Cournot's Model

The French economist Augustin Cournot proposed a model of price and output
determination in 1838. Although Cournot specifically analyzed a duopoly (a market with two
sellers), his model is also applicable to oligopoly situations where a few firms dominate the
market.
Assumptions of Cournot’s Model
Cournot's model is based on the following key assumptions:
1. There are two firms in the market (duopoly).
2. Each firm owns a mineral well producing homogeneous (identical) mineral water.
3. The cost of production is zero for each firm.
4. The number of buyers is large, ensuring a competitive demand side.
5. Each firm is fully aware of the linear market demand curve.
6. Each firm assumes that its competitor will not change its output.
7. Each firm independently decides its output level to maximize profit.
8. Price is not set by the firms; instead, it is determined by the market based on total
output.
Explanation with Diagram
Let us consider two firms, A and B, both producing identical mineral water with zero
production cost. Since cost is zero, total revenue equals profit. Therefore, each firm seeks
to maximize revenue, which happens when marginal revenue (MR) is zero.

Graphical Explanation
 X-axis: Output
 Y-axis: Price
  DD: Market demand curve
 MR curves: Marginal revenue for each firm based on residual demand
 Equilibrium is reached where each firm’s MR = MC = 0
Step-by-Step Process:
1. Firm A Starts:
o Assumes that Firm B will produce nothing.
o Acts as a monopolist and produces 1,000 units (half of total demand of 2,000
units).
o Sets price at OP where MR = MC = 0.
o At this point, price elasticity of demand equals 1, and TR is maximized.
2. Firm B Reacts:
o Assumes Firm A will stick to 1,000 units.
o Takes the residual demand: 2,000 – 1,000 = 1,000 units.
o Maximizes profit by producing half of residual demand = 500 units.
o Total market output becomes 1,500 units.
3. Firm A Responds:
o Assumes Firm B’s output (500) is fixed.
o Takes remaining market demand: 2,000 – 500 = 1,500 units.
o Produces half of it: 750 units.
4. Firm B Responds:
o Assumes Firm A’s 750 units fixed.
o Remaining demand = 1,250 units → produces half = 625 units.
This process continues with each firm adjusting its output based on the other’s previous level.
Gradually, the outputs converge:
 Firm A's sequence: 1,000 → 750 → 687.5 → 666.6 → ...
 Firm B's sequence: 500 → 625 → 656.25 → 666.6 → ...
Eventually, both firms produce 666.6 units, i.e., each supplies one-third of total demand,
and the market price stabilizes below monopoly price but above perfect competition price.
Implications of Cournot’s Model
 Equilibrium Output: Total output = 2/3 of the market demand.
 Equilibrium Price: Less than monopoly price, more than perfect competition price.
  If firms collude, they can produce less (1/3 each) and sell at monopoly price, earning
more.
 As the number of firms increases, total output approaches the perfectly competitive
level and price falls.
According to Koutsoyiannis, in a 3-firm scenario, each produces 1/4 of the total market.
More firms lead to lower prices and higher total output, moving closer to perfect
competition
Criticisms of Cournot’s Model
[Link] Assumption of Rival Output:
The model assumes that each firm believes its competitor will keep its output constant. In
reality, firms react and adapt to each other’s strategies, especially in competitive
environments.
[Link] Zero Cost of Production:
The assumption that both firms have zero production cost is highly unrealistic. In real
markets, cost structures significantly influence output decisions and pricing strategies.
[Link] Consideration of Adjustment Time:
The model does not specify how long it takes for firms to reach equilibrium. It provides a
sequence of reactions but fails to explain the time frame of these adjustments.
[Link] Market Structure:
Cournot’s model does not account for the entry or exit of firms. It assumes a fixed number
of firms (usually two), which is unrealistic in dynamic markets where barriers to entry and
market freedom play a vital role.
[Link] Price Competition:
Firms in Cournot’s model compete only on quantity, not price. However, in many real-world
oligopolies, price competition is also a key factor.
Stackelberg Duopoly Model
The Stackelberg model, developed by Heinrich von Stackelberg in 1934, is an oligopoly
model where firms compete on quantity rather than price. However, unlike the Cournot
model, firms do not decide their output simultaneously. Instead, one firm acts as a leader and
sets its output first, while the other firm, the follower, observes the leader's decision and then
chooses its own output.
This sequential decision-making process creates a first-mover advantage for the leader,
making the Stackelberg model different from other oligopoly models.
1. Assumptions of the Stackelberg Model
1. Two firms (duopoly) producing homogeneous (identical) goods.
2. Firms compete on quantity, not price.
3. One firm is the leader, choosing its output first.
 4. The other firm is the follower, setting its output after observing the leader’s
decision.
5. The leader knows the reaction function of the follower.
6. Both firms aim to maximize their profits.
How the Stackelberg Model Works
Leader-Follower Interaction
 The leader firm chooses its output, knowing how the follower will respond.
 The follower firm observes the leader’s decision and selects its output accordingly.
 The leader gains a strategic advantage by influencing the market environment in
which the follower operates.
This structure differs from Cournot competition, where both firms set output
simultaneously without knowing the other's decision.
Comparison: Stackelberg vs. Cournot Model

Feature Cournot Model Stackelberg Model

Sequential (Leader first, Follower

Decision Timing Simultaneous output setting
second)

Market Control Equal for both firms Leader has an advantage

Firms guess each other’s

Firm Strategy Leader chooses first, follower reacts
output

Profit for Leader Lower than in Stackelberg Higher than follower

Total Market Output Lower Higher (more competitive)

Price Level Higher (less output) Lower (more output)

First-Mover
None Yes, leader has more power
Advantage

Key Takeaway: The Stackelberg leader always produces more and earns higher profits than
in Cournot equilibrium. `
Market Outcomes in the Stackelberg Model
1. Leader’s Advantage:
o The leader firm produces more than the follower.
o It earns higher profits by influencing the follower’s decisions.
2. Follower’s Response:
o The follower optimally adjusts its output based on the leader’s decision.
 o It has less control over the market outcome.
3. Total Output & Price:
o Total output is higher compared to Cournot competition.
o Since more quantity is supplied, the market price is lower.
o Consumers benefit from lower prices.
4. Risk of Market Instability:
o If both firms try to be the leader, it can lead to market instability.
o This can cause price wars, competitive overproduction, or collusion.
Limitations of the Stackelberg Model
While the Stackelberg model provides insights into firm competition, it has some limitations:
1. Assumes Perfect Information
o The leader must know the follower’s reaction function accurately.
o In reality, firms do not always have perfect knowledge of competitors'
behavior.
2. Risk of Role Reversal
o If the follower does not accept its role, competition may turn into Cournot
or Bertrand competition.
3. Does Not Consider Pricing Strategies
o Assumes firms compete on quantity, not price.
o In real markets, price competition (Bertrand model) is also common.
4. Only Two Firms Considered
o The model does not apply well to markets with many firms (like
monopolistic competition).
Real-World Applications of Stackelberg Model
The Stackelberg model is useful for understanding markets with dominant firms that
influence competitors. Some real-world examples include:
1. Telecom Industry
o A large telecom company (leader) sets its data plan prices first.
o Smaller telecom companies (followers) adjust their plans accordingly.
2. Automobile Industry
o A market leader like Toyota decides production levels first.
o Other companies (followers) adjust production based on Toyota’s decisions.
 3. Airlines
o A major airline (like IndiGo) may set flight frequencies first.
o Smaller airlines (like Go First) adjust their schedules in response.
4. E-commerce & Retail
o Amazon often launches new product categories first.
o Other retailers follow, adjusting their product offerings.
Collusive Oligopoly
To avoid price wars or cut-throat competition, firms in an oligopolistic market may enter into
collusion. Collusion is essentially the opposite of competition. It refers to a situation where
firms cooperate with each other to take joint actions that enhance their collective bargaining
power against consumers.
According to Paul Samuelson,
“Collusion denotes a situation in which two or more firms jointly set their prices or output,
divide the market among them, or make other business decisions.”
Advantages of Collusion to Firms:
1. Increased profits
2. Decreased uncertainty
3. Better opportunity to prevent new entries into the market
Collusion may take two forms:
 Perfect Collusion
 Imperfect Collusion
Price Determination Under Perfect Collusion
Perfect Collusion typically involves a cartel arrangement. A cartel is a group of firms that
coordinate to make joint decisions regarding price and output.
As Boyce and Melvin define it,
“A cartel is an organisation of independent firms, whose purpose is to control and limit
production and maintain or increase prices and profits.”
Assumptions:
To analyze price determination under perfect collusion, the following assumptions are made:
1. All cartel firms produce a homogeneous product.
2. The market demand for the product is treated as the cartel’s total demand.
3. The demand at each possible price level is known.
 4. The marginal cost of each firm is known.
5. There are three firms in the cartel — Firm A, Firm B, and Firm C.

Collusion and Cartels:

 In an oligopoly, firms may form a cartel, an agreement where they work together to
set prices and output levels rather than competing independently.
 The goal of the cartel is to maximize joint profits by coordinating their actions. To do
so, the cartel determines the equilibrium output and price by equating marginal cost
(MC) with marginal revenue (MR).

Explanation of Model

Diagram Explanation:
 AR (Average Revenue) is the demand curve of the cartel.
 MR (Marginal Revenue) is the marginal revenue curve.
 MC1, MC2, MC3 represent the marginal cost curves of the three firms involved in
the cartel (A, B, and C).
 The ΣMC curve represents the cartel's total marginal cost, which is the sum of the
individual MC curves of the firms.
 The equilibrium point occurs where the ΣMC curve intersects the MR curve. At this
point, the output produced is OQ, and the price is OP.
Price and Output Determination:
 The equilibrium output is OQ where the cartel's marginal cost equals marginal
revenue (ΣMC = MR).
 The price at which the output is sold is OP, which corresponds to the price
determined by the demand curve (AR).
 This price and output level represent the monopoly price because the cartel behaves as
a monopoly in the market, coordinating output to maximize profits.
Distribution of Output:
 Each firm in the cartel will produce at the output level where its individual marginal
cost equals the industry's marginal revenue (OM).
 The total output (OQ) is the sum of the outputs from all firms: OQ = OA + OB + OC.
 The cartel aims to distribute output in a way that maximizes joint profits. If the
marginal cost of one firm is higher than another's, the cartel may shift output from the
higher-cost firm to the lower-cost firm to reduce overall production costs.
Cartel Output Allocation:
 Cartels may allocate output based on factors like past sales or productive capacity.
Alternatively, cartels may divide markets geographically, with each firm being
assigned specific regions or countries to control.

Prisoner’s Dilemma
Introduction: The Prisoner's Dilemma is a classic game theory scenario, widely used in
various fields such as economics, psychology, business management, political theory, and life
sciences. It was introduced by Merrill Flood and Melvin Dresher in 1950 while working at
Rand Corporation, and later formalized by Albert W. Tucker, who named it the "Prisoner's
Dilemma."
The Game: The scenario is explained as follows: Two suspects, A and B, are arrested for a
crime they committed together, but there is insufficient evidence to convict them of the
primary crime (armed robbery). However, they could each be convicted for possession of
stolen goods. Both suspects are interrogated separately, and each is given the following
options:
1. If one confesses and the other does not, the confessor goes free, and the other gets a
10-year sentence.
2. If both confess, each will serve 5 years.
3. If neither confesses, both will get 1 year for possession of stolen goods.
The dilemma arises because each prisoner must decide whether to confess or remain silent,
without knowing the decision of the other.
The payoff matrix for the prisoners’ decisions looks like this:

B Confesses B Does Not Confess

A Confesses 5, 5 0, 10

A Does Not Confess 10, 0 1, 1

Analysis of the Dilemma:

  Dominant Strategy: Each prisoner’s dominant strategy is to confess because,
regardless of what the other does, confessing results in a lesser sentence for the
confessor.
o If A confesses, A could either face 5 years (if B also confesses) or go free (if B
does not confess).
o If A does not confess, A could either face 10 years (if B confesses) or 1 year (if
B does not confess).
Thus, both A and B are incentivized to betray each other (confess) even though mutual
cooperation (not confessing) would result in a better outcome for both (only 1 year in prison
each).

Prisoner’s Dilemma in Economics: The concept of the Prisoner’s Dilemma is frequently

applied in economics, particularly in oligopoly markets. In such markets, firms face a similar
dilemma: to cooperate with competitors or to betray them for personal gain.
Example: Oligopoly Market (Crude Oil Production) In an oligopoly, two producers, A and
B, produce crude oil and must decide whether to follow an agreement to limit production or
increase production to earn more profit. The options and their payoffs are:

B Produces Low (300,000 Barrels) B Produces High (400,000 Barrels)

A Produces Low 18, 18 15, 20

A Produces High 20, 15 16, 16

 If both cooperate (produce low), they both earn $18 million.

 If one betrays the agreement and increases production, they earn $20 million, while
the other earns $15 million.
 If both betray the agreement, they both earn $16 million.
The dominant strategy for each producer is to betray the other by increasing production,
resulting in a suboptimal outcome for both ($16 million each) instead of the cooperative
outcome ($18 million each). This is the essence of the Prisoner’s Dilemma: both players,
seeking to maximize their individual payoffs, end up in a worse situation than if they had
cooperated.
Practical Examples:
1. OPEC and Oil Production: In the 1980s, Iran and Iraq violated the OPEC agreement
and increased their oil production, reducing prices and affecting the profitability of all
members.
2. Cold War Arms Race: Both the US and USSR engaged in an arms race, spending
enormous resources on weapons that could never be used. This competitive rivalry
mirrors the Prisoner’s Dilemma, where both sides could have benefited by reducing
armament spending.
 3. Climate Change: Despite the global acknowledgment that reducing carbon emissions
is vital for the planet’s survival, no country wants to unilaterally reduce emissions,
fearing that other nations will not do the same, leading to economic disadvantage.
4. Airline Price Wars (1992): Airlines in the U.S. (American, Continental, Delta,
United, and US Airways) engaged in a fare war, reducing prices to the point where all
airlines suffered losses, despite the possibility of maintaining higher prices for mutual
benefit.
Conclusion: The Prisoner’s Dilemma illustrates that cooperation is often the best strategy for
all parties involved, but individual incentives can lead to suboptimal outcomes. This scenario
is applicable not only in theoretical game theory but also in real-world situations such as
market competition, international relations, and environmental policies. Understanding the
dilemma highlights the challenges of fostering cooperation even when it benefits everyone.