Practice Problems

Cournot Oligopoly
Two Firms, identical product. Each firm acts in the next round assuming that the other firm will continue to
act as they did in the previous round.
Mkt Demand : Q = 500 - .5P
MCa = 20
MCb = 50

What is each firm’s reaction function?

P = 1000 – 2Q
P = 1000 – 2qa – 2qb
TRa = 1000qa – 2qa2 – 2qaqb
MRa = 1000-4qa –2qb
20 = 1000-4qa –2qb
4qa = 980 -2qb
qa = 245 -.5qb Reaction for a

P = 1000 – 2Q
P = 1000 – 2qa – 2qb
TRb = 1000qb – 2qb2 – 2qaqb
MRb = 1000-4qb –2qa
50 = 1000-4qb –2qa
4qb = 950 -2qa
qb = 237.5 -.5qa Reaction for b

What is the Nash Equilibrium? Explain why your answer qualifies as a Nash equilibrium
Set the reaction functions equal to each other:

qa = 245 -.5(237.5 -.5qa)

qa = 245 –118.75 +.25qa

.75 qa = 126.25
qa = 168.67

qb = 237.5 -.5(168.67) Reaction for b

qb = 153.16

check your work:

qa = 245 -.5(153.16)= 168 (Reaction for a). So a and b react to each other, but nothing changes. Each is
maximizing profit given the choice of the other (Nash), and nothing changes (Equilibrium)

Q= 153+168 = 321
P = 1000 – 2(321) = 358

What is the Monopoly outcome?

Set Market MR = Marginal cost
P = 1000 – 2Q
TR = 1000Q-2Q2
MR = 1000-4Q
1000-4Q = 20 (why?)
4Q = 980
Q = 245
P = 1000 – 2(245) = 510

What is the competitive outcome?

P= 20, Q = 960

Of the three, which is most likely to occur in this case?

Dominant Firm with competitive fringe

Mkt Demand: Q = 500 - .5P

MCd = 50 + 2Q
MCf = 40 + 4Q

What is the market share of the dominant firm?

What will happen to their share in the future if there is entry by more fringe firms?

Dominant firm sets price based on residual demand (market demand – fringe supply)
Fringe takes that price as given.
QT = 500 - .5P
Rewrite fringe supply in terms of Q (Q is a function of price since price = marginal cost)
P = 25 + 4Qf
-4Q = 40 – P
Qf = -10 + .25P

Qd = QT -Qf = 500 - .5P – (-10 + .25P)

Qd = 510 - .75P (residual demand faced by the dominant firm)
.75P = 510 -Qd
P =680 –1.33Qd
TR =680 Qd –1.33Qd2
MR =680 –2.66Qd
680 –2.66Qd = 50 + 2Qd
630 = 4.66 Qd
Qd = 135
P = 680 –1.33( 135)
P= 500

Qf = -10 + .25(500)
Qf = 115

Sd = 135/(135+115) = 54%