Cournot

Marian Blackford Cournot Oligopoly

Primary characteristics of a Cournot Oligopoly are (1) Output decisions are made as opposed to pricing decisions, (2) Each firm makes its output decision based on the quantity it expects other firms to produce, and (3) Each firm believes its output will have no impact on the output of other firms.

The Cournot model was named for Antoine Augustin Cournot (1801 – 1877) due to his observations of a spring water duopoly. (Ref 2) His observations led to the following defined features of the Cournot model:


 * Small number of firms (more than one) serving many customers
 * Firms compete in quantities, and choose quantities simultaneously
 * Firms believe rivals will hold output constant if it changes its output
 * Firms do not cooperate
 * Firms have market power
 * Barriers to entry make the number of firms fixed
 * There is strategic behavior by the firms to maximize profit
 * Product can be homogeneous or differentiated

Because it believes rivals will not adjust output in response to changes in its output, each firm believes it has market power in that market price will change in response to it increase or decrease in quantity produced. If it makes a decision to increase output, it believes market supply will increase, which will in turn, decrease price.

This creates the dilemma for the profit maximizing firm. To determine optimal output level, a firm needs to choose output where Marginal Revenue(MR) = Marginal Cost(MC). But unlike perfect competition, MR is impacted by the output of other firms because the greater the output of all firms, the lower the market price and thus the lower the MR.

So, the profit maximizing level for the firm depends on output of other firms. This relationship between the firms profit maximizing output and other firms’ outputs is called a best response function. That is, a best response function defines the profit maximizing level of output for a firm for given output levels of the other firms. Once a firm has determined its best response function, it can determine output equilibrium, and thus its profit maximizing level of output.

Output equilibrium is the point where the firms’ response function line intersects the best response function line of all other firms. At equilibrium, each firm produces output that maximizes its profit given the output of other firms.

To illustrate, let’s assume there are only two firms, a situation known as a Cournot duopoly. Their best response lines are r1 and r2. The profit maximizing level of output for firm1 given that firm 2 produces Q2 units of output is: (Ref 1)

Q1 = r1(Q2)

The profit maximizing level of output for firm 2 given that firm 1 produces Q1 units of output is: (Ref 1) Q2 = r2(Q1)

The best response functions can be drawn as lines falling from left to right where the y axis is the quantity produced by firm 2 and the x axis is quantity produced by firm 1. Equilibrium exists where the lines of firm 1 and 2 intersect. See "Graph of Cournot Equilibrium" below. (Ref 6)

Line r1 represents the best response function for firm 1. Firm 1’s monopoly point is where line r1 intersects the x axis. The monopoly point for firm 2 is where line r2 intersects the y axis.

If the firms have the same Marginal Cost, their lines will be symmetrical and they will produce the same output. Otherwise output will skew toward the firm with the lower cost.

Isoprofit Curves are used to graph the firms’ potential profits. Every point on a single curve produces the same profit for the firm. The closer the curve is to the firm’s monopoly point, the greater the profit. The graph below (Ref 6) shows firm 1 and firm 2’s best response lines and their equilibrium Isoprofit curves.

Note the oval area to the inside of the equilibrium point to where the lines intersect and the dashed line that runs through it connecting the monopoly points of the two firms. Output anywhere on this line maximizes industry profits.

Thus we see the area where the firms can collude, agreeing to restrict output and or charge higher prices. If they do so, their profit is greater as illustrated by the position of these points closer to their monopoly points.

However, keep in mind that it is not that easy for firms to agree and there is little if any way for firms to enforce any agreement reached.

Now that we’ve explored the framework in which Cournot Oligopolies function, let’s turn to the real world to determine if they actually exist, and if so, where and how.

OPEC is a well known group attempting to operate with agreement regarding the output of oil each member will produce. Since oil is a product with limited supply and strong demand, price is significantly impacted. By agreeing to limit supply, OPEC members have a good deal of market power and can keep prices higher than they would be otherwise. However, OPEC is also a prime example of the difficulty in enforcing an output agreement due to the lack of any enforcement mechanism. While one firm is limiting its production to observe the collusive contract, the other has an incentive to break its output agreement to gather additional market share and reveue. This happens within OPEC all the time. OPEC will establish production quotas and then member countries will exceed those quotas to increase their revenue at the expense of other member countries. Each country chooses its output based on its belief that other countries will not change their output, back to the original Cournot model without collusion.

An example of a Cournot Oligopoly in a non-collusive environment is two firms who together have 100% of the market share for liquer sales in a large Indian reservation. Because only two liquer licenses are allowed on the reservation, barriers to entry fix the number of firms at 2. Each firm's license restricts sales to the reservation so it has no other market for its product. Each firm is able to produce whatever quantity of liquer it chooses. Each firm operates to maximize profit and adjusts it output based on the the expected output of the other firm.

Multiple Choice Questions:

1. If a company operating in a Cournot Oligopoly incurs an increase in costs while others in the industry do not, their best response line will a. Shift to the left b. Shift to the right c. Remain unchanged d. Become more horizontal

Answer: Their best response line will shift to the left because the point where their marginal revenue will intersect with their marginal cost will shift.

2. If firms in a Cournot duopoly successfully collude to restrict output a. Prices will drop b. Prices will remain unchanged c. The industry will more likely maximize profits d. Barriers to entry will no longer exist

Answer: c. Collusion to restrict output will move output for firms closer to their monopoly profit points where profit is greatest.

3. A characteristic of Cournot Oligopoly is that a. Firms cooperate b. Firms have no individual market power c. There are barriers to entry d. Firms focus on profit maximizing through pricing

Answer: c. Barriers to entry are an important aspect of the Cournot Oligopoly.

4. In a Cournot Oligopoly, a firm’s Isoprofit curves a. Represent more profit for the firm as they move away from its monopoly point b. Each curve contains infinite profit points for the firm c. Each curve is made up of identical profit points of the firm d. Intersect at the most profit maximizing point

Answer: c. The curves each graph identical profit points for the firm at various output and pricing combinations.

5. In a Cournot Ogopoly, profit maximizing output for a firm is a. Dependent on pricing b. Dependent on the output of other firms c. Dependent on producing a homogeneous product d. Dependent on producing more than the other firms

Answer: A primary characteristic of Cournot Oligopoly is the interdependence of firms on the quantities they believe other firms will produce.

References: (Ref 1) [|www.economics.utoronto.ca/osborne/2x3tutorial/cournot.htm] (Ref 2) en.wikipedia.org/wiki/cournot_competition (Ref 3) http://www.intertic.org/Conference/Amir1.pdf (Ref 4) http://www.cbe.csuhayward.edu/~skamath/powerpoint/econ3551s9/tsld009.htm (Ref 5) http://myatt.oxonomica.org/2005/09/10/multiproduct-cournot-oligopoly/ (Ref 6) Michael R. Baye, Managerial Economics and Business Strategy, 5e; Copyright 2006 by The McGraw-Hill Companies, Inc.