Oligopoly Models
Edward Choi
Coquitlam College
Edward Choi (CC) Module 5 1 / 15
Oligopoly
Recall: There are four types of market structure used to distinguish
the competitiveness of the market.
¬ Perfect Competition
¬ Monopolistic Competition
¬ Oligopoly
¬ Monopoly
For this module, we will be extending our analysis of the oligopoly
market, which is a type of imperfectly competitive market with the
following attributes:
¬ few firms compete for the same group of customers
¬ each firm produces a homogeneous or differentiated product
¬ high barriers to entry into the market
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Oligopoly Models
There are three main models of oligopoly markets and each considers a
slightly different competitive economic setting:
Cournot Model
¬ competition is based on output, qi
¬ n firms choose their output simultaneously
Betrand Model
¬ competition is based on price, Pi
¬ n firms choose their price simultaneously
Stackelberg Model
¬ competition is based on output, qi
¬ n firms choose their quantities sequentially
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Cournot Model
Suppose there are two firms (the industry is a ”duopoly”), each firm’s cost
function is C (qi ) = cqi , marginal cost function is MC (qi ) = c and the
inverse demand function is P(Q) = a − bQ, where a, b, c are constants
and Q = q1 + q2 .
The firms are the players, their strategies are their quantity outputs
qi , and their payoffs are their profits πi .
To determine the equilibrium of this game, we need to determine each
firm’s best response function, which is each firm’s profit maximizing
output.
The profit maximizing rule tells us that to find the profit maximizing
output, we must set the marginal revenue to be equal to the marginal
cost.
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Cournot Model
For Firm 1
¬ π1 = P ∗ q1 − C (q1 ) = (a − b(q1 + q2 )) ∗ q1 − c ∗ q1
= q1 ∗ (a − bq1 − bq2 − c)
¬ MR1 (q1 ) = a − 2bq1 − bq2
¬ MC1 (q1 ) = c
¬ MR1 = MC1 => a − 2bq1 − bq2 = c => q1∗ = a−c 1
2b + 2 q2
For Firm 2
¬ π2 = P ∗ q2 − C (q2 ) = (a − b(q1 + q2 )) ∗ q2 − c ∗ q2
= q2 ∗ (a − bq1 − bq2 − c)
¬ MR2 (q2 ) = a − bq1 − 2bq2
¬ MC2 (q1 2) = c
¬ MR2 = MC2 => a − bq1 − 2bq2 = c => q2∗ = a−c 1
2b + 2 q1
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Cournot Model
The best response functions are then
¬ q1 (q2 )∗ = a−c
2b + 12 q2
¬ q2 (q1 )∗ = a−c
2b + 12 q1
Substituting one equation into the other yields
¬ q1∗ = a−c 1 a−c 1
2b + 2 ( 2b + 2 q1 )
a−c a−c 1
= 2b + 4b + 4 q1
3 ∗ a−c
4 1 = 4b
q
∗ a−c
q1 = 3b
And by symmetry, we know that q2∗ = a−c
3b
The Nash equilibrium is: (q1∗ , q2∗ ) = ( a−c a−c
3b , 3b )
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Cournot Model
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Betrand Model
When determining for the Betrand equilibrium, we have to take a
different approach as the firms are competing based on their price.
We have to consider three possible scenarios:
1 Firm 1’s price is greater (P1 > P2 )
2 Firm 2’s price is greater (P1 < P2 )
3 Both firm’s price is equal (P1 = P2 )
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Betrand Model
Suppose there are two firms (the industry is a ”duopoly”), each firm’s cost
function is C (qi ) = cqi , marginal cost function is MC (qi ) = c and the
inverse demand function is P(Q) = a − bQ, where a, b, c are constants
and Q = q1 + q2 .
1 When P1 > P2 > C (qi ), then q1∗ = 0 and q2∗ = a − bP
2 When P1 < P2 > C (qi ), then q1∗ = a − bP and q2∗ = 0
3 When P1 = P2 > C (qi ), then q1∗ = q2∗ = a−bP
2
The Nash equilibrium is: (q1∗ , q2∗ )
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Betrand Model
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Stackelberg Model
In the Stackelberg situation, firms are competing in quantity
sequentially; therefore, we identify which firm produces first as there
is a first mover advantage. When determining the equilibrium, we will
need to use the backwards induction method.
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Stackelberg Model
Suppose there are two firms (the industry is a ”duopoly”), each firm’s cost
function is C (qi ) = cqi , marginal cost function is MC (qi ) = c and the
inverse demand function is P(Q) = a − bQ, where a, b, c are constants
and Q = q1 + q2 . Assume that firm one chooses their output first.
Step 1: Determine the best response function (BRF) of firm 2 by
setting MR2 = MC2
Step 2: Substitute firm 2’s BRF into the inverse demand function.
Step 3: Solve firm 1’s optimal quantity by setting MR1 = MC1 .
Step 4: Identify firm 2’s optimal quantity.
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Stackelberg Model
Step 1: Firm 2’s BRF
¬ MR2 (q2 ) = a − bq1 − 2bq2
¬ MC2 (q2 ) = c
¬ MR2 = MC2 => a − bq1 − 2bq2 = c => q2∗ = a−c
2b − 21 q1
Step 2: Inverse Demand Function
¬ P = a − bq1 − bq2
¬ P = a − bq1 − b( a−c 1
2b − 2 q1 )
a c b
¬ P = a − bq1 − 2 + 2 + 2 q1
¬ P = a+c b
2 − 2 q1
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Stackelberg Model
Step 3: Firm 1’s Optimal Quantity
¬ MR1 (q1 ) = a+c
2 − bq1
¬ MC1 (q1 ) = c
∗
¬ MR1 = MC1 => a+c 2 − bq1 = c => q1 =
a−c
2b
Step 4: Firm 2’s Optimal Quantity
¬ q2∗ = a−c
2b − 12 q1
¬ q2∗ = a−c
2b − 12 ( a−c
2b )
¬ q2∗ = a−c
4b
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Stackelberg Model
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