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Oligopoly
(1)
x2 = r2 (x1 ).
This equilibrium is also known as a Cournot-Nash equilibrium in recognition of the fact that Augustine Cournot, a 19th. century French economist,
who studied this kind of equilibrium for this particular game well before
the advent of game theory. You can read about him here:
https://en.wikipedia.org/wiki/Antoine Augustin Cournot.
The game we are studying differs from the Kuwait-Iran game of Example
4.1 because each firm now has infinitely many strategies, not just two. And
this is why we need to consider reaction functions instead of a payoff matrix
with a finite number of cells.
5.2.1
An Example
or
x1 = 37.5 0.5x2 .
This is firm 1s reaction function.
x2
x1
Firm 1's Reaction Function
x2
25
25
Cournot-Nash Equilibrium
and firms face the same (constant) average and marginal cost: C1 (x1 ) = cx1
and C2 (x2 ) = cx2 . Derive the reaction functions of the two firms. Plot them
in a figure and show that a Cournot-Nash equilibrium (x1 , x2 ) is
x1 = x2 =
5.2.2
1 (a c)
3 b
Its instructive to compare the duopoly equilibrium with the other two market structures we have already studied: monopoly and perfect competition.
Suppose the demand and cost conditions are the same as in Exercise 5.2.1
(linear demand and constant marginal costs).
Recall from Exercise 3.2.xx that in a perfectly competitive equilibrium
firms equate marginal cost (MC) to the price and the aggregate output is:
xc =
(a c)
b
4
(C)
x1 + x2 =
2 (a c)
3 b
(M )
(D)
Not surprisingly, the duopoly output lies between the monopoly output
and the competitive output: the monopoly output is half the competitive
output and the (aggregate) duopoly output is two-thirds the competitive
output).
p
p = a - bx
MR
M
(a-c)
2b
CN
2(a-c)
3b
C
(a-c)
b
From Exercise 5.2.2 we know that the duopolists could increase their total
profits if they were to mimic the behavior of a monopolist. This, of course,
would require the two firms to coordinate their output decisions. A merger of
the two firms (if permitted) could achieve this. Another possibility is for the
duopolists to collude (if feasible) and agree to share the (higher) aggregate
profits equally. If they were able to collude, and maximize joint profits, they
will choose x1 and x2 to maximize:
[a b(x1 + x2 )](x1 + x2 ) c(x1 + x2 ).
The first order condition for x1 is:
a b(x1 + x2 ) b(x1 + x2 ) = c
which yields, not surprisingly,
x1 + x2 = xm .
The first order condition for x2 yields the same condition. Thus, joint profit
maximization involves a decision about the aggregate output, which turns
out to be the same as that of a monopolist. The firms could agree then to
split that in some way, e.g., equally. This could be done simply through an
agreement that each firm will produce 0.5xm .
The duopolists have an incentive to depart from the Cournot-Nash equilibrium and produce 0.5xm each. However, this is not feasible unless they
can make a binding agreement to abide by this collusive arrangement. To
put it differently, (0.5xm , 0.5xm ) is not on either firms reaction firm. If firm
2 produces 0.5xm , firm 1 will want to break the agreement and produce
more. (You should verify this assertion by examining the reaction function
you computed in Exercise 5.1.1).
5.2.3
It is generally the case that an agreement to collude (and share the monopoly
profits) is not a Nash equilibrium; each firm has an incentive to cheat on such
an agreement. We verify this by now consider an oligopoly with n identical
6
firms. (We continue to assume linear demand and constant marginal costs
in order to be able to compare our pervious results.
The inverse demand curve is a straight line:
p(X) = a bX
P
where X denotes aggregate output, X = i xi .
The profit of firm i will now depend on the output of all firms,
X
i = p(x)xi cxi = (a b
xj bxi )xi cxi .
j6=i
(a c)
.
b
Since all firms are identical, there is one solution to this collection of equations
with xi = x for all i,
1 (a c)
.
x=
n+1 b
x + xi =
n (a c)
.
n+1 b
(CN )