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Cournot Competition and Static Games

by Windy Natriavi S.

Agenda Presentation
Why do we need game theory? Types of Games (Cooperative Vs. Non-cooperative) Nash Equilibrium How does it apply in real life? Oligopoly Markets Cournot Oligopoly Cournot Oligopoly Theory Cournot Oligopoly Theory with Many Firms Cournot Oligopoly Theory with Different Costs What determines a firms operating profit margin? Its Concentration Index Profitability Conclusion

Why do we need game

theory?

Existence of economic profit drives firms to enter the market Lower barrier cost (can be seen through AFTA, improved technology, and faster application time to establish a business in Indonesia in only 60 days) More anti-trust laws are approved to protect the consumers and ensure healthy competitiveness in the market As a result, in an industry there are usually many firms and competitor (s) in the market.

Why do we need game

theory?

Because more firms enter the market, competitiveness gets tighter. The decision of each firm in the market is interdependent, meaning that in order to make decisions, a firm has to also consider other firms actions. So game theory is...concerned with situations in which

decision-makers interact with one another, and in which the happiness of each participant with the outcome depends not just on his or her own decisions but on the decisions made by everyone

differs in how companies formalize their interdependence and the timing

Types of Game Theory


Non-Cooperative Game Theory
described as all the moves/ strategies available to the firms (players) in the game

Cooperative Game Theory

described as all the outcomes available to the firms in the game as combinations of actions

firms can interact with each other and cooperative solution concepts

firms interact with one another to maximize their own goals

Example: two market players (Ponds and Olay) Example: a seller (player 1) has two potential are both competing in facial care toward the antibuyers (player 2 and player 3) and a production aging community. In this case, the players are cost of $4. Player two is willing to pay maximum $11 for a unit and player 3 is willing to pay playing a noncooperative game where both maximum $9. In these interactions between player players are competing toward obtaining the 1 and player 2/3, it is called a cooperative game largest market share.

Nash Equilibrium

..is the condition when no firm wants to change its current strategy given that no other firm changes its current strategy

the dominated strategy is the strategy that always gives the least pay-off to a firm no matter what the other player strategy is. In this case, Giant would never choose premium because it always gives the least pay-off to the firm no matter what Carrefour does. the dominating strategy is the strategy that always gives the highest pay-off to a firm no matter what the other player strategy is. In this cae, Giant would choose standard pricing strategy because it gives higher pay off no matter what Carrefour does. Using rationale, this strategy will be chosen.

Oligopoly Market Theory



oligopoly market is a market form in which a market or industry is dominated by a small number of producers ...has several forms which are differentiated by its emphasis: Cournot Oligopoly Theory with Two Firms Cournot Oligopoly Theory with Many Firms Cournot Oligopoly Theory with Different Costs

Cournot Oligopoly Theory with Two Firms



assumes that there are two big market players in the industry that dominates the other firms (ex: Coke and Pepsi) firms compete on the basis of quantity rather than price (Coke & Pepsis price is less or more the same which is SGD$3.3 for a 1.5 Liter bottle) each firm makes a decision assuming that the other firms behaviour is constant (fixed) in the short term. the market demand curve is supposed to be linear and marginal cost is constant (thats why in the short term the other firms behaviour is thought to be constant) To find the Nash Equilibrium in the market, we have to consider on how each firm reacts to a change in the output of the other firm. Nash equilibrium is reached when neither Coke nor Pepsi changes its strategy regardless of how it thinks the other firm is going to act.

Cournot Oligopoly Theory with Two Firms Example



Suppose that Coke & Pepsi are two big players in the carbonated soft drink industry Cokes demand function would be P = (a + bQ) and in which the oligopoly case it will be P = a + b(Q1 + Q2) Cokes demand function is noted as below P = (60-Q2) - Q1 where Q2 is the quantity produced by Pepsi and Q1 is the quantity produced by Coke. Marginal cost is constant at 12 dollars per unit. How does Coke maximize its production function? In other words, how does Coke optimize its quantity and price?

Cournot Oligopoly Theory with Two Firms Example


To find optimal solution, MR = MC

Cokes total revenue function would be = P x Q which in this case is Q[(60-Q2) - Q1] = 60Q1- Q1Q2 - Q12 The marginal revenue function would then be = 60 - Q2 - 2Q1 60 - Q2 - 2Q1 = 12 2Q1 = 48 - Q2 This also goes on for Pepsi, so in the end we will get the following equations:

Q1 = 24 - 0.5Q2 [1.1] Cokes perspective Q2 = 24 - 0.5Q1 [1.2] Pepsis perspective

Cournot Oligopoly Theory with Two Firms Example Equilibrium is


achieved by solving the equations simultaneously and is located at the intersection of the two reaction functions

Cournot Oligopoly Theory with Two Firms Example


As noted before, Q1 = 24 0.5 Q2 and Q2 = 24 0.5 Q1

If we solve the equation, we will have the answer that each firm produces 16 units of output.

P will then be written as (60 Q1 Q2) which is 60 32 = 28 As we can see, competition between the two firms causes them to overproduce, thereby making the price lower than it would have been in the case of monopoly price at (A-c)/2B. Output is also less than the competitive output (A-c) / B where price is equal to marginal cost.

Cournot Oligopoly Theory with Many Firms

There are cases where more than just two firms producing the same product, where Q = q1 + q2 + + qN Ex: Telkomsel, Indosat, XL, 3, etc. Demand can then be written as P = A - BQ = A - B(q1 + q2 + + qN). If we look at the perspective of Firm 1, its output would be P = A - B(q2 + + qN) - Bq1

Q-1 = q2 + q3 + + qN.

Therefore, the demand for firm 1 is

P = (A - BQ-1) - Bq1.

Cournot Oligopoly Theory with Many Firms


To find optimal solution, MR = MC

MR1 = (A - BQ-1) - 2Bq1

As the number of firms increases, the number of outputs Because the firms are identical, then we will have Q-1 = (N-1)Q1 produced by a firm is reduced, although Q1 = (A - c)/2B - (N - 1)Q1/2 the total aggregate number of outputs Q1 = (A - c)/(N + 1)B increases. The total number of outputs in the market will be summed up as Q= N(A - c)/(N + 1)B
We will solve the quantity of output for Firm 1 as Q1 = (A - c)/2B - Q-1/2 The equilibrium price in the firm will be written as P= A - BQ = (A + Nc)/(N + 1) Profit of firm 1 is P1 = (P* - c)Q1

Cournot Oligopoly Theory with Many Firms

We can also see that as the number of firms increases, the price tends to be closer to the marginal cost

Therefore, because of the larger aggregate output and the lower price which can be given to each firm, profit per firm will fal

Take for example McDonalds and Burger King where they both have different costs in producing a burger. For McDonalds the marginal cost is MD and for Burger King the marginal cost is MB. demand for the whole market can be written down as

Cournot Oligopoly Theory with Different Costs



P = A - B.Q = A - B(Q1 + Q2)

To maximize profit, MR1 = MC1 and MR2 = MC2.

If we see from the perspective of McDonalds, which is firm 1, this will bring us to another equation of (A - Bq2) - 2Bq1 = c1 the number of outputs produced by McDonalds as Q1 = (A - c1)/2B - q2/2 and the number of outputs produced by Burger King as Q2= (A - c1)/2B q1/2 the final output for McDonalds would be Q1 = (A - 2c1 + c2)/3B and the final output for Burger King would be Q2 = (A - 2c2 + c1)/3B

What would happen if in this case Firm 2 has a lower marginal cost? Its reaction curve will shift upward to the right Burger King) will have bigger capacity to produce than Firm 1, making the number of outputs that it produces compared to Firm 1 is higher. As a result, the number of outputs that are produced by Firm 2 increases and the number of outputs that are produced by Firm 1 decreases. In equilibrium, McDonalds would produce QC1 = (A - 2c1 + c2)/3B and Burger King would produce QC2 = (A - 2c2 + c1)/3B Total output therefore would be: Q = (2A - c1 c2)/3B

Cournot Oligopoly Theory with Different Costs

demand is written as P = A - B.Q.

Cournot Oligopoly Theory with Different Costs

price at P= A - (2A - c1 - c2)/3 = (A + c1 +c2)/3. measure the profit for McDonalds as (P*- c1)QC1 = (A - 2c1 + c2)2/9 and Burger Kings profit as (P* - c2)QC2 = (A - 2c2 + c1)2/9. equilibrium output is less than the competitive level product (burgers) is produced inefficiently In the idealistic condition, Burger King (Firm 2) should produce all of the burgers, since the lower cost of production will it make it possible for Burger King to produce more burgers than if Firm 1 and Firm 2 both produces burgers.

Concentration and Profitability



Firms operating in an oligopoly market will want to know how large its concentration and how profitable is the firm compared to other firms in the industry lets take an example of the shampoo industry which has Pantene Shampoo, Sunsilk Shampoo, and other shampoo brands such as Dove, Rejoice, and other brands in the market Lets assume that we have N number of firms in the market with different marginal costs Demand for Pantene (Firm 1) will be P = (A - BQ-1) - Bq1. The demand for the i firm (any other shampoo producers in the market except for Pantene) will be equal to P = (A - BQ-i) - BQi.

Concentration and Profitability


A - BQ-i - 2Bqi = ci
q*i) - Bq*i - ci = 0

MRi = MCi

This can be reorganized into the equilibrium function of A - B(Q*-i + P* - Bq*i - ci = 0 or P* - ci = BQ*i.
following:

If we take P* - ci = Bq*I and divided it by Q*/Q* we will obtain the

BQ*/P* = 1/ and q*i/Q* = si

Concentration and Profitability


What does this mean?

the operating profit of Pantene Shampoo will depend on

how large the size of Pantene compared to other firms in the industry as a whole (its market share) how attached consumers in the market are to Pantene Shampoo (demand elasticity twoards Pantene Shampoo)

As the industry concentration gets higher (more concentrated and less competitive), we can conclude that the operating profit (pricecost margin) will be higher for each firm especially the firm who are the market players.

in oligopoly markets, firms are interdependent of each other.

Conclusion

how the quantity produced by a firm is actually a reaction function to how it perceives the other firm will produce

Nash Equilibrium happens when firms choose the strategy that will give them the best pay-off regardless of how the other firms act. As many more firms exist in the market, the price will tend to adjust to the marginal cost, making each firms profit less than what it would have been with only a few players in the market. operating profit of each firm is dependent on its market share and demand elasticity in the market

Firms will have to find a way to lower down its cost (cost leadership strategy) or differentiate its product in the market (differentiation strategy) to be able to grab consumers and stay in the market.