Game Theory and Strategic Behaviour

Lecture 5
Applications - Cournot Model of Duopoly

Suppose there are two firms in the market who independently and
simultaneously choose the quantities they will produce, i.e. without
knowledge of the choice of quantity by the other firm.
Let q1 and q2 be the quantities of a homogeneous (identical)
product produced by firms 1 and 2 respectively.
Let P (Q) = a − Q be the price at which the market clears, i.e.
supply equals demand, when the aggregate quantity is Q = q1 + q2 .
Suppose the cost of producing qi is Ci (qi ) = cqi for firm i, c < a.
Thus, the Cournot (1838) model, is a static model where firms
choose their quantities simultaneously.
a = maximum willingness to pay (beyond this price customers are not willing to pay)
Applications - Cournot Model of Duopoly

Normal Form representation of the Cournot game

Players in the game - Firm 1, Firm 2
Strategies available to each player - the different quantities each firm
can produce, Si = [0, ∞) where a strategy, si , is a quantity choice
qi > 0.
Payoff received by each firm as a function of the strategies chosen
by both firms - profit of a firm i,
πi (qi , qj ) = qi [P (qi + qj ) − c] = qi [a − (qi + qj ) − c].
profit function for player i
Applications - Cournot Model of Duopoly
Solving for the Nash equilibrium
The strategy pair (qi∗ , qj∗ ) is a Nash equilibrium, if for each player i,
πi (qi∗ , qj∗ ) ≥ πi (qi , qj∗ ) for every feasible strategy in Si , i.e. for every
possible quantity that can be produced.
Thus, for every player i, qi∗ must solve
max0≤qi <∞ πi (qi , qj∗ ) = max0≤qi <∞ qi [a − (qi + qj ) − c].
Differentiating the above equation with respect to qi , i.e. holding qj
fixed, gives the first order condition for firm i’s optimisation problem
: qi = 21 (a − qj∗ − c).
Thus, for the quantities (q1∗ , q2∗ ) to be a Nash equilibrium, they must
satisfy
1
q1∗ = (a − q2∗ − c) (1)
2
1
q2∗ = (a − q1∗ − c) (2)
2
Solving the above system of equations yields q1∗ = q2∗ = a−c
3 .
Applications - Cournot Model of Duopoly

Each firm would like to be a monopolist, i.e. be the only firm in the
market and receive all the profits - it would choose qi to maximise
π(qi , 0). It would then produce qm = a−c2 and earn monopoly profits
(a−c)2
4 .
Total profits for the duopoly are maximised by setting q1 + q2 = qm ,
e.g. by setting qi = q2m . each firm has an incentive to deviate from the output s they want to act
in their own self interest

However, each firm has an incentive to deviate from the above

arrangement - since the market price, P (qm ) is high (as the
aggregate monopoly quantity is low), each firm would like to
increase production. This is reflected in equations (1) and (2) which
show that qi = q2m is not the best response to qj = q2m .
This temptation to increase output is lower at the Cournot
equilibrium - as the aggregate output is higher and the associated
price is lower - to the extent that firms are just deterred from
increasing production.
Applications - Cournot Model of Duopoly
Graphical representation of the Nash Equilibrium
Recall that firm 1’s best response to a quantity q2 produced by firm
2 is q1∗ = R1 (q2 ) = 12 (a − q2∗ − c). This is called firm 1’s Reaction
function.
Similarly, firm 2’s best response to a quantity q1 produced by firm 1
is q2∗ = R2 (q1 ) = 21 (a − q1∗ − c). This is called firm 2’s Reaction
function.
The intersection of the two reaction functions gives the Nash
equilibrium.
Applications - Bertrand Model of Duopoly

Bertrand (1883) argued that firms choose and compete on prices

when firm 1 is choose its price, it is
rather then quantities, as proposed by Cournot. unaware of the price chosen by firm 2

Suppose there are two firms in the market that independently and
simultaneously choose the price of their product.
Consider the case of differentiated products, i.e. products that differ
from one another with respect to some characteristics such as
quality, etc.
The quantity demanded by consumers when the two firms charge p1
and p2 respectively is qi (pi , pj ) = a − pi + bpj .
Marginal costs are constant, and equal c.
Applications - Bertrand Model of Duopoly

Normal form representation of the Bertrand game

Players in the game - Firm 1, Firm 2
Strategies available to each player - the price each firm may charge,
Si = [0, ∞) where a strategy, si , is a price pi > 0.
Payoff received by each firm as a function of the strategies chosen
by both firms - profit of a firm i,
πi (pi , pj ) = qi (pi , pj )[pi − c] = (a − pi + bpj )(pi − c).
Applications - Bertrand Model of Duopoly
Solving for the Nash equilibrium
The strategy pair (pi , pj ) is a Nash equilibrium, if for each player i,
πi (p∗i , p∗j ) ≥ πi (pi , p∗j ) for every feasible strategy in Si , i.e. for every
possible price that can be charged.
Thus, for every player i, p∗i must solve
max0≤pi <∞ πi (pi , p∗j ) = max0≤pi <∞ (a − pi + bpj )(pi − c).
Differentiating the above equation with respect to pi , i.e. holding pj
fixed, gives the first order condition for firm i’s optimisation problem
: pi = 12 (a + bp∗j + c).
Thus, for the prices (p∗1 , p∗2 ) to be a Nash equilibrium, they must
satisfy
1
p∗1 = (a + bp∗2 + c) (3)
2
1
p∗2 = (a + bp∗1 + c) (4)
2
Solving the above system of equations yields p∗1 = p∗2 = a+c
2−b .
References
Gibbons R., A Primer in Game Theory, Chapter 1.