Recap

Last class (January 13, 2004)

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Dominant and dominated actions

Best response
Nash equilibrium
Mixed strategies
Pareto dominance

Today (January 15, 2004)

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Examples of games with continuous action sets

Duopoly models: Cournot and Bertrand

Duopoly models
!
!

!
!
!
!

Two competing firms, selling a homogeneous good

The marginal cost of producing each unit of the good:
c1 and c2
The market price, P is determined by (inverse) market
demand:
! P=a-bQ if a>bQ, P=0 otherwise.
Both firms seek to maximize profits
Cournot:
Firms set quantities simultaneously
Bertrand:
Firm set prices simultaneously
Stackelberg:
Firms set quantities, firm 1
followed by firm 2

Cournot Competition
!

The market price, P is determined by (inverse)

market demand:
!

!
!

P=a-bQ if a>bQ, P=0 otherwise.

Each firm decides on the quantity to sell (market

share): q1 and q2
Q= q1+q2 total market demand
Both firms seek to maximize profits

Cournot Competition: Best response of Firm 1

Suppose firm 2 produces q2
! Firm 1s profits, if it produces q1 are:
c1q1
1 = (P-c1)q1 = [a-b(q1+ q2)]q1
= (Residual) revenue Cost
! How to choose q1 to maximize 1?
2
2
! First note that 1 is concave: d 1/dq1 = -2b <0
! First order conditions (FOC):

c1
d 1/dq1= a - 2bq1 - bq2
= Residual marginal revenue Marginal cost
=0
q1=(a-c1)/2b q2/2= R1(q2)
!

Cournot Competition: Best response of Firm 2

!
!

Suppose firm 1 produces q1

Firm 2s profits, if it produces q2 are:
c2q2
2 = (P-c2)q2 = [a-b(q1+ q2)]q2
= (Residual) revenue Cost
First order conditions:
d 2/dq2= a - 2bq2 bq1 c2 =
=
RMR
MC = 0
q2=(a-c2)/2b q1/2= R2(q1)

Example: Cournot Competition

!
!
!

P = 130-(q1+q2), so a=130, b=1

c1 = c2 = c = 10
Suppose Firm 2 thinks that Firm 1 will set q1=40
!
!

Residual demand of Firm 2: P= 90-q2

Residual revenue of Firm 2: RR=[90-q2]q2

Residual marginal revenue:

RMR=90-2q2
Setting RMR=MC=10
90-2q2=10 q2=40

Cournot Competition: Graphical solution

P
130

90

em
an
d:
P

-2q
90
R=
RM

50

Re
sid
ua
ld

40

90
-q

P=130-Q

90

MC=10
130

Cournot Equilibrium
!
!
!

q1=(a-c1)/2b q2/2
q2=(a-c2)/2b q1/2
Solving together for q1 and q2 :
qC2=(a-2c2+c1)/3b
qC1=(a-2c1+c2)/3b
Market demand and price:
QC = qC1+ qC2= (2a- c1- c2)/3b
P = a - bQC = (a+c1+c2)/3

Example: Cournot Competition

!
!
!

P = 130-(q1+q2), so a=130, b=1

c1 = c2 = c = 10
The firms best response functions:
q1=(a-bq2-c)/2b = (130-q2-10)/2=60-q2/2
q2=(a-bq1-c)/2b = (130-q1-10)/2=60-q1/2
Solving for q1 and q2 :
q1 = q2 = 40 Q=80 P = 50
Firms profits:
1 = 2 = (50-10)40 = 1600

Cournot Competition: Graphical solution

!

q1= R1(q2)= 60-q2/2

q2 = R2(q1)= 60-q1/2

q1

120

R2(q1)= 60-q1/2
60

Cournot equilibrium

40

R1(q2)= 60-q2/2
40

60

120

q2

Cournot Equilibrium with N firms

max qi i (qi , qi ) = [a bqi b q j ]qi ci qi
j i

First order conditions:

a 2bqi b q j ci = 0 i = 1,..., N
j i

Substitute Q=qi:

a bqi bQ ci = 0 i = 1,..., N
Sum over N:

Na bQ bNQ ci = 0
i

Cournot Equilibrium with N firms

QC =
PC =

Na
i ci

( N + 1)b ( N + 1)b
a
ci
+ i
N +1 N +1

If each firm has the same cost ci=c:

QC
ac
q =
=
N ( N + 1)b
C
i

PC =

a + Nc
N +1

Bertrand Equilibrium Model

!

Firms set prices rather than quantities

!

P=a-bQ

Customers buy from the firm with the cheapest

price
The market is split evenly if firms offer the same
price

Best response
!

Firm 1s profit function:

(P1)=(P1- c1) q1
To ensure q1>0 (recall: P=a-bQ and Q=(a-P)/b)
P1 a
To ensure nonnegative profits
P1 c1
Firm 1 should choose
c1 P1 a
Similarly, firm 2 should choose
c2 P2 a

Best response (cont.)

!

Firm is demand depends on the relationship between

P1 and P2

if Pi > Pj
0,

a Pi
qi =
, if Pi < Pj
i = 1,2
b

a P
2b , if Pi = Pj = P

Firm 1 should choose c1 P1 P2 (if possible)

Firm 2 should choose c2 P2 P1 (if possible)

Bertrand equilibrium
!

For both firms to sell positive quantities profitably

c1 P1 P2 and c2 P2 P1
Suppose c= c1= c2
P=c
q1= q2= (a-c)/2b
Suppose c1< c2
P1 = c2-
P2 c2
q1= (a- c2+)/b q2= 0

Example
!
!
!
!
!

P = 130-(q1+q2) (a=130, b=1)

c1 = c2 = c = 10
P=10
q1= q2= (a-P)/2b = 60 Q=120
Firms profits:
1 = 2 = 0

Quantity-setting monopolist
!
!

Single firm (monopolist), selling a single good

The marginal cost of producing each unit of the
good: c
The firm decides on the quantity to sell: Q (market
demand
The market price, P is determined by (inverse)
market demand:
!

P=a-bQ if a>bQ, P=0 otherwise.

The firm seeks to maximize profits

Quantity-setting monopolist
!

!
!
!

The firms profits, if it produces Q are:

= (P-c)Q = [a-bQ]Q cQ
= Revenue Cost
How to choose Q to maximize ?
First note that is concave: d2/dQ2 = -2b <0
First order conditions (FOC):
d /dQ = a - 2bQ

c
= Marginal revenue Marginal cost
=0
Q = (a-c)/2b
P = (a+c)/2

Example
!
!
!

P = 130-Q (a=130, b=1)

c = 10
Q = (a-c)/2b = 60
P = (a+c)/2 = 70
Monopolists profits:
= (70-10)60 = 3600

10

Monopoly vs. Cournot vs. Bertrand

Competitive

Bertrand

Cournot

Monopoly

Price

10

10

50

70

Quantity

120

120

80

60

3200

3600

Total Firm
Profits

Firm profits and prices:

Competitive Bertrand Cournot Monopoly

Monopoly vs. Cournot vs. Bertrand

Price
Quantity
Total Firm
Profits

Competitive

Bertrand

Cournot

Monopoly

(a+2c)/3

(a+c)/2

(a-c)/b

(a-c)/b

2(a-c)/3b

(a-c)/2b

2(a-c) 2/9b

(a-c) 2/4b

Firm profits and prices:

Competitive Bertrand Cournot Monopoly

11

Cournot competition
P
130
Consumer surplus=3200

90
P=130-Q
Firm profits=3200

50

Deadweight loss=800

MC=10
40

130

80

Bertrand competition
P
130
Consumer surplus=7200

P=130-Q

MC=10
120 130

12

Monopoly
P
130
Consumer surplus=1800

P=130-Q

70

Firm profits=3600
Deadweight loss=1800

MC=10
q

130

60

Monopoly vs. Cournot vs. Bertrand

Competitive

Bertrand

Cournot

Monopoly

7200

7200

3200

1800

Deadweight
loss

800

1800

Total Firm
Profits

3200

3600

Consumer
surplus

13