Reaction Function

ROLE OF REACTION FUNCTIONS IN NON COLLUSIVE MODELS OF OLIGOPOLY
Reaction functions help in explaining how one firm reacts to the quantity choice of the other firm. The
non collusive models of Oligopoly given by Cournot, Bertrand and Stackelberg explain the behavior of
firms using the case of two firms. In the Cournot model firms compete with respect to output; in Bertrand
model firms compete with reference to price. Stackelbergs model is the same as that of Cournots model
except that firms are believed to act in a more sophisticated way with one of the two firms emerging as
the leader and the other as a follower. In all the three models the market demand curve is assumed to be
linear and marginal costs are constant.
In Cournot s (Bertrands) model, to find the equilibrium, one determines how each firm reacts to a
change in the output )price) of the other firm. The reaction n is traced by the reaction curves.
Reaction functions are derived from firms iso profit curves, Isoprofit curves are similar to indifference
curves. An isoprofit curve for A in Cournots (Bertrands) model shows combinations of output ( price)
levels of A and B, that yield the same level of profit to A. In Cournots model As isoprofit curves are
concave As output axis and Bs isoprofit curves are concave to Bs output axis. As output levels are
measured on the X axis and Bs output levels are measured on Y axis. Lower the isoprofit curve higher
the level of profit.The following figure shows As Bs iso profit curves in the Cournot model and their
Reaction curves.
Firm A s reaction function shows how much it will produce as a function of how much it thinks Firm B
will produce. Firm B s reaction function shows how much it will produce as a function of how much it
thinks Firm A will produce. The path to equilibrium is a series of actions and reactions. The pattern
continues until a point is reached where neither firm desires to change what it is doing, given how it
believes the other firm will react to any change. The equilibrium is the intersection of the two firms
reaction functions which is shown below.
In Bertrands model the iso profit curves are convex to the respective axis along which each firms price
is measured. Thus As isoprofit curves are convex As price axis and Bs isoprofit curves are convex to
Bs price axis. As price levels are measured on the X axis and Bs price levels are measured on Y axis.
Higher the isoprofit curve higher the level of profit. The following figure shows As Bs iso profit curves
in the Bertrnad model and their Reaction curves. Bertrands equilibrium using reaction curves is shown
below.
In both Cournot model and Bertrnads model the two firms moves are simultaneous and equilibrium is
established at the intersection point of the two reaction curves. Firms have no incentive to move away
from the equilibrium once it is reached. The equilibrium is stable. Each firm maximizes its profits but the
industry profit is not maximized. If the firms could move to any of the three points such as a, d or k on the
contract curve cc, industry profit would be higher, i.e, such a move will benefit one of the firms without
affecting the other or benefit both. Thus the equilibrium of the firms under Cournot and Bertrnad and
Cournot model is stable where each firm maximizes its profits but not one where industry profit is
maximized. It is not an optimal equilibrium. The reaction functions trace the path of equilibrium as shown
below.
Stacklebergs model is slightly different from Cournot and Bertrnad models . The assumptions are the
same as the Cournot Model except that firms decide sequentially. In the first period the leader chooses
its quantity. This decision is irreversible and cannot be changed in the second period. In the second
period, the follower chooses its quantity after observing the quantity chosen by the leader (the quantity
chosen by the follower must, therefore, be along its reaction function). Thus the equilibrium is where the
firms iso profit curve is tangent to the rivals reaction curve. This is shown in the figure given below. In
the model when A acts as the leader A incorporates Bs reaction in its decision making and hence his
equilibrium is where As highest possible iso profit curve is tangent to Bs reaction curve. Similarly when
B acts as the leader B incorporates As reaction in its decision making and hence his equilibrium is where
his highest possible iso profit curve is tangent to As reaction curve. Thus when A acts as the leader point
m is the equilibrium and when B is the leader point n defines the equilibrium. Thus the equilibrium
output levels in Stackelbergs model are strikingly different from that in Cournot s and Bertrands model.
The role of reaction function in Stackelbergs model is also different. In Cournots and Bertrnads model
equilibrium is determined at the point of intersection of the reaction functions where as in the
Stackelbergs model equilibrium is defined at the point of tangency of the leader firms iso profit curve
with the reaction function of the rival ( follower ) firm.
Conclusion
The three models of oligopolistic behavior assumed that firms formed expectations about the reactions
(or variations) of other firms, called as conjectural variations which are traced by the reaction curves.
The Cournot, Bertrand, and Stackelberg models can be interpreted as conjectural variations models. In
each model, firms control only quantity or price. In the Cournot and Stackelberg models, firms choose
their output levels, and the demand curve determines price; in the Bertrand model, firms choose prices
and let demand determine output. In Cournot's model , a firm makes one of the simplest possible
assumptions about the behavior of other firms: other firms continue to produce the same level of output
no matter how it behaves. That is, each firm's conjecture is that other firms are satisfied to continue
selling their current quantity of output. In Stackelbergs model, the follower firms make the Cournot
conjecture. The Stackelberg leader takes those conjectures into account in making its decisions. In the
Bertrand model, each firm makes the conjecture that its rivals will not change their price in response to a
change in its own price.

Reaction Function

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ROLE OF REACTION FUNCTIONS IN NON COLLUSIVE MODELS OF OLIGOPOLY

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