Endogenizing the Cost Parameter in Cournot Oligopoly

Abstract

We study the effects of endogenous cost formation in the classic Cournot oligopoly through an extended two-stage game. The competing Cournot firms produce low-cost but limited quantities of a single homogeneous product. For additional procurements, they may refer to a revenue-maximizing supplier who sets a wholesale price prior to their orders. We express this chain as a two-stage game and study its equilibrium under two different information levels: complete and incomplete information on the side of the supplier about the actual market demand. In the deterministic case, we derive the unique subgame-perfect Nash equilibrium for different values of the retailers’ capacity levels, supplier’s cost and market demand. To study the incomplete information case, we model demand uncertainty via a continuous probability distribution. Under mild assumptions, we characterize the supplier’s optimal pricing policy as a fixed point of a proper translation of his expectation about the orders that he will receive from the retailers. If this expectation is decreasing in his price, then such an optimal policy always exists and is unique. Based on this characterization, we are able to proceed with comparative statics and sensitivity analysis, both analytically and numerically. Incomplete information gives rise to market inefficiencies because the supplier may ask for a too high price. Increasing supplier’s cost results in increasing wholesale prices, decreasing orders from the retailers and hence decreasing consumer surplus. Increasing retailers’ production capacities results in decreasing wholesale prices and increasing consumer surplus. Finally, as the number of second-stage retailers increases, the supplier’s profit may initially rise but eventually drops.