Residual Demand Curve: Monopoly Market Structure

Cournot model is an oligopoly model in which firms producing identical products
compete by setting their output under the assumption that its competitors do not
change their output in response.
Unlike a monopoly in which there is only one producer, an oligopoly in a market

structure in which there are more than one producer, and each is large enough to affect
the profit of other firms through its actions. Let’s assume that Reach and Dorne are the
only two producers of cotton in Westeros. If the total demand is 20 thousand tons per
annum and Reach produces 15 thousand tons in one period, there is only 5 thousand
tons left for Dorne to produce. If Dorne produces more than 5 thousand tons, the
market price will drop hurting both Reach and Dorne. Cournot model helps us
determine such an output level for an oligopoly at which no firm is better off by
changing its output unilaterally.
If Q is the total output, which is sum of QR, the quantity produced by Reach and QD, the
quantity produced by Dorne, the demand function for cotton can be written as follows:
P = 2,000 - 20Q
P = 2000 – 20(QR + QD)
P = 2,000 - 20QR - 20QD
The profit-maximizing output of the oligopoly as a whole occurs when marginal revenue
is equal to marginal cost.
Let’s assume that marginal cost is $1,500 in Reach and $1,600 in Dorne.
Marginal revenue function for Reach can be determined by finding the total revenue
function (as a product of Q and P) and then obtaining its first derivative with respect to
QR:
MRR = 2,000 - 40QR - 20QD

Similarly, the marginal revenue function for Dorne is as follows:
MRD = 2,000 - 20QR - 40QD
Residual Demand Curve

Going back to our example we see that if Reach produces 15 tons, the demand function
for Dorne can be written as follows:
P = 2,000 – 20(15) - 20QD = 1,700 - 20QD

The equation above is a function of a residual demand curve. A residual demand
curve is a demand curve which shows the demand left over for a firm given the supply
of other firms.
If Reach produces 20 tons, Dorne’s residual demand curve reduces to
P = 1,600 – 20QD and so on.
Using the residual demand curve, we can find out the residual marginal revenue curve.
One short-cut is to double the slope of the line (because MR curve has twice the slope
of the demand curve).
MR = 1,700 - 40QD
Using the MR = MC condition, we get the profit-maximizing output for Dorne given
Reach’s output of 15 tons as follows:
1,600 = 1,700 - 40QD
QD = 2.5
Similarly, if Reach’s output is 20 tons, Dorne’s optimal output is 0
1,600 = 1,600 - 40QD
QD = 0
It shows that Dorne’s profit-maximizing output changes when output of its rival
changes. But Reach is also facing the same dilemma and its profit-maximizing output
changes when Dorne’s output changes.
Reaction Curve or Best-Response Curve

A reaction curve (or best-response curve) is a graph which shows profit-maximizing
output of one firm in a duopoly given the output of the other firm. We can obtain a
firm’s reaction curve using the MRR = MCR condition.
1,500 = 2,000 - 40QR - 20QD

QR = 12.5 - 0.5QD
The equation above expresses the output of Reach in terms of output of Dorne. It shows
that both QR and QD are inversely-related. If Dorne increases output, Reach must
decrease its own.
Using the same steps i.e. MRD = MCD, we can find that the profit-maximizing output for
Dorne:
1,600 = 2,000 - 20QR - 40QD

QD = 10 - 0.5QR
If we plug different values of QR, we get the following QD values:
Q
QD
R
0 10
5 7.5
10 5
15 2.5
20 0
This table shows output of Dorne given output of Reach. If we plot this data, we get
Dorne’s reaction curve.
We can create a similar table for Reach (given Dorne’s output). If we plot both these
data series, we get the following graph:
Cournot Equilibrium
Cournot equilibrium is the output level at which all firms in an oligopoly have no
incentive to change their output. It is the point of intersection of the best-response
curves of the rivals in a duopoly.
Since both firms need to take the output decision simultaneously, we can find the
equilibrium by solving reaction curves of both firms.
Substituting the value of QR from Reach’s reaction curve in Dorne’s reaction curve, we
get:
QD = 10 - 0.5(12.5 - 0.5QD)
QD = 10 - 6.25 + 0.25QD
QD = 5
Substituting QD in the reaction curve for Dorne, we find that QR is 10.
QR = 12.5 - 0.5(5) = 10
The oligopoly price that corresponds to Cournot equilibrium is 1,666.8.
P = 2,000 – 20(5 + 10) = 1,700
Comparison: Cournot vs Bertrand vs Collusion

Cournot equilibrium tells us that an oligopoly which produces identical products, and
which compete based on output will produce a higher output than a monopoly but
lower output than a Bertrand oligopoly. It will charge a lower price than a monopoly but
a higher price than a Bertrand oligopoly.
Cournot model also tells us that a firm in an oligopoly with lower marginal cost will
produce a higher output and will have a higher market share. This is evident from the
example above: Reach has lower marginal cost and higher share of the output in
Cournot equilibrium.

Residual Demand Curve: Monopoly Market Structure

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Cournot model is an oligopoly model in which firms producing identical products

Unlike a monopoly in which there is only one producer, an oligopoly in a market

Let’s assume that marginal cost is $1,500 in Reach and $1,600 in Dorne.

MRR = 2,000 - 40QR - 20QD

MRD = 2,000 - 20QR - 40QD

Residual Demand Curve

P = 2,000 – 20(15) - 20QD = 1,700 - 20QD

If Reach produces 20 tons, Dorne’s residual demand curve reduces to

P = 1,600 – 20QD and so on.

Reaction Curve or Best-Response Curve

1,500 = 2,000 - 40QR - 20QD

1,600 = 2,000 - 20QR - 40QD

P = 2,000 – 20(5 + 10) = 1,700

Comparison: Cournot vs Bertrand vs Collusion

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