The Cournot model is an economic model that explains how companies that offer homogeneous goods to the market and that have identical costs compete. This model is based on the assumptions that each company seeks to maximize its total utility and that it maintains its level of production constant.
In other words, it is a static competition model where the most important choice of the competing companies is the volume of production. This as long as the companies have the same costs and compete by producing homogeneous goods in a relatively static environment. The fundamental idea is that it is possible to maximize the total utility when the IT (total income) and the TC (total cost) is equal to 0.
In addition, decisions about the level of production are made independently, but simultaneously. Since, the companies are producing homogeneous goods and because it is considered that the level of production is fixed.
Firms simultaneously decide how much product to produce. Each company maximizes its profits with the expectations or forecast about the production decision of the other competing company.
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Indeed, the Cournot model was created by Antoine A. Cournot, through observations he made of the way companies selling bottled mineral water competed. Cournot lived between the years of 1801 to 1877.
What is the Cournot model?
Assumptions from which the Cournot model starts
The most important assumptions that must be fulfilled are the following:
- Competing firms produce a single homogeneous good.
- The most relevant strategic decision is the quantity of production.
- Each company independently decides how much to produce, but the decisions are made simultaneously.
- The costs are the same for companies.
- The companies have no restriction to produce, so they can meet the market demand.
- Firms act rationally to maximize their utility.
How the Cournot model works
To exemplify, we will take the following information as a reference. Assuming that there is a company (company A) that offers a product x to the market. If only this firm participates in the market, the firm would be able to maximize its total revenue by selling 600 units at a price of $6.
Now, if a second company (company B) enters to compete. This implies that company B’s demand curve is given by the total market demand, minus the 600 units that company A sells. The demand curve is found in this way = 1200-600 =600. Therefore, Company B maximizes its total revenue by selling 300 units at the price of $3.
Finally, both firms maximize their revenue by selling 400 units at the price of $4.
How is equilibrium achieved?
Similarly, if Firm A reacts again, its new demand curve is established by subtracting from total market demand the 300 units supplied by Firm B. The new demand curve is obtained = 1200-300 = 900. Therefore Firm A will maximize its revenue by selling 450 units at a price of $4.50.
Company B then reacts and its new demand curve becomes 1200-450 = 750. It then maximizes its profit by selling 375 units at a price of $3.75. Similarly, total revenue is maximized by selling 400 units at the price of $4.
How is equilibrium achieved?
That is, both company A and company B will earn a total revenue of $1,600 by selling 400 units for $4. Likewise, each company generates a third of the total production of the market, which is a total of 1200 units.
In conclusion, it can be said that the Cournot model tends towards equilibrium. Since, when achieving equilibrium, the two competing companies manage to obtain the best results. Where, the most important decision variable is the amount to be produced. This as a consequence of the reaction of each company to the competitive situation of the market.
