4 Competitors and Competition:

Part II

BESANKO, CHAPTER 5
PEPALL, CHAPTERS 9, 10
& 11
 The Cournot Model: Many Firms
2
 What if there are more than two firms?
 Much the same approach.
 Say that there are N identical firms producing identical
products
 Total output Q = q1 + q2 + … + qN
 Demand is P = A - BQ = A - B(q1 + q2 + … + qN)
 Consider firm 1. It’s demand curve can be written:
P = A - B(q2 + … + qN) - Bq1
 Use a simplifying notation: Q-1 = q2 + q3 + … + qN (where
Q-1 denotes output of every firm other than firm 1)
 So demand for firm 1 is P = (A - BQ-1) - Bq1
 The Cournot Model: Many Firms
3

P = (A - BQ-1) - Bq1
Marginal revenue for firm 1 is
MR1 = (A - BQ-1) - 2Bq1
MR1 = MC
A - BQ-1 - 2Bq1 = c
∴ q*1 = (A - c)/2B - Q-1/2

The profit-maximizing choice

of output by firm 1 depends
upon the output of the other
firms
 The Cournot Model: Many Firms
4

q*1 = (A - c)/2B - Q-1/2

As the N firms are identical, they each produce the same good at the
same unit cost, c
∴in equilibrium each produce the same output, i.e. q*1 = q*2 = … =
q*N (q* for short)
Note: Q-1* = (N – 1) q*. Replace in best response function
q*= (A - c)/2B - (N – 1) q*/2
∴ (1 + (N - 1)/2)q* = (A - c)/2B
∴q*(N + 1)/2 = (A - c)/2B
∴q* = (A - c)/(N + 1)B
 The Cournot Model
5

Q*= Nq* = N(A - c)/(N + 1)B

∴P* = A - BQ* = A/(N + 1) + Nc/(N + 1)
∴Profit of firm 1 is π*1 = (P* - c)q*1 = (A - c)2/(N + 1)2B
 When N = 1 (Monopoly)
 Q* = (A - c)/2B (Monopoly quantity)
 P* = (A + c)/2 (Monopoly price)
 When N = 2 (Cournot Duopoly)
 Q* = 2(A - c)/3B (Cournot Duopoly quantity)
 P* = (A + 2c)/3 (Cournot Duopoly price)
 When N gets larger and larger
 P* approaches c (Perfectly Competitive price)
 Q* approaches (A - c)/B (Perfectly Competitive output)
 The Cournot Model: Different Costs
6
 What if the firms do not have identical costs?
 Once again, much the same analysis can be used
 Assume that marginal costs of firm 1 are c1 and of
firm 2 are c2.
 Demand is P = A - BQ = A - B(q1 + q2)
 We have marginal revenue for firm 1 as before
 MR1 = (A - Bq2) - 2Bq1
 Equate to marginal cost: (A - Bq2) - 2Bq1 = c1
∴ q*1 = (A - c1)/2B - q2/2
∴ q*2 = (A - c2)/2B - q1/2
 The Cournot Model: Different Costs
7
 q*1 = (A - c1)/2B - q*2/2
 q*2 = (A - c2)/2B - q*1/2
 Substitute for q*1 in q*2
 q*2 = (A - c2)/2B - (A - c1)/4B + q*2/4

 3q*2/4 = (A - 2c2 + c1)/4B

 q*2 = (A - 2c2 + c1)/3B

 q*1 = (A - 2c1 + c2)/3B

 In equilibrium the firms produce

q*1 = (A - 2c1 + c2)/3B; q*2 = (A - 2c2 + c1)/3B
 Total output is, therefore, Q* = (2A - c1 - c2)/3B
 The Cournot Model: Different Costs
8

 Recall that demand is P = A - BQ

 So price is P* = A - (2A - c1 - c2)/3 = (A + c1 +c2)/3
 Profit of firm 1 is π1 = (P* - c1)q*1 = (A - 2c1 + c2)2/9B
 Profit of firm 2 is π2 = (P* - c2)q*2 = (A - 2c2 + c1)2/9B
 Equilibrium output is less than the competitive level
 Output is produced inefficiently: the low-cost firm
should produce all the output
The Cournot Model: Differentiated Products
9
 What if firms produce differentiated products?

𝑃𝑃1 = 𝐴𝐴 − 𝐵𝐵𝑞𝑞1 − 𝑠𝑠𝑞𝑞2

𝑃𝑃2 = 𝐴𝐴 − 𝑠𝑠𝑞𝑞1 − 𝐵𝐵𝑞𝑞2

where 𝑠𝑠 ∈ [0,𝐵𝐵)

 Marginal cost for each firm is constant at c per unit

The Cournot Model: Differentiated Products
10
 Best response functions are given by

𝐴𝐴 − 𝑐𝑐 𝑠𝑠𝑞𝑞2
𝑞𝑞1∗ = −
2𝐵𝐵 2𝐵𝐵

𝐴𝐴 − 𝑐𝑐 𝑠𝑠𝑞𝑞1
𝑞𝑞2∗ = −
2𝐵𝐵 2𝐵𝐵
The Cournot Model: Differentiated Products
11
 In equilibrium each firm produces

𝐴𝐴 − 𝑐𝑐
𝑞𝑞1∗ = 𝑞𝑞2∗ =
2𝐵𝐵 + 𝑠𝑠

 Equilibrium price is
∗
𝐴𝐴𝐴𝐴 + 𝑐𝑐 𝐵𝐵 + 𝑠𝑠
𝑃𝑃 =
2𝐵𝐵 + 𝑠𝑠
The Cournot Model: Differentiated Products
12
 Equilibrium profits are then

2
𝐴𝐴 − 𝑐𝑐
𝜋𝜋1∗ = 𝜋𝜋2∗ = 𝐵𝐵
2𝐵𝐵 + 𝑠𝑠

 The equilibrium output per firm, price and profit per firm
are all decreasing in s.
 Stackelberg Model
13

 Stackelberg model is similar to Cournot with one

important difference: firms choose quantities
sequentially rather than simultaneously

 The firm that moves first is the leader and the firm
that moves second is the follower
 Stackelberg Model
14

 Demand function P = A - BQ
 Constant marginal cost = c
 Firm 1 is the leader and firm 2 the follower
 How should firm 1 make its choice?
 Stackelberg Model
15

 We solve for firm 2’s best response function exactly

as we did in the Cournot model. For any choice of
q1, firm 2 faces the inverse demand and marginal
revenue curves:
P = (A - Bq1) - Bq2
MR2 = (A - Bq1) - 2Bq2

 Equating MR2 to MC gives us

q*2 = (A - c)/2B - q1/2
 Stackelberg Model
16

 Firm 1 (leader) anticipates that firm 2 (follower)

will choose its output on the basis of its best
response function
 Firm 1 can then substitute for q2 in its demand
function so that its inverse demand function may be
written as:
P = (A - Bq1) - Bq2
P = (A + c)/2 – Bq1/2
 Stackelberg Model
17

MR1 = (A + c)/2 – Bq1

MR1 = MC
(A + c)/2 – Bq1 = c
q*1 = (A - c)/2B
 Given this output choice by firm 1, firm 2 selects its
best response as given by its best response function,
which is equal to
q*2 = (A - c)/4B
 Stackelberg Model
18

 Leader’s output is exactly equal to the monopoly

output
 Total industry output QS = 3(A - c)/4B
 QS is greater than the Cournot output (QC = 2(A -
c)/3B)
 Equilibrium price is lower in the Stackelberg model
than it is in the Cournot
 Bertrand
19

 In the Bertrand model, each firm selects its price

and stands ready to sell whatever quantity is
demanded at that price
 As homogeneous goods, consumers buy from low-
price firm
 If firms charge the same price, assume each firm
has market share of 1/2
 Bertrand
20

 Continue with demand and cost functions from

Cournot model but assume that A = 100, B = 1 and
c = 10
 In Cournot equilibrium P1 = P2 = 40. Could this be
also Bertrand equilibrium?
 If rival charges P2 = 40, can firm 1 change price to
increase profits?
 Bertrand
21

 Lower price to 39
 Since product is homogeneous, all consumers buy
from the low-price firm
 Price is only slightly lower but demand has
doubled
 Therefore firm 1 better off by charging 39
 Is P1 = 39 and P2 = 40 an equilibrium?
 Bertrand Equilibrium
22

 In Bertrand equilibrium P1 = P2 = 10
 If firm 1 increases price, it loses all customers. Not
profitable move.
 If firm 1 lowers price, all customers buy from firm 1
but it is selling below cost and making a loss.
 If more than two firms, Bertrand equilibrium does
not change
 Cournot and Bertrand Compared
23

 If the firms can adjust the output quickly, Bertrand

type competition will ensue
 If the output cannot be increased quickly (capacity
decision is made ahead of actual production)
Cournot competition is the result
 Bertrand Competition: Criticisms
24
 Bertrand Model assumes that any price deviation leads to
an immediate and complete loss of demand for the high
charging firm
 Cutting price to marginal cost rests on the assumption
that each firm has sufficient capacity to serve the entire
market demand at the competitive price
 Firms are unlikely to choose sufficient capacity to serve
the whole market when price equals marginal cost
 Since they get only a fraction in equilibrium
 So capacity of each firm is less than needed to serve the whole
market
 But then there is no incentive to cut price to marginal cost
 Bertrand Competition: Criticisms
25

 Original analysis also assumes that firms offer

homogeneous products
 Creates incentives for firms to differentiate their
products
 To generate consumer loyalty
 To not lose all demand when they price above their rivals (keep
the “most loyal”)
 When the products of the rival firms are differentiated,
the demand curves are different for each firm
 Lower price attracts some but not all or rival’s customers
 Differentiated Bertrand: U.S. Cola Market
26

 Coke and Pepsi are similar but not identical. As a

result, the lower priced product does not win the
entire market
 Gasini, Lafont and Quang (1992) estimated the
following demand curves:

Coke: Q1 = 63.42 – 3.98P1 + 2.25P2

Pepsi: Q2 = 49.52 – 5.48P2 + 1.40P1

 Differentiated Bertrand: U.S. Cola Market
27

 Profit function for

 Coke: πC = (PC - 4.96)(63.42 - 3.98PC + 2.25PP)
 Pepsi: πP = (PP - 3.96)(49.52 - 5.48PP + 1.40PC)

 Differentiate with respect to PC and PP respectively

 Differentiated Bertrand: U.S. Cola Market
28
Best response functions:
PC = 10.44 + 0.2826PP PP
RC
PP = 6.49 + 0.1277PC
These can be solved for
the equilibrium prices as $8.11 RP
indicated B
$6.49
The equilibrium prices
are each greater than
marginal cost
PC
Bertrand Equilibrium at B $10.44 $12.72
 Bertrand Competition with Differentiation
29

 When products are differentiated, price cutting is not

as effective a way to stealing business
 At some point (prices still above marginal costs),
reduced contribution margin from price cuts will not
be offset by increased volume by customers switching