Econ 1051: Section 3 Notes

TA: Zhenyu Lai (zlai@fas.harvard.edu), 2/18/2011

Cournot Equilibrium
Isoprot Curves
In Class: Discussion of PS3

1.

Oligopolistic Competition

Under monopoly, a rm with market power sets its own behavior without being aected by rivals.
Under perfect competition, rms are price takers. No rm can take an action signicant enough to
be able to inuence the outcomes of other rms.
Under oligopoly, a rms behavior can inuence market prices and demand. Firms hence have to
worry about strategic interaction and what other rms will do.
Q: 2 rms compete in a market for a homogeneous product, respectively producing Q1
and Q2 units. Cost of producing each unit is c. Inverse demand curve is given by
P =a

b (Q1 + Q2 )

Firms set quantities. What are the Cournot prices, quantities and prots of each rm?
A Solution Technique
1.

Firm 1 sets Q1 to maximize prot (given that Firm 2 produces Q2 )

max Prot
Q1

= max (Price - Marginal Cost) * Quantity

Q1

= max [a

b (Q1 + Q2 )

Q1

= max (a

c) Q1

Q1

2.

c] Q1

bQ21

bQ2 Q1

Take derivative with respect to Q1

a

2bQ1

bQ2 = 0

Rearranging, we obtain Firm 1s best response Q1 to Firm 2s quantity choice of Q2

Q1 =
3.

c bQ2
2b

For a given quantity Q2 produced by Firm 2, we can write Firm 1s reaction function R1 (Q2 ).
R1 (Q2 ) =

4.

a c bQ2
2b

if Q2
if Q2 >

a c
b
a c
b

(why?)

Repeat steps for Firm 2. Firm 1 sets Q2 to maximize prot (given that rm 1 produces Q1 )
max [a
Q2

FOC:

b (Q1 + Q2 )
c
1

2bQ2

c] Q2

bQ1 = 0

For a given quantity Q1 produced by Firm 1, we can write Firm 2s reaction function R2 (Q1 )
a c bQ1
2b

R2 (Q1 ) =

5.

if Q1
if Q1 >

a c
b
a c
b

Plot the graph

Fig 1: Reaction Functions

Along their respective reaction functions, rms are playing their best response to opponents action.
Note the unique pair (Q1 ; Q2 ) at which the reaction functions cross. At this point, rms are playing
their best response to what each other are currently playing. This is the Cournot-Nash equilibrium.
6.

Solve for equilibrium. Equate the two reaction functions. At equilibrium,

Q1 = R1 (Q2 ) =
Q2 = R2 (Q1 ) =

a
a

c bQ2
2b
c bQ1
2b

(1)
(2)

Solving (1) and (2)

a

Q1 =

7.

a c bQ1
2b

2b

Solve for required variables

Equilibrium Quantities: Q1 = Q2 =
Equilibrium Price: P = a
Per-Firm Prot:

3b
1
2
b (Q1 + Q2 ) = a + c
3
3

= (P

c) Qi =

(a

c)2
9b

2.

What is an iso-prot curve?

An isoprot curve traces out the combinations of (Q1 ; Q2 ) at which all combinations along the
curve yield an identical prot .
1.

Tracing out an iso-prot curve.

From previous, consider rm 1s prot for a given combination of (Q1 ; Q2 ) :
Fix rm 1s prot at a .
All combinations of (Q1 ; Q2 ) satisfying the following equation results in prot of
[a

b (Q1 + Q2 )

c] Q1 =

for rm 1.
(3)

For intuition, it may be helpful to rearrange equation (3).

For rm 1 to receive an exact prot of a , Q2 needs to be related to Q1 in the following way.
Q2 =

(a

c)
b

Q1

(4)

Q1

Lets trace out the iso-prot curve for the level of prot .

Fig 2: Iso-prot curve

2.

Comparing iso-prot curves

Now, lets trace out the iso-prot curves for dierent levels of .
Let c > b > a .
From equation (4), do you see that the iso-prot curve of b is necessarily below that of

a?

Fig 3: Increasing Iso-prot

Along a "lower" curve, combinations of (Q1 ; Q2 ) produce a greater level of prot for rm 1
3

3.

Graphing best response via iso-prot.

Suppose that rm 1 currently earns a prot of a . Now, suppose rm 2 chooses Q2 .

What combination of Q1 ; Q2 would allow rm 1 to earn his highest prot?
We know that that rm 1 would prefer to shift his iso-prot curve as inward as possible.
Remember that because rm 1 can only control Q1 , the only feasible iso-prot curves are those
which still allow combinations of (Q1 ; Q2 ) in which rm 2 can choose Q2 .
To maximize prot, rm 1 plays his best response by shifting to iso-prot curve

and playing Q1

Fig 4: Firm 1s best response

4.

Similarly, rm 2 also has a best response.

Remember that we can also x rm 2s prot at

Q1 =

(a

and graph a similar iso-prot curve.

c)
b

Q2

Q2

Similarly, rm 2 prefers to shift his iso-prot curve as inward as possible.

Suppose rm 1 chooses Q1 , the only feasible iso-prot curves are those which still allow combinations
of (Q1 ; Q2 ) in which rm 1 can choose Q1 . Recall that rm 2 can only control Q2 .
To maximize prot, rm 2 plays his best response by shifting to iso-prot curve

b0

and playing Q2

Fig 5: Firm 2s best response

Notice that this is exactly what we call iterated elimination of dominated strategies !
4

5.

Next, we can trace out the reaction function for rm 1.

Given every Q2 that rm 2 chooses, we can identify rm 1s best response in this manner.
This traces out rm 1s reaction function.

Fig 6: Firm 1s reaction function

6.

Intersection of reaction functions is Cournot equilibrium!

We can also trace out rm 2s reaction function.

Putting them on the same diagram, each rm best responses to the other until Cournot-Nash is
reached at the intersection of the reaction curves.

Fig 7: Cournot Equilibrium