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# Price-Output Determination in Oligopolistic Market Structures

We have good models of priceoutput determination for the structural cases of pure competition and pure monopoly. Oligopoly is more problematic, and a wide range of outcomes is possible.

Cournot

1 Model

Illustrates the principle of mutual interdependence among sellers in tightly concentrated markets--even

## where such interdependence is unrecognized by sellers.

Illustrates that social welfare can be improved by the entry of new sellers--even if post-entry structure is oligopolistic.
1 Augustin

Cournot. Research Into the Mathematical Principles of the Theory of Wealth, 1838

Assumptions
1. Two sellers 2. MC = \$40 3. Homogeneous product 4. Q is the decision variable 5. Maximizing behavior Let the inverse demand function be given by: P = 100 Q The revenue function (R) is given by: R = P Q = (100 Q)Q = 100Q Q2 [2] [1]

Thus the marginal revenue (MR) function is given by: MR = dR/dQ = 100 2Q Let q1 denote the output of seller 1 and q2 is the output of seller 2. Now rewrite equation [1] P = 100 q1 q2 The profit () functions of sellers 1 and 2 are given by: 1 = (100 q1 q2)q1 40q1 2 = (100 q1 q2)q2 40q2 [5] [6] [4] [3]

Mutual interdependence is revealed by the profit equations. The profits of seller 1 depend on the output of seller 2and vice versa

Monopoly case
Let q2 = 0 units so that Q = q1that is, seller 1 is a monopolist. Seller 1 should set its quantity supplied at the level corresponding to the equality of MR and MC. Let MR MC = 0 100 2Q 40 = 0 2Q = 60 Q = QM = 30 units Thus

PM = 100 QM = \$70
Substituting into equation [5], we find that: = \$900

Finding equilibrium
Question: Suppose that seller 1 expects that seller 2 will supply 10 units. How many units should seller 1 supply based on this expectation? By equation [4], we can say: P = 100 q1 10 = 90 q1 [7] [8] [9]

## The the revenue function of seller 1 is given by:

R = P q1 = (90 q1)q1 = 90q1 q12 Thus: MR = dR/dq1 = 90 2q1

Subtracting MC from MR

90 2q1 40 = 0
2q1 = 50 q1 = 25 units Thus the profit maximizing output for seller 1, given that q2 = 10 units, is 25 units. We repeat these calculations for every possible value of q2 and we find that the -maximizing output for seller 1 can be obtained from the following equation:

[10]
[11]

q1 = 30 - .5q2

[12]

Equation [12] is a best reply function (BRF) for seller 1. It can be used to compute the -maximizing output for seller 1 for any output selected by seller 2. 60

30 - .5q2
30

10
0 15 25 30 Output of seller 1

In similar fashion, we derive a best reply function for seller 2. It is given by:
q2 = 30 - .5q1 [13]

q2

30

q2 = 30 - .5q1

60

q1

So we have a system with 2 equations and 2 unknowns (q1 and q2) : The solutions are: q1 = 30 .5q2 q1 = 20 units q2 = 30 .5q1 q2 = 20 units
q2
60

Seller 1s BRF

Equilibrium is established when both sellers are on their best reply function

30 20

Equilibrium

Seller 2s BRF

20

30

60

q1

## Cournot duopoly solution

QCOURNOT = 40 Units (20 units each) PCOURNOT = \$60 1 = 2 = \$400 Note that:

## Implications of the model

The Cournot model predicts that, holding elasticity of demand constant, price-cost margins are inversely related to the number of sellers in the market

## This principle is expressed by the following equation

( P MC ) 1 P n

[14]

Where is elasticity of demand and n is the number of sellers. So as n , the price-margin approaches zero as in the purely competitive case.