Cournot Oligopoly: Extensions

Daniel Grodzicki
Econ 444 (Sec. 002)
The Pennsylvania State University

Spring 2016

Multiple Identical Firms

Suppose we have N firms instead of 2,

P
1 Let Qi =
j6=i qj , all other firms quantities,
2

Demand from is perspective is P = A BQi Bqi .

MRi = A BQi 2Bqi

Best response is:

qi =

(A c) Qi

2B
2

Multiple Identical Firms

To find equilibrium, use symmetry,

1

All firms will produce the same amount since they are
identical.

Substitute Qi = (N 1)qi ,

Solve for qi ,
qi =

Ac
(N + 1)B

Multiple Firms Punchline

Since there are N firms, total production is,

Q = Nqi =

N (A c)
N +1 B

For N = 1, we get the monopoly outcome.

For N = 2, we get the doupoly outcome.
As N , we converge to the competitive outcome.

Intuition: The more identical firms in the market, the less impact
each one has on demand, the more they look like price-takers.

Cournot and Market Efficiency

Big question: Is the Cournot outcome Pareto efficient?

Efficiency Total Surplus (TS), or the sum of consumers

(CS) and producers (PS) surplus.

Any departure from marginal cost pricing means there are

consumers willing to pay a price higher than the cost of

production who are priced out of the market.
Then, whenever P > MC there exist an allocation such both

producers and consumers are better off: TS P>MC < TS P=MC .

Player 1s Maximization

Total Surplus & Dead Weight Loss

Suppose for simplicity, suppose there are 2 Cournot competitors in
the market place (N = 2). Then, we can calculate total surplus
under Cournot as
CS CR =


A + 2c  (A c)
2(A c)2
1
(A P CR )Q CR = A

=
2
3
3B
9B

CR = 2(P CR c)QiCR =

 A + 2c
3

 2(A c)
2(A c)2
c
=
3B
9B

2(A c)2
(A c)2
<
= TS CE
3B
2B
With this we can calculate the DWL as the difference between the
total competitive surplus (TS CE ) and the total Cournot surplus
(TS CR )
(A c)2
DWL = TS CE TS CR =
>0
18B
TS CR = CS CR + PS CR =

Social Planner
Suppose there existed a social planner. This social planner
knows everything about everybody and wants reallocate goods
while making everyone happier. How would this social planner
accomplish this?
1

Force each firm to sell the good at its marginal cost

Obligate each consumer to make a lump sum transfer to the

firm equivalent to the maximum of zero and difference
between its current surplus and the Cournot price surplus.

Then (1) Firms are indifferent - they are making the same amount
of profit, and (2) Consumer surplus rises - new consumers are
getting positive surplus.

Cost Heterogeneity
What happens if the two firms have different marginal costs, c1
and c2 ?
Best response is a function of your cost and opponents

quantity,
qi
A ci

2B
2
Substituting in opponents best response shows that in
equilibrium, your quantity will depend on opponents cost also,
qi (qi ) =

qi =

A + ci 2ci
3B

Your output is decreasing is your cost but increasing in

opponents cost.

Cost Heterogeneity: Increasing Firm 2s

Costs

Cost Heterogeneity: Increasing Firm 2s

Costs

Insights from Cost Heterogeneity

Firms with lower cost get higher market share.

But firms with high cost still produce.
What happens to prices?
2Ac1 c2
1 Q = q1 + q2 =
3B
A+c1 +c2
2 P = A BQ =
3
So prices are determined by the sum of firm costs.
This is inefficient, a social planner would use only the low cost

firm to produce the good.

Cournot Model and Anti-Trust

Despite its simplicity, the Cournot model provides a basis for

anti-trust policy:
DoJ will challenge mergers in highly concentrated industries.
The Herfendahl index is used to measure concentration:

H=

N
X
i=1

where si =

qi
Q

is market share.

si2

Cournot Model and the Lerner Index

Suppose that we have multiple firms with different costs, then

firm is first order condition becomes,

A BQi
2Bqi ci = 0

A BQ ci = Bqi
Substitute P = A BQ ,

P ci = Bqi
q

Divide though by P, and use si = Qi ,

P ci
BQ
=
s
P
P i

Cournot Model and the Lerner Index

P ci

| P
{z }

BQ
s
P i

Lerner Index
The Lerner index is a firms markup over its marginal cost, it is

a measure of market power.

We have shown it is directly related to the firms market share.
Furthermore, notice that the left hand side includes the

inverse elasticity,
B

Q
dP P
1
=
=

P
dQ Q


So more elastic demand (smaller B) reduces market power.

Cournot Model and Concentration

si
P ci
=

P

To consider industry concentration, lets take a weighted average of
the Lerner index equation by summing all firms weighted by market
share,
N
N
X
X
si2
P ci
=

si
P

i=1

i=1

Substitute (weighted) average cost, c =

Herfindahl index,
P c
H
=

P


PN

i=1 si ci

and the

Some Anti-Trust Intuition

Industries with high concentration (high Herfindahl index) are

likely to have high markups.

Mergers that substantially raise the Herfindahl are likely to be

challenged.
Concern is greater for industries with inelastic demand.
Recall that this analysis assumes no entry and exit and

homogeneous goods.
Some questions to consider:
1

What if two firms sold goods that were slightly different?

How do you even define what firms are in the industry?

How do you define a market? What is the total demand?

Is it ever more efficient for two firms to merge even though

concentration would rise?

Summary

Game theory is a tool which helps us think about strategic

interaction.
In Nash equilibrium, each player is optimizing given their

opponents strategy.
The Cournot Model is a game where firms compete by

simultaneously choosing quantity.

The model shows that firms in oligopolies have less market

power than monopoly, but are not perfectly competitive.

Next, we will study a model where firms choose prices instead

of quantities...and get a different result.