Cournot

Games

Shengyu Li

Static Games
Intro

Nash
Introduction to Game Theory
Equilibrium
and Cournot Model
The Cournot
Model

Extensions

Concentration
Shengyu Li
and Anti-trust

Industrial Organisation - UNSW Business School

1 / 47
 Pre-Lecture Textbook Reading

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot (Main) Pepall, Richards, and Norman, Chapter 9; or

Model

Extensions
(Advanced) Tirole, Chapter 5.
Concentration
and Anti-trust

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 Oligopolies are Games

Cournot
Games

Shengyu Li

Static Games
Intro
When a few firms are participating in the same market, the
Nash actions of one affect the prospect of the others. (How?)
Equilibrium
To study an industry with several firms, we need to
The Cournot
Model understand how the firms interact.
Extensions
Game theory is used to analyze multi-player strategic
Concentration
and Anti-trust settings.
The theory sets up the “rules of the game” and then
solves the model assuming that all players are “rational”

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 Elements of a Game

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium 1 Players - Who is participating in the game.
The Cournot
Model 2 Rules - What can each player do, and when.
Extensions 3 Payoffs - What does each player get from each possible set
Concentration
and Anti-trust
of actions.

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 Strategies

Cournot
Games

Shengyu Li

Static Games A strategy is a player’s plan of action, it fully describes

Intro
how a player can play the game.
Nash
Equilibrium In this course, we will focus only on pure strategies, but
The Cournot
Model
there are also mixed strategies.
Extensions A player’s strategy set includes all possible strategies she
Concentration can use.
and Anti-trust
A strategy profile or strategy combination is a list of
strategies for each player, each strategy profile leads to a
particular payoff for each player.

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 Static Games

Cournot
Games

Shengyu Li

Static Games In a static game we assume each firm takes its action
Intro
simultaneously. If there are few possible strategies, the game
Nash
Equilibrium can be described in Normal Form:
The Cournot
Model Player 2
Extensions Left Right
Concentration Up 2, 3 4, 4
and Anti-trust Player 1
Down 1, 5 7, 7
This table shows strategies and payoffs for each player.

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 Dominant Strateges

Cournot
Games A player has a dominant strategy if that player’s strategy
Shengyu Li produces the best payoff regardless of his opponent’s strategy.
Static Games
Intro Player 2
Nash Left Right
Equilibrium
Up 2, 3 4, 4
The Cournot Player 1
Model Down 1, 5 7, 7
Extensions

Concentration
Right is a dominant strategy for Player 2, Left is Dominated:
and Anti-trust
If Player 1 plays Up, Player 2 is better off playing Right.
If Player 1 plays Down, Player 2 is better off playing Right.
Player 1 has no dominant or dominated strategy:
If Player 2 plays Left, Player 1 is better off playing Up.
If Player 2 plays Right, Player 1 is better off playing Down.
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 Deletion of Dominated Strategies

Cournot
Games

Shengyu Li If a strategy is (strictly) dominated, we know a rational player

Static Games
will never play it.
Intro

Nash
Player 2
Equilibrium
Left Right
The Cournot
Model Up 2, 3 4, 4
Player 1
Extensions Down 1, 5 7, 7
Concentration
and Anti-trust
Player 1 knows Player 2 is rational, so will not play Left.
Player 1’s choice is now easy, (Down, Right) is the
outcome of the game.
We will see that this is also a Nash Equilbrium.

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 Nash Equilibrium

Cournot
Games

Shengyu Li A strategy profile is a Nash Equilibrium if every player’s

strategy is a best response (leads to his highest possible payoff)
Static Games
Intro to the other players’ strategies, so no firm has an incentive to
Nash change its behavior.
Equilibrium

The Cournot
Model
Player 2
Extensions
Left Right
Concentration Up 2, 3 4, 4
and Anti-trust Player 1
Down 1, 5 7, 7

Check that (Down, Right) is a Nash Equilibrium:

If 1 plays Down, 2 prefers Right to Left, 7 > 5.
If 2 plays Right, 1 prefers Down to Up, 7 > 4.

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 Multiple Nash Equilibrium

Cournot
Games

Shengyu Li A game may have multiple Nash equilibria, here is an example:

Static Games
Intro
Anne and Bob are the only two students a class graded on a
Nash curve. If they get the same grade they both earn an A,
Equilibrium
otherwise only the high scorer gets an A.
The Cournot
Model Both are deciding whether or not to go to a party the
Extensions night before the exam, they get a utility of 2 from going.
Concentration
and Anti-trust If they get the same grade they both earn an A, otherwise
only the high scorer gets an A. Getting an A is worth
utility of 3 for each.
They are equally good students, and studying will help
improve their score by the same amount.

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 Multiple Nash Equilibrium

Cournot
Games

Shengyu Li
Bob
Static Games
Intro Study Party
Nash Study 3, 3 3, 2
Equilibrium Anne
Party 2, 3 5, 5
The Cournot
Model

Extensions Verify that this is the correct normal form for the game and
Concentration find all Nash Equilibria.
and Anti-trust
(Study, Study) is an equilibrium: if either chose to party,
they would receive a utility of 2 rather than 3.
(Party, Party) is an equilibrium: if either chose to study,
they would receive 3 rather than 5.

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 No Pure Strategy Equilibrium

Cournot
Games

Shengyu Li It is also possible for a game to have no pure strategy

Static Games
equilibrium. Consider a penalty kick game:
Intro

Nash Player
Equilibrium
Left Right
The Cournot
Model Left 1, 0 0, 1
Keeper
Extensions Right 0, 1 1, 0
Concentration
and Anti-trust
There is no pure strategy equilibrium, for any strategy
profile, someone has an incentive to change.
The only equilibrium involves mixed strategies, both
players randomize their actions.

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 Quick Summary

Cournot
Games

Shengyu Li

Static Games
Intro
Nash equilibrium is a strategy profile where each player is
Nash best responding to his opponents.
Equilibrium
The Nash equilibrium concept is supported by the
The Cournot
Model assumption that all player are rational.
Extensions
So far we’ve focused on games with 2 possible actions,
Concentration
and Anti-trust next we will consider a game where players can choose any
real number (e.g., production quantities).
The basic Nash Equilibrium concept remains the same.

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 Back to Industrial Organisation!

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
The Cournot Model is a model of firms who
Equilibrium simultaneously choose production quantities.
The Cournot
Model Because there are only a few firms, they have some degree
Extensions of market power, but are not monopolists.
Concentration
and Anti-trust This is one of the main models of oliogopoly, but not the
only one – pay attention to the assumptions.

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 Basic Cournot Model Assumptions

Cournot
Games

Shengyu Li

Static Games 1 Two firms produce homogeneous goods (consumers don’t

Intro
care which firm they purchase from).
Nash
Equilibrium 2 Firms compete by choosing quantities. A linear (inverse)
The Cournot
Model
demand curve that determines the price based on total
Extensions quantity produced.
Concentration 3 This is a simultaneous game, firms produce their
and Anti-trust
quantities without known their opponents production.
4 Marginal Cost is constant and the same for all firms,
MC = c.

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 Notation Guide

Cournot
Games

Shengyu Li

Static Games
Intro Firms are numbered 1 and 2 they produce quantities q1
Nash
Equilibrium
and q2 .
The Cournot I will generically refer to firm i ∈ {1, 2} where i stands for
Model
1 or 2. In this case, the notation q−i refers to the quantity
Extensions
of the opponent firm.
Concentration P
and Anti-trust
Total production is Q = q1 + q2 = i qi
You may get confused...ask questions.

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 Cournot Setup

Cournot
Games

Shengyu Li
Each firm chooses its own quantity qi , where i = {1, 2}. The
Static Games price is determined by the total quantity supplied according to
Intro
the inverse demand, P = A − BQ:
Nash
Equilibrium

The Cournot P(q1 , q2 ) = A − B(q1 + q2 )

Model

Extensions
Each firm is seeking to maximize its profit, which is:
Concentration
and Anti-trust
πi (qi , q−i ) = qi P(qi , q−i ) − cqi
= qi (A − Bqi − Bq−i ) − cqi

Firm i can choose qi but takes q−i as given.

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 Firm 1’s Marginal Revenue

Cournot
Games Suppose firm 2 plays q2 , how can firm 1 maximize profit?
Shengyu Li

Taking q2 as given, firm 1 faces linear demand,

Static Games
Intro

Nash P = A − Bq2 −Bq1

Equilibrium | {z }
Intercept
The Cournot
Model

Extensions
Then we can use the “twice as steep” rule to find firm 1’s
Concentration
and Anti-trust marginal revenue,

MR1 = A − Bq2 − 2Bq1

As usual, firm 1 maximizes by equating marginal revenue and

marginal cost.
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 Firm 1’s Maximization

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot
Model

Extensions

Concentration
and Anti-trust

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 Firm 1’s Maximization

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot
Model

Extensions

Concentration
and Anti-trust

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 Firm 1’s Maximization

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot
Model

Extensions

Concentration
and Anti-trust

21 / 47
 Firm 1’s Maximization

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot
Model

Extensions

Concentration
and Anti-trust

22 / 47
 First Order Condition

Cournot
Games

Shengyu Li

Static Games
Recall that πi (qi , q−i ) = qi (A − Bqi − Bq−i ) − cqi , player i
Intro
maximizes,
Nash
Equilibrium max qi (A − Bq−i ) − Bqi2 − cqi
qi
The Cournot
Model The first order condition is,
Extensions

Concentration ∂πi
and Anti-trust = A − Bq−i − 2Bqi − |{z}
c =0
∂qi | {z }
MR MC

So we get the same answer.

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 Best Response

Cournot
Games

Shengyu Li

Static Games
Start with the first order condition (or MR = MC),
Intro

Nash A − Bq−i − 2Bqi − c = 0

Equilibrium

The Cournot
Model Solving for qi we get the best response function,
Extensions
A−c q−i
Concentration qi∗ (q−i ) = −
and Anti-trust 2B 2
Whatever quantity its opponent chooses, firm i maximizes
profits by playing qi∗ (q−i ).

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 Nash Equilibrium for Cournot Model

Cournot
Games
A Pure Strategy Nash Equilibrium is a strategy profile (q1 , q2 )
Shengyu Li such that both firms are maximizing profits given their
opponents strategy, that is:
Static Games
Intro

Nash q1 = max π1 (q, q2 )

Equilibrium q
The Cournot q2 = max π2 (q1 , q)
Model q
Extensions

Concentration Using the best response functions, we have the following

and Anti-trust
system of equations:
A−c q2
q1 = −
2B 2
A−c q1
q2 = −
2B 2

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 Nash Equilibrium of Cournot Model

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot
Model

Extensions

Concentration
and Anti-trust

26 / 47
 Nash Equilibrium of Cournot Model

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot
Model

Extensions

Concentration
and Anti-trust

27 / 47
 Nash Equilibrium of Cournot Model

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot
Model

Extensions

Concentration
and Anti-trust

28 / 47
 Solving for Equilibrium

Cournot
Games

Shengyu Li
Substitute formula for q2∗ (q1 ) into q1∗ (q2 ) and solve for q1∗ ,
Static Games
Intro
A−c q ∗ (q1 )
Nash
Equilibrium q1∗ = − 2
2B 2
The Cournot
A − c A − c q1
Model
q1∗ = − +
Extensions 2B 4B 4
A − c
Concentration
and Anti-trust q1∗ =
3B
By a symmetric argument, we see that q2∗ = A−c
3B .
Plug these into demand to find prices and profits.

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 World Crude Oil Production

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot
Model

Extensions

Concentration
and Anti-trust

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 Comparing Outcomes

Cournot
Games

Shengyu Li
(A > c assumed) Price Quantity
A+c A−c
Static Games
Intro
Monopoly 2 2B
A+2c 2(A−c)
Nash Cournot Duopoly 3 3B
Equilibrium A−c
Competitive c B
The Cournot
Model

Extensions
Quantity produced under Cournot duopoly is higher than
Concentration
and Anti-trust under monopoly, but less than under perfect competition.
Price under Cournot duopoly is lower than under
monopoly, but higher than under perfect competition.
Cournot duopoly is not efficient, but is less inefficient than
monopoly.

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 Multiple Identical Firms

Cournot
Games

Shengyu Li

Static Games Suppose we have N firms instead of 2,

Intro P
1 Let Q−i = j6=i qj , all other firms quantities,
Nash
Equilibrium
2 Demand from i’s perspective is P = A − BQ−i − Bqi .
The Cournot
Model 3 MRi = A − BQ−i − 2Bqi
Extensions
4 Best response is:
Concentration
and Anti-trust
(A − c) Q−i
qi∗ = −
2B 2

32 / 47
 Multiple Identical Firms

Cournot
Games

Shengyu Li

Static Games
Intro To find equilibrium, use symmetry,
Nash
Equilibrium
1 All firms will produce the same amount since they are
The Cournot
identical.
Model
2 Substitute Q−i = (N − 1)qi ,
Extensions

Concentration
3 Solve for qi∗ ,
and Anti-trust A−c
qi∗ =
(N + 1)B

33 / 47
 Multiple Firms Punchline

Cournot
Games

Shengyu Li
Since there are N firms, total production is,
Static Games
Intro N (A − c)
Q = Nqi =
Nash
Equilibrium
N +1 B
The Cournot
Model

Extensions
For N = 1, we get the monopoly outcome.
Concentration For N = 2, we get the doupoly outcome.
and Anti-trust
As N → ∞, we converge to the competitive outcome.
Intiution: The more identical firms in the market, the less
impact each one has on demand, the more they look like
price-takers.

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 Cost Heterogeneity

Cournot
Games

Shengyu Li
What happens if the two firms have different marginal costs, c1
and c2 ?
Static Games
Intro Best response is a function of your cost and opponents
Nash quantity,
Equilibrium
A − ci q−i
The Cournot qi∗ (q−i ) = −
Model 2B 2
Extensions Substituting in opponents best response shows that in
Concentration
and Anti-trust
equilibrium, your quantity will depend on opponents cost
also,
A + c−i − 2ci
qi∗ =
3B
Your output is decreasing in your cost but increasing in
opponents cost.

35 / 47
 Cost Heterogeneity: How Best Response Changes

Cournot
Games

Shengyu Li

Static Games
Intro Recall that best response function describe how much a firm
Nash should produce as a function of the opponent firm.
Equilibrium

The Cournot
Model Suppose that firm 2’s production cost increased,
Extensions
how does this affect firm 1’s best response function?
Concentration
and Anti-trust how does this affect firm 2’s best response function?
how does this affect the equilibrium outcome?

36 / 47
 Cost Heterogeneity: Increasing Firm 2s Costs

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot
Model

Extensions

Concentration
and Anti-trust

37 / 47
 Cost Heterogeneity: Increasing Firm 2s Costs

Cournot
Games

Shengyu Li

Static Games
Intro

Nash
Equilibrium

The Cournot
Model

Extensions

Concentration
and Anti-trust

38 / 47
 Insights from Cost Heterogeneity

Cournot
Games

Shengyu Li

Static Games
Intro
The firms with lower cost gets a higher market share.
Nash But the firm with high cost still produces.
Equilibrium

The Cournot
What happens to prices?
1 −c2
Model 1 Q = q1 + q2 = 2A−c
3B
A+c1 +c2
Extensions 2 P = A − BQ = 3
Concentration
and Anti-trust So prices are determined by the sum of firm costs.
This is not Pareto efficient – a social planner would use
only the low cost firm to produce the good. Why?

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 An Illustrative Example

Cournot
Games
Two firms in a Cournot model with different marginal costs
Shengyu Li Market demand: P = 6 − Q;
Static Games Constant marginal cost for firm 1 is c1 = 1;
Intro
Constant marginal cost for firm 2 is c2 = 2.
Nash
Equilibrium

The Cournot
Model
Equilibrium:
Extensions (q1∗ , q2∗ ) = (2, 1) and P = 3.
Concentration
and Anti-trust
Firm 1’s profit: π1∗ = 4;
Firm 2’s profit: π2∗ = 1;
Consumer surplus: 0.5 × 3 × 3 = 4.5.
Social welfare = 4.5 + 4 + 1 = 9.5.

Is there an allocation plan that can achieve a larger value of

social welfare?
40 / 47
 An Illustrative Example

Cournot
Games

Shengyu Li Yes – a social planner can achieve a larger value of total

welfare by (1) shutting down the high-cost firm, (2) asking the
Static Games
Intro low-cost firm to produce all the quantities (while maintaining
Nash the market price), and (3) transferring some profit of firm 1 to
Equilibrium

The Cournot
firm 2. That is,
Model

Extensions
(q̂1 , q̂2 ) = (3, 0) and P̂ = 3.
Concentration Transfer 1 unit profit of firm 1 to firm 2.
and Anti-trust

Verify that, in this new allocation, there is at least one party is

strictly better off and all parties (consumers, firm 1 and firm 2)
are not worse off, comparing to the previous equilibrium
outcome.

41 / 47
 Cournot Model and Anti-trust

Cournot
Games From the above analysis, it seems that shutting down the
Shengyu Li high-cost (inefficient) firm is a way to improve social welfare.
Static Games
Intro In practice, this could happen in the format of merges and
Nash acquisitions, where low-cost firms acquire high-cost firms.
Equilibrium

The Cournot However, does this always produce better social outcomes?
Model

Extensions
What could be the concerns?
Concentration
and Anti-trust Cournot model provides an answer – market power, which
serves as a basis for anti-trust policies:
Merges and acquisitions will be (seriously) challenged in
highly concentrated industries.
The Herfendahl index is used to measure concentration:
HHI = N 2 where s = qi is market share.
P
s
i=1 i i Q

42 / 47
 Cournot Model and the Lerner Index

Cournot
Games
How this could be the case?
Shengyu Li Suppose that we have multiple firms with different costs,
Static Games
then firm i’s first order condition becomes,
Intro
∗
Nash A − BQ−i − 2Bqi∗ − ci = 0
Equilibrium

The Cournot
Model A − BQ ∗ − ci = Bqi∗
Extensions
Substitute P ∗ = A − BQ ∗ ,
Concentration
and Anti-trust
P ∗ − ci = Bqi
qi∗
Divide though by P, and use si∗ = Q∗ ,

P ∗ − ci BQ ∗ ∗
= s
P∗ P∗ i
43 / 47
 Cournot Model and the Lerner Index

Cournot
Games
P ∗ − ci BQ ∗ ∗
Shengyu Li What does ∗
= P ∗ si tell us?
| P{z }
Static Games
Intro Lerner Index
Nash The Lerner index is a firm’s markup over its marginal cost,
Equilibrium
it is a measure of market power.
The Cournot
Model We have shown it is directly related to the firm’s market
Extensions
share.
Concentration
and Anti-trust Furthermore, notice that the left-hand side includes the
inverse demand elasticity,
Q∗ dP Q ∗ 1
B ∗
= − ∗
=−
P dQ P η

44 / 47
 Cournot Model and Concentration

Cournot
Games
Combining the two equations above, we have:

si∗
Shengyu Li
P ∗ − ci
=
Static Games
Intro
P∗ −η
Nash
Equilibrium To consider industry concentration, take a weighted average of
The Cournot the Lerner index equation by summing all firms weighted by
Model
market share,
Extensions N N
Concentration
X P ∗ − ci X si∗2
and Anti-trust
si ∗
=
P −η
i=1 i=1
PN
Substitute the weighted-average cost, c̄ = i=1 si ci and the
definition of Herfendahl index, we have
P ∗ − c̄ HHI
∗
=
P −η
45 / 47
 Some Anti-trust Intuition

Cournot
Games
P ∗ −c̄ HHI
Shengyu Li What can we learn from P∗ = −η ?
Static Games
Intro
Industries with high concentration (high Herfendahl index)
Nash are likely to have high markups.
Equilibrium
Mergers that substantially raise the Herfendahl are likely
The Cournot
Model to be challenged.
Extensions
Concern is greater for industries with inelastic demand.
Concentration
and Anti-trust
Recall that this analysis assumes no entry and exit, but in
reality, entry and exit happen all the time. Thus, in
anti-trust court cases, the effect of entry and exit is always
a debatable issue.

46 / 47
 Summary

Cournot
Games
Game theory is a tool which helps us think about strategic
Shengyu Li
interaction.
Static Games
Intro
In Nash equilibrium, each player is optimizing given their
Nash opponents strategy.
Equilibrium

The Cournot
The Cournot Model is a game where firms compete by
Model simultaneously choosing quantity.
Extensions
The model shows that firms in oliogopolies have less
Concentration
and Anti-trust 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.
Interested in a deeper understanding? Extra reading:
Tirole, Chapter 5.
47 / 47