05.05.

2023 Daniela Silvestri BIE

EXERCISE SESSION MODULE E

ADVANCED COMPETITION MODELS
Basic assumption of the models: homogenous goods, same cost functions

EXERCISE 1
Consider a market for homogeneous products. Two firms (firm 1 and firm 2) are serving the market. The two
firms compete on quantities making simultaneous decisions.
Firms have the same marginal and average costs which are equal to 25.
The demand function is P=100-Q
Find the equilibrium price, quantities, and profit.
How does the duopoly equilibrium relate to a competitive or a monopoly equilibrium?

To find firm 1’s reaction function, we find the q1 that maximizes π1(q1, q2), under the assumption that q2 is
constant. Firm 1’s profit is:
𝑀𝑎𝑥 1 (𝑞1 , 𝑞2 ) = (100 − 𝑞1 − 𝑞2 )𝑞1 − 25𝑞1 =
= 75𝑞1 − 𝑞 21 − 𝑞2 𝑞1

Differentiating with respect to q1 while holding q2 constant, and setting the result equal to zero, gives:

∂1
= 75− 2𝑞1 − 𝑞2 = 0
∂𝑞1
Solving for q1 as a function of q2 gives firm 1’s best reply function:
1
𝑞1 = 37.5 − 𝑞2
2

Due to symmetry, for firm 2 we have:

𝑀𝑎𝑥 2 (𝑞1 , 𝑞2 ) = 75𝑞2 − 𝑞 2 2 − 𝑞2 𝑞1

Therefore firm 2’s reaction function is:

1
𝑞2 = 37.5 − 𝑞1
2

a-c/2b

a-c/b

Solving the system with the two best reply functions we find the quantity produced by the firms:
1 1
𝑞1 = 37.5 − (37.5 − 𝑞1 ) = 25
2 2

𝑞1∗ = 𝑞2∗ = 25

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Market price is 𝑃 = 100 − 𝑞1 − 𝑞2 = 50 and profits are equal for the two firms 𝜋1𝑐 = 𝜋2𝑐 =625

Competitive outcome: We would have the same demand curve, but price would be equal to marginal cost.
Combining this with the inverse demand curve
P = 25 = 100 – Q
gives a competitive equilibrium at p = 25 and Q = 75.

Monopoly outcome: The monopolist would maximize profit by setting marginal revenue equal to marginal cost.
TR = (100 – Q)*Q
MR(Q) = 100 – 2Q
MC(Q) = 25
Leading to the quantity and price of the monopoly equal to Q=37.5 ; P=62.5

The Cournot equilibrium lies between the perfect competitive and the monopoly outcome, both for quantity
and price.
Cournot Monopoly

Perfect competition

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05.05.2023 Daniela Silvestri BIE

EXERCISE 2
Two firms (firm 1 and firm 2) are serving the market. Market demand for a homogeneous good is
Q(p) = 750 - 3p.
The two firms employ the same technology, that is, they have the same linear cost function
C1(q1) = C2(q2) = Ci(qi)= 4qi.Both firms charge the same price, so each firm captures half of the market demand.
Find the equilibrium quantities, prices and profits under the Bertrand, Cournot, VS and collusive competition
regime.

a) Bertrand equilibrium
In the Bertrand model the main assumption is that firms have no cost advantages as firms have the same linear
cost function. In this case: c1 = c2 = 4.

In the (Nash) equilibrium of a Bertrand duopoly, the two firms charge the same price, which equals the
marginal costs, therefore p = MC thus p=4
The total quantity produced on the market is Q = 750 - 3*4 = 738
Firms share equally the market, thus q1 = q2 = Q/2 = 738/2 = 369, and they get zero profit, π1 = π2 = 0

Note that in the Bertrand model the strategic variable is price and for ease of computation you do not need to
derive the inverse demand.
Bear in mind that this exercise is related to the Bertrand Paradox that leads to the same results as in perfect
competition with just 2 firms having no profits. Specifically, for each firm, setting the price
- Lower than MC determines negative profits, so any other option bringing positive or no profits is preferred
- Higher than the MC is not an equilibrium
-
In equilibrium, prices must be at the marginal cost, only at the marginal costs firms have no incentives to
deviate from the equilibrium prices.

This happens under the assumption that products produced by the two firms are homogeneous and therefore
consumers will buy at the lowest price.

b) Cournot equilibrium
In a Cournot model with basic assumption, competition is based on quantities which represent the strategic
variable of the game.
Given that quantity is the strategic variable of the game, we calculate, for ease of computation, the inverse
demand function.

From the direct demand function given by the exercise, we derive the inverse demand function:
p = 250 - 1/3Q since Q= q1 + q2 we can write the inverse demand as

1
𝑝 = 250 − (q1 + q2 )
3

Each firm maximizes its own profit, which is function of the quantity produced by both.
So we write the profit maximizing function of the two firms:
1 1
Max π1(q1,q2) = p*q1 - MC*q1 = (250 − 𝑞1 − 𝑞2 ) ∗ 𝑞1 − 4𝑞1 =
3 3
1 2 1 1 1
250𝑞1 − 𝑞 1 − 𝑞2 𝑞1 − 4𝑞1 = 246𝑞1 − 𝑞 21 − 𝑞2 𝑞1
3 3 3 3

Given that the game is symmetric (both firms have the same cost function), we can immediately derive the
profit maximizing function of firm 2 which is the inverse of the profit maximizing function of firm1:
1 1
Max π2(q1,q2) = 246𝑞2 − 𝑞1 𝑞2 − 𝑞 2 2
3 3

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Applying the first order condition to the profit max. function of firm 1 and 2 we obtain the firms’ best reply
function:
∂1 2 1 1 2
= 246 − 𝑞1 − 𝑞2 = 0 → 246 − 𝑞2 = 𝑞1 →
∂𝑞1 3 3 3 3

1 3 738 1 1
𝑞1 = (246 − 𝑞2 ) ∗ = − 𝑞2 → 𝑞1 = 369 − 𝑞2 Firm 1 best reply function
3 2 2 2 2
(relationship between a firm’s profit maximizing output and the amount it thinks its
competitors will produce)

1
𝑞2 = 369 − 𝑞1 Firm 2 best reply function
2

Bear in mind that a best reply function indicates for example the quantity that firm 1 would produce as an
optimal reply to the quantity choice of firm 2.
By solving the system with the two best reply functions, we find the Cournot Nash equilibrium quantities:
1 1 1 4
𝑞1 = 369 − (369 − 𝑞1 ) → 𝑞1 = 369 − 184.5 + 𝑞1 → 𝑞1 = 184.5 ∗ = 246
2 2 4 3

𝑞1 = 246 𝑎𝑛𝑑 𝑞2 = 246 → 𝑄𝐶 = 𝑞1 + 𝑞2 = 492

Given the quantities produced by the two firms, we plug them in the inverse demand function, and we obtain
the price:
1
𝑝𝑐 = 250 − (492) = 86
3
Price results from the total quantity offered on the market.

The two firms earn the same profit, equal to:

𝜋1𝑐 = 𝜋2𝑐 = 86 ∗ 246 − 4 ∗ 246 = 21156 − 984 = 20172

When products are perfect substitutes, Cournot competition regime yields higher prices, higher profits and
lower quantities than Bertrand competition (however Bertrand yields higher consumer surplus and welfare).

c) Von Stackelberg
The VS model is solved via backward induction therefore we start from the best reply function of firm 2 which
is the follower:
1
𝑞2 = 369 − 𝑞1
2
Why do we solve the model via backward induction? Because we are in two period sequential game (no
simultaneous as in Cournot or Bertrand) therefore we first solve the problem in the 2nd period and then in the
1st period. This means that in the 2nd period firm 2 (by convention the follower) choose 𝑞2 given the quantity
that firm 1 (by convention the leader) has chosen in the 1st period. Please, at the exam read carefully the text
of the exercise to be sure about which of the two firms is the leader and the follower.

We go to the first stage of the game by backward induction, and we find the optimal price of firm 1 by plugging
in the best reply function of firm2 in the profit function of firm1:
1 1 1 1 1
Max 𝜋1 (𝑞1 , 𝑞2 ) = 246𝑞1 – 𝑞 21 – 𝑞2 𝑞1 = 246𝑞1 − 𝑞 21 – 𝑞1 ∗ (369 − 𝑞1 ) =
3 3 3 3 2
1 2 369 1 2 1 2
246𝑞1 − 𝑞 1 − 𝑞 + 𝑞 = 123𝑞1 − 𝑞 1
3 3 1 6 1 6

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Applying the first order condition:

∂1 1 1
= 123 − 𝑞1 = 0 → 𝑞 = 123 → 𝑞1 = 123 ∗ 3 = 369
∂𝑞1 3 3 1

We derive the optimal quantity for firm 2 based on its best reply function:
1 1
𝑞2 = 369 − 𝑞1 → 𝑞2 = 369 − (369) → 𝑞2 = 369 − 184.5 = 184.5
2 2

In equilibrium the overall quantity is 𝑄𝑉𝑆 = 𝑞1𝑉𝑆 + 𝑞2𝑉𝑆 Therefore 𝑄𝑉𝑆 = 553.5

This quantity will be sold at the price:

1 1
𝑝 = 250 − (q1 + q2 ) → 𝑝 = 250 − (369 + 184.5) → 𝑝𝑉𝑆 = 250 − 123 − 61.5 = 65.5
3 3
That is → 𝑝𝑉𝑆 = 250 − 184.5 = 65.5
The profit will be:
𝜋1𝑉𝑆 = 65.5 ∗ 369 − 4 ∗ 369 = 22693.5

𝜋2𝑉𝑆 = 65.5 ∗ 184.5 − 4 ∗ 184.5 = 11346.75

d) Collusion
If the two firms collude, they will charge the monopoly price:
1
𝑝 = 250 − 𝑄
3
1
𝑇𝑅 = (250 − 𝑄) ∗ 𝑄
3
2
𝑀𝑅 = 250 − 𝑄
3
Bear in mind that MR has double the slope of the price function.
2 3
MR=MC therefore 250 − 𝑄 = 4 → → 𝑄 = 246 ∗ = 369
3 2
Since we have two firms with Q=369 and Q= q1+q2 we have that q1=q2=184.5
P=250 – 1/3(369) = 250 – 123=127
𝜋1𝐶𝑜𝑙𝑙 = 𝜋2𝐶𝑜𝑙𝑙 = 127 ∗ 184.5 − 4 ∗ 184.5 = 22693.5

q1 q2 Q P π1 Π2
Bertrand 369 369 738 4 0 0
Cournot 246 246 492 86 20,172 20,172
Von Stack 369 184.5 553.5 65.5 22,693.5 11,346.75
Collusion 184.5 184.5 369 127 22,693.5 22,693.5

Note that duopoly output is greater than the monopoly’s but is less than it would have been under perfect
competition. Consequently, duopoly’s prices are greater than perfect competition, but less than monopoly’s.

A key question is whether collusion is stable and what are the conditions that facilitate it as for example
structural condition (concentrated industries) or demand evolution or factors related to the availability of
information.

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FORMULA MODULE E
Formula derived for the Cournot regime with symmetric cost functions

Assume you have the inverse demand function with a and b different from 1:

𝑃 (𝑄) = 𝑎 − 𝑏𝑄 𝑤𝑖𝑡ℎ 𝑄 = 𝑞1 + 𝑞2

The cost function is given by 𝐶 (𝑄) = 𝑐𝑄

The profit function would be for firm 1:

Each firm choose to maximize profits which given constant marginal cost is equal to

𝜋1 = 𝑃(𝑞1 + 𝑞2 )𝑞1 − 𝑐𝑞1 = [𝑎 − 𝑏(𝑞1 + 𝑞2 )]𝑞1 − 𝑐𝑞1 → 𝑎𝑞1 − 𝑏𝑞12 − 𝑏𝑞1 𝑞2 − 𝑐𝑞1

Due to the symmetry (same cost function among the two firms), the profit function of firm2 is just the
inverse.
𝜕𝜋1
The first order condition is give by: =0 𝑎 − 2𝑏𝑞1 − 𝑏𝑞2 − 𝑐 = 0 → 𝑎 − 𝑐 = 2𝑏𝑞1 + 𝑏𝑞2
𝜕𝑞1
𝑎 − 𝑏𝑞2 − 𝑐
𝑞1 =
2𝑏
𝑎−𝑐 1 𝑎−𝑐 1
The reply function would then be: 𝑞1∗ = 𝑅1 (𝑞2 ) = − 𝑞2 inverse for firm 2𝑞2∗ = 𝑅2 (𝑞1 ) = − 𝑞1
2𝑏 2 2𝑏 2
The Nash equilibrium is at the intersection of the two best reply functions with equilibrium quantities given
𝑎−𝑐
by: 𝑞1∗ = 𝑞2∗ =
3𝑏

2(𝑎−𝑐)
The total quantity is given by: 𝑄 = 𝑞1 + 𝑞2 =
3𝑏

2(𝑎−𝑐) 𝑎+2𝑐
The price is given by: 𝑃 = 𝑎 − 𝑏𝑄 = 𝑎 − 𝑏 ( )=
3𝑏 3
Price is greater than the marginal cost c.
The profit function for firm 1 would then be:
𝑎 + 2𝑐 𝑎 − 𝑐 𝑎−𝑐 (𝑎 − 𝑐)2
𝜋𝐶 = ∗ −𝑐∗ =
3 3𝑏 3𝑏 9𝑏

Summary of formula under the assumption of symmetric cost function:

𝑞∗ 𝑄∗ 𝑝∗ 𝜋∗
Monopoly 𝑎−𝑐 𝑎+𝑐 (𝑎 − 𝑐)2
2𝑏 2 4𝑏
Cournot 𝑎−𝑐 2(𝑎 − 𝑐) 𝑎 + 2𝑐 (𝑎 − 𝑐)2
3𝑏 3𝑏 3 9𝑏
Cournot (n-firms) 𝑎−𝑐 𝑎−𝑐 𝑛 𝑎 + 𝑐𝑛 (𝑎 − 𝑐)2
(𝑛 + 1)𝑏 𝑏 𝑛+1 𝑛+1 (𝑛 + 1)2 𝑏
Perfect 𝑎−𝑐
𝑏 c 0
competition
𝑎−𝑐 (𝑎−𝑐)2
VS 𝑞1∗ = 𝜋1∗ =
2𝑏 8𝑏
𝑎−𝑐 3(𝑎 − 𝑐) 𝑎 + 3𝑐
𝑞2∗ = (𝑎−𝑐)2
4𝑏
4𝑏 4 𝜋2∗ =
16𝑏

Cournot with n symmetric firms: as the number of firms increases, the price tends to marginal costs (as in
perfect competition); profits tend to be 0 (as in perfect competition), As the price decreases, the total quantity
increases and social welfare increases.
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