Monopoly power comes from a firm's ability to set prices. This ability is dictated by the shape of the demand curve facing that firm. If the firm faces a downward sloping demand curve, it is no longer a price taker but rather a price setter. In our perfect competition model, we assume there exist multiple participants, and because there are so many participants, the slice of the demand curve each firm sees is but a flat line. These firms are price takers.
There is a medium between monopoly and perfect competition in which only a few firms exist in a market. None of these firms faces the entire demand curve in the way a monopolist would, but each does have some power to set prices. A small collection of firms who dominate a market is called an oligopoly. A duopoly is a special case of an oligopoly, in which only two firms exist.
We will begin our discussion with an investigation of duopolies. For the following duopoly examples, we will assume the following:
In 1838, Augustin Cournot introduced a simple model of duopolies that remains the standard model for oligopolistic competition. In addition to the assumptions stated above, the Cournot duopoly model relies on the following:
In the Cournot model, the strategic variable is the output quantity. Each firm decides how much of a good to produce. Both firms know the market demand curve, and each firm knows the cost structures of the other firm. The essence of the model is this: each firm takes the other firm's choice of output level as fixed and then sets its own production quantities.
The best way to explain the Cournot model is by walking through examples. Before we begin, we will define the reaction curve, the key to understanding the Cournot model (and elementary game theory as well).