus has the same welfare
value as the increase in producer surplus.
Taken together these assumptions imply that imperfect competition would generate a net loss of
welfare L CS to the economy, which, we showed, was a fraction

of the total
(n 1)2

benefit society would obtain at the social optimum = competitive equilibrium.

How would conclusions differ if, in turn, we dropped these assumptions?
(a) Closed economy: distributional considerations.
Suppose now that even if the marginal utility of income is constant for any one consumer,
the marginal utility of income of a poor person is greater than that of a rich person. Then, to
the extent that, on average, profits ultimately accrue to people who are richer on average
than those who buy the product and so suffer the loss of consumer surplus the natural
case to consider - we would say that, in terms of welfare the loss of consumer surplus should
be given a greater weight than the increase in producer surplus: so
L CS ; 1 . In this case we still conclude that imperfect competition is
harmful and indeed causes even greater harm than our calculated loss of

(n 1)2

(b) Open Economy

Consider now the case of industries dominated by very large companies such as Microsoft,
Google, Samsung, Facebook etc. who sell their products to consumers all over the world, but
where the recipients of their profits may be heavily concentrated in the home country of
these companies. From the point of view of the welfare of the entire world, nothing
changes, and, other things equal, we conclude that imperfect competition is harmful.
But consider a single country, and suppose that a share ,

0 1 of the profits of this

industry accrue in that country while this country has just a fraction, ,

0 1 of the

consumers of the product made by this industry. Then the net welfare effect of imperfect
competition in that country is CS . Notice that if


1 then a country

may actually benefit from imperfect competition. On the other hand if almost none of the
profits accrue to individuals in a given country then the welfare effects of imperfect

competition are almost entirely consumer surplus and our conventional measure of the
welfare loss of imperfect competition may vastly under-states the true loss.
So, from the point of view of any particular country the net welfare effects of imperfect
competition can vary from 0 to CS 0 depending on the values of and .
Note: It is the competition authority of the European Commission (DGComp) that has taken
anti-competitive action against Microsoft and has seriously considered doing so with

3. Competition and Profitability

Suppose we have a homogeneous good duopoly, but firms now potentially have different costs of
production. The inverse aggregate demand curve is given by

p a q1 q2 ,
where a 0 , and qk ,

k 1, 2 is the output produced by firm 2.

Suppose that the two firms have constant unit costs od production ck ,

a c1 c2 0 . Let c

k 1, 2 where

c1 c2
be the average cost across the two firms in the industry.

Suppose that in choosing its output each firm conjectures that for every unit increase in its own
output the other firm will cut its output by , 0 1 units. If 0 we have the case of
Cournot competition. If 1 we have Bertrand/perfect competition. The parameter measures the
intensity of price competition.
It is straightforward to see that, if both firms produce a positive output, the first-order condition for
profit-maximisation for firm k is

a q1 q2 ck qk (1 ), k 1, 2


This implies



ac ,



qke q

c c .


From (1) it is also straightforward to see that

ke 1 qke


and so average industry profits are



1e 2e
(1 ). q

Substitute (2) into (3) and we get:


a c var(c)
(1 ).



So an increase in (increase in the intensity of price competition) has three effects on industry

it tends to lower profits because it forces prices down towards (average) marginal costs;
it raises industry output which increases profits;
it allows firms with cost advantages to really exploit these and so drive up industry
profits towards the monopoly level of the low-cost firm.

If firms were identical only the first two effects would be present and the first would dominate the
second leading to the conclusion that a greater intensity of price competition lowers profits.
However when firms are asymmetric then competition can drive up industry profits.
Greater intensity of price competition also increases the difference in profits between the two firms.
David Ulph
Feb 2016