Single variable unconstrained optimization V

Market structure problem: Duopoly

Duopoly market structure is characterized by two sellers of a homogeneous or differentiated product and numerous buyers.
The price quantity combination and profit of a duopolistic firm is dependent on the combined action of all the firms in the
market. Any single firm can control its own level of output (and price if the product is differentiated) but it does not have
any control over other variables that govern its profit. Its profit is dependent on the collective decision of all the players (for
duopoly it is two, for oligopoly it is few but more than two) of the market. Depending upon the interaction of two sellers a
number of outcomes may appear.
In the following problem we have two sellers of a homogeneous product operating in a market. We will cleverly denote
these two sellers as seller 1 and seller 2. Their production level is q1 and q2 respectively. They face the same price level P.
Depending upon how they react we will have many outcomes. Here we will consider only 4 of them:
Case 1: Quasi-competitive case: The quasi-competitive solution is achieved when all the members of the market work as if
they are in a competitive market. Perfect competition is marked by exogenous price level and equality of price and marginal
cost. So in this case each seller will want to equate his or her marginal cost with his or her price (in this case the price is
same for both of them). Profit of firm 1 is given by
) ( ) , (
1 1 2 1 1 1
q C q q R = and ) ( ) , (
2 2 2 1 2 2
q C q q R =
Let our cost and price functions be ) ( 5 . 0 100
2 1
q q P + = and cost function
1 1
5q C = and
2
2 2
5 . 0 q C =
Here the subscript of the profit function denotes the producer number. We can find our optimum level of production
through these two equations
5 ) ( 5 . 0 100
2 1
1
1
= + = q q
dq
dC
P and
2 2 1
2
2
) ( 5 . 0 100 q q q
dq
dC
P = + =
Solving these two equations simultaneously we get 185
1
= q and 5
2
= q . Corresponding price is 5 = P . Profit of two
sellers are 0
1
= and 5 . 12
2
=
Case 2: The case of collusion: Noting that the profit of each other is dependent on the action taken (through production
level) by the other, it is not unnatural that they can collude and essentially act as a single producer with two production
plant. Note that in this case it is very important to have their mutual trust. It may very well happen that one of them cheat
on other and get bigger market share. Nonetheless collusion is not uncommon in business world and it is a big issue in
antitrust literature.
Mathematically it is important to notice that in this case, we can write one common profit function and derive necessary
FOCs from it. The common profit function is (for our previous problem setups)
1
2
2
2
2 1 2 1
5 5 . 0 ) ( 5 . 0 ) ( 100 q q q q q q + + =
First derivative of profit with respect to
1
q and
2
q will be
5 ) ( 100
2 1
1
+ = q q
dq
d
, and
2 2 1
2
) ( 100 q q q
dq
d
+ =

When equated to zero then we get 90
1
= q and 5
2
= q . Corresponding price is 5 . 52 = P . Profit of two sellers are
4275
1
= and 250
2
= .
(Note: effect of collusion is higher price and lower production level)
Case 3: Cournot case: This solution is after the famous economist Augustine Cournot. He proposed that first seller 1 and
seller 2 fix their output level. Then seeing the production level of producer 2, producer 1 revises his production level. Then
seeing this revised level of producer 1, producer 2 also revises his level of production. This action provokes producer 1 to
revise his production level again and so on. This process runs until both firm reaches to equilibrium. This equilibrium level
of production is known as Cournot solution.
It is not difficult to see that to track down the behavior of two firms we can write what is known as Reaction functions of
seller 1 and 2. Reaction function of firm A, gives us the production of firm A in response to the production of its
competitor. This is a general function and it gives us the level of production of A, when we know the production level of
its competitor say producer B.
We can treat the whole problem theoretically. Suppose our price and cost functions are defined by
1

) (
2 1
q q B A P + = and
2
1 1 1 1 1
q b q a C + = and
2
2 2 2 2 2
q b q a C + =
So, our profit will be
) ( ) (
2
1 1 1 1 1 2 1 1 1
q b q a q q q B Aq + + = and ) ( ) (
2
2 2 2 2 2 2 1 2 2
q b q a q q q B Aq + + =
First order condition gives
0 2 ) 2 (
1 1 1 2 1
1
1
= + = q b a q q B A
dq
d
and 0 2 ) 2 (
2 2 2 2 1
1
1
= + = q b a q q B A
dq
d

Rearranging these two equations we get our reaction function
) (
) ( 2 ) ( 2
2 2
1 1
1
1
q q
b B
B
b B
a A
q =
+

= and ) (
) ( 2 ) ( 2
1 1
2 2
2
2
q q
b B
B
b B
a A
q =
+

=
When we solve these two equations simultaneously we get our Cournot solution
2
2 1
2 1 2
1
) )( ( 4
) ( ) )( ( 2
B b B b B
a A B a A b B
q
+ +
+
= and
2
2 1
1 2 1
2
) )( ( 4
) ( ) )( ( 2
B b B b B
a A B a A b B
q
+ +
+
=
These are equations of two straight lines with negative slope. The intersection of the straight lines will give us the Cournot
solution.

If we apply Cournot solution to our previous problem then we get
) ( 5 . 0 100
2 1
q q P + = and cost function
1 1
5q C = and
2
2 2
5 . 0 q C =
so our profit function will be
1 2 1
2
1 1 1
5 5 . 0 5 . 0 100 q q q q q = and
2
2 2 1
2
2 2 2
5 . 0 5 . 0 5 . 0 100 q q q q q =

1
We are using a different set of parametric cost and price functions
( )
1
q
( )
2
q
2
q
1
q
Reaction functions and Cournot solution
First derivative of production function when equated to zero gives us,
2 1 2 1 1
5 . 0 95 0 5 5 . 0 100 q q q q + = = = and
2 1 2 1 2
2 5 . 0 100 0 2 5 . 0 100 q q q q + = = =
From above two relationships we can find reaction functions of two producers
2 1
5 . 0 95 q q = and
1 2
25 . 0 50 q q =
Solving above two equations we get the equilibrium point 80
1
= q and 30
2
= q . Corresponding price is 45 = P . Profit
of two sellers are 3200
1
= and 900
2
=
Case 4: Stackelberg solution: In the above case we have assumed some behavior pattern of two firms and we got reaction
functions. In Stackelberg solution we will assume that one of the firms will act as a leader and other as follower. The leader
will cat first and then set his production level and follower will then accept leaders production level and will try to maximize
his profit. Which one will act as a leader and which one will be follower depends on relative profit in two situations. So as
we can assume we can have four situations:
1. Firm 1 wants to be a leader and firm 2 wants to be a follower
2. Firm 1 wants to be a follower and firm 2 wants to be a leader
3. Firm 1 wants to be a leader and firm 2 wants to be a leader
4. Firm 1 wants to be a follower and firm 2 wants to be a follower
In this exercise we will try to figure out whether the firm is going to act as a leader or follower.
Following our previous setup we can find profit of producer 1acting as a market leader:
1 1 1
2
1 1 1
5 ) 25 . 0 50 ( 5 . 0 5 . 0 100 q q q q q =
Here we have used reaction function of producer 2 as its production level. Using this profit function producer 1 can
maximize his profit and if we do the calculations then we will have that level 33 . 93
1
= q and 67 . 3366
1
= .
We can also find profit of producer 2 acting as a market leader:
2
2 2 2
2
2 2 2
5 . 0 ) 5 . 0 95 ( 5 . 0 5 . 0 100 q q q q q =
Here we have used reaction function of producer 2 as its production level. Using this profit function producer 2 can
maximize his profit and if we do the calculations then we will have that level 35
2
= q and 75 . 918
2
= .
We can also find profit of producer 1 and 2 when they act as a follower
Player 1 follower profit
5 . 77 5 . 0 95
2 1
= = q q and 125 . 3003
1
=
Player 2 follower profit
67 . 26 25 . 0 50
1 2
= = q q and 11 . 711
2
=
Following table compares the results of all four cases discussed above:

P 1
q
1

2
q
2

Quasi Competitive 5.00 185.00 0.0 5.00 12.5
Collusion 52.50 90.00 4275.0 5.00 250.0
Cournot 45.00 80.00 3200.0 30.00 900.0
Stackelberg
a) Producer 1as leader 40.00 93.33 3366.7 26.67 711.1
b) Producer 2 as leader 43.75 77.50 3003.1 35.00 918.8
(Can you infer which producer should take which option? And what will happen when they do not confirm each others
preference)