Microeconomic Essentials by Jay Prag;

Author:Jay Prag; [Prag, Jay]
Language: eng
Format: epub
Tags: Microeconomics; supply and demand; supply curve; demand curve; markets; market interference; free markets; consumer theory; theory of the firm; perfect competition; monopolies; monopoly; imperfect competition; oligopoly; game theory; input markets; public economics; cost-benefit analysis; international economics; trade;
Publisher: MIT Press
Published: 2020-09-11T00:00:00+00:00

8.4 Oligopoly: Cournot Competition

Since overt cooperation is both problematic and illegal in many cases, we need to consider models in which firms do not cooperate. But not cooperating does not mean they ignore the other firms in an industry with only a few firms. What we imagine is that firms observe and react. There are two well-known noncooperative models that are structured this way (and several others that spring from them). The first is called Cournot competition or quantity competition. Here, firms observe each other’s output and base their own output on this observation.

In the easiest version of the Cournot model, a firm observes other firms’ output and assumes other firms’ output is fixed. Suppose there are only two firms, firm A and firm B, and each firm can observe the other’s output. Suppose they are each initially producing half the (break-even) perfectly competitive output. Each of them will notice that it can do better. Firm A will observe firm B’s production (half the market) and assume that is fixed. Firm A would then monopolize its half of the market, decrease output, raise prices, and make profits.

Both firms would do this under this set of assumptions, and, after some iteration, they would each produce a share of the market that is less than half. Total output would then be less than the output in a perfectly competitive environment, and both firms would make a profit.

With a few more simplifications, we can get precise results for the Cournot model. Suppose there are two firms, each producing the same good (so consumers are indifferent), and each with straight (linear) demand. Suppose further that marginal costs are constant for all levels of output. As we recall our definitions from chapter 5, that assumption means that marginal cost equals average cost (because every unit costs the same). A linear demand will also have a linear marginal revenue, but with twice the slope (see the derivation in appendix 8.1).

Suppose the perfectly competitive output is one million units per day, and initially each firm is producing one-half of that. When they observe and react à la Cournot, they will each monopolize their share of the market. That means they will each reduce output to one quarter of the market, reducing total output to one-half of the market. That production decision—that each firm produces half its perceived share when they monopolize—is specific to this setup, in which we have a linear demand and constant marginal cost (see appendix 8.1). It helps us see the basic idea that each firm, acting like a residual monopolist but not cooperating or colluding, will choose to decrease output.

But that level of output won’t be the final equilibrium. Each firm will look at the other’s new output (now one quarter) and realize its calculation is wrong: if firm B is producing one quarter of the market, firm A’s (residual) share is three quarters of the market, and their monopoly output would be three-eighths (one half of the residual). Iteration, or calculations, would

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