Biresh Sahoo, Ph.D.

Full Professor, XIM, Bhubaneswar

Lecture 18
 Oliogopoly
1. Conditions for Oligopoly?
2. Role of strategic interdependence
3. Profit maximization in four Oligopoly settings
 Sweezy (Kinked-demand) model
 Cournot model (which I will be discussing)
 Stackelberg model
 Bertrand model

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 Conditions for Oligopoly
 A relatively smaller number of firms (usually less than
10) produce most output.
 Duopoly - two firms
 Triopoly - three firms
 The products firms offer can be either differentiated or
homogeneous.
 Recognized mutual interdependence
 Barriers to entry exist

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Role of strategic interaction
 Strategic behavior occurs when the best outcome
for one party depends upon the actions and
reactions of other rival parties.
 That is,
 What you do affects the profits of your rivals
 What your rival does affects your profits

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 An example
 You and another firm sell differentiated products
 How does the quantity demanded for your product
change when you change your price?

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 P D2 (Rival matches your price change)

PH

P0

PL

D1
(Rival holds its
price constant)

Q0 Q

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 P D2 (Rival matches your price change)

Demand if Rivals match price

reductions but not price increases

P0

D1
(Rival holds its
price constant)
D
Q0 Q

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 Key insight
 The effect of a price reduction on the quantity
demanded of your product depends upon
whether your rivals respond by cutting their
prices too!
 The effect of a price increase on the quantity
demanded of your product depends upon
whether your rivals respond by raising their
prices too!
 Strategic interdependence: You aren’t in complete
control of your own destiny!
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 Cournot model
 A few firms produce goods that are either perfect
substitutes (homogeneous) or imperfect
substitutes (differentiated)
 Firms set output, as opposed to price
 Each firm believes their rivals will hold output
constant if it changes its own output (The output of
rivals is viewed as given or “fixed”)
 Barriers to entry exist

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 Reaction functions
 Suppose two firms produce homogeneous
products.
 Firm 1’s reaction (or best-response) function is a
schedule summarizing the amount of Q1 firm 1
should produce in order to maximize its profits for
each quantity of Q2 produced by firm 2.
 Since the products are substitutes, an increase in
firm 2’s output leads to a decrease in the profit-
maximizing amount of firm 1’s product.

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 Graphically
Q2

Q2 *

r1 (Firm 1’s reaction function)

Q1 * Q1 M Q1

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How to find RFs for Cournot Duopoly
 The inverse market demand function in a homogeneous-
product Cournot duopoly is:
P  a  b(Q1  Q 2 )
where a and b are some positive constants.
and the respective cost functions of the two firms are:
C1 (Q1 )  c1Q1
C 2 ( Q 2 )  c2 Q 2
 The reaction functions of these two firms are (MRi = MCi):

a - c1 1 a - c2 1
Q1  r1 (Q 2 )   Q2 Q 2  r2 (Q1 )   Q1
2b 2 2b 2
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 Profit ( 1 )  R1 - C1
 PQ1 - c1Q1
 aQ1 - bQ12 - bQ1Q 2 - c1Q1
 1
Profit ( 1 ) is maximum when 0
Q1
a - 2bQ1 - bQ 2 - c1  0
a - c1 1 a - c1 1
Q1  - Q 2 i.e., Q1  r1 (Q 2 )  - Q2
2b 2 2b 2
 2
Similarly, by equating  0, one can have :
Q 2
a - c2 1
Q 2  r2 (Q1 )  - Q1
2b 2
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 Cournot equilibrium
 Situation where each firm produces the output
that maximizes its profits, given the output of
rival firms
 No firm can gain by unilaterally changing its
own output

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 Cournot equilibrium
Q2

r1

Cournot equilibrium
Q2 M

Q 2*

r2
Q1
Q1 M
Q1 *

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Solution of Cournot equilibrium
a - c1 1 Let’s assume: a = 1,000, b
Q1   Q2
2b 2 = 1, and c1 = c2 = 4
a - c1 1  a - c2 1 
    Q1  1,000  4 - 2 * 4
2b 2  2b 2  Q1* 
3 *1
a - c1 a - c2 1 996
   Q1   332
2b 4b 4 3
a  c2 - 2c1 1 Q*2  332
  Q1
4b 4
The reactions functions are
a  c2 - 2c1
Q1*  1,000 - 4 1 1
3b Q1  r1 (Q 2 )   Q 2  498  Q 2
2 *1 2 2
a  c1 - 2c2
Q2*  Q 2  r2 (Q1 ) 
1,000 - 4 1 1
 Q1  498  Q1
3b 2 *1 2 2
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Summary of Cournot equilibrium
 The output Q1* maximizes firm 1’s profits, given
that firm 2 produces Q2*
 The output Q2* maximizes firm 2’s profits, given
that firm 1 produces Q1*
 Neither firm has an incentive to change its output,
given the output of the rival
 Beliefs are consistent:
 In equilibrium, each firm “thinks” rivals will stick to
their current output --- and they do!

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Iso-profit curve for Firm 1
Profit ( 1 )  R 1 - C1  PQ1 - c1Q1
 aQ1 - bQ - bQ1Q 2 - c1Q1
2
1

To define iso-profit curve, we assign profit at some level, i.e.,  1   0

 0  aQ1 - bQ - bQ1Q 2 - c1Q1

2
1

(a - c1 )Q1 - bQ12 - bQ1Q 2   0  0

 a-c1  0  1
Q2     Q1 -  
 b   b  Q1
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Firm 1’s Isoprofit Curve
Q2
 The combinations of outputs of the two firms
r1 that yield firm 1 the same level of profit

B C

A 1 = $100 Increasing profits for Firm 1

D
1 = $200
Q1 M Q1
 Another Look at
Cournot Decisions:
Q2
r1
Firm 1’s best response to Q2*

Q2*
 1 = $100
 1 = $200

Q1 * Q1 M Q1

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 Another Look at
Cournot Equilibrium
Q2
Firm 2’s Profits
r1

Q2 M Cournot Equilibrium

Q2 *

Firm 1’s Profits

r2

Q1 * Q1M Q1

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 Q2
Cournot Equilibrium:
Case of Collusion
r1
• Firm 1’ s profit is highest at point A.
• Firm 2’s profit is highest at point B.
• If each firm agreed to produce an
output that in total equaled the
π C2 monopoly output, the firms would end
π Coll.
2 up somewhere on the line connecting
Q2M B points A and B.
C • In other words, any combination of
E
outputs along line AB would maximize
Q2Col. D total industry profits.
F
π1Coll.
π1C r2
A Q1
O M
Q1 Col. Q1

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 Q2
Cournot Equilibrium: Case of Cheating
• Suppose firms agree to collude, with
each firm producing collusive output
associated with point D.
r1 • Given that firm 2 produces Q2Col., firm 1
has an incentive to “cheat” on the
collusive agreement by expanding output
to point G.
π C2 Collude • At this point, firm 1 earns even higher
π2 profits that it would by colluding.
•This means that a firm can gain by
Q2 B
M inducing other firms to restrict output and
C then expanding its own output to earn
D higher profits at the expense of its
G
Q2Col. collusion partners.
π1Collude
π1CheatC r2
π1
A Q1
O Col. Q1 Chea Q1 M
Q1
t

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Finding profit at Cournot Equilibrium
 P = 1,000 – (332+332) = 1,000 – 664 = $336
 C1 = C2 = 4*332 = 1328
 Π1 = Π2 = 336*332 -4*332 = 332(336-4)=3322=$110,224

Under Collusion:
 MR = MC
 P = 1,000 – Q
 MR = 1,000 -2Q
 1,000 -2Q = 4  Q = 498 and P = $502 [=1,000 – 498 ]
 Π1 = Π2 = (502*249)- (4*249) = $124,002

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