Game Theory & Strategic

Analysis
Week 3
Static Games – Cournot Model & its Applications

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 • Cournot Model
• Background
• Basic Model
• Best Response Functions
Learning • Cournot Nash Equilibrium
Objectives • OPEC Example
• Cartel Solution
• Implications of Cournot
Model

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 • Suppose BBA is having a Chinese New Year Fair next week
• This class has committed to selling flowers - a single stalk of rose
• Suppose the class has decided to form two teams, each managing one stall
• Once at the fair, the teams compete fiercely to sell their flowers, which
results in a uniform price, determined by the demand for the flowers

A Quantity • After some research, the class deduces that the demand for flowers is as
follows:
Game Price = 50 – Total Quantity
• The class has also negotiated with the supplier so that each unit costs $2
• Each team has to independently decide how many units to order now with
the objective of making the most profit for its team
• How many units should each team order?
A Quantity Game
• Demand Function
Price = 50 – Total Quantity
A Quantity Game
• Scenario Analysis – For each quantity q2 by the other group, what is
my best response?
Price = 50 – (q1 + q2)
An Example
q2 q1 Price Profit
4 4 42 160 Profit = (Price – 2) q1
4 8 38 288
4 12 34 384 here, we conclude that q1 = 20
4 16 30 448 is the best
4 20 26 480 BUT
is q2 = 4 the best response
4 28 18 448 given q1 = 20?
4 32 14 384
4 36 10 288
A Quantity Game An Example if q2 = 20,
q2 q1 Price Profit
• Scenario Analysis – For each 20 4 26 96
quantity q2 by the other group, what 20 8 22 160
is my best response? 20 12 18 192
q2 q1 Price Profit 20 16 14 192
4 4 42 160 20 20 10 160
4 8 38 288 20 28 2 0
4 12 34 384 20 32 -2 -128
4 16 30 448 20 36 -6 -288
if q2 = 16,
4 20 26 480
4 28 18 448 q2 q1 Price Profit
4 32 14 384 16 4 30 112
4 36 10 288 16 8 26 192
16 12 22 240
16 16 18 256
Nash Equilibrium: A pair of Best Responses
16 20 14 240
16 28 6 112
aggregate qty in NE = 32
16 32 2 0
A Quantity Game
q2 q1 Price Profit
• Scenario Analysis – For each 20 4 26 96
quantity q2 by the other group, what 20 8 22 160
is my best response? 20 12 18 192
q2 q1 Price Profit 20 16 14 192
4 4 42 160 20 20 10 160
4 8 38 288 20 28 2 0
4 12 34 384 20 32 -2 -128
4 16 30 448 20 36 -6 -288
4 20 26 480 An Example
4 28 18 448 q2 q1 Price Profit
4 32 14 384 16 4 30 112
4 36 10 288 16 8 26 192
16 12 22 240
Nash Equilibrium: A pair of Best Responses
16 16 18 256
16 20 14 240
Aggregate Quantity in Nash 16 28 6 112
Equilibrium = 32 16 32 2 0
 A Quantity Game

px
Profit of Firm 1 maximise this eqn

profit F1 𝜋1 = (50 − 𝒒𝟏 − 𝑞2 − 2)𝒒𝟏 pi F1 = 48q1 - q1^2 - q1q2

Differentiate 𝜋1 with respect to 𝒒𝟏 : 48 − 2𝒒𝟏 − 𝑞2 = 0, or

firm 1 can only control q1
𝒒𝟏 = 𝟏/𝟐(𝟒𝟖 − 𝑞2 ) best response function
A Quantity Game

Four scenarios for Team 1’s reasoning:

Scenario Description Team 1’s conjecture q1 q2

Naive Ignores Team 2 aka imagine q2 = 0 none 24 12

so q1 = 0.5(48 - 0) = 24
Primitive Reasons that Team 2 reacts to Team q2 = 12 18 15
1’s previous output so q1 = 0.5(48 - 12) = 18

Sophisticated Reasons that Team 2 will deduce q2 = 15 16 ½ 15 ¾

that Team 1 considers Team 2’s so q1 = 0.5(48 - 15) = 16.5
reaction to Team 1’s monopoly
output

Ultra- Both Team 1 and Team 2 believe q2 = ½(48 –q1) 16 16

sophisticated that the other understands best
response logic
A Quantity Game
q1

24

q1= ½ (48-q2)

q2
48
A Quantity Game
q1

48
q2= ½ (48-q1)

24

q1= ½ (48-q2)

q2
24 48
A Quantity Game
q1

48
q2= ½ (48-q1)
Nash Equilibrium: (16, 16)
24 solv sim eqn

n7 n6
n5 n4
n1

n3 n2
q1= ½ (48-q2)

q2
24 48
 • If one teams gets to announce the committed quantity, does it change the
outcome of the game?
A Quantity profit of firm 1
Game pi = (50 - q1 - q2 - 2)q1 = (50 - q1 - 1/2(48- q1) - 2)q1
pi = (24 - q1/2)q1

differentiate pi wrt q1: 24 - q1 = 0 or,

q1 = 24
A Quantity Game
q2 q1 Price Profit
• Scenario Analysis – For each 20 4 26 96
quantity q2 by the other group, what 20 8 22 160
is my best response? 20 12 18 192
20 16 14 192
q2 q1 Price Profit
20 20 10 160
4 4 42 160
20 28 2 0
4 8 38 288
20 32 -2 -128
4 12 34 384
20 36 -6 -288
4 16 30 448
4 20 26 480
4 28 18 448 q2 q1 Price Profit
4 32 14 384 16 4 30 112
4 36 10 288 16 8 26 192
16 12 22 240
Nash Equilibrium: A pair of Best Responses
16 16 18 256
16 20 14 240
Is the Nash Equilibrium Efficient? 16 28 6 112
16 32 2 0
A Quantity Game
• To find the efficient outcome: Only one decision maker (monopoly)

Q Price Profit
4 46 176
8 42 320
12 38 432
16 34 512
20 30 560
24 26 576 Total Quantity = 24
28 22 560
32 18 512
36 14 432

Aggregate Quantity in Nash Equilibrium = 32 > 24!!

A Quantity Game
• To find the efficient outcome: Only one decision maker (monopoly)

Q Price Profit
4 46 176
8 42 320
12 38 432
16 34 512
20 30 560
24 26 576 Total Quantity = 24
28 22 560
32 18 512 What about each team order 24/2
36 14 432 = 12 units?

Aggregate Quantity in Nash Equilibrium = 32 > 24!!

A Quantity Game
• To find the efficient outcome: Only one decision maker (monopoly)

q2 q1 Price Profit
12 4 34 128
12 8 30 224
12 12 26 288
12 16 22 320
12 18 20 324 Best Response to the
12 28 10 224 other team choosing 12
12 32 6 128 units is 18 units
 A dominant strategy (q = 16)
Nash equilibrium leading to
A Quantity Game an inefficient outcome!
Team 2

Team 1 q = 12 q = 16

288 320
q = 12
similar to prisoners dilemma 288 240
BUT THERE IS A
BETTER OUTCOME

but is p1 pick 12, p2 inclined to pick 16

240 256
q = 16
324 256
DOM STRAT NE
A Quantity Game

• Underlying Mechanism
• The pursuit of individual self-interest does NOT
maximize the well-being of the group as a whole -
characteristic of oligopolistic industries
• When a firm expands its output, it reduces the
market price and thus lowers the sales revenue of its
rivals inc o/p, dec mkt px, lower rev of rivals
• The firm does not care about this revenue
destruction effect because it is maximizing its own
profit, not total industry profit – the firm does not
suffer the entire cost of overproduction!
A Quantity
Game
• Example: OPEC
Cournot Model:
Background
• Motivation of Cournot Model
• With a more concentrated
market, each firm will analyze
the likely effects of its actions
on competitors
• Anticipate what competitors
might do in reaction

• Example of Oil Market (OPEC):

• 10 large manufacturing nations
account for >80% of oil
production
• Organization of Petroleum
Exporting Countries (OPEC)
accounts for 75% of that output.

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Cournot Model:
Background
• More on OPEC…
• Formed in 1961, tried to keep
world oil prices high by
restricting production levels
(via production quotas on its
members).
• High prices of OPEC quotas
incentivize non-OPEC nations
to invest in new oil fields and
increase production levels.
• Increased pressure on OPEC,
with some cheating on their
quotas.
• Some members (Ecuador)
left, but the core of OPEC
remain steady, larger
producers show no signs of
dissolving OPEC anytime in
the near future.
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Cournot Model: Background

•As such…
• OPEC nations might
worry about response
of non-OPEC nations
• Will their attempt to
maintain high oil
prices be frustrated by
increased production
from non-OPEC
nations?

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 DUOPOLY
• Cournot Model of Duopoly (1838)
• Two firms selling a homogeneous product
Cournot Model: • q1 : quantity produced by firm 1
Basic Model • q2 : quantity produced by firm 2
• Q = q1 + q2 = aggregate quantity
• Firms 1 & 2 operate on the same demand
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 Cournot Model: Basic PModel

•Demand Function: P = a – b Q

• P is the market price Q

• Q is the total quantity produced in the market
• a is the intercept, b is the slope (gradient)
• ci is the unit cost of production for Firm i (where i = 1,2)
• Assume cost function is the same for each firm with
constant marginal cost (MC)
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 Recall …
BEST IDEAS
Framework
To derive the Nash Equilibrium
B – Best response for ID – InDifferent for
E – Each E – Each
S - Scenario A – Appropriate
T – Together S - Strategy
Pure Strategy Nash Equilibrium Mixed Strategy Nash Equilibrium

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 How much should Firm 1 produce to maximize profits if Firm 2
produced q2 in a static simultaneous-move game?

Cournot •Analyze from the perspective of Firm 1

Model: • Since Firm 1 is NOT the only firm, its

production decision alone does NOT
Best determine the market price.
Response • It cannot simply compute profits from
Function selling various quantities and pick the one
which maximizes profits
• Market price depends on production of
BOTH firms.

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01

Cournot Model: Implications

•OPEC & Oil Prices: Sky-high supply, rock-bottom demand
• What happened to Saudi Arabia (OPEC) and Russia (Non-OPEC) in March 2020?
• Both could not agree on cutting oil production to stabilize oil prices.
• Saudi Arabia retaliated by increasing oil production sharply.
• Large oil supply increase occurred concurrently with steep decreases in demand for oil as the world
was dealing with COVID-19, leading to a huge decrease in oil prices.
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 Cournot Model: Another Example

THE ACTUAL AMOUNT OF THIS INFORMATION ADJUSTS

ELECTRICITY DEMAND AT ANY TIME THE ELECTRICITY SUPPLY
IS UPDATED GENERATED IN ACCORDANCE
TO THE DEMAND

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Cournot Model: …Likewise, electricity prices fluctuate in
accordance to the amount of electricity
Another Example generated.

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 Summary

• Cournot Model
• Background & Motivation
• Basic Model
• Best Response Functions &
Cournot Nash Equilibrium
• Implications of Cournot Model
• Another Example: Electricity
Market

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Exercise 1 © Copyright National University of Singapore. All Rights Reserved.
Please work on it prior to class. We will go through it in class next week

Mock Test 1 © Copyright National University of Singapore. All Rights Reserved.