Chapter 1:Monopolistic Competition

What is there in monopolistic competition that is

not there in perfect competition or monopoly?
Main Features of Monopolistic Competitive
There are many sellers and many consumers in a given
market
The implication of this characteristic is that no
firm can influence the market based on size alone
Differentiated Products
Under monopolistic competition, each firm
produces goods that are slightly differentiated
Yet, they are close substitutes 5-2
Because of this heterogeneity or product
differentiation firms under monopolistic
competition cannot be called an industry rather
they form a product group
This is because their products are somewhat
dissimilar and not homogenous as is the case
under competitive industry
There is free entry and exit in the group
A profit that one monopolistic competitive firm
obtains attract others to business
If firms loose money and make negative
economic profits, then some firms will drop out
of the industry one by one 5-3
The goal of the firm is profit maximization,
both in the short run and in the long run
The firm is assumed to behave as if it knows
its demand and cost curves with certainty
Monopolistically competitive market includes
the markets for restaurants, books, clothing,
films and service industries in large cities.
The many cigarette brands available and the
many different detergents in the market could
also be other examples

5-4
 Product Differentiation and the Demand Curve

 Product differentiation is intended to distinguish the

product of one producer from other producers in the
product group
 This differentiation can be real or fancied
 Real differentiation: is when the inherent characteristics
of the product are different or when there are differences
in the specification of the products or in the factor inputs,
or the location of the firm, which determines the
convenience with which the product is accessible to the
consumer, or the services provided by the producer
5-5
Fancied differentiation: occurs when the
products are basically the same, but the
consumer is persuaded that the products are
different
This is established by advertising, difference in
packaging, difference in design, or simply by
brand name
But, product differentiation must leave the
products closely related for them to be included
in the same product group
The firm can raise its prices without losing all its
customers, owing to brand loyalty 5-6
This means that an individual firm's demand
curve is downward sloping, in contrast to
perfect competition, which has a perfectly
elastic demand schedule
If the firm increases its price, it will lose some, but
not all of its customers
Although it is downward sloping, the demand is
highly elastic because of a large number of
sellers with close substitutes and the cross price
elasticity is also so high
 The demand in monopolistic competitive shows the
quantities demanded for a particular style, associated
services, offered with a specific selling strategy 5-7
Thus, the demand curve will shift if:
the style, services associated with the product like
service delivery, or the selling strategy of the firm
changes;
competitors change their price, output, services or
selling policies and
 tastes, incomes, prices or selling policies of
products from other industries change
Monopolistically Competitive Market
It is competition because of the presence of a
large number of firms and freedom of entry
 It is monopolistic because each firm has some
control over market conditions 5-8
it is not a pure competition because the
products are not homogenous but
differentiated, and the price is not uniform
It is not a monopoly because the producer is
not a single individual and there is no
restriction on entry and the goods are close
substitutes
Demand Curve of a Monopolistically
Competitive Firm Revisited
In monopolistically competitive market, firms
have the capacity to alter their demand curve
to their advantage (for example, using
advertisements, packaging, etc) 5-9
When products are differentiated more buyers
are likely to be attracted
Then the firm gains extra control over demand
and market conditions
As a result of this, the demand curve of a firm
will alter to the advantage of a firm
It will become more flexible and shift upwards

5-10
 Equilibrium Under Monopolistic Competition
The way a firm maximizes its profit differs
significantly when it is in the short run and when
it is in the long run
Even in the long run, equilibrium could be
achieved, through price competition, through
competition from entry and when both these are
in play
According to Chamberlin there are two
assumption to analysis the equilibrium of the
firms in monopolistic competitive market
Uniformity Assumption: Both demand
conditions and cost conditions, and demand and
supply curves are uniform throughout the group
for all products produced
This requires that consumer’s preferences be
evenly distributed among the different sellers and
that difference between the products doesn’t give
rise to differences in costs
This ensures again that the ability of a firm to
influence buyers is not caused by a difference in
the demand or cost structures of the firm
The influence of the firm must arise purely out of
its ability to differentiate products
He made this assumption to show the equilibrium
of the firm and the ‘group’ on the same diagram
Symmetry Assumption: Any adjustment made
in the price or the product by an individual firm
spreads its influence over a large number of
competitors
The impact of such adjustments is insignificant
The net effect of these two assumptions is on the
demand curve of a product differentiating firm
The other important assumption that underly
Chamberlin’s debates is that the long run consists
of a number of identical and independent short
run periods
That means the optimum decision for one period
is the optimum decision for any other period
 Short run Equilibrium of the Firm
A firm is considered to be at its short run
equilibrium if it operates at a profit maximizing
situation
In the short run, the monopolistically
competitive firm faces limited competition
(Why?)
There are other firms that sell products that are
good, but not perfect substitutes for the firm's
own product
Every firm has therefore a monopoly of its own
product 5-15
When the product is differentiated, that means the
firm has some monopoly power – may be not
much, if the competing products are close
substitutes, but some monopoly power
That means we must use the monopoly analysis to
see the short run equilibrium situation
In order to maximize its profit, the firm should
operate at the level of output in which its marginal
cost of production is equal to its marginal revenue
5-17
The shaded area in the above graph shows the
abnormal profit the firm in a monopolistically
competitive market is getting
But the fact that the firm is at its equilibrium does
not guarantee that it will make abnormal profit
This depends totally on the value of average cost
in relation to average revenue or demand at the
point where marginal cost (MC) equals marginal
revenue (MR)
Therefore, it is possible that a firm operating in
monopolistic competition could earn abnormal
profits, normal profits or make a loss
5-18
MR= MC, price and average cost are equal


The above figure shows break evening firm in its
short run equilibrium (Neither profit nor loss)
It is also possible for the firm to make a loss at
equilibrium
In our previous discussion we said that “a firm
is considered to be at its short run equilibrium if
it operates at a profit maximizing situation”
How you match these two concepts?
As indicated in figure below the firm is making
a loss since AR is lower than AC at the
equilibrium position.
 Long Run Equilibrium
In a monopolistically competitive firm
equilibrium explanation, Chamberlin has made
two heroic assumptions, namely, that firms have
identical costs, and consumers’ preferences are
evenly distributed among the different products
That is, although the products are differentiated,
all firms have identical demand and cost curves
Under these assumptions, the price in the market
will be unique

5-22
Using the heroic assumptions, three distinct
models of long run equilibrium of the firm
were developed
The first model assumes that all the existing
firms are in their short run equilibrium and
realizing abnormal profits
As a result, the existing firms do not have any
incentive to adjust their price
In this case, long run equilibrium is attained
by new entrants who are attracted by the
existing abnormal profits and high profit
margins
In the second model, it is assumed that the
number of firms in the industry is optimal
That is, there would be no entry of new firms
or exit of the existing firms
In this case, long run equilibrium is attained
through price adjustments or price
competitions of the existing firms
In the third model, the assumptions in the
previous two models don’t hold
That is, neither the existing firms are in their short run
equilibrium (and hence, to maximize their profit, there
is an incentive for price adjustment) nor the number
of firms in the industry is optimal
Thus, in this last model long run equilibrium is
reached through both price adjustments of
the existing firms and by new firms entering
the industry
The three models therefore can be listed as:
a. Equilibrium through entry of new firms;
b. Equilibrium through price competition, and
c. Equilibrium through both price competition and
entry of new firms
In this third model: The idea that the existing firms at
optimal, and at short run equilibrium and realizing
abnormal profit are not hold. Hence, equilibrium can
be achieved both via enter of new firms in industry
and price competition.
 Equilibrium with New Firms Entering the
Industry

As we pointed out earlier, in this model, each

firm is assumed to be in short run equilibrium
maximizing its profits at abnormally high levels
The firm, after having the cost structure depicted
by LAC (Long run average cost) and the LMC
(long run marginal cost) curves and faced with
demand curve dd’, will set the price at P M which
corresponds to the intersection of the MR and the
MC curves
5-26
This price yields maximum profits (equal to
ABCPM).
The firm, being in equilibrium (at C), does not
have any incentive to change its price
But the abnormal profit will attract new
competitors into the market
The result of new entry is a downward shift of
the demand curve dd’ since the market is
shared by a larger number of sellers
 Assuming that the cost curves will not shift as entry
occurs, each shift to the left of the original demand curve
will be followed by a price adjustment as the firm reaches
a new equilibrium position, equating the new marginal
revenue (on the shifted MR curve) to its marginal cost
 This process will continue until the demand is tangent to
the average cost curve and excess profits are wiped out
 In the final equilibrium, the price will be PE and the
ultimate demand curve dEd’E
 There will be no further entry into the industry since the
profits are just normal (zero economic profit)
 The equilibrium is stable because any firm will lose by
either raising or lowering the price PE
 Equilibrium with Price Competition

 Here it is assumed that the number of firms in the

industry is compatible with long run equilibrium
 Such that the number of firms is just optimal
 Therefore, no entry or exit will take place
 But the going price in the short run is assumed to be
higher than the equilibrium one
 That means firms are not maximizing their short run
profits and to achieve they will try to adjust their
prices, and this in turn will spur price competition
 The analysis of this case requires the introduction of a
second demand curve labeled as DD’
5-30
 This shows the actual sales of the firm at each price
after accounting for the adjustment of the prices of
other firms in the group
 DD’ is also called the actual sales curve or share-of-
the-market curve, since it incorporates the effects of
actions of competitors to the price changes by the firm
 The DD’ curve shows the full effect upon the sales of
the firm which results from any change in the price it
charges
 DD’ is the locus of points of shifting dd’ curves as
competitors, acting simultaneously, change their price
 The change in the price does not take place as
a deliberate reaction to other firms’ reductions
 but as an independent action aiming at the profit
maximization of each firm acting independently of
the others
 The DD’ curve shows a constant share of the market
and it has the same elasticity as the market demand at
any one price
 The DD’ curve is steeper than dd’ curve because
the actual sales from reduction in price are smaller
than expected on the basis of dd’ as all firms
reduce their price and expand their own sales
simultaneously
Long Run Equilibrium through Price Competition
and Free Entry

5-34
 Price adjustments are shown along the dd’ curve
while entry (exit) cause shifts in the DD’ curve
 Equilibrium is stable if the dd’ curve is tangent to
the AC curve and expected sales are equal to actual
sales , that is, if the DD’ curve cuts the dd’ curve at
the point of its tangency to the AC curve
 It is assumed that profits at point e1 are assumed
abnormal
 Hence, new firms are attracted until DD shifts to
DD’
 One might think that long run equilibrium takes
place at e2 (with price P and output X) since only
normal profits are earned
 However, this is not the case because each
entrepreneur thinks that dd is his/her demand curve
and believes that if he/she reduces his/her price their
sales would expand along dd and profits would
increase
 However, each firm has the same incentive and all
firms reduce their price
 As price is reduced by all firms, dd slides down D’D’
and every firm realizes a loss instead of positive
abnormal profits
 For example, at position d’d’ the firm has reduced its
price to P’ but, as all firms act similarly, X1 is
produced with a total loss equal to the shaded area
ABP’C
 However, the firm acts on ‘the myopia curve’ d’d’
and so long as this lies above the LAC it believes that
it can obtain the profits by cutting its price
 The loss increases still further since dd slides further
down along D’D’
 This process would not stop even when dd becomes
tangent to the LAC
 This would be so if the firms could produce X*
 However, there are many firms in the industry and the
share of the firm is only X2
 The firm still on the ‘myopia assumption’ believes
that it can reach X* if it reduces price to P*
 However, all firms do the same and d*d* falls below
the LAC with ever increasing loss
 The financially weakest firms will leave the industry
first, and allow the surviving firms to have larger
share
 D’D’ moves to the right along with dd
 Exit will continue until dd becomes tangent to the AC
curve and DD cuts dd at the point of tangency, E.
 Equilibrium is then stable at point E with normal
profits earned by all firms no entry or exit taking
place.
 The equilibrium price, P*, is unique and each firm
has a share equal to OX*.
 Excess Capacity and Welfare Loss in
Monopolistic Competition
 The long run equilibrium of the firm in monopolistic
competition takes place at the point of tangency of the
demand curve to the LAC curve
 That is, at this point, MC=MR and AC=P but P>MC
while in pure competition the LR equilibrium condition
is MC=MR=AC=P.
 As a consequence of the different equilibrium conditions
price will grow higher and output will be lower in
monopolistic competition as compared with the
competitive model
 However, profits will remain just normal in the LR in
both models
 In monopolistic competition there will be too many firms
in the industry or product group, each producing an
output less than optimal i.e. at a cost higher than
minimum
 This is because the tangency of AC and demand occurs
necessarily at the falling part of the LAC, i.e., at a point
where LAC has not reached its minimum level
 This means firm’s profit maximizing output is less than
the output associated with minimum average cost
 In monopolistic competition firms incur selling costs
(like the costs for advertisement) which are not present
in pure competition and this is another reason for the
total cost (and price) to be higher
In monopolistic competition, there are ‘too
many, too small’ firms, each working with
‘excess capacity’, as measured by the
difference between the ‘ideal’ output and the
actual output
The ‘ideal’output is the output level
corresponding to the minimum point on the
LAC curve (point XF in Figure below )
The actual output is the one actually attained in
long run equilibrium (point XE in Figure
below)
Here, there is misallocation of resources in the
long run because the firm in monopolistic
competition doesn’t employ enough of the
economy’s resources to reach minimum
average cost
That is, it works at suboptimal scales having
unexhausted economies of scale
Excess capacity
Consumer surplus: the difference between
the maximum price a consumer is willing to
pay and the actual price they do pay
Producer surplus: the amount that producers
benefit by selling at a market price that is
higher than the lowest price at which they
would be willing to sell
The quantity produced by monopolistic firms
is less than what would be produced in a
perfectly competitive market
It also means that producers will supply goods
below their manufacturing capacity
5-44
 As compared to perfect competition, in monopolistic
competition, there is a loss of welfare that is not being
appropriated either by consumers or producers which is
called dead weight loss
 Let Pmc and Ppc are prices in monopolistic and
competitive market structures respectively, while Qmc
and Qpc are equilibrium quantities in monopolistic and
competitive markets respectively
 The change (reduction) in consumers’ surplus as a result
of monopolistic competition is equal to area A + B
 Reduction from producers’ surplus is C while increase in
producer’s surplus is A
 Therefore, B + C would be deadweight loss
Dead weight loss
 Chamberlin argued that the criticism of excess
capacity is valid only if one assumes that demand
curve of the firm is horizontal
 Chamberlin’s argument is based on the association of
active price competition and free entry
 Under this circumstances output will be very close to
the minimum cost output because firms will be
competing along their individual dd curves which are
very elastic
 Chamberlin argued that if firms avoid price competition
and instead enter into non-price competition, there will be
excess capacity in each firm insufficient productive
capacity in the industry; that is, unexhausted economies
of scale for the firm and the industry.
Without excess capacity (according to Chamberlin)
 Chamberlin argued that excess capacity and higher
prices are the result of non-price competition coupled
with free entry
 In this case, the firm ignores its dd curve (since no price
adjustments are made) and concern itself only with its
market share. i.e. DD becomes the relevant demand
curve of the firm
 Here, long run equilibrium is reached only after entry
has shifted the DD curve to a position of tangency with
LAC curve
 According to Chamberlin, excess capacity is the
difference between X and XE, the later being the ideal
level of output in a differentiated market
Chamberlin's excess capacity
 Socially optimal output is where MC=P

 This is because, if MC = P, consumers are being asked to

cover only cost of providing that same good

 In monopolistic competition, however, this is impossible

since all firms would be at loss in the LR

 The LRMC curve intersects demand below the LAC

curve so that any policy aiming at the equalization of P
and MC would imply a loss
CHAPTER 2: OLIGOPOLY MARKET STRUCTURE

Oligopoly is a market structure in which a few

firms dominate the industry
These few firms recognize their rivalry(r/ship) and
interdependence, fully aware that any action on
their part is likely to induce counter-actions by
their rivals (competitors)
This leads us to consider strategies and counter-
strategies between market participants.
The central task of market theory in
microeconomics is to predict how firms will set
prices and output 2-52
In perfect competition, the long run price will be
equal to the minimum long-run average cost of the
firm
Adam Smith called this concept ‘natural price’
In pure monopoly, the firm seeking to maximize
its profits will restrict output and raise price until
the marginal revenue exactly equals marginal
costs
In oligopoly, as we will see, there can be no such
precision
Some features that differentiate oligopoly from
monopolistic competition
There are few sellers in oligopoly, and new entry is
difficult; there are many sellers in monopolistic
competition, and new entry is easy
Products in oligopoly may be either homogeneous
or differentiated while products in monopolistic
competition are invariably differentiated (non-
homogeneous)
Firms in oligopoly recognize their interdependence;
firms in monopolistic competition act
independently
Prices in oligopoly tend to be ‘sticky’ or rigid while
prices in monopolistic competition tend to be
flexible.
 Key characteristics of oligopoly
 A few large producers
‘The terms like: ‘Big Three’, Big Four’ or ‘Big Six’, refer
to as oligopolistic industry
 Homogeneous or differentiated products
 An oligopoly may either be a homogeneous oligopoly
or a differentiated oligopoly depending on products the
firms produce
Many industrial products (steel, zinc, copper,
cement, industrial alcohol) are virtually
standardized products that are produced in
oligopolies.
 Alternatively, many consumer goods industries
(automobiles, tires, household appliances, electric
equipments, cigarettes) are differentiated oligopolies
 Control over price, but mutual interdependence
 Because firms are few in oligopolistic industries,
each firm is a ‘price maker’
 unlike the monopolist, which has no rivals, the
oligopolists must consider how its rivals will react to
any change in its price, output, product
characteristics, or advertising
 Oligopoly is thus characterized by mutual
interdependence
 Mutual interdependence means, the action of one
firm will affect the price and sales of the rival firm
in the industry and vice versa
 Mutual interdependence is the ‘key’ feature that
makes oligopoly firms different from firms in other
market structure
 Because of this mutual interdependence, it is very
difficult to develop a model that predicts the
output and pricing behavior of oligopolistic firms
 Entry barriers
 Economies of scale are important entry barriers in
a number of oligopolistic industries such as
aircraft, and cement factories.
 A closely related barrier is the large expenditure
for capital – the cost of obtaining the necessary
plant and equipment – required to enter certain
industries
 The ownership and control of raw materials
explain the oligopoly that exists in many mining
industries
 Patents also serve as barriers in some industries
like electronics and pharmaceuticals
 The two types of oligopoly models
 Non-collusive oligopoly: when firms enter into some
form of agreement as to the price level they charge or
the quantity of output they produce,
 non-collusive oligopoly: if there is no any form of
agreement between firms
 NON-COLLUSIVE OLIGOPOLY
There is no cooperation among rivals
Under non-collusive oligopoly each firm develops an
expectation about what the other firms are likely to
do
Since firms are mutually interdependent, a firm expects
some reaction from its rivals when it decides to take a
given course of action
what kind of reaction does a firm expect to its
action? What then is the implication of this
expectation on the behavioral pattern of
oligopolists?
 The basic distinctions between the different types of
non-collusive oligopoly models lie on:
The assumption as to the kind of action an oligopoly
firm will take;
The kind of reaction a firm will expect from its rival as
a response to its action; and
The resultant effects of these behavioral patterns
(action and reaction) of oligopolists on equilibrium
output and/or price.
 Non-collusive Oligopoly Models
The Kinked Demand Model
Cournot's Duopoly Model
Bertrand’s Duopoly Model
Stackelberg’s Duopoly Model
 The kinked Demand Model
 Prices in oligopoly market tend to be ‘sticky’ or rigid
as compared to other market structures
 The prices of products produced by oligopoly firms,
are more stable as compared to the prices of
products in other market structures
 To explain why prices often remain stable in
oligopoly markets even when costs rise, Paul Sweezy
developed the ‘kinked-demand’ model
 An oligopoly firm will face two demand curves for
different ranges of prices
Look at the figure 2.1 on the left side
slide
Suppose a firm knows that any time
it raises its prices, all other firms
in the industry will do the same
In this case it faces AB, which is a
relatively inelastic curve
If, on the other hand, no other firms
follow its changes in prices the
firm will instead find itself on CD,
a much more elastic demand
curve
If the firm is the only one to raise
prices, it will experience a large
drop in sales.
The above figure shows that if a firm
increases price from P0 to P1, it
will sell OQ1 amount (not OQ2)

5-62
 This is because, when the firm increases price, other firms
will not do the same
 Hence, the firm that increased price would lose some of its
customers to firms that maintained their previous price
 The firm will then face a demand curve given by CD
 If, on the other hand, the firm decreases its price from P 0 to
P2, the firm will sell only OQ3 amount
 This is because following the price decrease other firms
will also decrease their price in order to keep up their
customers.
 Hence, the firm will not be able to sell OQ4 as given by the
demand curve CD. Rather the firm will sell only OQ 3
amount.
 The firm’s demand curve would, therefore, be kinked at
point E as depicted in the figure by the bold line CEB.
In this model the demand curve is kinked or
shows a bend rather than being continuous.
The kinked demand curve model explain as to
why a price is rigid at a given price level such
as P0.
This is because increasing price as well as
decreasing price would only bring lose to a
firm changing its price
Given a certain production cost increasing
price above P0 will be followed by a larger fall
in sales, on the other hand, reducing price will
be followed by a smaller increase in sales.
 Hence, if a firm increases price above P0 or reduces
price below that point, the revenue of the firm will
reduce implying that the profit of the firm will
decline.
 Due to this, all firms will be reluctant to change
the established price irrespective of their cost
structure
 Hence, once a given price is established, it tends to
remain in effect for long periods
 How a firm experiencing a kinked demand curve
maximizes its profit?
 The curve AD in the demand curve is steeper

This tendency shows that

even though the firm
decreases its price, it will
be selling fewer
additional amounts
because other firms will
also react by reducing
their price in order to
keep up their customers

5-66
Any increase in price above Pe will have the
opposite effect
Competing firms will not match the increase
and as a result, the demand curve above point
A will be relatively elastic
A relatively flatter demand curve above point A
is due to the reason that the firm that increased
its price will lose most of its customers for
other firms that did not increase their price.
As a result, the percentage decline in sales will
then be more than the percentage increase in
price resulting in a relatively flatter demand
curve.
The drawbacks of kinked demand curve model

The theory does not explain how oligopolists set

an initial price; it explains merely why a price,
once set, might be stable
Kinked demand is not a theory of price
determination
It doesn’t clearly show how an equilibrium price
is reached
The assertion that prices are more sticky under
oligopoly than under other market forms has not
received strong support from empirical studies.
The precise nature of any kink in the demand
curve may depend in the economic conditions
prevailing at the time
For example, some studies have found that price
increase are more likely to be followed during
booms, while price reductions are more likely to
be followed during times of recession
 Cournot's Duopoly Model

The word ‘duo’ means ‘a set of two or pair’ and

‘poly’ means ‘seller’
 The common charactestics of Cournot's, Bertrand’s and
Stackelberg’s duopoly models:
 They assume a certain pattern of reaction of
competitors in each period and despite the fact that
the expected reaction does not in fact materialize, the
firm continue to assume that the initial assumption
holds.
 In other words, firms are assumed never to learn from
past experience, which makes their behavior at least
naive (if not stupid).
Cournot in 1838 illustrated his model with the example of two firms each owning a spring of mineral water,
which is produced at zero cost (see figure below). Of course, this assumption may appear strange and later
on it will be relaxed and can be generalized using reaction curve approaches. Before we go to the detail of
the reaction curve approach, let us see the simplest example.
 There are two firms-firm A and firm B-in the market
 They sell their output in a market with a straight line
demand curve DD’
 Each firm acts on the assumption that its competitor
will not change its output, and decides its own output
so as to maximize profit
 Assume that firm A is the first to start producing and
selling mineral water
 To find the profit maximizing level of output and the
price, we use marginal principle
 Profit will be maximized at a point where MR is equal to
MC
 Since production cost is assumed to be zero, the MC at any level of output
will be zero. The idea is to find a point at which MR of firm A is zero
 Therefore, the firm will produce quantity Q1, at price P
where profits are at a maximum, because at this point
MC = MR = 0
 The elasticity of market demand at this level of output is
equal to unity and the total revenue of the firm is a
maximum
 With zero costs, maximum revenue (R) implies
maximum profits
 The output level of OQ1 is half of the total demand OD’
The equilibrium level of output that each firm produces can be derived in the following way.

The product of firm A in successive periods

Period 1 1 1 = 1
2 2
Period 2 1 (1 - 1 ) = 3
2 4 8
Period 3 1 (1 - 5 ) = 11
2 16 32
Period 4 1 (1 - 21 ) = 43
2 64 128
Period 5 1 (1 - 85 ) = 171
2 256 512

The product of firm B in successive Periods

Period 1 1 (1 - 1 ) = 1
2 2 4
Period 2 1 (1 - 3 ) = 5
2 8 16
Period 3 1 (1 - 11 ) = 21
2 32 64
Period 4 1 (1 - 43 ) = 85
2 128 256
Period 5 1 (1 - 171 ) = 341
2 512 1024
We observe that the output of A declines gradually. We may rewrite this expression as follows.

Product of A in equilibrium in successive periods is given by

Period 1: ½
Period 2: ½ (1-1/4) = 3/8 = ½ -1/8
Period 3: ½ (1-5/16) = 11/32 = ½ - 1/8 – 1/32
Period 4: ½ (1-42/128) = 43/128 = ½ - 1/8 – 1/32 – 1/128
We can observe that the output of firm A declines gradually. We may rewrite this expression as follows:

XA = ½ - 18  1 32  1128  1 512 ...

= 1   1  1  1  1  1 
2
 1  1   ...
3

2  8 8 4 8 4 8 4 

The expression in the parenthesis is a declining geometric progression with ratio r = ¼

Applying the summation formula for an infinite geometric series
a
 1 r

(Where  sum, a = first term of series, r = ratio) we obtain
1
XA = ½ - 8
 1
3
1 1
4
The product of firm B in successive periods is
Period 1 = 1 1  1   1
2 2 4
Period 2 = 1 1  3   5  1  1
2 8  16 4 16
Period 3 = 1 1  11   21  1  1  1
2  32  64 4 16 64
Period 4 = 1 1  43   85  1  1  1  1
2  128  256 4 16 64 256
We observe that B’s output is increasing, but at a declining rate. We may write
2 3
XB = 1  1  1   1  1   1  1   ...
4 44 44 44
Applying the same expression for the summation of a declining geometric series, we find
1
XB = 4
 13
1  14
Thus, the Cournot solution is stable.
 Example - Assume the total market demand of mineral
water is 100 bottles per week. If firm A is the only firm
in the market, it will produce one-half of the total
demand-50 bottles. Then, when firm B enters into the
industry, it assumes that firm A will keep on producing
50 bottles and considers that its demand will be the
remaining 50 bottle. Firm B, facing an unsatisfied
market demand of 50 bottles, produces half of this
demand, which is 25 bottles (one-fourth of the total
market demand). Do this by yourself and for any
difficult points please contact me.
 Reaction curve approach

 Cournot's model can be extended to account for different

demand curves and different cost structures
 This can be done by the introduction of the concept of
reaction-curves approach
 The reaction-curves approach is a more powerful method
of analysis of oligopolistic markets because it allows the
relaxation of the assumption of identical costs and
identical demands
 The reaction curves of each rival firm are derived from
isoprofit curves
 An isoprofit curve is a locus of points yielding a given
level of profit 5-78
An isoprofit curve for firm A is the locus of
points defined by different levels of output of A
and his rival B, which yield to A the same level of
profit

5-79
 Properties of Isoprofit Curves

1. Isoprofit curves for substitute commodities

are concave to the axes along which we
measure the output of the rival firms: this
shows how a firm can react to rival's output
decisions so as to retain a given level of profit
2. The farther the isoprofit curves lie from the
axis; the lower is the profit and vice versa:
 The closer the isoprofit curve lies, the higher
the profitability of the firm is

5-80
For any given output that firm B may produce,
there will be a unique level of output for firm A
which maximize the latter’s profit
This unique profit-maximizing level of output
will be determined at the point of tangency of
the line through the given output of firm B and
the lowest attainable isoprofit curve of firm A
The profit-maximizing output of A (for any
given quantity of B) is established at the highest
point on the lowest attainable isoprofit curve of
firm A
3. For firm A, the highest points of successive
isoprofit curves lie to the left of each other. Look
at the following figures( figure 2.6a and 2.6b)
 Firstly, for any level of output that firm B may
produce, there is a unique level of output for firm A
that maximize the profit of firm A
 This unique profit maximizing level of output is
obtained at the point of tangency between the
horizontal lines through the given level of output of
firm B and the isoprofit curve for firm A nearest to its
output axis – QA.
 As shown in Figure 2.6a above, these unique points
that maximize the profit of firm A are shown by the
points a, b, c, and d that corresponds to the given
level of output of firm B as given by B1, B2, B3, and B4.
 Secondly, as we go farther away from QA-axis, these
successive highest points of the isoprofit curves of
firm A (point a, b, c, and d) lie to the left of each other,
that is, ‘b’ lies to the left of ‘a’, ‘c’ lies to the left of ‘b’, ‘d’
lies to the left of ‘c’
 This happens to be so because, as the rival firm (firm
B) increases its output from B1 to B2, the other firm
(firm A) must decrease its output in order to
maximize its profits
 But, given larger increase in output by firm B
followed by smaller decline in output by firm A, the
total supply in the market increases resulting and
price would fall
 Thus, firm A will face two things – its sales will fall
and will also be facing lower price resulting in lower
profit
 The same condition occurs as the firm moves from
‘b’ to ‘c’ and ‘c’ to ‘d’
 Similarly, B's isoprofit curves are concave to the Q B
axis.
 Their shape and position are determined by the
same factors as the ones underlying firm A's
isoprofit curves.
 The highest points of the isoprofit curves of B lie to
the right of each other as we move to curves further
away from the QB axis ( b’ lies to the right of a’, c’ lies
to the right of b’, d’ lies to the right of c’)
 Reaction Curves
Reaction curve: It is the locus of points of the
highest profit that one firm can attain given the
level of output of its rival
 For example, we have two firms, firm A and
firm B in a given market. Each point on the
reaction curve shows how much output A must
produce in order to maximize its own profit,
given the level of output of its rival B
Connecting point a, b, c, and d together gives us
firm A’s reaction curve ( see figure 2.6a).
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The reaction curve is shown by an arrow
pointing towards the quantity axis of firm A
implying that given its rival output, A chooses
an isoprofit curve more near to its quantity axis
Reaction curve of a firm is the locus of points of
highest profit that the firm can attain given the
level of output of its rival
The contract curve is the locus of points of
tangency between the isoprofit curves of the
respective firms
Points on the contract curve correspond to
situations where profits for the industry are
maximized; points off the contract curves
corresponds to non-profit maximizing
situations for the industry
The Cournot equilibrium, e, is off the contract
curve
 Only points (output combinations) on the contract
curve maximize joint or industry profits
5-88
 The independent acting firms that produce at
Cournot equilibrium point if enter in to a contract
can increase the profit of the industry. How???
 Mathematical Derivation of the Reaction Curves: A
Mathematical Version of Cournot's Model

Assume that the market demand facing the

duopolist is given by the following function
X = a* + b*P b* < 0
Where - X - is the total market demand which
is the sum of the equilibrium output of each
firm (X1 + X2) i.e. X1 is the equilibrium output of
firm A and X2 is the equilibrium output of firm
B
P - is the market price
5-90
The inverse demand function will be
P  a  bX b0
Given that X  X 1  X 2
Assume that the two duopolists have different cost functions given by:
C1  f1 ( X 1 ) and C 2  f 2 ( X 2 )
The first duopolist maximizes his profit by assuming Q B constant, irrespective of his own decisions, while
the second duopolist maximizes his profit by assuming that Q A will remain constant. The first-order
condition for maximum profits of each duopolist is
 1 R1 C1
  0
X 1 X 1 X 1
(1)
 2 R2 C 2
  0
X 2 X 2 X 2
Rearranging we have
R1 C1

X 1 X 1
(2)
R2 C 2

X 2 X 2
 Solving the first equation of (1) for X1 as a function of
X2, we obtain the reaction curve of A.
 This reaction curve expresses the output which A must
produce in order to maximize his profit for any given X 2
of his rival
 Solving the second equation of – for X2 we obtain X2 as
a function of X1, that is, we obtain the reaction function
of firm B
 If we solve the two functions simultaneously we obtain
the Cournot equilibrium, the values of X1 and X2 which
satisfy both equations; this is the point of intersection of
the two reaction curves
 The second-order condition for equilibrium requires that
The second-order condition for equilibrium requires that
 2 i  2 Ri  2Ci
 2  2  0 (i  1, 2)
X i X i X i
2

Or
 Ri  Ci
2 2
 2
X i X i
2

Each duopolist’s MR must be increasing less rapidly than his MC, that is, the MC must cut the MR from
below, for both duopolists.
 Bertrand's Duopoly Model
 Bertrand argues that it is more realistic to suppose that a
rival firm will select the price that maximizes its profit
rather than the output
 Each firm then assumes that the rival firm will not
change its price
 Bertrand further assumes that in duopoly, that each firm
has sufficient capacity to meet the entire market demand
 Bertrand's model differ from Cournot's in that it
assumes that each firm expects that the rival will
keep its price constant, irrespective of its own
decision about pricing

5-94
 Thus, each firm is faced by the same market demand,
and aims at the maximization of its own profit on the
assumption that the price of the competitor will remain
constant
 The competition in Bertrand duopoly model is on price
not on quantity of output as in the case of Cournot
duopoly model
 In Cournot duopoly model, isoprofit curves are concave
to the quantity axes, but in that of Bertrand’s, their
shape is convex to the price axes
 The convex shape shows the fact that if firm B cuts its price
successively from PB1 to PB2 and then to PBe, firm A must react by
lowering its price in successive stages from P A1 to PA2 and then to
PAe, in order to maintain the level of its profits at π A2.( See figure 2.11a
below)
 However, after that price level has been reached and if B
continues to cut its price, firm A will be unable to retain
its profits (at πA1), even if it keeps its own price
unchanged (at PAe).
 If, for example, firm B cuts its price from PBe to Pe (see
figure 2.11a), firm A will find itself at a lower isoprofit
curve (πA1), which shows lower profits (an isoprofit curve
that lies near to a price axis shows lower level of profit)
 The reduction of profit of A is due in part to a fall in B’s
price that take consumers (and therefore revenue) from
A, and possibly in part to higher average costs now A is
facing (as a result of the loss of output causing existing
plant to be run by A at suboptimal levels)
Bertrand's model does not lead to the
maximization of the industry (joint) profit, due
to the fact that firms behave naively, by always
assuming that their rival will keep its price
fixed
They never learn from their past experiences
which showed that the rival didn’t in fact keep
its price constant
The industry profit could be increased if firms
recognize their past mistakes and abandoned
the Bertrand pattern of behavior

5-98
5-99
 If firms moved on any points between c and d on the
Edgeworth contract curve (which is the locus of
points of tangency between the isoprofit curves of the
two firms), one or both firms would have higher
profits, and hence industry profit would be higher
 At point c firm B would retain the same profit as at
point e, (because B is on the same isoprofit curve B8
as point e) while firm A would move to a higher profit
level - A12
 Alternatively, at point d, firm A would have the same
profit A6 as Bertrand equilibrium e, but firm B would
move to a higher level of profit curve - A14
 Finally, at any point between c and d, both firms would
realize higher profits
 Criticism of Cournot’s and Bertrand’s
Duopoly Models
 The same ‘naivety’ assumption applies in both cases in
that firms fail to learn from past experience
 In both cases, a stable equilibrium point exists
 In both cases the equilibrium condition will not maximize
the industry’s profit rather each firm maximizes its own
profit based on the assumption that the rival firm would
keep –
 In Cournot its output or in Bertrand its price – constant
 In the same way as in the Cournot’s model, Bertrand’s
model is also closed model in the sense that it assumes no
entry or exit of firms
5-101
 Stackelberg’s Duopoly Model

Here, it is assumed that one duopolist is

sufficiently sophisticated to recognize that
his/her competitors act on the Cournot
assumption
This recognition allows the sophisticated firm
to determine the reaction curve of his/her rival
and incorporates it in his own profit function,
which s/he then proceeds to maximize like a
monopolist

5-102
 If firm A is the sophisticated oligopolist, it will
assume that its rival will act on the basis of its
reaction curve
 This recognition will permit firm A to choose and set
its output at the level which maximizes its own profit
 This is point a which lies on the lowest possible
isoprofit curve of A (a profit level of πA3 which is the
nearest possible isoprofit curve to the quantity axis
of firm A), denoting the maximum level of profit firm
A can attain given B’s reaction curve
 Look carefully at the two points a and c on an isoprofit
curve - A3
 If firm A produces at point c, for A it is the maximum
attainable level of profit given firm B’s quantity of q b
 However, if firm A chooses output level of qa, firm B will
react by producing at qb1 as indicated by its reaction curve
 Output combination qaqb1 in turn forces firm A to react by
reducing its output (because this output combination does
not enable A to attain A3) and this action and reaction
will finally lead to point e – Cournot equilibrium.
 Firm by recognizing interdependence, it takes another
measure
 What if, for example, firm A produces at point a? For firm A, point
a yields the same profit as point c.
 Nevertheless, point a leads to Stackelberg’s equilibrium because at
this point, firm B will not react because it is on its reaction curve.

5-105
Point a leads to a stable equilibrium because of
two reasons:-
First, a is on the same isoprofit curve - A3 as
point c and
Secondly, A recognize that point c will not lead
to a stable equilibrium because at that point B
is off of its reaction curve, and it will inevitably
react by producing qb1 not qb

5-106
For this two reason, firm A, the sophisticated firm,
acting as a monopolist (by incorporating B’s
reaction curve in his profit maximizing
computation) will produce QA, and firm B will
react by producing QB according to its reaction
curve
The sophisticated oligopolist becomes in effect the
leader, while the naïve rival (firm B) who acts on
the Cournot’s assumption becomes the follower

5-107
 Clearly, sophistication is rewarding for A because
he/she reaches an isoprofit curve closer to his axis
than if he behaved with the same naivety as his rival
 The naïve follower is worse off as compared with the
Cournot equilibrium, since with this level of output he
reaches an isoprofit curve further away from his axis
 In summary, if only one firm is sophisticated, it will
emerge as a leader and a stable equilibrium will
emerge since the naïve firm will act as a follower.
 What happen to market situation if both firms are
sophisticated?
 Market situation becomes unstable and this is known
as Stackelberg’s disequilibrium.
 The effect will either be a price war until one of the firm
surrenders and agrees to act as a follower or a collusion is
reached, with both firms abandoning their naïve reaction
functions and moving to a point closer to the Edgeworth
contract curve with both of them attaining higher profits
(see Figure 2.15 below).
 Figure 2.15 clearly depicts that naïve behavior does not
pay
 Any points on the Edgeworth contract curve, as shown in
figure 2.15 above, at least one firm or both firms will be
better off if they inter into some form of agreement – or
contract than they would otherwise be in Cournot’s
equilibrium.
 The rivals should recognize their interdependence.
 By recognizing each other’s reactions, each duopolist can
reach a higher level of profits for himself.
 If both firms start recognizing their mutual interdependence, each
starts worrying about the rival’s profits and the rival’s reactions.
 If one ignores the other, a price war will be inevitable, as a result of
which both will be worse off.
 Numerical examples of Stackelberg’s model

Isoprofit functions

 1  95 X 1  0.5 X 12  0.5 X 2 X 1 (7)

 2  100 X 2  0.5 X 1 X 2  X 22 (8)

Reaction functions

X 1  95  X 1 (9)
X 2  50  0.25 X 1 (10)

Given the above isoprofit and reaction functions, let us now see together the derivation of Stackelberg
equilibrium. As you have seen in the Stackelberg’s model, the model assumes one firm as a sophisticated
and the other as a follower. The different scenarios are shown below.
5-111
1. Stackelberg’s solution with 1 being the
sophisticated leader
 Firm 1 will substitute firm 2’s reaction function in its
own profit function, which it will then maximize as if it
were a monopolist.
 After you get the profit function of the sophisticated firm,
you can just differentiate it with respect to X 1 and equate the
result to zero.
Firm 2 would be the
follower. It would
assume that firm 1
would produce 93.33
units; thus, firm 2
substitutes this amount
in its reaction function.

5-113
 COLLUSIVE OLIGOPOLY
One way of avoiding the uncertainty arising from
oligopolistic interdependence is to enter into
collusive agreements
There are two main types of collision, cartels and
price leadership
Both forms generally imply tacit (secrete)
agreement since open collusive action is
commonly illegal in most countries at present
Collusion-agreement between firms in an industry
is to set certain prices or to share markets in
certain ways
 Cartels
Cartel is a combination of firms whose objective
is to limit the scope of competitive forces within
the market.
It may take open the form of collusion, the
member firms entering into an enforceable
contract pertaining to price and possibly other
variables
On other words, a cartel may be formed by secrete
collusion among sellers
 Two forms of cartel: cartels aiming at joint profit maximization
and cartels aiming at the sharing of the market
5-115
 The key objective of the cartel is the maximization of the
joint profits on behalf of its members
 The firms may, therefore, seek to use some form of
centralized body to coordinate their price, output and
other policies to achieve maximum profits for the
members of the cartel
 In extreme cases, the firms may act together as a
monopoly, aggregating their marginal costs and equating
these with marginal revenue of the whole market
 If successfully implemented, the situation is identical with
that of a multi-plant monopolist who seeks the
maximization of his profit
 Example: OPEC (Organization for Oil Producing and Exporting Countries),
in which many oil exporting countries meet regularly to agree on prices and set
production quotas.
 In the Cournot’s case, each firm attempts to maximize
only its own profit (by producing at the highest point of
its isoprofit curve), given the existing level of output the
rival is producing
 The firm does this because it assumes that the rival will
keep on producing that level of output
 However, their want will not materialize because the rival
firm will also do the same
 These independent actions and reactions will finally lead
firms to a condition which is less than it would otherwise
be if firms recognized their interdependence and acted
jointly
 Two points to note are: 1. Firms can maximize their joint profits
(the profit of the industry) through collusion
 They can raise the industry’s profit from 4100 to 5525
 That is, they can attain higher level of joint profit if both
recognize their interdependence and abandon their naïve
behavior
 2. Collusion under such cartel requires some
arrangements about the distribution of profits between
the two firms
 If each firm is going to earn only the profit generated by
its self, there is a danger that one firm will be better off
leaving the other worse off
 Firm 1 will be better off because it can raise its profit
from 3200 (under Cournot’s equilibrium) to just 4275 (in
the cartel)
5-119
 However, firm 2 will be worse off, under this
circumstance, if it joins the cartel for its profits declines
from 900 to 250 (a loss of 650)
 But one appealing feature of cartel is that the cartel can
arrange and control the distribution of profit in such a
way that either both firms or at least one firm will be
better off
 This could happen, for instance, if the cartel compensated
firm 2, by just deducting from firm 1, by an amount equal
or greater than it has lost due to collusion (which is 650).
 Deducting 800 from firm 1 and redistribute to firm 2 will
make both firms better off (firm 1’s profit increases from
3200 to 3475 and firm 2’s increase from 900 to 1050).
If cartel has this advantage, why then all such firms
 Cartels are illegal in most countries as they restrain
competition
 When permitted, cartels are in most cases unable to
realize maximum joint profit
 Problem in reaching at agreement
 Remain in the cartel and honor the agreements is
another problem
 Problems associated with profit distribution
 By how much the most advantageous firm must
compensate the disadvantageous one? this question
as remains to be one of the difficult question that get
answer.
Dear students, hope you are the generation that try to solve
such question using different techniques. Try your best 5-121
 Market Sharing Cartel
The firms agree to share the market, but keep a
considerable degree of freedom concerning the
style of their output, their selling activities and
other decisions
There are two basic methods of sharing markets:
market sharing through non-price competition
and through determination of quotas
Non-price competition
agreements
In this form of ‘loose’, cartel the member firms
agree on a common price, at which each of
5-122
The price is set by bargaining, with the low-cost
firms pressing for a lower price and the high cost
firms for a high price
The agreed price must be such that it would allow
some profits to all members
The firms agree not to charge a price below the
cartel price, but they are free to vary the style of
their product and/ or their selling activities
This form cartel is indeed ‘loose’ in the sense that
it is more unstable than the complete cartel aiming
at joint profit maximization
5-123
 P is not the joint profit maximizing price level
rather it is decided through bargaining
From the figure, if each firm wants to maximize
their individual profit, firm A will charge Pa and
firm B will charge Pb (i.e., at the point where their
MR is equal to MC)
Hence, in the bargaining process firm A will
press towards P­a and B will press towards Pb
Finally, they will agree in between these two
prices
But the problem is that the agreed price, P, will
not be stable because firm B has an incentive to
reduce price in order to sell a profit maximizing
output level
 This can be seen in the graph, in Figure 2.17 (b), the
figure shows that if firm B reduces price from P
(agreed price) to Pb, it can sell more and earn an
additional profit represented by the shaded area
Firm B may do this without the knowledge of the
cartel and the other partner, firm A
However, this reduction of price by firm B will
attract some existing customers away from firm A Due
to this, firm A will be the looser and this could lead to a
price war
Firm B has lower costs than A, and hence B will have the
incentive to decrease price and prefer to split from the cartel but
firm B prefer to remain in the cartel
Thus, the cartel is inherently unstable, unless supported by
tight legislation
Sharing of the Market by Agreements on Quotas
The second method for sharing the market is
the agreement on quotas that is agreement on
the quantity that each member may sell at the
agreement price (or prices)
If all firms have identical costs, the monopoly
solution will emerge, with the market being
shared equally among member firms
 For example, if there are only two firms with identical
costs, each firm will sell at the monopoly price one-half
of the total quantity demanded in the market at that price
 In Figure 2.18 the monopoly price is P and the quotas
which will be agreed are XA = XB = ½X 5-127
However, if costs are different, the quotas and
shares of the market will differ
Allocation of quota-shares on the basis of costs is
again unstable
Shares in the case of cost differentials are decreed
by bargaining
The final quota of each firm depends on the level
of its costs as well as on its bargaining skill
 Price Leadership
 In this form of coordinated behavior of oligopolies, one
firm sets the price and the others follow it because it is
advantageous to them or because they prefer to avoid
uncertainty about their competitors’ reactions even if this
implies departure of the followers from their profit
maximizing position
 Price leadership is widespread in the business world
and practiced either by explicit agreement or
informally
 In nearly all cases, price leadership is tacit (secret)
since open collusive agreements are illegal in most
countries
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 The most common types of price leadership
1.Price leadership by a low cost firm;
2.Price leadership by a large (dominant) firm and
3.Barometric price leadership.
 The Model of the Low Cost Price Leader
The important condition for this model is that the
firms have unequal costs
Firms produce homogeneous product at different
costs which clearly must be sold at the same price
The firms may have equal markets (or they may
come to an agreement to share the market equally
or they may have unequal markets (or agree to
share the market with unequal shares)
 The Model of the Dominant Firm Price Leader
In this model, it is assumed that there is a large
dominant firm which has a considerable share
of the total market and smaller firms, each of
them having a small market share
The market demand is assumed to be known to the
dominant firm
In addition, the dominant firm knows the supply function of
small firms and can derive the market supply curve of
small firms.
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Barometric Price Leadership
In this model, it is formally or informally agreed
that all firms will follow (exactly or
approximately) the changes of the price of a
firm which is considered to have a good
knowledge of the prevailing conditions in the
market and can forecast better than the others
the future developments in the market
In short, the firm chosen as the leader is
considered as a barometer, reflecting the
changes in economic environment.
The barometric firm may be neither a low-cost
not a large firm
Usually, it is a firm which from past behavior
has established the reputation of a good
forecaster of economic changes