Oligopoly (Game Theory)

Oligopoly: Assumptions
◆ Many buyers
◆ Very small number of major sellers
(actions and reactions are important)
◆ Homogeneous product (usually, but not
necessarily)
◆ Perfect knowledge (usually, but not
necessarily)
◆ Restricted entry (usually, but not
necessarily)
 Oligopoly Models
1. “Kinked” Demand Curve
2. Cournot (1838)
3. Bertrand (1883)
4. Nash (1950s): Game Theory
 “Kinked” Demand Curve
P

Elastic

p*
Inelastic
D or d

Q* or q* Q or q
 “Kinked” Demand Curve
P
Where do p*
Elastic and q* come
from?

p*
Inelastic

D or d
Q* or q* Q or q
 Cournot Competition
◆ Assume two firms with no entry allowed
and homogeneous product
◆ Firms compete in quantities (q1, q2)
◆ q1 = F(q2) and q2 = G(q1)
◆ Linear (inverse) demand, P = a – bQ where
Q = q1 + q2
◆ Assume constant marginal costs, i.e.
TCi = cqi for i = 1,2
◆ Aim: Find q1and q2 and hence p, i.e. find
the equilibrium.
 Cournot Competition
Firm 1 (w.o.l.o.g.)
Profit = TR - TC
Π1 = P.q1 - c.q1
[P = a - bQ and Q = q1 + q2,
hence
P = a - b(q1 + q2)
P = a - bq1 - bq2]
 Cournot Competition
Π1 = Pq1-cq1
Π1 = (a - bq1 - bq2)q1 - cq1
Π1 = aq1 - bq12 - bq1q2 - cq1
 Cournot Competition
Π1 = aq1-bq12-bq1q2-cq1
To find the profit maximising level of q1 for
firm 1, differentiate profit with respect to q1
and set equal to zero.

∂Π 1
= a − 2bq1 − bq2 − c = 0
∂q1
 Cournot Competition
a − 2bq1 − bq2 − c = 0
− 2bq1 − bq2 = c − a
2bq1 + bq2 = a − c
2bq1 = a − c − bq2

a − c − bq2 Firm 1’s “Reaction”

q1 = curve
2b
 Cournot Competition

a − c − bq2 Next graph with

q1 = q1 on the
2b
horizontal axis
Do the same steps to find q2 and q2 on the
vertical axis
a − c − bq1
q2 = Note: We have two
2b equations and two
unknowns so we
can solve for q1
and q2
 Cournot Competition

q2 a − c − bq2
q1 =
2b COURNOT
EQUILIBRIUM

a − c − bq1
q2 =
2b

q1
 Cournot Competition
q1 =
a − c − bq2 a − c − bq1
q2 =
2b 2b
Step 1: Rewrite q1 Step 3: Factor out 1/2
a c bq2 1a c 
q1 = − − q1 =  − − q2 
2b 2b 2b 2 b b 
Step 2: Cancel b Step 4: Sub. in for q2
a c q2 1  a c  a − c − bq1  
q1 = − − q1 =  − −  
2b 2b 2 2b b  2b 
 Cournot Competition
1  a c  a − c − bq1  
q1 =  − −  
2b b  2b 
Step 5: Multiply across by 2 to get rid of the fraction
 a c  a − c − bq1  
2q1 = 1 − − 1 
b b  2b 
Step 6: Simplify

a c a c q1
2q1 = − − + +
b b 2b 2b 2
 Cournot Competition
a c a c q1
2q1 = − − + +
b b 2b 2b 2

Step 7: Multiply across by 2 to get rid of the fraction

2a 2c 2a 2c 2q1
4q1 = − − + +
b b 2b 2b 2
Step 8: Simplify
2a 2c a c
4q1 = − − + + q1
b b b b
 Cournot Competition
2a 2c a c
4q1 = − − + + q1
b b b b
Step 9: Rearrange and bring q1 over to LHS.
2a a 2c c
4q1 − q1 = − − +
b b b b
Step 10: Simplify

a c a−c
3q1 = − Step 11: Simplify q1 =
b b 3b
 Cournot Competition
a−c Step 12: Repeat above for q2
q1 =
3b
a−c
q2 =
3b
Step 13: Solve for price (go back to demand curve)

P = a − bQ

Step 14: Sub. in a−c a−c

for q1 and q2 P = a − b + 
 3b 3b 
 Cournot Competition
a−c a−c
P = a − b +  Step 14: Simplify
 3b 3b 

a−c a−c
P = a − + 
 3 3 

a c a c
P = a − − + − 
 3 3 3 3
 Cournot Competition
a c a c
P = a − − + − 
 3 3 3 3
1 1 1 1
P =a− a− a+ c+ c
3 3 3 3

2 2 1 2
P =a− a+ c P = a+ c
3 3 3 3

a + 2c
P=
3
Cournot Competition: Summary

a−c a−c
q1 = q2 =
3b 3b
a−c a−c
Q= +
3b 3b

2a −c
Q=  
3 b 
 Cournot v. Bertrand
Cournot Nash (q1, q2): Firms compete in quantities,
i.e. Firm 1 chooses the best q1 given
q2 and
Firm 2 chooses the best q2 given q1
Bertrand Nash (p1, p2): Firms compete in prices,
i.e. Firm 1 chooses the best p1 given p2 and
Firm 2 chooses the best p2 given p1
Nash Equilibrium (s1, s2): Player 1 chooses the best
s1 given s2 and Player 2 chooses the best s2
given s1
Bertrand Competition: Bertrand
Paradox
Assume two firms (as before), a linear
demand curve, constant marginal costs
and a homogenous product.

Bertrand equilibrium: p1 = p2 = c
(This implies zero excess profits and is
referred to as the Bertand Paradox)
 Perfect Competition v. Monopoly
v. Cournot Oligopoly
Given
P = a − bQ and TC i = cqi
Perfect Competition
pc a −c
P = MC ⇒ P = C ⇒ Q =
b
Π = TR − TC
Monopoly Π = PQ − CQ
Π = ( a − bQ ) Q − CQ
Π = aQ − bQ 2 − CQ
Perfect Competition v. Monopoly
v. Cournot Oligopoly
2
Π = aQ − bQ − CQ
∂Π P = a − bQ
= a − 2bQ − C = 0
∂Q  a −C 
P = a − b 
 2b 
2bQ = a − C
M a +C
m a −C P =
Q = 2
2b
Perfect Competition v Monopoly
v Cournot Oligopoly
CO 2a −c a + 2c
Q =   P CO
=
3 b  3

Qm < Qco < QPC

Pm > Pco > Ppc