1. Monopolistic Competition and Oligopoly
Chapter 10

2. Monopolistic Competition
Characteristics
Many firms
Free entry and exit
Differentiated product
The amount of monopoly power depends on the degree of differentiation.
Examples of this very common market structure include:
Toothpaste
Soap
Cold remedies

3. Two important characteristics
Toothpaste
Crest and monopoly power
Procter & Gamble is the sole producer of Crest
Consumers can have a preference for Crest – taste, reputation, decay preventing efficacy
The greater the preference (differentiation) the higher the price.
Two important characteristics
Differentiated but highly substitutable products
Free entry and exit

4. A Monopolistically Competitive Firm in the Short and Long Run
$/Q
Short Run
$/Q
Long Run MC AC MC AC
DSR
MRSR
QSR
PSR
DLR
MRLR
QLR
PLR
Quantity
Quantity

5. A Monopolistically Competitive Firm in the Short and Long Run
Short-run
Downward sloping demand – differentiated product
Demand is relatively elastic – good substitutes
MR < P
Profits are maximized when MR = MC
This firm is making economic profits

6. A Monopolistically Competitive Firm in the Short and Long Run
Profits will attract new firms to the industry (no barriers to entry)
The old firm’s demand will decrease to DLR
Firm’s output and price will fall
Industry output will rise
No economic profit (P = AC)
P > MC  some monopoly power

7. Oligopoly – Characteristics
Small number of firms
Product differentiation may or may not exist
Barriers to entry
Scale economies
Patents
Technology
Name recognition
Strategic action
Examples
Automobiles
Steel
Aluminum
Petrochemicals
Electrical equipment

8. Oligopoly – Equilibrium
If one firm decides to cut their price, they must consider what the other firms in the industry will do
Could cut price some, the same amount, or more than firm
Could lead to price war and drastic fall in profits for all
Actions and reactions are dynamic, evolving over time
Defining Equilibrium
Firms are doing the best they can and have no incentive to change their output or price
All firms assume competitors are taking rival decisions into account.
Nash Equilibrium
Each firm is doing the best it can given what its competitors are doing.
We will focus on duopoly
Markets in which two firms compete

9. Oligopoly The Cournot Model
Oligopoly model in which firms produce a homogeneous good, each firm treats the output of its competitors as fixed, and all firms decide simultaneously how much to produce
Firm will adjust its output based on what it thinks the other firm will produce
● reaction curve Relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce.
● Cournot equilibrium Equilibrium in the Cournot model in which each firm correctly assumes how much its competitor will produce and sets its own production level accordingly.

10. Oligopoly The Reaction Curve
The relationship between a firm’s profit-maximizing output and the amount it thinks its competitor will produce.
A firm’s profit-maximizing output is a decreasing schedule of the expected output of Firm 2.

11. Reaction Curves and Cournot Equilibrium
Firm 1’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 2 will produce. The x’s
correspond to the previous model.
100 75
Firm 2’s Reaction
Curve Q*2(Q2) 50
Firm 2’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 1 will produce. x
Firm 1’s Reaction
Curve Q*1(Q2) x 25 x x Q2 25 50 75
100

12. The Linear Demand Curve
An Example of the Cournot Equilibrium
Two firms face linear market demand curve
We can compare competitive equilibrium and the equilibrium resulting from collusion
Market demand is P = 30 - Q
Q is total production of both firms:
Q = Q1 + Q2
Both firms have MC1 = MC2 = 0

13. Oligopoly Example Total revenue for firm 1: R1 = PQ1 = (30 –Q)Q1
then MR1 = ∆R1/∆Q1 = 30 – 2Q1 –Q2
Setting MR1 = 0 (the firm’s marginal cost) and solving for Q1, we find
Firm 1’s reaction curve:
By the same calculation, Firm 2’s reaction curve:
Cournot equilibrium:
Total quantity produced:

14. Oligopoly Example
If the two firms collude, then the total profit-maximizing quantity can be obtained as follows:
Total revenue for the two firms: R = PQ = (30 –Q)Q = 30Q – Q2, then MR = ∆R/∆Q = 30 – 2Q
Setting MR = 0 (the firms’ marginal cost) we find that total profit is maximized at Q = 15.
Then, Q1 + Q2 = 15 is the collusion curve.
If the firms agree to share profits equally, each will produce half of the total output: Q1 = Q2 = 7.5

15. First Mover Advantage – The Stackelberg Model
Oligopoly model in which one firm sets its output before other firms do.
Assumptions
One firm can set output first
MC = 0
Market demand is P = 30 - Q where Q is total output
Firm 1 sets output first and Firm 2 then makes an output decision seeing Firm 1 output
Firm 1
Must consider the reaction of Firm 2
Firm 2
Takes Firm 1’s output as fixed and therefore determines output with the Cournot reaction curve: Q2 = 15 - ½(Q1)

16. Suppose Firm 1 sets its output first and then Firm 2, after observing Firm 1’s output, makes its output decision. In setting output, Firm 1 must therefore consider how Firm 2 will react.
P = 30 – Q
Also, MC1 = MC2 = 0
Firm 2’s reaction curve:
Firm 1’s revenue:
And MR1 = ∆R1/∆Q1 = 15 – Q1
Setting MR1 = 0 gives Q1 = 15, and Q2 = 7.5
We conclude that Firm 1 produces twice as much as Firm 2 and makes twice as much profit. Going first gives Firm 1 an advantage.

17. Price Competition
Competition in an oligopolistic industry may occur with price instead of output.
The Bertrand Model is used
Oligopoly model in which firms produce a homogeneous good, each firm treats the price of its competitors as fixed, and all firms decide simultaneously what price to charge
Assumptions
Homogenous good
Market demand is P = 30 - Q where Q = Q1 + Q2
MC1 = MC2 = $3
Can show the Cournot equilibrium if Q1 = Q2 = 9 and market price is $12 giving each firm a profits of $81.

18. Price Competition – Bertrand Model
Assume here that the firms compete with price, not quantity.
Since good is homogeneous, consumers will buy from lowest price seller
If firms charge different prices, consumers buy from lowest priced firm only
If firms charge same price, consumers are indifferent who they buy from
Nash equilibrium is competitive output since have incentive to cut prices
Both firms set price equal to MC
P = MC; P1 = P2 = $3
Q = 27; Q1 & Q2 = 13.5
Both firms earn zero profit

19. Price Competition – Differentiated Products
Firms set prices at the same time
If P2 is fixed:

20. In our example, there are two firms, each of which has fixed costs of $20 and zero variable costs. They face the demand curves:
Firm 1’s demand:
Firm 2’s demand:
We found that in Nash equilibrium each firm will charge a price of $4 and earn a profit of $12, whereas if the firms collude, they will charge a price of $6 and earn a profit of $16.
But if Firm 1 charges $6 and Firm 2 charges only $4, Firm 2’s profit will increase to $20. And it will do so at the expense of Firm 1’s profit, which will fall to $4.

21. Payoff Matrix for Pricing Game
Firm 2
Charge $4
Charge $6
Charge $4
$12, $12
$20, $4
$16, $16
$4, $20
Firm 1
Charge $6

22. An example in game theory, called the Prisoners’ Dilemma, illustrates the problem oligopolistic firms face.
Two prisoners have been accused of collaborating in a crime.
They are in separate jail cells and cannot communicate.
Each has been asked to confess to the crime.
Prisoner B
Confess
Don’t confess
Confess
-5, -5
-1, -10
-2, -2
-10, -1
Prisoner A
Would you choose to confess?
Don’t
confess

23. Price Signaling and Price Leadership
Implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit
Price Leadership
Pattern of pricing in which one firm regularly announces price changes that other firms then match
The Dominant Firm Model
In some oligopolistic markets, one large firm has a major share of total sales, and a group of smaller firms supplies the remainder of the market.
The large firm might then act as the dominant firm, setting a price that maximizes its own profits.

24. The Dominant Firm Model
Dominant firm must determine its demand curve, DD.
Difference between market demand and supply of fringe firms
To maximize profits, dominant firm produces QD where MRD and MCD cross.
At P*, fringe firms sell QF and total quantity sold is QT = QD + QF

25. Cartels
Producers in a cartel explicitly agree to cooperate in setting prices and output.
Typically only a subset of producers are part of the cartel and others benefit from the choices of the cartel
If demand is sufficiently inelastic and cartel is enforceable, prices may be well above competitive levels
Examples of successful cartels
OPEC
International Bauxite Association
Mercurio Europeo
Examples of unsuccessful cartels
Copper
Tin
Coffee
Tea
Cocoa