Lecture 10: Continuous Strategies: Cournot

Competition
Vera Sharunova

Games in Markets for Homogeneous Goods

In the previous lecture, we introduced the Bertrand model of price competition between
two firms. We have shown that, under the assumptions of this model, the two firms
engage in a fierce price competition and end up pricing at the cost of production, just as
a firm in a perfectly competitive market would do. The result is called the Bertrand
paradox, and if taken at face value, leads us to conclude that even two firms are enough
to support perfectly competitive market outcomes. Of course, this conclusion is far from
reality and is produced by several restrictive assumptions – namely, (i) consumers are
very sensitive to small price changes; (ii) costs of the two firms are identical; (iii) total
production costs are linear in the number of units produced. You will relax assumptions
(i) and (ii) in your homework, and we will consider an alternative model of firm compe-
tition later today. However, there are a few more interesting observations that we can
make using the Bertrand model.

1 Bertrand Duopoly and Collusion

Recall the best response diagram we drew last time (see Figure ??). The two firms
simultaneously choose what price to charge for a unit of a homogeneous good. The two
best responses intersect at pi = p−i = c, which constitutes a unique pure-strategy Nash
equilibrium of the game. Notice that the best response functions are upward-sloping,
meaning that when one firm raises the price, the other firm has an incentive to raise its
price too. If one player is decreasing (or increasing) its choice variable and the opponent
responds by also decreasing (or increasing) its choice variable, then the two choice vari-
ables are called strategic complements. This definition will be important for lectures
to come.

Since the two firms sell their goods at the production cost in equilibrium, both firms
end up with zero profits. They may want to coordinate on a higher price to achieve
higher profits. Q: If explicit collusion were legal in the United States, what price should
the two firms coordinate on? What profits would each of them get? If two firms collude,
they act as a single monopolistic entity and maximize the joint profit. Therefore, they

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pi
BR
pi > p−i −i pi = p−i

PM BRi

pi < p−i

c
NE

p−i
c PM
Figure 1: Best responses of the competing firms in Bertrand duopoly.

should agree on charging the monopoly price P M and split the monopoly profits ΠM in
some way, perhaps evenly.

Q: Do you think such collusion is sustainable? No, each firm would be tempted to
undercut the competitor’s price P M by an ε and steal all consumers. This game is sim-
ilar to prisoners’ dilemma, where both of the prisoners want to coordinate on defecting
(or, in our setting, not admitting to having a gun), but are too tempted to snitch and
therefore both choose to confess, ending up in a bad outcome with higher sentence. The
competitors may start off charging high prices, but eventually give into the tempta-
tion, and lower them. This phenomenon is well-documented empirically and is known
as Edgeworth price cycles. Figure 2 is an example of the fluctuations of average
daily and weekly gas prices at gas stations in Toronto and Windsor, Canada observed in
2007.1 As we can see, Toronto’s gas stations start each day with high prices, which get
progressively lower over the course of the day. Similar situation is observed at Windsor’s
gas stations with the evidence presented at the weekly level.

In reality, competitors are not allowed to discuss their pricing strategies with each other,
but may resort to tacit collusion. Tacit collusion is a situation in which firms silently
adopt strategies that minimize competition. Price-match guarantees are an example of
sustaining tacit price collusion. As described by Cabral et al. (2018), if a firm lowers
its price when both firms adopt price-match guarantees, it has the effect of lowering
1
The figure is taken from Noel (2015).

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Figure 2: Weekly Edgeworth price cycle in Windsor and daily Edgeworth price cycle in
Toronto, 2007. Source: Figure 1 in Noel (2015).

the rival firm’s price by the same amount. Thus, temptation to cheat on the colluding
partner disappears. We will explore more examples of tacit collusion when we talk about
repeated prisoners’ dilemma later in the course.

2 Quantity Competition: Cournot Duopoly

We will now consider a more realistic model of competition that was developed by a
French economist Antoine Augustin Cournot in 1838. In this model, the two firms com-
pete by simultaneously choosing quantity qi to sell in the market. Assume as before
that the market demand is given by Q(P ) = A − bP , where Q stands for the number of
units (quantity) sold, P stands for the price of the good, and A and b are some positive
constants. Also, for the time being, assume that the two firms produce a homogeneous
good at a constant per-unit cost c > 0.

First, we need to set up the profit functions of the two firms as a function of their
individual outputs qi and q−i . Since we only have two firms in the market, the total
quantity in the market is just the sum of the two firms’ individual quantities. In other
words, Q = qi + q−i . Notice also that the market demand curve is currently expressed
as a function of price P . Since the two firms compete in quantities, and therefore will
be maximizing their profits with respect to quantities, we need to rewrite the market
demand curve as a function of Q. In economics, we refer to this function P (Q) as an
inverse demand function.
A Q
Q(P ) = A − bP ⇒ bP = A − Q(P ) ⇒ P (Q) = −
b b

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A
Plug Q = qi + q−i into the inverse demand function and let b
= α, 1b = β to get
A qi + q−i
P (qi , q−i ) = − = α − β(qi + q−i )
b b
We are now ready to set up the profit function of firm i.

max πi (qi , q−i ) = P (qi , q−i )qi − cqi = (α − β(qi + q−i ) − c)qi
qi | {z } |{z}
Total Revenue Total Cost

∂πi
= α − 2βqi − βq−i − c = 0
∂qi

Rearrange the first order condition to get the best response of firm i as a function of q−i
α − βq−i − c
qi = (1)
2β

Since both firms face the same inverse demand curve P (qi , q−i ) and have the same costs,
the best response of firm −i is the same as the best response of firm i.
α − βqi − c
q−i = (2)
2β
In order to find the pure-strategy Nash equilibrium of this game, we need to find a pair
of (qi∗ , q−i
∗
) that are best responses to each other. In other words, we are looking for a
∗ ∗
pair of (qi , q−i ) that simultaneously satisfy both equations (1) and (2).
{ { ( ) {
qi = α−βq2β−i −c α
qi = 2β − 21 α−βq
2β
i −c
− c
2β
= α
4β
− c
4β
+ qi
4 qi∗ = α−c
3β
α−βqi −c α−βqi −c ∗ α−c
q−i = 2β q−i = q−i = 3β
2β

The pure-strategy Nash equilibrium profile is qi∗ = q−i∗

= α−c
3β
. In fact, we could have
avoided solving this system of equations by noticing that that the two firms are identical
and will choose the same output qi∗ = q−i∗
= q ∗ in equilibrium. This means that we can
drop the i and −i subscript in firm i’s or −i’s best response and solve a single equation
with q ∗ as its unknown.

∗ α − βq ∗ − c 3 α−c α−c
q = ⇒ q∗ = ⇒ q∗ =
2β 2 2β 3β

Let us now find the price at which a unit of the good is sold. Plug the equilibrium qi∗
∗
and q−i into the inverse demand function.

2(α − c) α + 2c
∗
P ∗ = P (qi∗ , q−i )=α−β =
3β 3

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Similarly to the Bertrand duopoly, we can graph the two firms’ best responses in the
qi -q−i coordinate plane. See Figure ??.

qi

α−c
β

BR−i

α−c
2β

α−c NE
3β

BRi
q−i
α−c α−c α−c
3β 2β β
Figure 3: Best responses of the competing firms in Cournot duopoly.

Let us start by graphing firm i’s best response. Since it is linear in q−i , we only need to
find two points to graph it, e.g. its intercepts:
α−c
1. When q−i = 0, qi = .
2β
α−c
2. If qi = 0, q−i = .
β
The best response function of firm −i is symmetric to the best response of firm i. The
two lines intersect at qi∗ = q−i
∗
= α−c
3β
, which is the pure-strategy Nash equilibrium of the
Cournot duopoly game.

Notice that the best response functions are downward-sloping, meaning that when one
firm increases the output, the other firm will respond by decreasing its output. If one
player is decreasing (or increasing) its choice variable and the opponent responds by
increasing (or decreasing) its choice variable, then the two choice variables are called
strategic substitutes.
Collusion can also exist when firms compete in quantities. For example, OPEC is an
international cartel of oil producing countries, where the member states agree on pro-
duction quotas to control oil prices. The incentives to cheat and produce above the
agreed production quotas are still present, much like in the price collusion example.

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References
[1] Cabral, L., Dürr, N., Schober, D., & Woll, O. (2018). Price Matching Guarantees
and Collusion: Theory and Evidence from Germany. Working Paper, New York
University.

[2] Noel, M. D. (2015). Do Edgeworth Price Cycles Lead to Higher or Lower Prices?.
International Journal of Industrial Organization, 42, 81-93.