Nash equilibrium in pure strategies: Cournot

model. Bertrand model with differentiated

product. Collusion
Different forms of market
• Perfect Competition
• Monopoly
• Monopolistic competition
• Oligipoly
Perfect competition
• Market with many buyers and sellers trading identical products so that
each buyer and seller is a price taker
• Characteristics
1. Many buyers and many sellers in the market
2. Goods offered by the various sellers are largely the same
3. Firms can freely enter or exit the market

Examples: market for milk, rice, wheat

Monopoly
• A firm that is the sole seller of a product without close substitutes
• Fundamental cause: barriers to entry
• Sources of barriers to entry
1. Monopoly resources: A key resource required for production is owned by a
single firm
2. Government regulation: The government gives a single firm the exclusive
right to produce some good or service
3. The production process: A single firm can produce output at a lower cost
than can a larger number of firms
Monopolistic Competition
• Many sellers: there are many firms competing for the same group of
customers
• Product differentiation: each firm produces a product that is at least
slightly different from those of other firms. Rather than being a price
taker, each firm faces a downward-sloping demand curve
• Free entry and exit: Firms can enter or exit the market without
restriction.
• The number of firms in the market adjusts until economic profits
are driven to zero
Eg: books, DVDs, computer games, restaurants, piano lessons, cookies,
clothing
Oligopoly
• Few firms dominate the market-high concentration ration
• Differentiated Products-price makers
• High barriers to entry exit
• Interdependence-price rigidity
• Non-price competition
• Profit maximization not sole objective
Games and market

• Monopoly and perfect competition: Does not have to track the actions
of its competitors

• Real-world markets: the most prevalent scenario is one where there are
a few firms in any given market

• Example: automobile manufacturing, aircraft manufacturing industry,

Organization of Petroleum Exporting Countries
When there are only a few firms in its market
• A firm will analyze the likely effect of its actions on its competitors
• Try to anticipate what the competition might do.
• For example, before increasing the price of a product these are the
questions
• Will the competition match the change?
• Will they raise prices too, or will we lose customers? Will the
competition offer discounts? If they do, what will we do then?
OPEC
• When OPEC's oil ministers meet to consider future production plans,
they clearly worry about the response from non-OPEC
oil-producing nations.
• Will their attempt to maintain a high world crude oil price be
frustrated by increased production from those nations?
• Game theory is the tool designed to formalize these questions
Models of duopololy
(interdependence)
• Cournot model-An economic model in which competing firms choose a
quantity to produce independently and simultaneously
• Edgeworth model-Similar to the duopoly model developed by
Joseph Bertrand, in which two firms producing the same good compete in
terms of prices. Edgeworth’s model presents a slight modification as it also
includes constraints in the production capacity of the firms.
• Chamberlin model-analyses and explains the short and long run
equilibriums that occur under monopolistic competition
• Price-leadership model-Price leadership occurs when a leading firm in a
given industry is able to exert enough influence in the sector that it can
effectively determine the price of goods or services for the entire market.
Models of duopololy
(interdependence)
• Bertrand model-interactions among firms (sellers) that set prices and their
customers (buyers) that choose quantities at the prices set
• Kinked demand-Curve-the demand curve facing an oligopolist has a kink at the
level of the prevailing price.
• Centralized cartel model-firms producing a homogeneous product form a
centralized cartel board in the industry. The individual firms surrender their
price-output decisions to this central board. The board determines for its
members the output, quotes the price to be charged and the distribution of
industry profits.
• Market sharing cartel model-an agreement between competitors to divide the
market or markets among themselves by agreeing not to compete for each other's
customers, or not to enter or expand into a competitor's market.
Cournot model
• Developed by French economist Augustin Cournot in 1838
• Two firms compete in a market for a homogeneous product (virtually
indistinguishable from the consumers' standpoint)
• Therefore, the two firms are faced with a single demand curve in the
market
• Suppose that the demand curve is given by

• Where
Cournot Model
• The inverse demand function is

• Let us simplify this demand curve by writing

• Inverse demand curve
• If b=1 and a=10, the demand curve looks like
Demand curve
Cournot model
• Suppose the cost function is the same for each firm
• Cost per unit does not vary with the number of units produced
(constant marginal cost function)
• The cost of producing Qi is cQi
• Where s the constant marginal cost and i=1,2
How much would each firm
produce?
• Firms would take two steps
• Make a conjecture about the other firm's production: give an idea
about the likely market price (for example, if it thinks the rival is
going to produce a lot, then the price will be low no matter how much
it produces)
• Determine the quantity to produce: the firm has to weigh the
benefits from increasing production against the costs of doing so that
is, that these extra units will sell at a lower price (and will need to be
produced at a higher total cost).
An industry-wide Nash equilibrium will obtain when both firms
satisfactorily resolve these two issues (Proof)
Solving Cournot model
• Let us first analyze the two questions from the perspective of firm 1.
• If it was the only firm in the market, firm 1's production decision
would determine the market price.
• It could then compute the profits from selling different quantity levels
and pick the quantity that maximizes profits.
• This is no longer true; the market price will depend on both its own
production Q1 and the other firm's production.
• As a start, what firm 1 can do is ask, if firm 2 were going to produce ,
what quantity should I produce in order to maximize profits?
Finding the best response function
and equilibrium P, Q and Profits
• Solving of best response function of both firm 1 and firm 2 and
finding Cournot Nash Equilibrium
Reaction functions in the Cournot
model
Equilibrium in Cournot duopoly
Per firm Price Per-firm Profit
quantity

In Cournot 3 4 9
duopoly
Cartel Solution
• Let us compute the quantities that would be produced if the two firms
operate as a cartel (they coordinate their production decisions)
• Set production targets in such a way as to maximize their joint or total
profits
• Two firms acknowledge explicitly that profits are determined by their
total production (difference between best response)
• In the best response problem, each firm computes profits on the basis
of its own output alone (and assumes that the other firm would hold
rigidly to some quantity level).
Equilibrium in Cournot duopoly and
cartel
Per firm Price Per-firm profit
quantity
Cournot duopoly 3 4 9

Cartel 2.25 5.5 10.123

Comparison of outcomes
• If the firms operate as a cartel they produce a smaller quantity than in
the Nash equilibrium
• The cartel output is 75 percent of the Cournot Nash equilibrium output
level.
• Both firms make lower profits in Nash equilibrium than if they operate
as a cartel (because in equilibrium they overproduce).
Why not follow cartel?
• Given that there are higher profits to be made in this market, why don't
the two firms increase profits (by cutting back production)?
• What is good for the group is not necessarily good for the individual.
• If the firms tried to produce as a cartel, there would be incentives for
each firm to cheat and increase its own profit at the expense of the
other firm
• Same as prisoners dilemma
Difference between the duopoly
problem and Prisoners dilemma
• One important respect—there is no dominant strategy.
• Note that the reaction function is a downward-sloping line;
• The more the other firm produces, the less a firm should produce in
best response.
In a cartel
• Lets say firm 1 increases output more than the agreed amount
• The profit of firm 1 will increase
• Firm 2 doesnot increase production
• But because of firm 1, the market output increases and price
decreases
• Firms 2 profit goes down
• So Firm 1 cheats and increases its profits but lowers Firm 2’s profits by
even larger amount
Case study by OPEC
• The Organization of Petroleum Exporting Countries (OPEC) is a
consortium of major oil-producing countries
• OPEC was formed in 1961 and has tried since then to keep world oil
prices high by restricting production levels (through production quotas
on its
members).
• It has had varying degrees of success with this policy; the early 1970s
was a period of spectacular success, but the recent history has been
mixed
Case study OPEC
• Here are some facts about recent performance.
• First, by keeping prices high, OPEC quotas have made it worthwhile
for non-OPEC oil-producing nations to invest in new oil fields and
increase production levels.
• Second, this response has put pressure on OPEC itself.
• Some members have left—such as Ecuador in 1992.
• Others have been known to cheat on their quotas.
• Yet the core of OPEC is holding steady; the larger producers show
no signs of dissolving OPEC anytime in the near future.
Case study: OPEC

• Let us analyze the first two facts by way of a simple Cournot model.
• Simplify the number of real-world players down to two: OPEC and the
non-OPEC producing nations.
• Assume that the costs of production are $5 a barrel for OPEC and $10
a barrel for the non-OPEC producers.
• Assume the following demand curve for the world oil market:

Where is OPEC’s production and is non-OPEC production

Case study: OPEC
• Find the best responses
• Find the reaction functions of OPEC and non-OPEC producers
• Find the equilibrium Quantity, Price and Profit
Equilibrium in duopoly
Quantity Price OPEC Profit

OPEC 65 26.66 1408.33

NON-OPEC 50 26.66 833.33

Forming a Cartel
• What would happen if non-OPEC producers joined OPEC?
• Note that costs of production are lower in OPEC’s fields ($5 versus
$10 in non-OPEC fields).
• If this giant cartel wants to hold down costs, all production should
come out of OPEC fields.
• Why?
• Applying the general formula we can now infer the following global
oil cartel solution
Solution
Quantity Price Profit

OPEC 65 26.66 1408.33

Non-OPEC 50 26.66 833.33

Total in duopoly 115 26.66 2241.66

Cartel 90 35 2700
(Combined)
Comparisons
• Total profits are higher in Cartel than in Nash equilibrium (because
production is
lower).
• Even if OPEC paid the non-OPEC producers their profits in the Nash
equilibrium (833.33)—OPEC would still have 1866.67 as left over.
• OPEC would make $458 million more per day in this arrangement
Why not cartel in OPEC?
• The problem for OPEC is that there is no obvious arrangement
whereby it can pay cost-inefficient non-OPEC producers not to
produce.
• And what is worse is that ex-OPEC members like Ecuador have found
that it is more profitable to benefit from OPEC quotas by being
outside OPEC
• They are no longer subject to the quotas and yet they benefit from the
consequent higher prices.
Stackelberg Model
• In the Cournot model presumed that the two firms would pick quantities
simultaneously.
• In his 1934 criticism of Cournot, the German economist Heinrich von
Stackelberg pointed out that the conclusions would be quite different if the
two firms chose quantities sequentially.
• Suppose that firm 1 decides on its quantity choice before firm 2.
• How much should each of the two profit-maximizing firms produce?
• Note that firm 2’s decision is made when it already knows how much firm 1 is
committed to producing.
• It follows from our reaction function analysis that, if firm 1 is producing Q1 ,
then firm 2 can do no better than produce its best response quantity R2(Q1).
Stackelberg Model
• Check that firm 1’s profits are higher in the Stackelberg solution than
in the Nash equilibrium but firm 2’s are smaller. Why?
• By committing to produce more than it would in the Nash equilibrium,
firm 1 forces firm 2 to cut back on its own production.
• This commitment keeps the price relatively high—although lower
than in the cartel solution—but more importantly yields firm 1 two-
thirds of the market—as opposed to the market share of half that it
gets in the Nash equilibrium.
The common problem
• A common (resource or commodity) has two characteristics: it is
accessible to everyone, and its amount depletes upon usage
• In the Nash equilibrium of a commons game, each player overuses the
resource because he gets all of the immediate benefits from usage and
bears only a fraction of the future costs of depletion.
• In a socially optimal solution, there is enough of the resource set aside
for desirable regeneration.
• The tragedy of the commons is exacerbated in large populations.
• There are many real-world illustrations of the tragedy of the
commons; the historical extinction of the American buffalo and the
current possibility of global warming are two such examples.
• Various solutions have been proposed to avert a tragedy (privatiza-
tion, taxes or user fees, and limits to accessibility)