Economic Theory

Economic Theory

The Cournot Theory of Duopoly

The Cournot theory of duopoly is utilized to explain a case where two firms that offer the consumers the same products compete on the amount of commodities they produce simultaneously but in an independent manner (Bornier, 1992). In an oligopoly, there few firms that are operating, and they face a low level of competition.  Even so, each of the few firms that are in this market will always be trying to “eat” from the others’ market share so that it can emerge as the market leader and make more significant profits. One of the strategies used by such companies is altering the number of goods that are sold. That borrows from the law of demand and supply, which asserts that when the supply of a particular commodity is on the rise, it will drive down the prices, and the opposite is true. So, for the two companies that are competing in a duopoly, they must make consideration of the output of the competitor so that they can maximize their level of profit.

In this theory, the amount of output that one of the company produces will affect the price of a commodity and hence the demand. Thus, it will affect the level of production of the other company. To give an example, Companies A and B produces shoes that are used for running. In this market, Company A is the leader and hence has the most significant market share as compared to B. During the athletics season, company A projects that there is going a high demand for the running shoes and hence wants to increase profitability by raising the prices and also reducing the level of output. In such an instance, Company B studies the output level of A and decides to produce more identical shoes and sell them at a lower price. It does so through the application of economies of scale, which tends to lower the cost of production. In such an instance, more customers will switch from A to B, given the low prices. Notably, B will be able to “eat” to the market share of A and may end up being the market leader. In this situation, it is evident that company B has used the level of output and price as a strategy in the perfect competition.

So, any firm will want to do us avoid the situation that has been described above where it has to lose its market share. Therefore, what the Cournot theory does is to ensure that the market share and profitability are maximized through setting and optimum price. Notably, the optimum price which will be arrived at using the Cournot approach is the same, so that none of the companies will end up losing their market share. Such a situation is referred to as a Nash equilibrium, whereby none of the competitive participants gain at the expense of the other (Leonard, 1994). Nonetheless, some of the assumptions that are put into consideration are not applicable in the practical sense. For example, in the case two firms in a duopoly are producing the same commodity, it is highly unlikely they are going to operate in a vacuum as proposed by the model. In many cases, such a firm will be highly responsive to strategies that have been employed by other firms. Lastly, this model has issues in its application, given that it assumes that commodities that are produced by the companies are identical, and hence there are no differentiating factors. Notably, even in the running shoe market, a person will not be able to find homogenous products. That is because companies will always tweak their product in an effort to find a selling point.

The Modern Game Theory

Modern game theory studies the manner that rational decision-makers in the economy make their decisions. The principle tenet of the modern game theory is that firms that operate in the same market are not likely to trust each other even in the case they collude and agree to alter the price of a commodity. Give this dilemma, the Nash equilibrium is often used as the solution to ensure that none of the players is better off than the other (Myerson, 1999). In this instance, for a player to get the best outcome from the game, it is vital to examine the moves of the other player. The Nash equilibrium will be reached when one participant is unable to improve their position independently by altering their strategy. So, in such a case, it means that none of the two companies will lose.

An example of the Nash equilibrium is when there two technologies X and Y that can be adopted by firms A and B. If a firm decides to take technology X, there will be an increase in the level of sales. On the other side, if a firm goes for technology Y, there will be a zero increase in the number of sales. Logically, both companies A and B will go for technology X since it will increase their sales and hence raise the levels of profits. In such an instance, when the strategy of firm A is revealed to firm B, it will result in no change given; it has already maximized its profits. Therefore, knowing the strategy that has been adopted by the other organization means little and does not result in a change in firms’ behavior. With that in mind, it seems that technology X is the Nash Equilibrium.

The utilization of modern game theory has several implications in the field of economics. That is especially the case in the process of predicting the behavior of firms that operate in an oligopoly. For instance, the practice of simple cost-plus pricing among firms that have similar prices. It is common in companies that sell fuel. As well, it will be used in explaining why there are firms that are considered to be market leaders in an oligopoly while there are others that are followers. In such an instance, it implies when the marker leader increases the price of a commodity to a certain extent, other firms will follow suit given they will not lose their market share to the leader. Also, there instances where supermarkets will agree to raise the price of commodities together so that none of them ends up losing customers. In such a situation, all the firms are better off. In general, firms in an oligopoly will keep the prices stable so that they do not suffer retaliation and lose their market share. Therefore, a modern game theory emerges to be a vital tool that is used in the process of decision making. Nonetheless, one issue that arises with the use of modern game theory in the process of strategy formulation is the emergence of multiple equilibriums. That creates uncertainty and hence affects the player negatively.

References

Bornier, J. M. (1992). The “cournot-bertrand debate”: A historical perspective. History of Political Economy, 24(3), 623-656. doi:10.1215/00182702-24-3-623

Leonard, R. J. (1994). Reading Cournot, reading Nash: The creation and stabilisation of the Nash equilibrium. The Economic Journal, 104(424), 492-511. doi:10.2307/2234627

Myerson, R. B. (1999). Nash equilibrium and the history of economic theory. Journal of Economic Literature, 37(3), 1067-1082. doi:10.1257/jel.37.3.1067