🛒principles of microeconomics review

key term - Reaction Function

Definition

A reaction function is a mathematical representation of a firm's strategic decision-making process in an oligopolistic market. It describes how a firm will respond to changes in the decisions or actions of its competitors.

5 Must Know Facts For Your Next Test

  1. Reaction functions are used to model strategic interactions between firms in an oligopolistic market.
  2. The shape of a firm's reaction function depends on whether the firms compete on output (Cournot) or price (Bertrand).
  3. Firms with downward-sloping reaction functions are engaging in strategic substitutes, while firms with upward-sloping reaction functions are engaging in strategic complements.
  4. The intersection of the reaction functions of all firms in an oligopoly represents the Nash equilibrium, where no firm has an incentive to deviate from its current strategy.
  5. Reaction functions can shift in response to changes in market conditions, such as changes in demand, costs, or the number of firms in the market.

Review Questions

  • Explain how a firm's reaction function is used to model its strategic decision-making in an oligopolistic market.
    • A firm's reaction function represents its optimal output or price decision given the expected output or price of its competitors. The shape of the reaction function depends on whether the firms are competing on output (Cournot) or price (Bertrand). Firms with downward-sloping reaction functions are engaging in strategic substitutes, where an increase in one firm's output or decrease in price will lead the other firm to respond by decreasing its own output or increasing its price. Conversely, firms with upward-sloping reaction functions are engaging in strategic complements, where an increase in one firm's output or price will lead the other firm to respond by increasing its own output or price.
  • Describe how the intersection of the reaction functions of all firms in an oligopoly represents the Nash equilibrium.
    • The Nash equilibrium in an oligopolistic market is the point where the reaction functions of all firms intersect. At this point, no firm has an incentive to deviate from its current strategy, as each firm is making the best decision for itself given the decisions of the other firms. The Nash equilibrium represents a stable outcome where each firm is maximizing its profits given the actions of its competitors. Changes in market conditions, such as shifts in demand or costs, can cause the reaction functions to shift, leading to a new Nash equilibrium.
  • Analyze how a firm's reaction function can be used to predict its strategic response to changes in market conditions.
    • A firm's reaction function can be used to predict how it will respond to changes in market conditions, such as shifts in demand or changes in the number of firms in the market. If a firm's costs decrease, for example, its reaction function will shift outward, indicating that it will produce more at any given level of output by its competitors. Similarly, if a new firm enters the market, the existing firms' reaction functions will shift inward, as they will need to produce less to maintain the Nash equilibrium. By understanding the shape and shifts of reaction functions, firms can anticipate their competitors' strategic responses and make more informed decisions about their own output or pricing strategies.

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