Oligopoly: homogeneous goods (References: SHY chaps 6,7)

Markets are rarely in the extreme states of either perfect competition or pure monopoly. The
wide term used for degrees of competition between these two extremes is, Imperfect
competition. This could include Oligopoly, and Monopolistic Competition. The first has few
sellers and the good being sold may be homogeneous or differentiated between different
sellers, while the second has large numbers of sellers, each selling a slightly differentiated
product.

Competition between strategic rivals in an Oligopoly can be thought of either as that occurring
in quantity decisions (Cournot game), or in price decisions (Bertrand game).

Basic Cournot model of Oligopoly – Augustine Cournot

The model makes simplifying assumptions:

i. All sellers know market demand

ii. Each seller knows the other’s costs
iii. The sellers sell exactly the same product (homogeneous) such that they are perfect
substitutes
iv. Each seller has the same constant marginal and average cost c , per unit of the good

Let the market (inverse) demand be given by p=a−bQ; Q=q1 +q 2.

Illustrate on a diagram.

Notice that it should be that a> c .

The game is such that each seller decides what quantity of the good to sell in the market, and
a
the two sellers make these decisions simultaneously; i.e. q i ∈ [ 0 , q{ max } ] ; q {max }= (from setting
b
p=0 in the inverse demand function).

a
 p=a−b ( qi +q j ) ; if qi +q j ≤
b

Therefore a firm’s profit function is a function of both quantities, and a seller (firm) chooses its
quantity to maximize this:

max π i ( qi , q j )= ( p−c ) qi=[¿ a−b ( q i+ q j )−c ]q i ¿

{q i }

Gives FOC: a−b ( q i +q j )−c−b q i=0

 a−2 b qi −b q j−c=0
 a−b q j −c
 q ¿i =
2b

This is seller i ’s best response function, i.e. its optimal quantity, given its rival’s quantity.

a−b q2−c a−b q1−c

Therefore, q ¿1= ; and q ¿2= are each seller’s best response functions. In a
2b 2b
Nash equilibrium, both sellers must simultaneously be playing their best responses to each
other’s decisions, such that neither has any incentive to deviate.

Therefore, solving them both simultaneously, gives

[ ]
¿
¿ a−c a−b q1−c
q=
1 −
2b 4b

¿
 q 1 1− [ ] 1 ( a−c )
4
=
4b

¿ a−c
 q 1=
3b

a−c ¿ ¿
Because both sellers are identical, we also have from symmetry, q 2= . Or you could use q 1
3b
a−b q1−c ¿ a−c a−c 2 ( a−c ) a−c
and the equation q ¿2= to give q 2= − = = .
2b 2b 6b 6b 3b

These are the Cournot equilibrium quantities that both sellers will sell in this market game.
¿ ¿ 2 ( a−c ) 2 a+2 c
Market price therefore is p=a−b ( q1 +q 2 )=a−b =a− ( a−c )= .
3b 3 3

Each seller therefore makes the same profit, which is equal to

[ ]
2
a+2 c a−c (a−c) (a−c ) ( a−c )
π ¿i =[ p−c ] q¿i = −c = =
3 3b 3 3b 9b

And we have consumer surplus in the market equal to

CS=
1
2 (
a−
3 3b )
a+2 c 2(a−c) 1 2 ( a−c )
=
2 3 [ ][ 3b ]
2 ( a−c ) 2 ( a−c )2
=
9b

a +2 c
−c
3 a−c
Lerner index ¿ =
a+2 c a+ 2c
3
Comparative statics:

∂ CS −4 (a−c)
CS decreases as sellers’ costs c increase. = <0
∂c 9b

∂ LI {−( a+ 2 c ) −2 ( a−c ) } −3 a
But Lerner index also is smaller for a higher c . = = <0
∂c ( a+ 2 c ) 2
( a+ 2 c )2

Compare the price, profits, CS, lerner index in the Cournot outcome with what would have been
if the market were a monopoly, and if it were perfect competition. p=a−bQ

Monopoly: max π= ( a−bQ−c ) Q

Q

 a−2 bQ−c =0
¿ a−c a−c a+c
 Q= ; p=a− = ;
2b 2 2

[ ]
2
a+ c a−c ( a−c )
π= −c =
2 2b 4b

p−c a−c
 lerner index= =
p a+ c

( )( )
2
1 a+c a−c ( a−c )
 CS= a− =
2 2 2b 8b

⇒ a−c
Perfect competition: p=c ❑ a−bQ=c; Q= ; π i=0 .
b

 Lerner index=0
2
1 a−c ( a−c )
 CS= ( a−c ) =
2 b 2b

Comparing the total quantities in the three markets:

a−c 2(a−c) a−c

Qmonopoly = <Qcournot = <Q perfcomp =
2b 3b b

Therefore the deadweight loss is smaller in a Cournot market than would be in a monopoly, but
there’s still restriction of output compared with a perfectly competitive market.

a+c a+2 c
pmonopoly = >p = > p perfcomp =c
2 Cournot 3
Compare the three CS and the three lerner indices as well.

Cournot is in the middle with respect to any of these comparisons.

( a−c )2 2 ( a−c )
2
( a−c )2
C S monopoly= <C S cournot= <C S perfcomp=
8b 9b 2b

a−c a−c
LI perfcomp=0< LI cournot= < LI monopoly=
a+ 2 c a+ c

Many (identical) firms Cournot

p=a−bQ; MC=c; Q=qi + ( n−1 ) q j; Q−i =( n−1 ) q j

max π i=( a−b qi−b Q−i−c ) q i

qi

 a−2 b qi −b ( n−1 ) q j −c=0

 q ¿i =
( a−b ( n−1 ) q j−c )
2b

Because all sellers are identical, q j=qi.

 q= ¿ [ a−b ( n−1 ) q¿i −c ]

i
2b
¿
 q i 1+ (
n−1 a−c
2
=
2b )
¿ a−c
 qi = ; The larger the number of sellers, the smaller each seller’s Cournot
b (1+n)
quantity.

n ( a−c )
 Qcournot =
b(1+ n)

∂ Qcournot [ b ( 1+n ) ( a−c )−n ( a−c ) b ] [ b ( a−c ) (1+ n−n ) ] a−c

 = = = >0
∂n 2
b (1+ n )
2 2
b (1+ n )
2
b ( 1+n )
2
 bn ( a−c ) n ( a−c ) an+ a−an+cn a+ cn
 p=a− =a− = =
b ( 1+n ) n+1 n+1 n+1

∂ p [ ( n+1 ) c− ( a+cn ) ] c −a
 = = <0
∂n ( n+1 )2 ( n+1 )2

What happens to price as n → ∞ ?

As n → ∞ , p → c. Interpret.

Bertrand competition model (basic)

The same assumptions as in Cournot model are made here as well:

i. All sellers know market demand

ii. Each seller knows the other’s costs
iii. The sellers sell exactly the same product (homogeneous) such that they are perfectly
substitutable
iv. Each seller has the same constant marginal and average cost c , per unit of the good
v. All buyers are assumed to know both list prices before they decide where to purchase

a− p
Let the market (inverse) demand be given by p=a−bQ;∨Q= be the demand curve.
b

The game is that the sellers simultaneously choose their list prices, which then are known by
consumers who decide where to purchase as functions of the two prices.

What is the intuition behind the Nash equilibrium in this game?

{
a−p i
( pi−c ) b ; if pi < p j
max π i ( p i , p j )=¿ a−p
i
¿
pi ( pi−c ) 2 b ; if pi= p j
0 ; if pi > p j

a. Notice that pi > p j can never be a Nash equilibrium, because if seller i is making zero
profit and seller j is making positive profit, seller i can profitably cut price down to
rival’s level. While if seller j is making zero profit, it can profitably increase price by a bit.
b. That leaves pi= p j= p, say. If p>c , it cannot be a Nash equilibrium because either seller
can with an ϵ ≈ 0 price cut, profitably deviate.
c. Therefore, the unique Nash equilibrium is pi= p j=c .
That is, as long as there are two identical sellers competing in prices in a homogeneous good
market with perfectly informed demand, the only Nash equilibrium in prices is both selling at
marginal cost. The Bertrand game achieves the perfect competition outcome with two or more
sellers.

In Bertrand competition there is no question of collusive incentives, in the absence of other

commitment devices. Price matching policies can be used to facilitate collusion in Bertrand
games with homogeneous goods. We will discuss these later.

But first, is collusion possible without any external policies or props in the Cournot sense with
homogeneous goods? That is, we want to illustrate why the Cournot quantities constitute an
equilibrium between rival sellers.

Consider the basic first example of linear demand curve and identical sellers.

p=a−bQ; Q=q1 +q 2

cournot a−c
 qi =
3b

cournot a+2 c
p = .
3

cournot ( a−c )2
π i =
9b

m a−c m a+ c ( a−c )2
Monopoly: Q = ; p = ; π m=
2b 2 4b

If both sellers somehow (tacitly because explicit agreements to collude are illegal) agreed to
some amount of quantity each such that they together maximized the total profit in the market
and then equally split the spoils, each would sell

m a−c
qi = ;
4b

( a−c )2
And earn profit π mi =
8b

Notice that π mi > π cournot

i .

What stops them from colluding in this way?

If one seller sold this agreed upon quantity, what is the best response of the other seller?

a−c a−b q j −c
Use q j= in q ¿i = .
4b 2b

¿ a−c ( a−c ) 3 ( a−c ) m

 qi = − = > qi
2b 8b 8b

Intuition?

The game in fact has characteristics of a prisoners’ dilemma in continuous strategies, as each
seller has incentives to produce and sell more than the joint profit maximization quantities. The
game therefore settles in the Cournot equilibrium.

Collusion is therefore not sustainable. Unless there are punishments of some kind. Usually
possible in a repeated game, especially infinite repetitions; eg. Grim trigger strategies or tit-for-
tat strategies.

Price matching and possibility of tacit collusion in Bertrand game

a− p
Remember the Bertrand game above. p=a−bQ;∨Q= is the demand curve. Each seller
b
has marginal cost c .

Suppose now that each seller could while listing a price also adopt a price-match policy – a
policy that promises to consumers to deliver any lower prices in the market. Let all consumers
be perfectly informed as before.

Adopting price-matching transforms sellers’ profit functions, such that if both adopt it, profit is
as follows for each:

{
a− pi
( p i−c ) 2 b ; if p i< p j
a− pi
max π ( pi , p j )=¿ ( p i−c ) ; if pi =p j ¿
p i 2b
a− p j
( p j−c ) 2 b ; if pi > p j

What is/are the Nash equilibria now?

Neither seller now has the incentive to undercut its rival’s price. Therefore, any p ∈[c , pm ]
becomes a Nash equilibrium, with both sellers adopting price-match policies and listing the
same price.
Multiple equilibria. The most profitable of these prices, is pm the monopoly price. Price-
matching policies can thus facilitate tacit collusion if sellers are identical and all buyers are fully
informed.

Explain dominant strategy.

Dominant strategy here? Weak or strict dominance?

There are also other arguments to why price matching might be used: price discriminate
between informed/sophisticated and uninformed/unsophisticated consumers, bargaining with
consumers, etc.

Stackelberg model of quantity competition (Cournot) OR the leader follower Cournot model

p=a−bQ; Q=q1 +q 2 ; MC=c, for both sellers

The game is different in the following sense. Seller 1 is the leader and chooses its level of sales
(quantity) in period 1 of the game, before seller 2. Once chosen, seller 1’s quantity is observed
by seller 2; it is also a binding commitment such that q 1 cannot be changed in period 2. In
period 2, seller 2 after observing its rival’s quantity, chooses its own. Market price is then
determined as a function of total quantity sold, and profits are earned by both sellers as
functions of how much each sold.

The sequential nature of the game brings up questions of mover advantages. And also, whether
this may lead to a better or worse outcome in terms of consumer, producer, and total welfares.

We solve the game using backward induction. Therefore, we first analyze the second period of
the game. Observing q 1, seller 2 will choose its q 2 as a best response to q 1. We can therefore
use the Cournot best response function for seller 2’s decision in period 2.

a−b q1−c
q 2=
2b

Because of the common knowledge of rationality assumption in game theory, seller 1 should
know that seller 2 will use this function to choose its quantity. Therefore, seller 1 can use this
function in place of seller 2’s quantity, to arrive at its own optimum choice of quantity.

(
max π 1= a−b q 1−b
q1
( a−b2bq −c )−c) q =[ a−b q − (a−b2q −c ) −c ] q =( a−b2q −c ) q
1
1 1
1
1
1
1
FOC: ( a−b2q −c )− b2 q =0
1
1

a−c
 =b q1
2
s ( a−c )
 q 1=
2b

Using this, we can solve for seller 2’s optimum quantity :

¿
s a−c q 1 a−c
q=
2 − =
2b 2 4b

Notice that the leader sells a larger q . This should also mean that the leader earns a larger profit
in this SPE than the follower, because the market price and the marginal cost are the same for
both sellers.

a−c
Also notice that the (simultaneous game) Cournot quantity ( ) lies in between the two
3b
quantities found here.

s 3 ( a−c )
Total quantity in the market is Q =q1 +q 2=
4b

 Qs >Q cournot

s s 3 ( a−c ) a+3 c
Market price in the Stackelberg model is p =a−b Q =a− = .
4 4

And each seller earns profit as follows:

( )
2
a+3 c ( a−c ) ( a−c )
π s1= −c =
4 2b 8b

( )
2
a+3 c a−c ( a−c )
π s2= −c =
4 4b 16 b

Compare this price with that obtained for the simple Cournot model. And compare the profits
as well. ps < p cournot. And π s1 >π cournot
i
s
> π 2. The leader gets a profit larger than the Cournot profit,
while the follower earns much less. This implies that if given an opportunity to make the first
move, each seller would welcome it. First mover advantage.

cournot
=
a+2 c ( a−c )2
To recount; ( p ; π cournot = ).
3 i
9b
Because price is lower and a larger quantity is sold, consumer surplus in the Stackelberg market
is greater than in Cournot. But producer surplus is smaller in Stackelberg, as the sum of profits
2 2
3 ( a−c ) 2 ( a−c )
is , which is smaller than the sum in Cournot, .
16 b 9b

A Stackelberg setup in the Bertrand game (choosing prices) with homogeneous goods and
identical costs is not interesting and doesn’t add much to our knowledge.

Why do you think so?

Practice Q (from SHY Exercise 6.8 #2).

In an industry there are N identical firms producing a homogeneous product. Let q i denote the
output level of firm i ,i=1 , 2 , … , N ; and let Q denote the total industry production level such
N
that Q=∑ qi . Assume that the demand curve facing the industry is given by p=100−Q ; and
i=1

each firm has the cost function as follows:

{
2
T C i ( qi ) = F +q i ; if q i >0
0 ; if q i=0

Solve the following problems:

1. Let N be small such that each firm makes positive profit. Calculate the output, price, and
profit levels of each firm in a Cournot equilibrium (Treat N as a constant).
2. Now assume that there is free entry and exit in the market such that in long run
equilibrium, each firm’s profit is reduced to zero. Assuming that old and new firms are
identical, find the equilibrium number of firms as a function of F . Hint: equate the firm’s
profit found in (1) above to zero and solve for N .

[ ]
N
max π i= 100−∑ qi qi −F−q2i
i=1

 100−2 qi−∑ q j−2 qi=0

{−i }
  100−( N −1 ) q=4 q
100 ¿
 =q
N +3

p=100−N ( N100+3 )= N300+ 3

[
π i= 100−N ( N100+3 )] N100+3 −F− (100002
N +3 )

[ 100 N +300−100 N ] 100 10000

π i=0 => − =F
N +3 N +3 2
( N +3 )

20000
 =F
( N +3 )2

( )
1 /2
20000
 N= −3
F

This question takes you from an oligopoly structure toward a market that is more like a
perfectly competitive market.