1:IndustrialOrganization:What,How,andWhy

OneofthemostsuccessfulcompaniesinthehistoryofbusinessisCocaCola.Indeed,CocaColaissaid
tobethesecondmostwellknownphraseintheworld,thefirstbeingokay.1Yetdespiteitsiconicstatusin
Americanpopularculture,CocaColaisnotamonopoly.CocaColasharesthecarbonatedsoftdrinkmarket
sharewithitsarchrivalPepsiCo.Anongoingbattleformarketsharehasengagedthesetwocompaniesfor
almost100years.Thecolawarshavebeenfoughtwithanumberofstrategies,oneofwhichisthefrequent
introductionofnewsoftdrinkproducts.PepsilaunchedPepsiVanillainthesummerof2003inresponseto
theyearearlierintroductionofVanillaCoke.In2006,Cokeinitiateditsbiggestnewbrandcampaignin
twentytwoyearsforitsnewdietdrink,CokeZero.ThisfollowedPepsi'srevitalizationofitsPepsiOnebrand
madewithSplendasweetenerinsteadofAspartame.
Infightingthesecolawars,eachcompanymustidentifyandimplementthestrategythatitbelievesisbest
suitedtogainingacompetitiveadvantageinthesoftdrinkindustry.IfCocaColawereamonopoly,itwould
nothavetoworryaboutanyrivals.Nebbitherdoesaperfectlycompetitivefirm.Thepuremonopolisthasno
rivalsandthecompanyinaperfectlycompetitivemarkethasnoeffectonitsrivals.Eachsuchfirmisso
smallthatitsdecisionshavenoeffectatallontheindustry.
However,Coke,Pepsi,andmanyifnotthemajorityofotherrealworldfirmsliveinthemiddlegroundof
oligopoly,inwhichfirmshavevisiblerivalswithwhomstrategicinteractionisafactoflife.Eachfirmisaware
thatitsactionsaffectothers,andtherefore,promptreactions.Eachfirmmust,therefore,takethese
interactionsintoaccountwhenmakingadecisionaboutprices,output,orotherbusinessactions.Game
theoryistheanalyticframeworkusedtoformallyanalyzestrategicinteraction.Asaresult,gametheoryand
thestudyofoligopolyarecloselyintertwined.Inthischapterweintroducesomebasicgametheoretic
analysistoshowhowitmaybeusedtounderstandoligopolymarkets.
Gametheoryitselfisdividedintotwobranches:noncooperativeandcooperativegametheory.2The
essentialdifferencebetweenthesetwobranchesisthatinnoncooperativegames,theunitofanalysisisthe
individualdecisionmakerorplayer,forexample,thefirm.Bycontrast,cooperativegametheorytakesthe
unitofanalysistobeagrouporacoalitionofplayers,forexample,agroupoffirms.Wewillfocusalmost
exclusivelyonnoncooperativegametheory.Theindividualplayerwillbethefirm.Therulesofthegamewill
definehowcompetitionbetweenthedifferentplayersorfirmstakesplace.Thenoncooperativesetting
meansthateachplayerisconcernedonlywithdoingaswellaspossibleforhimselforherself,andnotin
advancingamoregeneralgroupinterest.Asweshallseethough,suchnoncooperativebehaviorcan
sometimeslookverymuchlikecooperativebehaviorbecausecooperationsometimesturnsouttomaximize
thewellbeingofeachindividualplayer,aswell.
Twobasicassumptionsunderlietheapplicationofnoncooperativegametheorytooligopoly.Thefirstisthat
firmsarerational.Theypursuewelldefinedgoals,principallyprofitmaximization.Thesecondbasic
assumptionisthatfirmsapplytheirrationalitytotheprocessofreasoningstrategically.Thatis,inmakingits
decisions,eachfirmusesalltheknowledgeithastoformexpectationsregardinghowotherfirmswill
behave.Themotivationbehindtheseassumptionsisthatourultimategoalistounderstandandpredicthow
realfirmswillact.Weassumethatfirmsarerationalandreasonstrategicallybecausewesuspectthatreal
firmsdopreciselythisorwillbeforcedtodosobymarketpressures.Hence,understandingwhatrational
andstrategicbehaviorimpliesoughttobeusefulforunderstandingandpredictingrealworldoutcomes.

Thereisonecautionthatanyintroductiontothestudyofoligopolymustinclude.Itisthat,unlikethetextbook
competitionandmonopolycases,thereisnosingle,standardoligopolymodel.Differencesintherulesofthe
gamesuchasthenumberofplayers,theinformationavailabletothevariousplayers,andthetimingofeach
player'sactionsallconspiretoyieldanumberofpossiblescenarios.Yetwhilethereisnotasingletheoryor
modelofoligopoly,commonthemesandinsightsfromthevariousmodelsofoligopolydoemerge.
Understandingthesebroadconceptsisourgoalforthenextthreechapters.Moreover,weshouldaddthat
thelackofonesingleoligopolymodelisnotentirelyadisadvantage.Rather,itmeansthatonehasarich
assortmentofmodelsfromwhichtochooseforanyparticularinvestigation.Onemodelwillbeappropriate
forsomesettings,adifferentmodelforothersettings.Becausetherealbusinessworldenvironmentisquite
diverse,itisusefultohaveavarietyofanalysesfromwhichtodraw.Wewillpresentthreedifferentoligopoly
models.InthischapterweintroducetheCournot(1836)modelofoligopoly,inthenextchaptertheBertrand
model,andtheninChapter11theStackelbergmodel.

9.1STRATEGICINTERACTION:INTRODUCTIONTOGAMETHEORY
Ingametheory,eachplayer'sdecisionorplanofactioniscalledastrategy.Alistofstrategiesshowingone
particularstrategychoiceforeachplayeriscalledastrategycombination.Anygivenstrategycombination
determinestheoutcomeofthegame,whichdescribesthepayoffsorfinalnetgainsearnedbyeachplayer.
Inthecontextofoligopolytheory,thesepayoffsarenaturallyinterpretedaseachfirm'sprofit.
Foragametobeinteresting,atleastoneplayermustbeabletochoosefrommorethanonestrategyso
thattherewillbemorethanonepossiblestrategycombination,andthusmorethanonepossibleoutcometo
thegame.Yetwhiletheremaybemanypossibleoutcomes,notallofthesewillbeequilibriumoutcomes.By
equilibriumwemeanastrategycombinationsuchthatnofirmhasanincentivetochangethestrategyitis
currentlyusinggiventhatnootherfirmchangesitscurrentstrategy.Ifthisisthecase,thenthecombination
ofstrategiesacrossfirmswillremainunalteredbecausenooneischanginghisorherbehavior.Themarket
orgamewillcometorest.NobelLaureateJohnNashdevelopedthisnotionofanequilibriumstrategy
combinationforanoncooperativegame.Inhishonor,itiscommonlyreferredtoastheNashequilibrium
concept.3
Intheoligopolymodelsstudiedinthenextthreechapters,afirm'sstrategyfocusesoneitheritspricechoice
oritsoutputchoice.Eachfirmchooseseitherthepriceitwillsetforitsproductorhowmuchofthatproduct
toproduce.AcorrespondingNashequilibriumwill,therefore,beeitherasetofprices,oneforeachfirm,ora
setofproductionlevels,againoneforeachfirm,forwhichnofirmwishestochangeitsprice(quantity)
decisiongiventhoseofalltheotherfirms.
Wenoteparentheticallyherethat,unlikethemonopolycase,thepricestrategyoutcomediffersfromthe
quantitystrategyoutcomeinoligopolymodels.Foramonopolist,thechoiceofpriceimpliesviathemarket
demandcurveauniqueoutput.Inotherwords,themonopolistwillachievethesamemarketoutcome
whethertheprofitmaximizingpriceortheprofitmaximizingoutputischosen.4Mattersaredifferentinan
oligopolysetting.Whenfirmsinteractstrategically,themarketoutcomeobtainedwheneachfirmchooses
thepricewillusuallydifferfromtheoutcomeobtainedwheneachfirmchoosesitsoutputlevel.Thefactthat
theoutcomedependsonwhethertherulesofthegamespecifyapricestrategyoraquantitystrategyisjust
oneofthereasonsthatthestudyofoligopolydoesnotyieldauniquesetoftheoreticalpredictions.

Becauseinteractionisthecentralfactoflifeforanoligopolist,rationalstrategicactionrequiresthatsuch
interactionberecognized.Forexample,whenonefirminanoligopolymarketlowersitsprice,itsrivalswill
noticetheeffectastheylosecustomerstothepricecutter.Ifthesefirmsthenlowertheirpricetoo,theymay
winbacktheiroriginalcustomers.Becausepriceshavefallenthroughouttheindustry,thequantity
demandedateachfirmwillincrease.However,eachfirmwillnowbemeetingthatdemandatalowerprice
thatearnsalowermarkup.Ourassumptionthattheoligopolyfirmisarationalstrategicactormeansthat
thefirmwillunderstandandanticipatethischainofeventsandthatthefirmwillincludethisinformationin
makingthedecisionofwhetherornottolowerpricesinthefirstplace.
Ouropeningstoryaboutcarbonatedbeveragesisanexampleofsuchaninteraction,exceptthatinsteadof
apricedecision,CocaColaandPepsiweremakingproductdesignchoices.Indoingso,eachformssome
ideaastohowitsrivalwillreact.ItwouldbeirrationalforCoketoanticipatenoreactionfromPepsi,when,in
fact,CokeunderstandsthatnotreactingisnotinPepsi'sinterest.Similarly,ifCokelowersthepriceofitssoft
drinks,itdoesn'tmakesenseforCoketohopethatPepsiwillcontinuetochargeahighpriceifCokeknows
thatPepsiwoulddobettertomatchitspricereduction.
Howcananoligopolistanticipatewhattheresponseofitsrivalswillbetoanyspecificaction?Thebestway
tomakesuchapredictionistohaveinformationregardingthestructureofthemarketandthestrategy
choicesavailabletootherfirms.Inasymmetricsituationinwhichallfirmsareidentical,suchinformationis
readilyavailable.Anyonefirmcanproceedbyaskingitself,WhatwouldIdoifIweretheotherplayer?
Sometimes,evenwhenfirmsarenotsymmetric,theywillstillhaveenoughexperience,businesssavvy,or
otherinformationtobefairlyconfidentregardingtheirrivals'behavior.Asweshallseelater,preciselywhat
informationfirmshaveabouteachotherisacrucialelementdeterminingthefinaloutcomeofthegame.
Anothercrucialelementindeterminingtheoutcomeofthegameisthetimedimensionofthestrategic
interaction.Inatwofirmoligopolyorduopoly,suchasCocaColaandPepsi,wecanimaginethatonefirm,
sayCocaCola,makesitschoicetointroduceVanillaCokefirst.Theninthenextperiod,theotherfirm,
Pepsi,followswithitschoice.Inthatcase,thestrategicinteractionissequential.Eachfirmmovesinorder
andeach,whenitsturncomes,mustthinkstrategicallyabouthowthecourseofactionitisabouttochoose
willaffectthefutureactionoftheotherfirmandhowthosereactionswillthenfeedbackonitsownfuture
choices.ChessandCheckersareeachaclassicexampleofatwoperson,sequentialgame.Sequential
gamesareoftencalleddynamicgames.
Alternatively,bothplayersmightmaketheirchoicessimultaneously,therebyactingwithoutknowledgeasto
whattheotherplayerhasactuallydone.5Yeteventhoughtheotherplayer'schoiceisunknown,knowledge
ofthestrategychoicesavailabletotheotherplayerpermitsaplayertothinkrationallyandstrategically
aboutwhatotherplayerswillchoose.Thechildhoodgame,RockPaperScissorsisanexampleofa
simultaneoustwopersongame.Suchsimultaneousgamesareoftencalledstaticgames.
Whetherthegameissequentialorsimultaneous,therequirementthatthestrategicfirmrationallypredicts
thechoicesofitsrivalsisthesame.Onceithasdonethis,thefirmmaythenchoosewhatactionisinitsown
bestinterest.Inotherwords,beingrationalmeansthatthefirm'schoiceofstrategyistheoptimal(profit
maximizing)choiceagainsttheanticipatedoptimalactionsofitsrivals.Wheneachfirmdoesthis,andwhen
eachhas,asaresultofrationalstrategizing,correctlypredictedthechoiceoftheothers,wewillobtaina
Nashequilibrium.InthischapterwewillfocusonsolvingforNashequilibriainsimultaneousorstaticgames.

9.2DOMINANTANDDOMINATEDSTRATEGIES
SometimesNashequilibriaarerathereasytodetermine.Thisisbecausesomeofafirm'spossible
strategiesmaybedominated.Forexample,supposethatwehavetwofirmsinamarket,AandB,andthat
oneofA'sstrategiesissuchthatitisneveraprofitmaximizingstrategyregardlessofthechoicemadebyB.
Thatis,thereisalwaysanalternativestrategyforfirmAthatyieldshigherprofitsthandoesthestrategyin
question.Thenwesaythatthestrategyinquestionisdominated.Itwillneverrationallybechosen.PlayerA
wouldneverchooseadominatedstrategybecausetodosowouldbetoguaranteethatA'sprofitwasnot
maximized.NomatterwhatBdoes,thedominatedstrategydoesworseforAthanoneofA'sother
strategies.Inturn,thismeansthatindeterminingthegame'sequilibrium,wedonothavetoworryaboutany
strategycombinationsthatincludethedominatedstrategy.Becausethesewillneveroccur,theycannot
possiblybepartoftheequilibriumoutcome.
Dominatedstrategiescanbeeliminatedonebyone.Oncethedominatedstrategiesforonefirmhavebeen
eliminated,wecanturntotheotherfirmstoseeifanyoftheirstrategiesaredominatedgiventhestrategies
stillremainingforthefirstfirmthatweexamined.Wecanproceedfirmbyfirm,eliminatingalldominated
strategiesuntilonlynondominatedonesremainavailabletoeachplayer.Oftenbutnotalways,thisiterative
procedureofeliminatingdominatedstrategiesleavesoneormoreplayerswithonlyonestrategychoice
remaining.6Itisthenasimplemattertodeterminethegame'soutcomebecause,forsuchfirms,theircourse
ofactionisclear.
Asanexample,considerthecaseoftwoairlines,DeltaandAmerican,eachofferingadailyflightfrom
BostontoBudapest.Weassumethateachfirmhasalreadysetapricefortheflightbutthatthedeparture
timeisstillundecided.Departuretimeisthestrategychoiceinthisgame.Wealsoassumethatthetwofirms
choosedeparturetimessimultaneously.Neithercanobservethedeparturetimeselectedbytheotherbefore
itmakesitsowndeparturetimeselection.Managersforeachairlinedorealize,however,thatatthevery
timeAmerican'smanagersaremeetingtomaketheirchoice,Delta'smanagersareaswell.Thetwofirms
areengagedinastrategicgameofsimultaneousmoves.
Inpart,thechoiceofdeparturetimewilldependuponconsumerpreferences.Supposethatmarketresearch
hasshownthat70percentofthepotentialclientelefortheflightwouldprefertoleaveBostonintheevening
andarriveinBudapestthenextmorning.Theremaining30percentpreferamorningBostondepartureand
arrivalinBudapestlateintheeveningofthesameday.Bothfirmsknowthisdistributionofconsumer
preferences.Bothalsoknowthat,ifthetwoairlineschoosethesameflighttime,theysplitthemarket.Profits
ateachcarrieraredirectlyproportionaltothenumberofpassengerscarriedsothateachwishesto
maximizeitsshareofthemarket.
Iftheyarerationalandstrategic,Delta'smanagerswillreasonasfollows:IfAmericanfliesinthemorning,
thenweatDeltacaneitherflyatnightandserve70percentofthemarketor,likeAmerican,departinthe
morninginwhichcasewe(Delta)willserve15percentofthemarket(halfofthe30percentservedbythe
twocarriersintotal).Ontheotherhand,ifAmericanchoosesaneveningflighttime,thenweatDeltamay
chooseeitheranightdepartureaswell,andserve35percent(halfof70percent)ofthemarketor,instead,
offeramorningflightandfly30percentofthemarket.
AlittlereflectionwillmakeclearthatDeltadoesbetterbyschedulinganeveningflightnomatterwhich
departuretimeAmericanchooses.Inotherwords,choosingamorningdeparturetimeisadominated

strategy.IfDeltaisinterestedinmaximizingprofits,itwillneverselectthemorningflightoption.Butof
course,American'smanagerswillreasonsimilarly.Theywillrecognizethatflyingatnightistheirbestchoice
regardlessofDelta'sselection.Theonlyequilibriumoutcomeforthisgameistohavebothairlineschoose
aneveningdeparturetime.
Table9.1illustratesthelogicjustdescribed.Thetableshowsfourentries,eachconsistingofapairof
values.Theseentriesdescribethepayoffs,ormarketshares,associatedwiththefourfeasiblestrategy
combinationsofthegame.American'sstrategychoicesareshownasthecolumns,whileDelta'schoicesare
shownastherows.Thepairofvaluesateachrowcolumnintersectiongivesthepayoffstoeachcarrierif
thatparticularstrategycombinationoccurs.Thefirst(lefthand)valueofeachpairisthepayoffthepercent
ofthetotalpotentialpassengermarketthatgoestoDelta.Thesecond(righthand)valueisthepayoffto
American.
Table9.1Strategycombinationsandfirmpayoffsintheflightdeparturegame

NowweputourselvesintheshoesofDelta'smanagersandaskfirstwhatDeltashoulddoifAmerican
choosesamorningflight.Theanswerisobvious.IfDeltaalsochoosesamorningflightthenDelta'smarket
sharewillbe15percent,whereasifDeltachoosesaneveningflightitsmarketsharewillbe70percent.The
eveningflightisclearlythebetterchoice.NowconsiderDelta'sresponseshouldAmericanchoosean
eveningflight.IfDeltaoptsforamorningdeparture,itsmarketshareis30percent,whereasifitgoesforan
eveningdepartureitsmarketshareis35percent.Onceagain,theeveningdepartureisthebetterchoice.In
otherwords,nomatterwhatAmericandoes,Deltawillneverchoosetodepartinthemorning.Whateverthe
equilibriumoutcomeis,itmustinvolveDeltachoosinganeveningflight.
IfwenowplaceourselvesinAmerican'sshoes,wegetthesameresult.AmorningflightisneverAmerican's
rationalchoice.JustasitwasforDelta,flyinginthemorningisadominatedstrategyforAmerican.Hence,
justlikeDelta,Americanwillalwayschoosetheeveningdeparturetime.
Theoutcomeofthegameisnowfullydetermined.Bothcarrierswillchooseaneveningdepartureandshare
equallythe70percentofthepotentialBostontoBudapestflyerswhopreferthattime.ThatthisisaNash
equilibriumiseasytoseebyvirtueofthedominatedstrategyargument.Clearly,neithercarrierhasan
incentivetochangeitschoicefromeveningtomorningbecauseneithercarrierwouldeverchoosea
morningflighttimeinanycase.
Solvingtheflightdeparturegamewaseasybecauseeachcarrierhadonlytwostrategiesandforeach
playeroneofthestrategiesthemorningflightwasdominated.Toputitanotherway,wemightrefertothe
eveningdeparturestrategyasdominant.Adominantstrategyisonethatoutperformsallofafirm'sother
strategiesnomatterwhatitsrivalsdo.Thatis,itleadstohigherprofits(orsales,orgrowth,orwhateverthe
objectiveis)thananyotherstrategythefirmmightpursueregardlessofthestrategiesselectedbythefirm's
rivals.Thisdoesnotimplythatadominantstrategywillleadafirmtoearnhigherprofitsthanitscompetitors.
Itonlymeansthatthefirmwilldothebestitpossiblycanifitchoosessuchastrategy.Whetheritspayoffis
asgoodas,orbetterthanthepayoffsobtainedbyitsrivalsdependsonthestructureofthegame.

Exceptwhenthenumberofstrategychoicesistwo,afirmmayhavesomedominatedstrategieschoices
thatarenevergoodonesbecausebetteronesareavailablebutnothaveanydominantstrategies,ora
choicethatalwaysyieldsbetterresultsthanallothers.Sometimes,afirmwillhaveneitheradominantnora
dominatedstrategy.Butforafirmthathasadominantstrategy,thechoiceisclear.Useit!Suchafirmreally
doesnothavetothinkverymuchaboutwhatotherfirmsdo.
Table9.2Strategycombinationsandfirmpayoffsinthemodifiedflightdeparturegame

Let'sreworkthedeparturetimegamesothatatleastonefirmhasnodominatedordominantstrategy.To
dothis,wewillnowsupposethatbecauseofafrequentflyerprogram,someofthepotentialBostonto
BudapestflyerspreferDeltaevenifthetwocarriersflyatthesametime.Specifically,assumenowthat
departingatthesametimedoesnotyieldanevensplitofcustomersbetweenthetwocarriers.Instead,
wheneverthetwocarriersscheduleidenticaldeparturetimes,Deltagets60percentofthepassengersand
Americangetsonly40percent.Table9.2depictsthenewpayoffsforeachstrategycombination.
Ascanbeseenfromthetable,aneveningflightisstillthedominantstrategyforDelta.Italwayscarries
morepassengersbychoosinganeveningflightthanitwouldbychoosingamorningflight,regardlessof
whatAmericandoes.However,American'sstrategychoicesarenolongersoclear.IfDeltachoosesa
morningflight,Americanshouldflyatnight.ButifDeltachoosesaneveningdeparturetime,Americandoes
betterbyflyinginthemorning.
AssumingthateachcarrierknowsthepayoffsdescribedbyTable9.2,however,thegame'soutcome
remainsclear.Lookingatthetable,AmericancanreadilydeterminethatDeltawillalwaysselectanevening
flight.KnowingthatDeltawillchooseaneveningdeparture,itisthenaneasymatterforAmericantoselecta
morningdepartureasitsbestresponse.Theequilibriumoutcomeforthismodifieddeparturetimegameis
thereforejustastransparentasthatfortheearlierversion.Inthiscase,theequilibriuminvolvesDelta
choosinganeveningflightandAmericanoptingtoflyinthemorning.Again,itiseasilyverifiedthatthis
equilibriumsatisfiestheNashcriteria.
Insolvingboththepreviousgames,wemadeextensiveuseoftheabilitytoruleoutdominatedstrategies
and,whenpossible,tofocusondominantones.7Weshowedthattheoutcomesobtainedbythisprocess
wereNashequilibriumoutcomes.Howeverinmanygamesnodominatedordominantstrategiescanbe
found.Insuchcases,theNashequilibriumconceptbecomesmorethanjustacriteriontocheckour
analysis.Itbecomespartofthesolutionprocedureitself.Thisisbecauserational,strategicfirmswillusethe
Nashconcepttodeterminethereactionsoftheirrivalstotheirownstrategicchoice.Inthemodified
departuretimegamejustdescribed,forinstance,Deltacanworkoutthatifitselectsaneveningdeparture,
thenitsrivalAmericanwillchooseamorningflight.Deltacanthereforededucethatthestrategycombination
ofbothcarriersflyingatnightcanneverbeanequilibriumintheNashsensebecauseifthatoutcome
occurred,Americanwouldhaveaclearincentivetochangeitschoice.

9.3NASHEQUILIBRIUMASASOLUTIONCONCEPT

InordertounderstandmoredeeplyhowtousetheNashequilibriumconcepttosolveagame,let'schange
theBostontoBudapestgametoagameinprices.
Althoughmanypricestrategiesareavailabletoeachfirminreality,let'slimitourselvesheretojustthreea
low,medium,andhighprice.Thisyieldsninepossiblestrategycombinations.Wewillassumethatthe
payoffs(inthiscaseprofits)foreachsuchcombinationaredescribedbythenewairfaregamematrixshown
inTable9.3.Asisnowourconvention,thepayoffentriesineachrowcolumnintersectionshowtheprofitof
therowplayer(Delta)asthefirstentryineachcase.
WecouldinprinciplecheckeachcellofthematrixinTable9.3todetermineifitsatisfiestheNash
equilibriumrequirementthatneitherairlinewantstochangeitsstrategy.Forexample,examinationofthe
upperlefthandcornercellquicklyrevealsthatthestrategycombinationPD=PA=LowisnotaNash
equilibrium,becauseeachairlineinthatcasewouldwanttoswitchtoamediumprice.Similarly,themiddle
cellofthelefthandcolumnwithPD=MediumandPA=LowisnotaNashequilibrium.WhileDeltacannot
improveitsprofitgiventhatAmericanischargingalowfare,Americanwoulddobetterbyraisingitsownfare
tothemediumlevelgiventhatDeltaisalreadydoingjustthat.IfAmericanfollowedthisinclination,however,
itwouldmovethegameintothePA=PD=Mediumcellinthemiddleofthematrix,anditiseasytoseethat
thatstrategycombinationisaNashequilibrium.Indeed,followingthissameprocedureforallothercells
wouldrevealthatPA=PD=MediumistheuniqueNashequilibriumforthisgame.
Amoreappealingapproachistostartbyidentifyingthatthestrategyofsettingahighpriceisneverthebest
strategyforeitherfirm.Thatis,PD=HighandPA=HighareeachdominatedstrategiesforDeltaand
American,respectively.Wecanthereforeeliminatethethirdcolumnandthirdrowcellsfromconsideration.
Havingdonethat,weareleftwiththesimple22gameinwhicheachfirmsetseitheralowormedium
price.Withinthosechoiceshowever,wenowfindthatPD=LowandPA=Lowareeachdominatedby,
respectively,PD=MediumandPA=Medium.Thus,peelingoffthedominatedstrategiesassuggested
earlierallowsustoreachtheresultthatPD=PA=MediumistheuniqueNashequilibriumforthisgame.
ThefactthatthereareanumberofwaysofidentifyingtheNashequilibriumforanygamesuggeststhat
behindeachisacommonbutdeepermeaningoftheNashconcept.Thismorefundamentalinsightmaybe
madeclearbynotingthatifplayersarerational,wewouldnotexpectthegameabovetoevolvealongthe
pathsuggestedbyourfirstsolutiontechniqueinwhichbothfirmsstartbysettingPD=PA=Low,followedby
DeltachoosingPD=MediumandthenAmericandoingthesamething.Instead,giventhefactthatboth
playersknowtheabovepayoffmatrixandtherulesofthegame,eachshouldchooseamediumpriceright
fromthestart.Why?ConsideragainDelta'smanagement.Lookingatthegame,theycanseethatAmerican
willneversetPA=High.Thus,recognizingthatPA=HighisadominatedstrategyallowsDeltatorestrict
American'spossiblechoicestoeitherPA=LoworPA=Medium.However,furtherconsiderationrevealsthat
AmericanwouldonlyeverchoosePA=LowifitthoughtthatDeltawasgoingtosetPD=High,forifDelta
choosesalowormediumprice,Americandoesbetterbychoosingamediumpriceaswell.Yetitisnot
rationalforAmericanevertothinkthatDeltawouldchoosePD=Highbecauselookingatthesametable,
Americancanseethatwhetheritsetsalowormediumprice,DeltaalwaysdoesbestbychoosingPD=
Medium.Therefore,itwouldbefoolishforAmericanevertosetPA=Low.Thus,DeltacansetPD=Medium
withacompleteconfidencethatAmericanwilldothesamethingand,moreimportantly,thatwhenDelta's
choiceofamediumpriceisrevealed,thepredictedAmericanstrategyofPA=Mediumisinfactpreciselythe
choiceAmericanwouldwanttomakegivenDelta'schoiceofPD=Medium.Ofcourse,Americancanfollow
theexactsamereasoning.Asaresult,eachfirmwillselectamediumpricingstrategyfromthestart.There

willbenoactionandreactionthateventuallyconvergetothePD=PA=Mediumcombination.Itisthis
deeperlogicalconsistencythefactthateachfirm'sstrategychoicereflectsitsbestresponsetothechoice
predictedforitsrivalwhich,inturn,istherival'sbestresponsetothefirm'sownselectedstrategythat
givestheNashequilibriumconceptitstruepower.
Table9.3Payoffmatrixfortheairfaregame

9.1PracticeProblem
Firm1andFirm2aremovieproducers.Eachhastheoptionofproducingablockbusterromanceora
blockbustersuspensefilm.Thepayoffmatrixdisplayingthepayoffsforeachofthefourpossiblestrategy
combinations(inthousands)isshownbelow,withFirm1'spayofflistedfirst.Thegameisplayed
simultaneously.DeterminetheNashequilibriumoutcome.

9.4STATICMODELSOFOLIGOPOLY:THECOURNOTMODEL
Allthegamesoftheprevioussectionaresingleperiodorstatic.DeltaandAmerican,forexample,are
assumedtochooseeithertheirdeparturetimesortheirairfaressimultaneouslyandwithoutregardtothe
possibilitythat,atsomelaterdate,theymightplaythegameagain.Thisisafeatureofearlierworkon
modelingoligopolymarkets.Firmsinthesemodelsmeetonlyonceandthemarketclearsonceandforall.
Thereisnosequentialmovementovertimeandnorepetitionoftheinteraction.Thesemaybelimitations.
Yettheanalysisisstillcapableofgeneratingimportantinsights.Moreover,studyingsuchstaticmodelsisa
goodpreparationforlaterexaminingdynamicmodels.
ThemostwellknownstaticoligopolymodelsaretheCournotandBertrandmodels,eachnamedafterits
respectiveauthor.Bothworkswerecompletedinthe19thcentury,hencethesemodelswerenotexpressed
intheformallanguageofmoderngametheory.Nevertheless,theequilibriumproposedbytheauthorof
eachmodelfullyanticipatestheNashconcept.Indeed,forthisreasononeoftenseesthatoutcomereferred
toastheCournotNashortheBertrandNashequilibriumintributetothesetwoearlyscholarsandtheir
anticipationofNash'sresult.Presentingbothmodelsalsohelpsustounderscoreacriticalpointthatshould
berecognizedbygametheorystudentseverywhere,namely,thattherulesofthegamematter...alot.The
rulesfortheCournotandNashgameareidenticalinallrespectsexceptforthevariableofstrategicchoice.
IntheCournotmodel,thatvariableisthefirm'soutputlevel,whereasintheBertrandmodelitisprice.Yet
thisseeminglysmallchangehasenormousimplicationsfortheoutcomeofthegame.

AugustinCournot,aFrenchmathematician,publishedhismodelin1836.Althoughitsinsightsremained
largelyunrecognizedforthenext100years,itisnowatthefoundationofmodelsofoligopolisticmarkets.
ThestorythatCournottoldtomotivatehisanalysiswentasfollows.Assumeasinglefirmwishestoentera
marketcurrentlysuppliedbyamonopoly.Theentrantisabletoofferaproductthatisidenticalinallrespects
tothatoftheincumbentmonopolistandtoproduceitatthesameunitcost.Entryisattractivebecauseunder
theassumptionofconstantandidenticalcosts,weknowthatthemonopolistisproducingwherepriceis
greaterthanmarginalcost,whichmeansthatthepricealsoexceedsthemarginalcostofthewouldbe
entrant.Hence,theentrantfirmwillseethatitcanprofitablysellsomeamountinthismarket.Howeverthe
newentrantwill,Cournotreasoned,chooseanoutputlevelthatmaximizesitsprofit,aftertakingaccountof
theoutputbeingsoldbythemonopolist.
Ofcourse,ifentryoccurredandthenewfirmproduceditschosenoutput,themonopolistwouldreact.
Beforeentry,themonopolistchoseaprofitmaximizingoutputassumingnootherrivals.Now,theformer
monopolistwillhavetoreoptimizeandchooseanewlevel.Insodoing,themonopolistwill(asdidthenew
entrantpreviously)chooseanoutputlevelthatmaximizesprofitsgiventheoutputsoldbythenewrivalfirm.
Thisprocessofeachfirmchoosinganoutputconditionalontheother'soutputchoiceistoberepeatedat
leastasamentalexercise.Foreveryoutputchoicebytheincumbent,firm1,theentrant,firm2,isshownto
haveaunique,profitmaximizingresponseandviseversa.Cournotcalledthegraphrepresentationsof
theseresponsesReactionCurves.EachfirmhasitsownReactionCurvethatcanbegraphedintheq1q2
quadrant.ThatCournotanticipatedNashisevidencedbythefactthathedescribedtheequilibriumoutcome
ofthisprocessasthatpairofoutputlevelsatwhicheachfirm'soutputchoiceistheprofitmaximizing
responsetotheother'squantity.Otherwise,Cournotreasoned,atleastonefirmwouldwishtochangeits
productionlevel.AfurtherappealingaspectofCournot'sduopolymodelisthattheequilibriumpriceresulting
fromtheoutputchoicesofthetwofirmsisbelowthatofthepuremonopolyoutcome.Yetitisalsogreater
thanthatwhichwouldoccuriftherewerenottwofirmsbutmanyfirmsandpurecompetitionprevailed.In
otherwords,theCournotmodelcarriestheintuitiveimplicationthatmorecompetitionisbetterthanless.
TopresentCournot'sanalysismoreformallyweassumethattheindustryinversedemandcurve8islinear,
andcanbedescribedby:

whereQisthesumofeachfirm'sproduction,i.e.,thetotalamountsoldonthemarketq1istheamountof
outputchosenbyfirm1,theincumbentfirmandq2istheamountofoutputchosenbyfirm2,thenew
competitor.Asnotedearlier,weshallalsoassumethateachfirmfacesthesame,constantmarginalcostof
production,c.

Figure9.1Firm2'sdemandcurveintheCournotduopolygamedependsonfirm1'soutput

Anincreaseinq 1toq1shiftsD2,thedemandcurvefacingFirm2,downwards.

Ifwenowconsiderfirm2alone,andtakefirm1'soutput,q1,asgiven,theinversedemandcurve,facingfirm
2is:

whichisformallyidenticalto(9.1).However,fromfirm2'sperspective,thefirsttwotermsontherighthand
sidearenotpartofitsdecisionmaking,andcanbetakenasgiven.Inotherwords,thosetwotermstogether
formtheinterceptoffirm2'sperceiveddemandcurvesothatfirm2understandsthattheonlyimpactits
outputchoicehasonpriceisgivenbythelasttermoftheequation,namely,Bq2.Note,however,thatany
changeintheanticipatedoutputchoiceofthefirmwouldbecommunicatedtofirm2bymeansofashiftin
firm2'sperceiveddemandcurve.Figure9.1illustratesthispoint.
AswecanseefromFigure9.1,adifferentchoiceofoutputbyfirm1willimplyadifferentdemandcurvefor
firm2and,correspondingly,adifferentprofitmaximizingoutputforfirm2.Thus,foreachchoiceofq1there
willbeadifferentoptimallevelofq2.Wecansolveforthisrelationshipalgebraically,asfollows.Associated
witheachdemandcurveillustratedinFigure9.1thereisamarginalrevenuecurvethatistwiceassteeply
slopedasdiscussedinChapter2.Thatis,firm2'smarginalrevenuecurveisalsoafunctionofq1givenby:

Marginalcostforeachfirmisconstantatc.SettingmarginalrevenueMR2equaltomarginalcostc,as
requiredforprofitmaximization,andsolvingforq*2yieldsfirm2'sReactionCurve.ThuswehaveMR2=c,
whichimpliesthatABq12Bq*2=cor2Bq*2=AcBq1.FurthersimplificationthengivestheReaction
Curveforfirm2:

Equation(9.4)describesfirm2'sbestoutputchoice,q*2,foreverychoiceofq1.Notethattherelationshipis
anegativeone.Everyincreaseinfirm1'soutputlowersfirm2'sdemandandmarginalrevenuecurvesand,
withaconstantmarginalcost,alsolowersfirm2'sprofitmaximizingoutput.
Ofcourse,mattersworkbothways.Wemaysymmetricallyreworktheindustrydemandcurvetoshowthat
firm1'sindividualdemanddependssimilarlyonfirm2'schoiceofoutput,sothatasq2changes,sodoesthe
profitmaximizingchoiceofq1.Then,wemayanalogouslyderivefirm1'sReactionCurvegivingitsbest
choiceofq1foreachalternativepossiblevalueofq2.Bysymmetrywithfirm2,thisisgivenby:

Aswasthecaseforfirm2,firm1'sprofitmaximizingoutputlevelq*1fallsasq2increases.9TheReaction
CurveforeachfirmisshowninFigure9.2inwhichthestrategicvariablesforeachfirmandfirmoutputsare
ontheaxes.
Considerfirst,theReactionCurveoffirm1,theinitialmonopolist.Thiscurvesaysthatiffirm2produces
nothing,thenfirm1shouldoptimallyproducequantity

,whichis,infact,thepuremonopolylevel,atwhichweassumedfirm1tobeproducinginthefirstplace.
NowconsidertheReactionCurveforfirm2.Thatcurveshowsthatiffirm1wereproducingattheassumed

levelof

,thenfirm2'sbestbetistoproduceatlevel

,thatis,firm2shouldenterthemarket.However,iffirm2doeschoosethatlevel,thenfirm1willnolonger
dobestbyproducingthemonopolylevel.Instead,firm1willmaximizeprofitsbyselectingquantityq1=

.
AsCournotunderstood,noneoftheoutputorstrategycombinationsjustdescribedcorrespondstoan
equilibriumoutcome.Ineachcase,thereactionofonefirmisbaseduponachoiceofoutputfortheother
firmthatisnot,itself,thatotherfirm'sbestreactiontotheinitialchooser'sselection.Fortheoutcometobe
anequilibrium,itmustbethecasethateachfirmisrespondingoptimallytothe(optimal)choiceofitsrival.
Forthattobethecasethough,requiresthatbothfirmsbeontheirrespectiveReactionCurves.This
happensatonlyonepointinFigure9.2,namely,theintersectionofthetwoReactionCurves.

Figure9.2Bestresponse(Reaction)curvesfortheCournotduopolymodel

Toseehowthisworks,recalltheReactionFunctionforfirm2:q*2=

.Weknowandfirm2knowsthatinanequilibrium,firm1mustalsobeonitsReactionCurve,orthatq*1=

.Substitutingthisintofirm2'sReactionCurveallowsfirm2(andalsous)tosolvefor:

sothat

.Inturn,thisimplies:q*2=

.Becausethetwofirmsareformallyidentical,itfollowsthatq*1=

aswell.TotaloutputforthismarketisQ*=

.Substitutingthisintothedemandfunctiongivestheequilibriumprice:P=ABQ=

.Profitforeachfirmistotalrevenuelesstotalcostwhichcanbesolvedasi=

.
AsFigure9.2makesclear,theCournotduopolymodeljustpresentedhasauniqueNashequilibrium.
Unfortunately,Cournot'soriginaldiscussionsomewhatobscurestheunderlyingNashinsightthatwe
emphasizedearlier.Inparticular,Cournot'sstorysuggestsakindoftrialbyerrorlearningprocessbywhich
thetwofirmsactandreactandtherebymovealongtheirReactionCurvesuntiltheequilibriumisachieved.
ButthepoweroftheNashequilibriumisthatitmakesitunnecessarytoplayoutsuchaniterativeprocedure
inrealtime.Iftheentrant,firm2,isrationalandstrategictheninchoosingitsownproductionlevel,itmust
anticipatethattheincumbent,firm1,willdowhatevermaximizesitsprofits.Anexpectation,forinstance,by
firm2thattheincumbentwillcontinuetoproducethemonopolyoutput

afterfirm2entersandproduces

isnotarationalexpectationasthatisnotfirm1'sbestresponsetotheproductionchoicebyfirm2.Thatis,
firm2oughtnevertopredictq1=

.Theonlyrationallypredictionthatfirm2canpossiblymakeisinfactthatq1=

thevalueofq1intheNashequilibrium.Foriffirm2predictsq1tobeequalto

,thenfirm2willoptimallychoosethatoutputlevel,too.Inturn,thisoutputchoicebyfirm2issuchthatfirm1
shouldindeedproduceatthelevelof

ifitwishestomaximizeitsprofits.Ofcourse,thesameholdstrueforfirm1'sexpectationsoffirm2'soutput.
Inotherwords,foreachfirmtheonlylogicallyconsistentexpectationisthatitsrivalwillproduce

inwhichcaseeachfirmwillalsochoosetoproduceexactlythatamountandtherebyfulfilltheexpectation.
RationallystrategicfirmscanworkthroughtheCournotmodelasapurethoughtexperiment,andselectthe
uniqueNashequilibriumoutputq*i=

withoutanytimeconsumingrealworldtrialsanderrors.Forthisreason,manyeconomists,includingthe
authorsofthisbook,prefertousethetermbestresponsefunctioninsteadofReactionCurve.Thepoint
istoemphasizethatthecorrectNashinterpretationoftheCournotmodelisnotoneofactionandreaction
butoneinwhichequilibriumisachieveddirectlybyeachseller'srecognitionthatitschoicesbelogically
consistent.10
Asanumericexample,considertwofirms,UntelandCyrox,whosupplythemarketforcomputerchipsfor
toasterovens.Untel'schipsareperfectsubstitutesforCyrox'schipsandviceversa.Marketdemandfor
chipsisestimatedtobeP=12020Q,whereQisthetotalquantity(inmillions)ofchipsbought.Bothfirms
haveaconstantmarginalcostequalto20perunitofoutput.UntelandCyroxindependentlychoosewhat
quantityofoutputtoproduce.Thepricethenadjuststoclearthemarketofthetotalquantityofchips
produced.WhatquantityofoutputwillUntelproduce?WhatquantityofoutputwillCyroxproduce?Whatwill
bethepriceofcomputerchipsandhowmuchprofitwilleachfirmmake?
Let'sputourselvesonthemanagementteamatUnteltoseetheproblemfromitsperspective.Thedemand
curvethatUntelfacescanbewrittenasP=12020qc20qu,whereqcistheoutputofCyroxandquisthe
outputofUntel.Untel'smarginalrevenuecurveisMRu=12020qc40qu.Tomaximizeprofit,Untel
choosesaquantityofoutputq*usuchthatitsmarginalrevenueisequaltomarginalcost.Thatis,12020qc
40q*u=20.Thisconditionforprofitmaximizationimpliesthat:

ThisisUntel'sbestresponsefunctiondescribingitsoptimalchoiceforanygivenlevelofoutputbyCyrox.In
additionhowever,UntelknowsthatCyroxisalsoaprofitmaximizer,andsoUntelanticipatesthatCyroxwill
wanttoproduceq*ctosatisfythesamebestresponseconditionforitsprofitmaximization.Thatis,by
preciselythesameargumentthatwehavejustgonethrough,UntelknowsthatCyrox'sbestresponse
functionissimilarly:q*c=

quorq*c=

qu.UntelcanrecognizethatCyrox'schoiceofoutputdependsonUntel's.UntelalsoknowsthatCyroxknows
thatUntelisaprofitmaximizer,andthatCyroxwillanticipatethatUntelwillchooseaprofitmaximizinglevel
ofoutputq*u.Therefore,UntelpredictsthatCyroxwillchooseq*c=

q*u.SubstitutingthispredictionintoUntel'sbestresponsefunction,equation(9.6),leadsUnteltoproduce

Nowlet'sputourselvesonthemanagementteamatCyroxandrepeattheexercise.Becausethetwofirms
areidenticalthereisnoreasonwhyCyroxwoulddoanythingdifferentfromUntel,andsowecanquickly
jumptotheconclusionthatCyroxwillalsoproduceq*c=

.NotethatwhenUntelproduces

,Cyrox'sbestresponseistoproduceq*c=

,andsimilarlywhenCyroxproduces

,Untel'sbestresponseistoproduceq*u=

.AggregatemarketoutputthereforeisQ*=

,andsothepricethatclearsthemarketisP*=12020

=$53.33.Foreachfirmthemarginofpriceoverunitcostis$33.33sothateachfirmmakesaprofitof
$55.55.
9.2PracticeProblem
Assumethattherearetwoidenticalfirmsservingamarketinwhichtheinversedemandfunctionisgivenby
P=1002Q.Themarginalcostsofeachfirmare$10perunit.CalculatetheCournotequilibriumoutputs
foreachfirm,theproductprice,andtheprofitsofeachfirm.

9.5VARIATIONSONTHECOURNOTTHEME:MANYFIRMSAND
DIFFERENTCOSTS
Cournot'smodelisinsightfulinitstreatmentoftheinteractionamongfirmsandremarkablymoderninits
approach.Yetthesearenotitsonlystrengths.Cournot'sanalysishasthefurtheradvantagethat,asnoted

earlier,theresultsalsoblendwellwitheconomicintuition.InthesimpleCournotduopolymodeldescribed
above,eachfirmproducesitsNashequilibriumoutputof

,implyingthattotalindustryoutputis

.Thisisclearlygreaterthanthemonopolyoutputfortheindustry,whichwouldbeQM=

.Yetitisalsolessthantheperfectlycompetitiveoutput,QC=

,wherepriceequalsmarginalcost.Accordingly,themarketclearingpriceinCournot'smodelP=

islessthanthemonopolypricePM=

butitishigherthanthecompetitiveprice,c,whichisequaltomarginalcost.Thatis,Cournot'sduopoly
modelhastheintuitivelyplausibleresultthattheinteractionoftwofirmsyieldsmoreindustryoutputata
lowerpricethanwouldoccurunderamonopoly,butlessoutputatahigherpricethanresultsunderperfect
competition.
ItisnaturaltoaskiftheforegoingresultgeneralizestotheCournotmodelwhenthenumberoffirmsgrows
tothree,four,orN.Thatis,wouldintroducingathirdfirmbringtheindustrystillclosertothecompetitive
idealand,ifso,wouldafourthbringuscloserstill?IstheCournotmodelconsistentwiththenotionthatwhen
therearemanyfirmsthepriceconvergestomarginalcost?
Theanswertothisquestionisstraightforwardinthelineardemandframeworkwehavebeenusing.Tosee
this,assumethatinsteadoftwothereareNidenticalfirms,eachproducingthesamehomogenousgood
andeachwiththesame,constantmarginalcostc.IndustrydemandisagaingivenbyP=ABQwhereQis
aggregateoutput.However,nowwehavethatQ=q1+q2+...+qN=

qisothatP=AB

qi,whereqiistheoutputoftheithfirm.Inturn,thismeansthatwecanwritethedemandcurvefacingjusta
singlefirm,sayfirm1,as:P=(ABq2Bq3...BqN)Bq1.Theparentheticalexpressionreflectsthe
factthatforfirm1,thissumisbeyonditscontrolandmerelyappearsastheinterceptinfirm1'sdemand
curve.ItisconvenienttousethenotationQ1asashorthandmethodofdenotingthesumofallindustry
outputexceptthatoffirm1's.Usingthisnotation,wecanwritefirm1'sdemandcurveevenmoresimplyas:

P=ABQ1Bq1.Clearly,firm1'sprofitsdependonbothQ1,overwhichithasnocontrol,anditsown
productionlevel,q1,whichitisfreetochoose.Givenitsconstantunitcostofc,firm1'sprofits1canbe
writtenas:1(Q1,q1)=(ABQ1Bq1)q1cq1.Inturn,thetwiceassteepruleimpliesthatfirm1's
marginalrevenueisgivenbyABQ12Bq1.Hence,theconditionMR=MCnecessaryforprofit
maximizationimplies:

Solvingthisequationforq*1givesusthebestresponsefunctionforfirm1:

Becauseallfirmsareidentical,wecanextendthissamelogictodevelopthebestresponsefunctionforany
firm.Usingthesameshorthandnotation,wecanuseQitomeanthetotalindustryproductionexcludingthat
offirmi.Thebestresponsefunctionforanyfirmiis:

InaNashequilibrium,eachfirmichoosesabestresponse,q*i,thatreflectsacorrectpredictionofthe
outputsthattheotherN1firmswillchoose.DenotebyQ*ithesumofalltheoutputsexcludingq*iwhen
eachelementinthatsumiseachfirm'sbestoutputresponsedecision.Thenanalgebraicrepresentationof
theNashequilibriumis:

However,sincetheNfirmsareidentical,eachwillproduceinequilibriumthesameoutput,thatis,q*1=q*2=
...=q*N,orjustq*forshort.Hence,foranyfirmi,wemusthaveQ*i=(N1)q*.Therefore,wecanwrite
equation(9.11)as:

fromwhichitfollowsthattheequilibriumoutputforeachfirmintheCournotNashequilibriumis:

IfeachoftheNfirmsproducesq*asgivenbyequation(9.13),thenwemayeasilyderivetheCournotNash
equilibriumindustryoutput,Q*=Nq*,andtheCournotNashequilibriumindustryprice,P*=ABQ*,as:

Examinethetwoequationsin(9.14)carefully.Recallthat
isthecompetitiveindustryoutput.Thus,forthelineardemandandconstantcostcase,theNfirmCournot
modelindustryoutputis
timesthecompetitiveoutput.Thisrule,sometimescalledthe

rulepredicts(correctly)thatthemonopolyoutputisofthecompetitiveoutput.Aswemovetoaduopoly,
therulesaysthatindustryoutputrisesto2/3ofthecompetitiveoutput.Atthreefirms,theproportionrisesto
3/4andsoon.Inotherwords,ourearlierresultdoesgeneralize.TheCournotmarketoutputrises
progressivelyclosertothecompetitiveoutputasthenumberoffirmsNrises.Likewisecloseinspectionof
thepriceequation(9.14)revealsthattheequilibriumCournotpricecorrespondinglymovesprogressively
closertothecompetitiveequilibriumpriceP=casNrises.
Inshort,theCournotmodelimpliesthatasthenumberofidenticalfirmsinthemarketgrows,theindustry
equilibriumgetscloserandclosertothatprevailingunderperfectcompetition.Thatis,forthissymmetric
case,theCournotmodelhastheappealingfeaturethatitpredictsmarketoutcomeswillimproveasmarket
concentrationfalls.
Whatifthefirmscompetinginthemarketarenotidentical?Specifically,whatifeachfirmhasadifferent
marginalcost?Wefirsthandlethisquestionforthecaseoftwofirms.Assumethatthemarginalcostsoffirm
1arec1andoffirm2arec2.Weusethesameapproachasbeforewiththeduopolymodel,startingwiththe
demandfunctionforfirm1,whichwecanwriteas:
TheassociatedmarginalrevenuefunctionisMR1=(ABq2)2Bq1.
Asbefore,firm1maximizesprofitbyequatingmarginalrevenuewithmarginalcost.ThussettingMR1=c1
andsolvingforq1givesthebestresponsefunctionforfirm1as:
Byanexactlysymmetricargument,thebestresponsefunctionforfirm2is:
NoticethattheonlydifferencefromourinitialanalysisoftheCournotmodelisthatnoweachfirm'sbest
responsefunctionreflectsitsownspecificmarginalcost.
Animportantfeatureofthesebestresponsefunctionsthatisobscuredwhenthefirmsareidenticalisthat
thepositionofeachfirm'sbestresponsefunctionisaffectedbyitsmarginalcost.Forexample,ifthe
marginalcostoffirm2increasesfromsay,c2toc2,itsbestresponsecurvewillshiftinwards.
Figure9.3illustratesthispoint.Itshowsthebestresponsefunctionforeachfirmassuminginitiallythateach
firmhasidenticalcostsasinFigure9.2.Itthenshowswhathappenswhenfirm2'sunitcostrises.As
equation(9.15b)makesclear,thiscostincreaselowersfirm2'sbestoutputresponseforanygivenlevelof
q1.Thatis,itshiftsfirm2'sbestresponsecurveinward.Thischangeinfirm2'sbestresponsefunction
affectstheequilibriumoutputsthatthetwofirmswillchoose.Asyoucanseefromthediagram,anincrease
infirm2'smarginalcostleadstoanewequilibriuminwhichfirm1producesmorethanitdidintheinitial
equilibriumandfirm2producesless.Thismakesintuitivesense.Weshouldexpectthatlowcostfirmswill
generallyproducemorethanhighcostfirms.Thechangesarenotoffsetting,however.Firm2'soutputfalls
bymorethanfirm1'sproductionrisessothatthenewequilibriumischaracterizedbylessoutputintotal
thanwastheoriginalequilibrium.(Canyousaywhy?)
Figure9.3TheCournotduopolymodelwithdifferentcostsacrossfirms
AriseinFirm2'sunitcostshiftstheFirm2BestResponseFunctiondownwardfromR2toR2.Inthenewequilibrium,Firm1producesmoreandFirm
2produceslessthanpreviously.

TheCournotNashequilibriumcanbeobtainedasbeforebysubstitutingtheexpressionforq*2intofirm1's
bestresponsetosolveforq*1.Thenwemayusethisvaluetosolveforq*2.Inotherwords,wehave:

whichcanbesolvedforq1togivetheequilibrium:
Byanexactlysymmetricargument,theequilibriumoutputforfirm2is:
Itiseasytocheckthattherelativeoutputsofthesetwofirmsaredeterminedbytherelativemagnitudesof
theirmarginalcosts.Thefirmwiththelowermarginalcostswillhavethehigheroutput.
Let'sreturntoourUntelandCyroxexampleofthetwofirmswhoproducecomputerchipsfortoasterovens
butnowchangethisstoryabit.WhilewestillassumethatUntel'schipsareperfectsubstitutesforCyrox's
chipsandviceversa,wenolongerassumethattheyhaveidenticalcosts.Instead,wenowassumethat
Untelisthelowcostfirmwithaconstantunitcostof20,andCyroxisthehighcostproducerwithaconstant
unitcostof40.MarketdemandforchipsisstillestimatedtobeP=12020Q,whereQisthetotalquantity
(inmillions)ofchipsbought.WhatnowhappenswhenUntelandCyroxindependentlychoosethequantityof
outputtoproduce?WhatquantityofoutputwillUntelproduce?WhatquantityofoutputwillCyroxproduce?
AgainweputourselvesonthemanagementteamatUnteltoseetheproblemfromUntel'sperspective.The
demandcurvethatUntelfacesisstillP=12020qc20qu,whereqcistheoutputofCyroxandquisthe
outputofUntel.Untel'smarginalrevenueisagainMRu=12020qc40qu.Tomaximizeprofit,Untelshould
sellaquantityofoutputq*usuchthatatthatquantitymarginalrevenueisequaltomarginalcost.Thatis,120
20qc40q*u=20,andsotheconditionforprofitmaximizationimpliesthat:
Untel'sprofitmaximizingchoiceofoutputstilldependsontheoutputthatthehighercostrival,Cyrox,
choosestoproduce.Equallyimportantly,acomparisonofequation(9.16)with(9.6)indicatesthatUntel's
bestresponsefunctionisunaffectedbytheassumedincreaseinCryox'smarginalcost.WhataboutCryox?
Bythesameargument,thedemandcurvethatCryoxfacesisP=12020qu20qcanditsmarginal
revenuecurveisMRc=12020qu40qc.Equatingthiswithmarginalcostof40andsolvingforqcgivesthe
bestresponsefunctionforCryoxofq*c=
quorq*c=
qu.Asweexpected,thebestresponsefunctionforCryoxisshifteddownwardbytheassumedincreaseinits
marginalcost.
UntelknowsthathighercostCyroxisalsoaprofitmaximizerandthereforeanticipatesthatCyroxwillwantto
produceq*cthatmaximizesitsprofit.Itisalsothecase,asitwasbefore,thatUntelknowsthatCyroxknows
thatUntelisaprofitmaximizer,andsoknowsthatCyroxwillanticipatethatUntelwillchooseaprofit
maximizinglevelofoutputq*u.AllofthisimpliesthatUntelpredictsthatCyroxwillchooseq*c=2
q*u.SubstitutingthisnewpredictionintoUntel'sbestresponsefunctionleadsUnteltoproduceq*u=
q*c=

q*u=2.
NowweputourselvesonthemanagementteamatCyroxandrepeattheexercise.Tocuttothechase,we
knowthatCyrox'sbestresponseisq*c=2

qu.MoreoverweknowthatCyroxwillpredictthatUntelwillproduceabestresponsethatisbasedona
predictionthatCyroxwillalsoproduceabestresponse.Thatis,CryroxpredictsthatUntelwillproduceq*u=
q*c.SubstitutingthispredictionintoCyrox'sbestresponsefunctionleadsto:q*c=2
q*u=2

q*c=1.AgainnotethatwhenUntelproduces2,Cyrox'sbestresponseistoproduceq*c=1,andsimilarly
whenCyroxproduces1,Untel'sbestresponseistoproduceq*u=2.
Althoughtheforegoinganalysisislimitedtojusttwofirms,itstillyieldsimportantinsights.First,thereisa
disadvantagetobeingahighcostfirm.Itmeansasmallermarketshareandlessprofit.Second,whilethe
disadvantageisrealitisnotfatal.Ahighcostfirmisnotdrivenoutofbusiness,Itissimplylesssuccessful
thanitsostrival.Finally,whencostsvaryacrossfirms,theequilibriumCournotoutputQ*isnotonlytoolow
(i.e.,lessthanthecompetitivelevel),itisalsoproducedinefficiently.AsweknowfromChapter4,efficient
productionamongtwoormorefirmswouldallocateoutputsuchthat,inthefinalconfiguration,eachfirm's
marginalcostisthesame.Thiswouldbetheoutcome,forexample,iftheindustrywerecomprisedofa
single,profitmaximizingmultiplantmonopolist.Itwillalsoobtainunderperfectcompetition.However,the
noncooperativefeatureoftheCournotNashequilibriummeansthatfirms'marginalcostsarenot
equalized.11Hence,theoutputallocationatequilibriumwhencostsaredifferentisnotanefficientone.
9.3PracticeProblem
Whatisaggregateoutput,marketprice,Untel'sprofit,andCyrox'sprofitfortheabovecaseinwhichUntelis
thelowcostproducerandCyroxthehighcostone?Compareyouranswerstotheonesyouworkoutwhen
thetwofirmsareidenticalandhaveaconstantunitcostof20.

9.6CONCENTRATIONANDPROFITABILITYINTHECOURNOT
MODEL
Let'snowtrytocombinethecaseofmanyfirmstogetherwiththeassumptionofnonidenticalcosts.Thatis,
let'sanalyzetheCournotmodelwithNfirms,eachwithitsown(constant)marginalcostsuchthatthe
marginalcostoffirmiisci.Wecanusethefirstorderconditionforprofitmaximizationforeachfirmi,
equation(9.8),andsubstituteciforcinthisequation.Thisgivesusthefollowing:
whereQiagainisshorthandfortheindustryproductionaccountedforbyallfirmsotherthantheithone.
InaNashequilibrium,theequilibriumoutputq*iforeachfirmimustsatisfythefirstorderprofitmaximizing
condition.Hence,intheNashequilibrium,thetermQimustbethesumoftheoptimaloutputsq*jforeachof
thenotifirms.DenotethisequilibriumsumasQ*i.Thenwecanrewrite(9.18)as:
Bydefinition,thetotalequilibriumoutput,Q*,equalsthesumofQ*iandq*i.Hence,(9.19)impliesthat
whichcanbereorganizedtogive:

WealsoknowthattheNashequilibriumprice,P*,isobtainedbysubstitutingtheNashequilibriumoutputinto
theindustrydemandcurveyielding,P*=ABQ*.Substitutionintoequation(9.20)thenyields:
Dividingbothsidesofequation(9.21)byP*andmultiplyingtherighthandsideby
,weobtain:
wheres*i=
istheithfirm'smarketshareinequilibrium.
Let'sconsiderequation(9.22)stepbystep.Thelefthandsidetermisthedifferencebetweenthepriceand
firmi'smarginalcostasaproportionofmarketprice.ThisisjusttheLernerIndexofMonopolyPowerthat
wemetinChapter3.Thenotionisthatthegreaterfirmi'smarketpower,thegreateritsabilitytokeepprice
abovemarginalcost.
Therighthandsideof(9.22)hastwoterms.Thefirstistheslopeofindustrydemandcurvetimestheratio
ofindustryoutputtoprice.ButtheslopeisjustB=P/Qsothatwehave
.Recallthedefinitionofthepriceelasticityofdemand:=
.Sothefirsttermontherighthandsideofequation(9.22)isjusttheinverseofthepriceelasticityof
demand.Thesecondtermisjustthemarketshareoftheithfirm,thatis,itsoutputrelativetototalindustry
output.Hence,equation(9.22)mayberewrittenas:
whereisthepriceelasticityofindustrydemand.
Equation(9.23)isafurtherimplicationoftheCournotmodel,nowextendedtoallowformanyfirmswith
differingcosts.Whatitsaysisthis:Afirmthatproducesinanindustrywheredemandisrelativelyinelastic
andwhereithasarelativelylargemarketsharewillalsobeafirmwithasubstantialdegreeofmarketpower
asmeasuredbytheLernerIndexorthefirm'spricemarginalcostdistortion.
Therelationshipdescribedinequation(9.23)tellsusaboutmarketpoweratthelevelofthefirm.InChapter
3,wediscussedthestructureconductperformance(SCP)paradigminindustrialorganizationthatlinked
marketpower,asmeasuredbytheLernerIndex,tothestructureoftheindustry.Thequestionthatremains
iswhetherwecanextendtherelationshipinequation(9.23)atthefirmleveltotheleveloftheentire
industry.
Toseehow,let'sfirstmultiplyeachsideofequation(9.23)bythefirm'smarketshare,s*i.Thenaddtogether
themodifiedequationforfirm1withthatforfirm2andthatforfirm3andsoonuntilweaddtogetherallN
modified(9.23)equations.ThelefthandsideofthissumofNequationsis:
RealityCheckpoint
CournotTheoryandPublicPolicy:The1982MergerGuidelines
InourreviewofantitrustpolicyinChapter1,wenotedthedramaticchangeinpolicyregardingthetreatment
ofmergersthatoccurredin1982.Inthatyear,theDepartmentofJusticeissuedanewversionofits

HorizontalMergerGuidelines.Thisversionreplacedtheoriginalguidelinesissuedin1968.Likethatfirstset
ofguidelines,the1982documentspecifiedtheconditionsunderwhichthegovernmentwouldchallenge
horizontalmergers.Unliketheirpredecessor,however,thenewguidelineswerebasedexplicitlyonthe
HerfindahlIndex.Specifically,theystatedthatamergerwouldnotbechallengediftheindustryHerfindahl
Indexwaslessthan1,000.Amergerwouldalsonotbechallengediftheindexwasover1,000butlessthan
1,800andifthemergerdidnotraisetheHerfindahlIndexbyover100points.IftheHerfindahlIndex
exceeded1,800points,thenanymergerthatraisedtheindexbyover50pointswouldcauseconcernand
likelybechallenged.
WewilldiscusstheseguidelinesandtheirmorerecentmodificationsagaininChapter15.Fornow,thepoint
tonoteisthattheexplicituseoftheHerfindahlIndexmaybeviewedasabowtotheCournotmodelwhich,
asshowninthetext,directlyconnectsthatindextothepricecostmarginmeasureofmonopolypower.
Source:DepartmentofJustice,HorizontalMergerGuidelines(1982,1984).
where
istheweightedaverageunitcostofproduction,theweightsbeingthemarketsharesofthefirmsinthe
industry.TherighthandsideofthesummedNequationsis:
whereHIistheHerfindahlIndexthatwedefinedasameasureofconcentrationinChapter4(here
expressedusingfractionalshares,e.g.,a10percentshareisrecordedassi=0.10).Thereforeequation
(9.23)aggregatedattheleveloftheindustryimpliesthat:
OurgeneralizedCournotmodelthusgivestheoreticalsupportfortheviewthatasconcentration(here
measuredbytheindustry'sHerfindahlIndex)increases,pricesalsorisefurtherandfurtherabovemarginal
cost.
Avariantoftherelationshipinequation(9.24)wastestedinMarionetal.(1979)forfoodproducts.They
collectedpricedataforabasketofninetyfourgroceryproducts,andmarketsharedataforthirtysixfirms
operatinginthirtytwoUSStandardMetropolitanStatisticalAreas,andfoundthatpriceissignificantlyhigher
inmarketswithahigherHerfindahlIndex.Likewise,Marvel(1989)foundthatfortwentytwoUScities,
concentrationintheretailmarketforgasoline,asmeasuredbytheHerfindahlIndex,hadasignificantimpact
ontheaveragepriceofgasoline.

9.7EMPIRICALAPPLICATION:COURNOTCOMPETITIONINAN
AIRLINEDUOPOLY
TheexamplesabovesuggestthatatleastsomeoftheimplicationsoftheCournotmodelareconsistentwith
realworlddata.However,suchresultsmightalsobecompatiblewithothermodelsaswellthatdifferinan
importantrespectfromthepreciseassumptionsoftheCournotmodelpresentedinthischapter.Onesuch
differenceconcernstheCournotfirm'sunderstandingofhowrivalswillreacttoitsoutputchoice.
Consideragainthebasicduopolymodelwithalineardemandcurve:P=ABQ.Asbefore,assumeaswell
thateachfirmhasaconstantmarginalcostci.Aswedescribedabove,theindustrydemandperceivedby
eachfirmisdescribedbyP=ABq1Bq2.Considerfirm1.TheCournotmodelhypothesisisthatin

calculatingtheimpactofchangesinitsoutput,i.e.,incalculatingitsmarginalrevenue,firm1assumesthat
firm2'soutputisunchanged.Hence,asinequation(9.3),theprofitmaximizingoutputforfirm1satisfies
MR1=ABq22Bq1=c.However,wewanttowritethisequationslightlydifferentlytomakeakeypointof
theCournotmodel.RecognizingthatABq1Bq2=P,wecanrewritefirm1'sprofitmaximizingcondition
asfollows:
ThetermB=
isofcoursetheslopetermthatsimplycharacterizesthe(negative)effectontheindustrypriceofchangesin
industryoutput.Itspresencereflectsthefactthatwhenfirm1makesasmallmarginalincreaseinitsown
output,q1,theCournotassumptionthatq2doesnotchangeimpliesthatQ=q1sothattheresultantfall
inpriceisB.Multiplyingthisoverfirm1'scurrentoutputthencapturesthedownsideoffurtherincreasesin
q1.Similarly,theCournotmodelassumesfirm2alsoexpectsnoreactiontoasmallchangeinitsoutputq2
sothatitperceivesQ=q2.
Itispossible,however,thatinsteadofnoresponseeachfirmanticipatesthatitsrivalwilladjustitsoutputas
theinitialfirmchangesitsownproduction.Thatis,firm1maybelievethatq2=vq1sothatwhenfirm1
changesitsoutput,thetotalchangeinindustryoutputisnowQ=(1+v)q1.Likewise,firm2maybelieve
thatQ=(1+v)q2.Asaresult,themovementinpricefromasmallincreaseatthemargininfirm1's
outputwillbeB(1+v).Hence,theprofitmaximizingfirstorderconditioninequation(9.25)nowbecomes:
Symmetrically,firm2'sprofitmaximizingconditionisnow:
Becausetheparametervreflectsthefirm'sconjectureregardingtheoutputresponsetheirownchoiceswill
induce,itisoftenreferredtoastheconjecturalvariationsparameter.Withalittleintuition,wecanuse
equations(9.26a)and(9.26b)toputsomeboundsonthevaluesthatvcantake.Inthisregard,observethat
ifv=1,thetwoequationsimplyP=c.Thatis,v=1correspondstoperfectcompetitivebehaviorinwhich
priceisdriventomarginalcost.Toseetheimplicationifv=1,recallfromChapter2thatthemonopoly
outputisQM=
,sothatthemonopolypriceisPM=
.Assumethateachfirmproduceshalfthemonopolyoutputaswouldbethecaseifthefirmsactedlikea
cartel.Hence,q1=q2=
.ThenouradjustedequationseachyieldP=
,i.e.,themonopolyprice.Thus,ourconjecturalvariationsparametermustliebetweenalowerboundofv=
1reflectingperfectlycompetitivebehaviorandanupperboundofv=+1reflectingcartelormonopoly
behavior.Theintermediatevalueofv=0reflectsCournotbehavior.
Table9.4EstimatedconjecturalvariationparametervforAmericanairlinesandUnitedairlinesin33city
marketspairedwithChicago
Letusnowallowforthetwofirmstohavedifferentmarginalcostsciandthereforedifferentmarketsharessi.
Thenrecognizingthatfirmi'soutputqi=siQwemaygeneralizeequations(9.25a)and(9.25b)asfollows:

SolvingforviandrecognizingthatB=
sothat
,whereistheelasticityofdemand(expressedasapositivenumber),equation(9.27)mayberewrittenas:
BranderandZhang(1990)usedatafromthirtythreeairlineroutesemanatingfromChicagointhe1980s
thatwereservedbyjustthetwocarriers,AmericanAirlinesandUnitedAirlines.Theirbaselinecaseusesan
assumedelasticityof=1.6(basedonotherresearch)andmarginalcostestimatesderivedfromthe
operatingexpensesforeachfirm(includinganallowanceformarginalcosttovarywiththelengthofthe
flightwithanelasticityof0.5).TheircalculatedvivaluesforeachfirmineachmarketareshowninTable9.4
above.
Theroughcalculationbehindthesemeasuresimpliesthattheywillincludeafairbitofnoise.Evenso,the
overwhelmingmajorityor57ofthe66estimatedviparametersliewithinthetheoreticalupperandlower
boundsof1and1.Moreimportantly,theestimatedmeanisverycloseto0forbothfirmsandacrossthe
entiresample.Classicalstatisticaltestswouldrejectthenullhypothesisthatvequalseither1or1They
wouldnotrejecttheCournothypothesisthatv=0.Thus,thisroughexercisegivesfairlystrongsupportto
theCournotmodelasausefuldescriptionofrealworldbehavior.

Summary
Forindustriespopulatedbyarelativelysmallnumberoffirms,strategicinteractionisafactoflife.Eachfirm
isawareofthefactthatitsdecisionshaveasignificantimpactonitsrivals.Eachfirmwillwanttotake
accountoftheanticipatedresponseofitsrivalswhendeterminingitscourseofaction.Itisreasonableto
believethatfirms'anticipationsorexpectationsarerational.
Gametheoryisthemodernformaltechniqueforstudyingrationalstrategicinteraction.Eachplayerina
gamehasasetofstrategiestochoosefrom.Astrategycombinationisasetofstrategiesoneforeach
player.Eachsuchstrategycombinationimpliesaparticularpayofforfinaloutcomeforeachplayer.ANash
equilibriumisastrategycombinationsuchthateachplayerismaximizinghisorherownpayoffgiventhe
strategieschosenbyallotherplayers.InaNashequilibrium,noplayerhasanincentivetochangebehaviors
unilaterally.
Inthischapter,wepresentedthewellknownCournotmodelofcompetition.Itisastaticorsinglemarket
periodmodelofoligopoly.Althoughthismodelwasdevelopedpriortothedevelopmentofformalgame
theory,theoutcomeproposedbyCournotcapturesbasicgametheoreticprinciples,specificallytheNash
equilibriumsolution.
TheCournotmodelmakescleartheimportanceoffirmsrecognizingandunderstandingtheir
interdependence.Themodelalsohastheniceintuitiveimplicationthatthedegreeofdeparturefrom
competitivepricingmaybedirectlylinkedtothestructureoftheindustryasmeasuredbytheHerfindahl
Index.WhiletheCournotmodelisnottheonlygametheoreticmodelofimperfectcompetition,anumberof
itspredictionsareborneoutbyempiricalevidence.

Itisimportanttorememberthoughthat,aspointedoutinChapter4,marketstructureisendogenous.
Strategiesthatgenerateabovenormalprofitsforexistingfirmswillinducenewfirmstoenter.Atthesame
time,incumbentfirmsmaybeabletotakeactionsthatdetersuchentry.Weneedtoextendouranalysisin
waysthatallowustoexaminetheseissues.
Further,theCournotmodelstudiedinthischapterhasfirmsinteractingonlyonce.Thereality,ofcourse,is
thatfirmsareinvolvedinstrategicinteractionsrepeatedly.Insuchasetting,issuessuchaslearning,
establishingareputation,andcredibilitycanbecomequiteimportant.Weturntoaconsiderationofhowthe
natureofstrategicinteractionovertimeaffectsmarketstructureinChapters1113.

Problems
1.HarrisonandTyleraretwostudentswhometbychancethelastdayofexamsbeforetheendofthe
springsemesterandthebeginningofsummer.Fortunately,theylikedeachotherverymuch.
Unfortunately,theyforgottoexchangeaddresses.Fortunately,eachremembersthattheyspokeof
attendingacampuspartythatnight.Unfortunately,therearetwosuchparties.Onepartyissmall.Ifeach
attendsthisparty,theywillcertainlymeet.Theotherpartyishuge.Ifeachattendsthisone,thereisa
chancetheywillnotmeetbecauseofthecrowd.Ofcourse,theywillcertainlynotmeetiftheyattend
separateparties.Payoffstoeachdependingonthecombinedchoiceofpartiesareshownbelow,with
Tyler'spayoffslistedfirst.
1.IdentifytheNashequilibriaforthisproblem.
2.IdentifytheParetooptimaloutcomeforthistwopartysystem.
2.SupposethatthesmallpartyofProblem1ishostedbytheOutcasts,twentymenandwomenstudents
tryingtoorganizealternativestotheexistingcampuspartyestablishment.AlltwentyOutcastswillattend
theparty.ButmanyotherstudentsnotunlikeHarrisonandTyleronlygotoapartytowhichothers(no
oneinparticular,justpeopleingeneral)areexpectedtocome.Asaresult,totalattendanceAatthesmall
partydependsonjusthowmanypeopleXeveryoneexpectstoshowup.LettherelationshipbetweenA
andXbegivenby:A=20+0.6X
1.Explainthisequation.Whyistheintercept20?WhyistherelationbetweenAandXpositive?
2.Iftheequilibriumrequiresthatpartygoers'expectationsbecorrect,whatistheequilibriumattendance
attheOutcasts'party?
3.AgameknownwelltobothacademicsandteenageboysisChicken.Twoplayerseachdrivetheircar
downthecenterofaroadinoppositedirections.EachchooseseitherSTAYorSWERVE.Stayingwins
adolescentadmirationandabigpayoffiftheotherplayerchoosesSWERVE.Swervinglosesfaceand
hasalowpayoffwhentheotherplayerstays.Badasthatis,itisstillbetterthanthepayoffwhenboth
playerschooseSTAYinwhichcasetheyeacharebadlyhurt.Theseoutcomesaredescribedbelowwith
PlayerA'spayoffslistedfirst.
1.FindtheNashequilibriainthisgame.
2.Thisisagoodgametointroducemixedstrategies.IfPlayerAadoptsthestrategySTAYonefifthofthe
time,andSWERVEfourfifthsofthetime,showthatPlayerBwillthenbeindifferentbetweeneither
strategy,STAYorSWERVE.
3.Ifbothplayersusethisprobabilitymix,whatisthechancethattheywillbothbebadlyhurt?

4.Youareamanagerofasmallwidgetproducingfirm.Thereareonlytwofirms,includingyours,that
producewidgets.Moreoveryourcompanyandyourcompetitor'sareidentical.Youproducethesame
goodandfacethesamecostsofproductiondescribedbythefollowingtotalcostfunction:TotalCost=
1500+8qwhereqistheoutputofanindividualfirm.Themarketclearingprice,atwhichyoucansell
yourwidgetstothepublic,dependsonhowmanywidgetsbothyouandyourrivalchoosetoproduce.A
marketresearchcompanyhasfoundthatmarketdemandforwidgetscanbedescribedas:P=2002Q
whereQ=q1+q2,whereq1isyouroutputandq2isyourrivals.TheBoardofDirectorshasdirectedyou
tochooseanoutputlevelthatwillmaximizethefirm'sprofit.Howmanywidgetsshouldyourfirmproduce
inordertoachievetheprofitmaximizinggoal?MoreoveryoumustpresentyourstrategytotheBoardof
Directorsandexplaintothemwhyproducingthisamountofwidgetsistheprofitmaximizingstrategy.
5.Youarestillamanagerofasmallwidgetproducingfirm.Nowhowevertherearefourteensuchfirms
(includingyours)intheindustry.Eachfirmisidenticaleachoneproducesthesameproductandhasthe
samecostsofproduction.Yourfirm,aswellaseachoneoftheotherfirms,hasthesametotalcost
function,namely:TotalCost=200+50qwhereqistheoutputofanindividualfirm.Thepriceatwhich
youcansellyourwidgetsisdeterminedbymarketdemand,whichhasbeenestimatedas:P=290
QwhereQisthesumofalltheindividualfirmsproducinginthisindustry.So,forexample,if120widgets
areproducedintheindustrythenthemarketclearingpricewillbe250,whereasif300widgetsare
producedthenthemarketclearingpricewillbe190.TheBoardofDirectorshasdirectedyoutochoose
anoutputlevelthatmaximizesthefirm'sprofit.Youhaveanincentivetomaximizeprofitsbecauseyour
jobandsalarydependupontheprofitperformanceofthiscompany.Moreoveryoushouldalsobeableto
presentyourprofitmaximizingstrategytotheBoardofDirectorsandexplaintothemwhyproducingthis
amountmaximizesthefirm'sprofit.
6.TheinversemarketdemandforfaxpaperisgivenbyP=4002Q.Therearetwofirmswhoproducefax
paper.Eachfirmhasaunitcostofproductionequalto40,andtheycompeteinthemarketinquantities.
Thatis,theycanchooseanyquantitytoproduce,andtheymaketheirquantitychoicessimultaneously.
1.ShowhowtoderivetheCournotNashequilibriumtothisgame.Whatarefirms'profitsinequilibrium?
2.Whatisthemonopolyoutput,i.e.,theonethatmaximizestotalindustryprofit?Whyisn'tproducing
onehalfthemonopolyoutputaNashequilibriumoutcome?
7.ReturntoProblem6,butsupposenowthatfirm1hasacostadvantage.Itsunitcostisconstantand
equalto25whereasfirm2stillhasaunitcostof40.WhatistheCournotoutcomenow?Whatarethe
profitsforeachfirm?
8.WecanusetheCournotmodeltoderiveanequilibriumindustrystructure.Forthispurpose,wewilldefine
anequilibriumasthatstructureinwhichnofirmhasanincentivetoleaveorentertheindustry.Ifafirm
leavestheindustry,itentersanalternativecompetitivemarketinwhichcaseitearnszero(economic)
profit.Ifanadditionalfirmenterstheindustrywhentherearealreadynfirmsinit,thenewfirm'sprofitis
determinedbytheCournotequilibriumwithn+1firms.Forthisproblem,assumethateachfirmhasthe
costfunction:C(q)=256+20q.Assumefurtherthatmarketdemandisdescribedby:P=100Q.
1.Findthelongrunequilibriumnumberoffirmsinthisindustry.
2.Whatindustryoutput,price,andfirmprofitlevelswillcharacterizethelongrunequilibrium?

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1CocaColaisokayhasbeenclaimedtobeunderstoodinmoreplacesbymorepeoplethananyother

sentence(Tedlow1996).
2Agoodtextbookthatoffersamoreformaltreatmentofgametheoryanditsapplicationstoeconomicsis

Rasmusen(2007).
3Nashsharedthe1994prizewithtwoothergametheorists,R.SeltenandJ.Harsanyi.Theawardtothe

threegametheoristsservedaswidelypublicizedrecognitionoftheimportancegametheoryhasachieved
asawayofthinkingineconomicanalysis.SeeSchelling's(1960)seminalworkformuchoftheintuitive
foundationofstrategicanalysis.
4Competitivefirmshavenooptionastowhichchoicevariablepriceorquantitytoselect.Competitive

firmsbydefinitioncannotmakeapricechoice.Theyarepricetakersandcanonlychoosethequantityof
outputtheysell.
5Theimportantaspectofsimultaneousgamesisnotthatthefirmsinvolvedactuallymaketheirdecisionsat

thesametime.Rather,itisthatnofirmcanobserveanyotherfirm'schoicebeforemakingitsown.Thislack
ofinformationmakestheactionsofeachfirmeffectivelysimultaneous.

6Iftheprocesscontinuesuntilonlyonestrategyremainsforeachplayer,thenwehavefoundaniterated

dominanceequilibrium.
7Somecareneedstobetakeninrulingoutdominatedstrategies.Whileonecaneliminatestrictlydominated

strategiesasarationalchoice,weaklydominatedstrategiescannotbesoruledout.Astrategyisweakly
dominatedifthereexistssomeotherstrategy,whichispossiblybetterbutneverworse,yieldingahigher
payoffinsomestrategycombinationsandneveryieldingalowerpayoff.TheNashequilibriummaybe
affectedbytheorderofexclusionofweaklydominatedstrategies.SeeMasColell,etal.(1995),23841.
8SeeGreenandNewberry(1992)foramodelinwhichfirmscompeteinsupplyschedulesrelatingthe

volumeofoutputofferedtoaspecificprice.SeealsoWolfram(1999).
9Wecouldalternativelysolveforq* bywritingfirm2'sprofitfunction,2,asrevenuelesscost,or: (q ,
2
2
1
2
q2)=(ABq1Bq2)q2cq2=(ABq1c)q2Bq2 .Whenwedifferentiatethisexpressionwithrespect

toq2andsettheresultequalto0,(firstorderconditionformaximization),andthensolveforq*2,wegetthe
sameresultasequation(9.4).Asimilarproceduremaybeusedtoobtainq*1.
10Friedman(1977)includesabriefdiscussionoftheseissues,particularlyvaluabletothoseinterestedin

thehistoryofeconomicthought.HenotesthatCournot'sfatewasnotquiteoneoftotalobscurityowingto
hisfriendshipwiththefatheroftheFrencheconomistWalras.TheEnglisheconomistMarshallapparently
wasalsowellawareofandinfluencedbyCournot'swork.
11Ourexampleassumedconstantbutdifferentmarginalcostsacrossfirms.Thesameinsightcouldbe

easilyobtainedforthemoregeneralpresentationinwhichthemarginalcostoffirmi,ci,isageneralfunction
ofitsoutput,qi,asinci=ci(qi).