4 Market equilibrium

Fundamental equation of the theory of the firm and industry

1. Factor market (everything is a function of x) ⎧
⎨ p(y) : product demand
⎪
max p f (x) − wx = p( f (x)) f (x) − w(x)x, where y = f (x),
x ⎪
⎩ w(x) : f actor supply
F.O.C.: p′ (y) f ′ (x) f (x) + f ′ (x) p − (w′ (x)x + w(x)) = 0
p f ′ (x)( p′ (y) yp + 1) − w(w′ (x) wx + 1) = 0
∂y p
[ Note: ε (y) = 1
∂ p y , ε (y) = p′ (y) yp ; → product demand elasticity < 0
∂x w 1
ε (x) = ∂ w x , ε (x) = w′ (x) wx ] → factor supply elasticity > 0
p f ′ (x)(1 + ε (1y) ) = w(1 + ε (1x) ) → link the product and factor market

2. Product market (everything is a function of y)

max py − c(w, y) = p(y)y − c(w(x(y)), y)
y
F.O.C.: p′ (y)y + p(y) − ( ∂∂wc ∂∂wx ∂∂ xy + ∂∂ cy ) = 0
p(1 + p′ (y) yp ) − (x w′ (x) f ′ 1(x) + ∂∂ cy ) = 0
∂y p
[Note: ε (y) = 1
∂ p y , ε (y) = p′ (y) yp
min wx s.t. f (x) = y
x
L = wx + λ (y − f (x))
∂L w
∂x = w + λ (− f ′ (x)) = 0 ⇒ λ = f ′ (x)
dwx ∂L w ∂c
dy = ∂y =λ = f ′ (x)
= MC = ∂y ]
p(1 + p′ (y) yp ) − (x w′ (x) f ′ 1(x) + w
f ′ (x)
) =0
p(1 + ε (1y) ) − w
f ′ (x)
(1 + x w1 w′ (x)) =0
p(1 + ε (1y) ) = w
f ′ (x)
(1 + ε (1x) )

⎧ ⎧
⎨ p f ′ (x) = V MP : f actor demand
⎪ ⎨ w(x) : f actor supply
⎪
Aside :
⎪ ⎪
⎩ p(y) : product demand ⎩ MC : product supply

they determine monopolistic price, they determine monopsonistic price

Summary &
% % &⎫
′ 1 1 ⎪
Factor market : p f (x) 1 + = w 1+ ⎪
ε (y) ε (x) ⎬
% & % & these are obtained from profit maximization
1 w 1 ⎪
Product market : p 1 + = ′ 1+ ⎪
⎭
ε (y) f (x) ε (x)

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3. Competitive market: ε (y) = −∞; ε (x) = +∞ (many sellers and many buyers)
Factor market: p f ′ (x) =w Product market: p = w
* +, - f ′ (x)
value o f marginal product (V PM )
[ f ′ 1(x) is increasing in x]
[ f ′ (x) is decreasing in x ]
$/x $/y
product supply
↑ w
f ′ (x)
= MC
f actor supply
↑
wc pc p
w ↓
product demand
→ f actor demand
V MP
xc x yc y

4. Monopolistic market: −∞ ≤ ε (y) < 0; ε (x) = +∞ (one seller and many buyers)
Factor market: (VMP is the constraint) Product market: (DD is the constraint)
1 w
p f ′ (x)(1 + ε (1y) ) = w p (1 + )= ′
ε (y) f (x)
V MP(1 + ε (1y) ): marginal revenue product (MRP)
* +, - * +, -
MR MC
$/x $/y
MC

wm pm
wc pc ε (y) = −1
w
V MP

MRP MR p (y)
(DD)
xm xc x ym yc y

5. Monopsonistic market: ε (y) = −∞; 0 ≤ ε (x) < +∞ (one buyer and many sellers)
Factor market: (SS is the constraint) Product market: (MC is the constraint)
1 w
p f ′ (x) = w( 1 + ) p = ′ (1 + ε (1x) )
* +, - ε (x) f (x)
V MP * +, - * +, -
marginal f actor cost (MFC ) MC
$/x $/y MC (1 + ε (1x) )

MFC
w( x )
(SS) MC

pc p
w
wmc pm

V MP

xmxc x ym yc y

19
 Oligopoly
When the monopoly power is big (fixed cost is high), quantity becomes the strategic variable, (natural
monopoly b/c technical barrier)
As n ↑: Q ↑, P ↓, π ↓, consumer surplus (CS) ↑.
A perfectly competitive firm: The market: n ↑ (S → S′ ), Q ↑, P ↓, π ↓
p p
MC S S′
→
p LS
D→ D′
q Q

1. Cournot model: Strategic variable is the output (simultaneous move) (n ≥ 1)

P(Q) = a − Q; TC = cQ ⇒ MC = AC = c
P
a
a−Q

MC = AC = C (CRS product f unction)

market demand : Q = a − P
a−c
Q Q

• n = 1: Monopoly (Q = q)
π = PQ − cQ = (a − Q − c)Q
dπ a−c
dQ = a − 2Q − c = 0 ⇒ Q = 2 =q
a+ c (a−c)2 1 a−c a+ c (a−c)2
P= 2 ; πmax = 4 ; CS = 2 2 (a − 2 ) = 8
∂TR ∂ (a−Q)Q a−c
MR = ∂Q = ∂Q = a − 2Q = MC = c ⇒ Q = 2

• n = 2: Duopoly
Q = q1 + q2
π1 = Pq1 − cq1 = (a − q1 − q2 )q1 − cq1 = (a − q1 − q2 − c) · q1 ; (P = P(q1 + q2 ))
∂ π1
∂ q1= a − 2q1 − q2 − c = 0 →Solve for q1 to obtain q1 ’s best response function.
⎧
a − c − q2
⎨ q 1 = R1 ( q 2 ) =
⎪
2 Solve for q1 , q2 , and obtain the N.E. (q∗1 , q∗2 )
⎪
⎩ q = R (q ) = a − c − q 1
2 2 1
2
q1 = q2 = q∗ = a−c 3 ; Q = q1 + q2 = 23 (a − c); P = a − Q = a − 32 (a − c) = a+2c
3
(a−c)2
π1 = ( a−c 2
3 ) = 9 ; π = π1 + π2 = 92 (a − c)2 ; CS = 12 Q2 = 92 (a − c)2

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 q2
Cournot-Nash Equilibrium
a -c

Firm 1’s best response

(reaction) curve:
a  c  q2
q1  R1(q2 ) 
2

Cournot-Nash Equilibrium
a c
2

Firm 2’s best response

a c
(reaction) curve:
3 a  c  q1
q2  R2 (q1 ) 
2

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a c a c a c q1
3 2

• n ≥2: Oligopoly
n n
Q = ∑ q j; P = a−Q = a− ∑ qj (P is a function of Q, Q is the total output of all firms)
j =1 j =1
n
πi = P · qi − c · qi = (P − c) · qi = (a − ∑ q j − c) · qi , ∀i, j = 1, . . . , n
j =1
Note: πi = aqi − cqi − qi (q1 + q2 + · · · + qi + q j + · · · + qn )
n n
∂ πi
∂ qi = a − c − ( ∑ q j + qi ) = a − c − ( ∑ q j + 2qi )
j =1 j̸=i
n
Note: ∑ summation without the term, qi
j̸=i
[ or: πi = aqi − cqi − (qi q1 + qi q2 + · · · + qi 2 + qi q j + · · · + qi qn )
n
∂ πi
∂ qi = a − c − (q1 + q2 + · · · + 2qi + q j + · · · + qn ) = a − c − ( ∑ q j + 2qi ) ]
j̸=i

n
∂ πi
∂ qi = a − ∑ q j − 2qi − c = 0
j̸=i
Solve for qi ’s best response function (i and j must be included in the equation)
n
n a−c− ∑ q j
j̸=i
q i = Ri ( ∑ q j ) = 2 , ∀i, j = 1, . . ., n
j̸=i
That is, how does firm i respond to the total output of all other firms in the market

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 n ≥ 2 can also use
. MRi =/MCi to solve for qi , i.e., ith firm’s best response function
n 0 . / 1
∂ a− q q ∑ j i n n
∂ T Ri j =1
MRi = ∂ qi = ∂ qi = ∂ aqi − ∑ q j + qi qi /∂ qi = a − ( ∑ q j + 2qi ) = c
j̸=i j̸=i
n
n a−c− ∑ q j
j̸=i
⇒ q i = Ri ( ∑ q j ) = 2
j̸=i

Solve for the linear equation system:

i=1 2q1 + q2 + · · · + qn = a − c ⇒ ( n + 1 ) q∗ = a − c
i=2 q1 + 2q2 + · · · + qn = a − c (By symmetry q1 = q2 = · · · = qn = q∗ )
..
.
i=n q1 + q2 + · · · + 2qn = a − c
a−c n
q∗ = n+ 1 ; Q = n · q∗ = n+ 1 (a − c); P = a − n+n 1 (a − c) = a+nc
n+ 1

π i = q1 2 = q2 2 = · · · = q∗ 2
n 2
π = ∑ πi = n · q∗ 2 = n · ((na−c )
+ 1)2
i=1
n2 (a−c)2
CS = 12 Q(a − P) = 21 Q2 = 2(n+ 1)2

• n → ∞: Perfect competition
P(Q) = a − Q = MC = c ⇒ Q = a − c
n n(a−c)2
[ Alternatively, use Q = lim (a − c) = lim 1+1 1 (a − c) = a − c; π = lim =0
n→∞ n+1
2
n→∞ n n→∞ (n+1)
a +c
a+nc 1 2 1
P = lim = lim 1 = c;
n
CS = 2 Q = 2 (a − c)2 ]
n→∞ n+1 n→∞ 1+ n

2. Stackelberg’s leadership model (sequential move, n = 2)

This model is based on sequential move game with perfect information, we can use backward induction.
Firm 1 is the leader, and firm 2 is the follower. We first derive firm 2’s best response function (i.e.,

reaction curve), q2 = R2 (q1 ), and then we derive firm 1’s choice of q1 .

π2 = Pq2 − cq2 = (a − q1 − q2 )q2 − cq2 = (a − q1 − q2 − c)q2
∂ π2 a−q1 −c
∂ q2 = a − q1 − 2q2 − c = 0 ⇒ q 2 = R2 ( q 1 ) = 2

π1 = Pq1 − cq1 = (a − q1 − R2 (q1 ))q1 − cq1 = − 12 q1 2 + 12 (a − c)q1

⎫
∂ π1 1 a − c⎪
= −q1 + (a − c) = 0 ⇒ q1 = ⎪
⎬
∂ q1 2 2
N.E.(q1 ∗ , q2 ∗ )
a − q1 − c a − c ⎪
⎪
q 2 = R2 ( q 1 ) = = ⎭
2 4

22
 Q = q1 + q2 = 43 (a − c); P = a−Q = a+3c
4

π1 = − 12 q1 2 + 12 (a −c)q1 = 18 (a −c)2 ; 1
π2 = q2 (P −c) = 16 (a −c)2 ; 3
π = π1 + π2 = 16 (a −c)2
CS = 12 · Q · (a − P) = 12 · Q2 = 9
32 (a − c)
2

Leader’s quantity = monopolist’s quantity; so the leader has first mover advantage.

3. Collusion model (n = 2)
P = a − Q, TCi = cqi , Q = q1 + q2
max P(q1 + q2 ) − (cq1 + cq2 ) = (a − q1 − q2 )(q1 + q2 ) − c(q1 + q2 ) = Q (a − Q − c)
Q=q1 +q2
∂π a−c a−c
∂ Q = a − Q − c + (−1) · Q = 0 ⇒ Q = 2 ; q1 = q2 = 4
(a−c)2 (a−c)2 (a−c)2
P = a − Q = a+2
c
; π = 4 ; π 1 = π 2 = 8 ; CS = 1 2
2 Q = 8

[ Show that when the two firms max their own profits at the same time, then q1 = q2 .
π1 = Pq1 − cq1 = (a − q1 − q2 − c)q1 ; π2 = Pq2 − cq2 = (a − q1 − q2 − c)q2
∂ π1 ∂ π2
∂ q1 = a − 2q1 − q2 − c = ∂ q2 == a − q1 − 2q2 − c ⇒ 2q1 + q2 = q1 + 2q2 ⇒ q1 = q2
However, they could sign contract and so could be anywhere on the line of arrangements. ]

q2
Stackelberg’s equilibrium compared with Cournot’s equilibrium,
a c collusion, and monopoly

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Monopoly
a c a c a c  q1
4 3 2

23
4. Bertrand model (n ≥ 2)
Assumption: product must be homogeneous
Firms have small monopolistic power, so price becomes the strategic variable. Use the demand function
Q(P) = a − P. If we look at firm 1’s profit, π1 :

• if P1 < P2 , firm 1 gets the total output of the market, q1 = Q = a − P1 ,

π1 = P1 Q − cQ = (P1 − c)(a − P1 )

• if P1 = P2 = P, firm 1 and firm 2 equally shares the total output of the market, q1 = 12 Q = 21 (a −P),
π1 = P · 21 Q − c · 12 Q = 21 Q(P − c) = 12 (a − P)(P − c)

• if P1 > P2 , firm 2 gets the total output of the market, q2 = Q = a − P2 , and firm 1’s q1 = 0, π1 = 0.

In summary
⎧ ⎧
⎪
⎪
⎪
⎪ (P1 − c)(a − P1 ) i f P1 < P2 ⎪
⎪
⎪
⎪ (Pi − c)(a − Pi ) i f Pi < Pj
⎪ ⎪
1 1
⎨ ⎨
π1 = (P − c)(a − P) i f P1 = P2 = P πi = (P − c)(a − P) i f Pi = Pj = P
⎪
⎪
⎪ 2 ⎪
⎪
⎪ 2
⎪
⎪ ⎪
⎪
⎩ 0 i f P1 > P2 ⎩ 0 i f Pi > Pj

N.E. P1 ∗ = P2 ∗ = c; π1 = π2 = 0; Q = a − c; q1 = q2 = 21 Q = 21 (a − c)
This is the same as perfect competition.

[Consider when firm j breaks the equilibrium. If Pi = c, Pj > c ⇒ q j = 0; Pj < c ⇒ π j < 0 ]

24