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- May 23, 2018

ECONOMIC ANALYSIS By Introduction A market structure exhibited by two firms that control the largest share of the market is a special form of oligopoly known as duopoly. In both dynamic and static economic models, the major struggle for most large firms in the market is choosing simultaneously both the price and quantity since these two factors must be in a clear consistency with the consumer demand, but both firms seeks to maximize their profits. Yet, in a case where each of the two firms in an industry produce at the same marginal cost, but with zero fixed costs, there are some implications on price and output on each firm as discussed in two situations below:

a. Competition based on the price of their output

When the mode of competition of the two firms is based on the prices of their output rather than quantities produced from each firm, then the customers will tend to buy from the firms with the cheapest price. The market is split evenly if firms tend to offer the same price to the market. This situation is better explained by the Bertrand equilibrium model, where, P=a-bQ.

Each firm’s profit function is stipulated by the price the firm sets since the marginal costs are the same for the two firms. Consider the graph below;

P1 $900

Firm 1 $600 Nash equilibrium

$500 (MC) (Bertrand)

$500 (MC) $600 $900 Firm 2 P2

b. Competition based on the quantity produced (Cournot competition)

In this case, each firm decides on the quantity to sell (the market share, Q=q1 +q2) and the market price, P, is determined by the inverse of the market demand. Both the firms will seek to maximize profits, thus, P=a-bQ, if a>bQ

Suppose firm 2 decides to produce q2, then firm 1’s profit if it decides to produce q1 too is P-C1 (q1). On the other hand, if firm 1 decides to produce q1, then firm 2 will make a profit equaling to P-C2 (q2) if firm 2 also decides to produce at q2. Consider the graph below;

Q1

Firm 1’s reaction function to Q2 of firm 2 Cournot equilibrium point

Firm 2’s reaction function to quantity, Q1 of firm 1

Q2

References

Besanko, D., Braeutigam, R. R., & Gibbs, M. (2011). Microeconomics. Hoboken, NJ, John Wiley.

Krugman, P. R., & Wells, R. (2005). Microeconomics. New York, NY, Worth.

a. Competition based on the price of their output

When the mode of competition of the two firms is based on the prices of their output rather than quantities produced from each firm, then the customers will tend to buy from the firms with the cheapest price. The market is split evenly if firms tend to offer the same price to the market. This situation is better explained by the Bertrand equilibrium model, where, P=a-bQ.

Each firm’s profit function is stipulated by the price the firm sets since the marginal costs are the same for the two firms. Consider the graph below;

P1 $900

Firm 1 $600 Nash equilibrium

$500 (MC) (Bertrand)

$500 (MC) $600 $900 Firm 2 P2

b. Competition based on the quantity produced (Cournot competition)

In this case, each firm decides on the quantity to sell (the market share, Q=q1 +q2) and the market price, P, is determined by the inverse of the market demand. Both the firms will seek to maximize profits, thus, P=a-bQ, if a>bQ

Suppose firm 2 decides to produce q2, then firm 1’s profit if it decides to produce q1 too is P-C1 (q1). On the other hand, if firm 1 decides to produce q1, then firm 2 will make a profit equaling to P-C2 (q2) if firm 2 also decides to produce at q2. Consider the graph below;

Q1

Firm 1’s reaction function to Q2 of firm 2 Cournot equilibrium point

Firm 2’s reaction function to quantity, Q1 of firm 1

Q2

References

Besanko, D., Braeutigam, R. R., & Gibbs, M. (2011). Microeconomics. Hoboken, NJ, John Wiley.

Krugman, P. R., & Wells, R. (2005). Microeconomics. New York, NY, Worth.