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5.

Oligopoly

We have already studied a competitive industry as well as a monopoly. Those


are two extreme market structures. Both share the feature that the firm is a
decision maker who maximizes her objective taking market conditions (the
price or the demand curve) as given.
When there are several firms in a market, but not enough to justify assuming perfect competition, then we are in a fundamentally different decisionmaking scenario. Each firm will need to predict the behavior of its rivals
in order figure out its best strategy. And its rivals are similarly driven by
maximizing their own profits that depend on the actions of other firms. In
other words, this is a setting with interactive decision making and we will
need game theory to analyze the optimal decisions of each participant.
The simplest case to illustrate this with is that of a duopoly or two firms.
Suppose firms 1 and 2 have cost functions C1 (x1 ) and C2 (x2 ), respectively,
where x1 is 1s output and x2 is 2s output. The market price is given by the
inverse demand function, which will of course depend on the total output of
the two firms: the inverse demand function is p(x1 + x2 ).
If there are only two firms in the industry each one knows that its profit
depends on its output as well as that of its rival.
In fact, the demand curve tells each firm exactly how price relates to the
industry output, which is the sum of the two firms output.
Since each firm can choose any non-negative number as its output this
is not a finite game and we will have to use reaction curves to find a Nash
equilibrium. Firm 1s profit is:
(x1 , x2 ) = p(x1 + x2 )x1 C1 (x1 )
The first order condition for maximizing this is:
dp(x1 + x2 )
x1 + p(x1 + x2 ) = C10 (x1 )
dx1
1

Rewriting this equation, we get


x1 = r1 (x2 )

(1)

which is firm 1s reaction function.


Similarly, firm 2s optimal choice of x2 depends on x1 , and this is shown
by 2s reaction function:
x2 = r2 (x1 ).
(2)
In a Nash equilibrium, (x1 , x2 ), both (1) and (2) must hold simultaneously:
x1 = r1 (x2 ),

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

Consider a dupololy with a linear inverse demand curve p 100 (x1 + x2 )


and constant marginal cost in each firm: C(x1 ) = 25x1 and C(x2 ) = 25x2 .
Firm 1 chooses x1 to maximize
[100 (x1 + x2 )]x1 25x1
which implies
100 2x1 x2 = 25
2

or
x1 = 37.5 0.5x2 .
This is firm 1s reaction function.
x2

x1 = r1 (x2 ) = 37.5 - 0.5 x2

x1
Firm 1's Reaction Function

A similar exercise for firm 2 yields its reaction function:


x2 = 37.5 0.5x1
(You should check the calculus for yourself). A Nash equilibrium (or a
Cournot-Nash equilibrium) is found by solving these two equations. It easy
to see that solving for this equilibrium, (x1 , x2 ), we have:
x1 = x2 = 25.
This can also been graphically by drawing the two reaction curves and verifying that their intersection is at (25, 25).
Exercise 5.1.1 The aim of this exercise is to generalize the previous example
and derive a duopoly equilibrium for any linear demand function and constant
marginal costs. Suppose the demand function is linear:
p = a b(x1 + x2 )
3

x2

x1 = r1 (x2 ) = 37.5 - 0.5 x2

25

x2= r2 (x1 ) = 37.5 - 0.5 x1


x1

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

Comparison with Perfect Competition and Monopoly

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)

If the market is controlled by a monopolist, then profit maximization implies


equating marginal revenue (MR) to MC, and the equilibrium output is:
1 (a c)
2 b
From Exercise 5.2.1 we know that aggregate duopoly output is:
xm =

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

Comparison of Monopoly, Competition and Cournot-Nash

Exercise 5.2.2 Compute the total surplus (sum of consumers surplus


and industry profit) in each of these three market structures and show that it
is the highest under perfect competition and lowest under monopoly. Compute the total profits in the industry under each of the three market structures.
5

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

An oligopoly many firms

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

The first order condition for profit maximization is:


X
xj 2bxi = c
ab
j6=i

which means that

(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 =

The aggregate output in a Cournot-Nash equilibrium is therefore,


X = nx =

n (a c)
.
n+1 b

(CN )

Comparing this to (M), (D) we see that the aggregate Cournot-Nash


output is higher when there are more firms in the industry. It remains lower
than the aggregate output under perfect competition, which according to
(C) is (ac)
. However, as n goes to infinity, it converges to the competitive
b
output.
Discussion
7

(a) In what way is a Cournot-Nash equilibrium in an oligopoly similar to a


prisoners dilemma (from the view point of the firms)? Is there an important
respect in which it is different from a prisoners dilemma?
(b) If a society is interested in maximizing the total surplus in an oligopoly,
assess the importance of having anti-trust laws that make it illegal for firms
to collude. OPEC can (simplistically) be viewed as a collection of firms that
happen to be sovereign nations. Why is it that they seem to be unable to
agree to restricting their individual output levels even though that would
increase their profits?