Chapter 5: Market Structures

1
 Market Structures

 Market Structure refers to:

 the relative number and size of firms in an industry
 characteristics of the market that significantly affect the
behavior and interaction of buyers and sellers.
 Four Main Characteristics:
 Number and size distribution of sellers
 Number and size distribution of buyers
 Product Differentiation
 Conditions of entry and exit

2
Market structures
 Types:
 Perfectly competitive
 Pure monopoly
 Monopolistic competition
 Oligopoly

3
 4.1 Price Determination in a Perfectly
competitive market
 Characteristics of a perfectly competitive
market
 many buyers and sellers,
 identical (also known as homogeneous)
products,
 no barriers to either entry or exit, and
 buyers and sellers have perfect information.

4
 Price Determination in a
Perfectly competitive market
 As a result of its characteristics, the perfectly
competitive market has the following
outcomes:
 The actions of any single buyer or seller in the
market have a negligible impact on the market
price.
 Each buyer and seller takes the market price as
given. Thus, each buyer and seller is a price
taker.
5
 Perfectly competitive markets
 Markets for agricultural products (e.g.
wheat, egg,…) can be taken as an example
of perfectly competitive market, though it is
more of theoretical market structure.

6
 Demand curve facing a single firm
 no individual firm can affect the market price
 demand curve facing each firm is perfectly elastic

7
 Revenue of a Competitive Firm

Total revenue for a firm is the selling

price times the quantity sold.
TR = (P X Q)

8
 Revenue of a Competitive Firm
Marginal revenue is the change in
total revenue from an additional
unit sold.

MR =TR/ Q=P

9
Revenue of a Competitive Firm

For competitive firms, marginal

revenue equals the price of the
good.

10
 Total, Average, and Marginal
Revenue for a Competitive Firm
Quantity Price Total Revenue Average Revenue Marginal Revenue
(Q) (P) (TR=PxQ) (AR=TR/Q) (MR=TR / Q )
1 $6.00 $6.00 $6.00
2 $6.00 $12.00 $6.00 $6.00
3 $6.00 $18.00 $6.00 $6.00
4 $6.00 $24.00 $6.00 $6.00
5 $6.00 $30.00 $6.00 $6.00
6 $6.00 $36.00 $6.00 $6.00
7 $6.00 $42.00 $6.00 $6.00
8 $6.00 $48.00 $6.00 $6.00
11
 Profit maximization
 The goal of a competitive firm is to maximize
profit.
 This means that the firm will want to produce
the quantity that maximizes the difference
between total revenue and total cost.
 produce where MR = MC

12
Profit Maximization: Numerical example

13
Profit-maximizing level of output

14
 Profit Maximization for the
Competitive Firm

When MR > MC increase Q

When MR < MC decrease Q

When MR = MC Profit is maximized. The firm

produces up to the point where MR=MC

15
Economic Profits > 0

Economic profit

16
Economic loss

17
Loss minimization and the
shut-down rule
 Suppose that P < ATC. Since the firm is
experiencing a loss, should it shut down?
 Loss if shut down = fixed costs
 Shut down in the short run only if the loss
that occurs where MR = MC exceeds the loss
that would occur if the firm shuts down (=
fixed cost)
 Stay in business if TR > VC. This implies that
P > AVC. Shut down if P < AVC.

18
The Firm’s Short-Run Decision to
Shut Down
 A shutdown refers to a short-run
decision not to produce anything
during a specific period of time
because of current market
conditions.

19
Loss if shut down

20
Break-even price
 If price = minimum
point on ATC
curve, economic
profit = 0.
 Owners receive
normal profit.
 No incentive for
firms to either
enter or leave the
market.

21
P < AVC

22
 The Firm’s Short-Run Decision to
Shut Down
 The firm shuts down if the revenue it gets
from producing is less than the variable cost
of production.
Shut down if TR < VC
Shut down if TR/Q < VC/Q
Shut down if P < AVC

23
 The Firm’s Short-Run Decision to Shut Down
Firm’s short-run
Costs supply curve.
MC
If P > ATC,
keep producing
at a profit.
ATC
If P > AVC,
keep producing AVC
in the short run.

If P < AVC,
shut down.

0 Quantity
24
Short-run supply curve
 A perfectly
competitive
firm will
produce at
the level of
output at
which P =
MC, as long
as P > AVC.

25
 The Firm’s Short-Run Decision to
Shut Down

 The portion of the marginal-cost

curve that lies above average
variable cost is the competitive
firm’s short-run supply curve.

26
 Exercise
1. Consider a profit maximizing firm operating under conditions of
perfect competition. Suppose that the market price is birr 50 and
the firm faces a total cost function of TC = 10 + 5Q2, find the
profit maximizing level of output and the maximum profit
possible.
2. A firm in a perfectly competitive industry is producing 50 units at
its profit maximizing quantity. Industry price is Birr 2 and average
total cost of the firm at profit-maximizing level is Birr 1.50. Find
the firm's economic profit.
3. Assume, at an output level of 100 units, the firm incurs an
average variable cost of birr 5 and average fixed cost of birr 2.
Compare the losses/gains of shutting down and continuing to
produce if equilibrium price is a) birr 8; b) birr 7; c) birr 6; d) birr
5; and e)birr 4.
27
Long run
 Firms enter if economic profits > 0
 market supply increases
 price declines
 profit declines until economic profit equals zero
(and entry stops)
 Firms exit if economic losses occur
 market supply decreases
 price rises
 losses decline until economic profit equals zero

28
Long-run equilibrium

29
 The Firm’s Long-Run Decision to Exit
or Enter a Market

 In the long-run, the firm exits if the

revenue it would get from producing is
less than its total cost.
Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC
30
 The Firm’s Long-Run Decision to Exit
or Enter a Market

 A firm will enter the industry if such an

action would be profitable.
Enter if TR > TC
Enter if TR/Q > TC/Q
Enter if P > ATC

31
 The Competitive Firm’s Long-Run Supply
Curve
Costs
LMC
Firm enters
if P > LATC
LATC

Firm
exits
if P <
LATC
0 Quantity
32
Perfectly competitive markets: Summary

 Because a competitive firm is a price

taker, its revenue is proportional to the
amount of output it produces.
 The price of the good equals both the
firm’s average revenue and its marginal
revenue.

33
Perfectly competitive markets: Summary

 To maximize profit, a firm chooses the

quantity of output such that marginal
revenue equals marginal cost.
 This is also the quantity at which price
equals marginal cost.
 Therefore, the firm’s marginal cost
curve above shut-down point is its
supply curve.
34
Perfectly competitive markets: Summary

 In the short run, when a firm cannot

recover its fixed costs, the firm will
choose to shut down temporarily if the
price of the good is less than average
variable cost.
 In the long run, it will choose to exit if
the price is less than long-run average
total cost.
35
Perfectly competitive markets: Summary

 In a market with free entry and exit,

profits are driven to zero in the long run
and all firms produce at the efficient
scale.
 In the long run, the number of firms
adjusts to drive the market back to the
zero-profit equilibrium.

36
4.2 Price Determination in Pure Monopoly
Monopoly
 a single seller producing a product with no
close substitutes,
 effective barriers to entry into the market,
and
 the firm is a price maker (price setter)
 demand curve for a monopolist is the market
demand curve and it is downward sloping.

37
 Monopoly
 A firm is considered a monopoly if . . .
 it is the sole seller of its product.
 its product does not have close substitutes.
(Unique product).
 The fundamental cause of monopoly is
barriers to entry.

38
 Why Monopolies Arise
 Barriers to entry have three sources:
 Ownership of a key resource.
 The government gives a single firm the
exclusive right to produce some good.
 Costs of production make a single producer
more efficient than a large number of
producers.

39
 Monopoly Resources
 Although exclusive ownership of a key resource is
a potential source of monopoly, in practice
monopolies rarely arise for this reason.
 A firm owning the entire supply of a raw material
input that is essential to the production of a
particular commodity monopolizes the market.

40
 Government-Created Monopolies

 Governments may restrict entry by giving a

single firm the exclusive right to sell a
particular good in certain markets.
 Patents, Copyright, and government licensing

41
 Natural Monopoly
 An industry is a natural monopoly when a single
firm can supply a good or service to an entire market
at a smaller cost than could two or more firms.
 The market demand is too small to support many
firms
 When there are economies of scale over a wide

range of output

42
 Natural monopoly
 a monopoly that arises because of the
existence of economies of scale over the
entire relevant range of output.
 a larger firm will always be able to
produce output at a lower cost than could
a smaller firm.
 only a single firm can survive in a long-run
equilibrium.

43
Local monopoly

 Local monopoly – a monopoly that

exists in a local geographical area (e.g.,
local newspapers)

44
Actions by firms to create and protect
monopoly power

 patents and copyrights,

 high advertising expenditures result in
high sunk costs (costs that are not
recoverable on exit), and
 illegal actions designed to restrict
competition

45
 Demand Curves for Competitive and
Monopoly Firms
(a) A Competitive Firm’s (b) A Monopolist’s
Demand Curve Demand Curve
Price Price

Demand

Demand

0 Quantity of 0 Quantity of
Output Output
46
A Monopoly’s Revenue

 Total Revenue
P  Q = TR
 Average Revenue
TR/Q = AR = P
 Marginal Revenue
TR/Q = MR

47
Table: A Monopoly’s Total, Average, and Marginal
Revenue

48
 Monopoly’s Marginal Revenue

 A monopolist’s marginal revenue is always less

than the price of its good.
 The demand curve is downward sloping.

49
 Figure: Demand and Marginal-Revenue Curves for a
Monopoly
Price
$11
10
9
8
7
6
5
4
3 Demand
2 Marginal (average
1 revenue revenue)
0
–1 1 2 3 4 5 6 7 8 Quantity
–2
–3
–4

50
Copyright © 2004 South-Western
51
 Profit Maximization

 A monopoly maximizes profit by producing

the quantity at which marginal revenue
equals marginal cost.
 It then uses the demand curve to find the
price that will induce consumers to buy that
quantity.

52
Profit Maximization

 Comparing Monopoly and Competition

 For a competitive firm, price equals
marginal cost.
P = MR = MC
 For a monopoly firm, price exceeds
marginal cost.
P > MR = MC

53
 A Monopoly’s Profit

 Profit equals total revenue minus total

costs.
 Profit = TR - TC
 Profit = (TR/Q - TC/Q)  Q
 Profit = (P - ATC)  Q

54
 Figure: Profit Maximization for a Monopoly

2. . . . and then the demand 1. The intersection of the

curve shows the price marginal-revenue curve
Costs and consistent with this quantity. and the marginal-cost
Revenue curve determines the
B profit-maximizing
Monopoly quantity . . .
price

Average total cost

A

Marginal Demand
cost

Marginal revenue

0 Q QMAX Q Quantity
55
Copyright © 2004 South-Western
 Figure: The Monopolist’s Profit
Costs and
Revenue

Marginal cost

Monopoly E B
price

Monopoly Average total cost

profit

Average
total D C
cost
Demand

Marginal revenue

0 QMAX Quantity
56
Copyright © 2004 South-Western
A Monopolist’s Profit

 The monopolist will receive economic

profits as long as price is greater than
average total cost.

57
Zero-profit monopolist

58
Monopolist receiving economic loss

59
Monopolist that shuts down in the short run

60
Monopoly price setting
 There is a unique profit-maximizing price and
output level for a monopoly firm.
 It is optimal to produce at the level of output
at which MR = MC and to charge the price
given by the demand curve at this output
level.
 Charging a higher (or lower) price results in
lower profits.

61
PRICE DISCRIMINATION
 Price discrimination is the business
practice of selling the same good at
different prices to different customers,
even though the costs for producing for
the two customers are the same.
 Examples of Price Discrimination
 Movie tickets
 Airline prices
62
 Price discrimination
 Necessary conditions for price discrimination:
 the firm must not be a price-taker
 firms must be able to sort customers by their elasticity
of demand
 resale must not be feasible

63
Example: air travel

64
 Price Discrimination

 Two important effects of price discrimination:

 It can increase the monopolist’s profits.
 It can reduce deadweight loss.
 But in order to price discriminate, the firm must
 Be able to separate the customers on the basis of willingness to
pay.
 Prevent the customers from reselling the product.

65
 Price Discrimination
 A price discriminating monopolist has to decide on the
total output that he/she must produce, how much to
sell in each market and at what price.
 Assume we have two markets for discriminating price.
The total profit is maximized when the monopolist
equates the common MC to the individual marginal
revenues in each market.
 i.e., MC = MR1 = MR2
 If MR in one market is larger, the monopolist would
sell more in that market and less in the other, until
the above condition is fulfilled.
66
 Price Discrimination: exercise
 Assume the following for price discriminating monopolist
aimed at maximizing profit. Total demand for the product of
the monopolist is Q = 50-5P (P = 10-0.2Q)
 Demand in Market one is Q1 = 32-0.4P1 (P1 = 80-2.5Q1)
 Demand in Market two is Q2 = 18-0.1P2 (P2 = 180-10Q2)
 Cost function is C = 50+40Q (where Q = Q1+ Q2)
 Find equilibrium quantities (Q1 and Q2), equilibrium prices
(P1 and P2), profit (π), and elasticities (ε1 and ε2 ).

67
 Multi-plant Monopolist
 Consider a monopolist with two plants each with
different cost structures at two different locations.
 The monopolist now is expected to make two
decisions:
 How much output to produce altogether and at what price
to sell it so as to maximize profit?
 How to allocate the production of the optimal (profit
maximizing) output between the two plants?

68
 Multi-plant Monopolist
 The monopolist maximizes his output by utilizing each
plant up to the level at which the marginal costs are
equal to each other and to the common marginal
revenue. i.e., MC1 = MC2 = MR
 if MC1 is less than MC2, the monopolist would increase
his profit by increasing the production in plant 1 and
decreasing it in plant 2, until the condition of MC1 =
MC2 =MR is satisfied.

69
 Multi-plant Monopolist: exercise
 Assume that the demand equation of the multi-plant
monopolist is given as Q = 200 – 2P (P=100-0.5Q),
and costs of the two plants are given as C1 = 10Q1
and C2 = 0.25Q22. Find equilibrium levels of price and
outputs to be produced in the two plants, and the
maximum level of profit.

70
 Dumping
 If firms practice price discrimination by charging
different prices in different countries, they are
often accused of dumping in the low-price
country.
 Predatory dumping occurs if a country charges
a low price initially in an attempt to drive out
domestic competitors and then raises prices once
the domestic industry is destroyed.
 There is little evidence of the existence of
predatory dumping.
71
Figure: Deadweight Loss of Monopoly
p, $ per unit
24
MC

em
A = $18 C =$ 2
pm = 18
B = $12 ec
p c = 16

MR =MC=12 D =$60 E= $4

Demand
MR

0 Q m = 6 Q c= 8 12 24
Q , Units per day

72
 Exercises
1. Assume that you have a market where the demand curve
is P=100-4Q . Assume also that all firms produce the good
using constant marginal cost function where MC=4, no
matter how many units are produced.
A) What price will maximize the sum of producer and
consumer surplus in this market (socially optimum
price)?
B) What price will be set in a market if a monopolist sets
the price to maximize its profit?
C) What is the loss in consumer surplus resulting from the
monopoly?
73
 Exercises

2. If the demand curve of a profit maximizing monopolist

is given as Q = 40 − 0.2P and cost function as C = 30 +
30Q, find equilibrium output level, monopolist price, and
profit.

3. If the inverse demand curve of profit maximizing

monopolist is given as P =1200 − 2Q , and cost function as
C = Q3 − 61.25Q2 +1528.5Q + 2000 , find equilibrium
output level, monopolist price, and profit.

74
THE WELFARE COST OF MONOPOLY

 In contrast to a competitive firm, the

monopoly charges a price above the
marginal cost.
 From the standpoint of consumers, this
high price makes monopoly undesirable.
 However, from the standpoint of the
owners of the firm, the high price
makes monopoly very desirable.
75
 Other costs associated with monopoly

 X-inefficiency – occurs if firms do not have an

incentive to engage in least-cost production
(since they are not faced with competitive
pressure). The monopolist produces less than
the socially efficient quantity of output.
 Rent-seeking behavior – the cost of using
resources (such as lawyers, lobbyists, etc.) in
an attempt to acquire monopoly power. This
behavior does not benefit society and diverts
resources away from productive activities.
76
 PUBLIC POLICY TOWARD MONOPOLIES

 Government responds to the problem of

monopoly in one of four ways.
 Making monopolized industries more
competitive.
 Regulating the behavior of monopolies.
 Turning some private monopolies into public
enterprises.
 Doing nothing at all.

77
 Monopoly: Summary
 A monopoly is a firm that is the sole seller
in its market.
 It faces a downward-sloping demand curve
for its product.
 A monopoly’s marginal revenue is always
below the price of its good.

78
 Monopoly: Summary
 Like a competitive firm, a monopoly
maximizes profit by producing the quantity
at which marginal cost and marginal
revenue are equal.
 Unlike a competitive firm, its price exceeds
its marginal revenue, so its price exceeds
marginal cost.

79
 Monopoly: Summary
 A monopolist’s profit-maximizing level of
output is below the level that maximizes
the sum of consumer and producer
surplus.
 A monopoly causes deadweight losses
similar to the deadweight losses caused by
taxes.

80
 Monopoly: Summary
 Policymakers can respond to the
inefficiencies of monopoly behavior with
regulation of prices or by turning the
monopoly into a government-run
enterprise.
 If the market failure is deemed small,
policymakers may decide to do nothing at
all.
81
 Monopoly: Summary
 Monopolists can raise their profits by
charging different prices to different buyers
based on their willingness to pay. …price
discrimination.

82
 Monopoly: Exercises
1. A monopolist faces the inverse demand function described
by p = 32-5q where q is output. The monopolist has no
fixed cost and his marginal cost is 7 at all levels of output.
Derive the monopolist’s profit function. (Ans.: 25q-5q2)
2. A monopolist faces the inverse demand curve p = 192 -
4q. At what level of output is his total revenue
maximized? (Ans.: q=24)
3. if demand for is Q = 900- 300p; derive marginal revenue
function. (Ans.: MR=3-Q/150)

83
4.3 Price Determination in
Monopolistic Competitive Market

84
The Four Types of Market Structure

Number of Firms?

Many
firms

Type of Products?

One Few Differentiated Identical

firm firms products products

Monopolistic Perfect
Monopoly Oligopoly Competition Competition

85
 Characteristics of a monopolistically
competitive market
 a large number of firms,
 the product is differentiated (i.e., each firm
produces a similar, but not identical,
product),
 relatively easy entry and exit, and
 the firm is a price maker that faces a
downward sloping demand curve.
 Some features of monopoly and some
features of perfect competition 86
 Relationship to other market
models
 Monopolistic competition is similar to perfect
competition in that:
 There are many buyers and sellers
 There are no barriers to entry or exit
 Monopolistic competition is similar to monopoly in
that:
 Each firm is the sole producer of a particular product
(although there are close substitutes)
 The firm faces a downward sloping demand curve for
its product

87
 Monopolistic Competition
 Many Sellers
 There are many firms competing for the same
group of customers.
 Product examples include books, CDs, movies,
computer games, restaurants, cookies, furniture,
etc.

88
 Monopolistic Competition
 Product Differentiation
 Each firm produces a product that is at least
slightly different from those of other firms.
 Rather than being a price taker, each firm faces
a downward-sloping demand curve.
 The number of firms in the market adjusts
until economic profits are zero.

89
Demand curve facing a
monopolistically competitive firm

90
 Short-run equilibrium in a
monopolistically competitive industry

 Economic profits
lead to entry and
a reduction in
the demand
facing a typical
firm.

91
 Short-run equilibrium in a
monopolistically competitive industry
 Short-run economic profits encourage new firms
to enter the market. This:
 Increases the number of products offered.

 Reduces demand faced by firms already in the

market.
 Incumbent firms’ demand curves shift to the

left.
 Demand for the incumbent firms’ products fall,

and their profits decline.

92
 Long-run equilibrium in a
monopolistically competitive industry
 Entry
continues until
economic
profit equals
zero for a
typical firm.
 This
equilibrium is
often referred
to as a
“tangency
equilibrium.” 93
 Short-run equilibrium with
economic losses
 Economic
losses lead to
exit and a rise
in the
demand
facing a
typical firm.

94
Short-run equilibrium with
economic losses
 Short-run economic losses encourage firms
to exit the market. This:
 Decreases the number of products offered.
 Increases demand faced by the remaining
firms.
 Shifts the remaining firms’ demand curves to
the right.
 Increases the remaining firms’ profits.

95
 Long-run equilibrium
 Exit continues
until economic
profit equals
zero for a
typical firm.

96
 Short-Run and Long-Run Equilibrium
for a Monopolistic Competitor

Short-Run Profits Short-Run Losses

Long-Run Equilibrium

 Firms will enter and exit until economic profits

become zero.
97
 Monopolistic Competitor in the Long Run
Price

MC
ATC

P = ATC

Demand
MR
0
Profit-maximizing Quantity
quantity
98
Copyright©2003 Southwestern/Thomson Learning
 Monopolistic Competitor
Long-Run Equilibrium in the Long Run

 Two Characteristics
 As in a monopoly, price exceeds marginal
cost.
 Profit maximization requires MR=MC.
 The downward-sloping demand curve makes
marginal revenue less than price.
 As in a competitive market, price equals
average total cost. (but not at min ATC)
 Free entry and exit drive economic profit to
zero.
99
Monopolistic competition vs. perfect
competition

 There are two noteworthy differences

between monopolistic and perfect
competition - excess capacity and
markup.

100
 Excess Capacity in Monopolistic Competition

 There is no excess capacity in perfect competition

in the long run.
 Free entry results in competitive firms producing at the
point where average total cost is minimized, which is the
efficient scale of the firm.
 There is excess capacity in monopolistic competition
in the long run. i.e. it produces a level of output
that is below the least-cost.
 In monopolistic competition, output is less

than the efficient scale of perfect competition.

101
Figure 3 Monopolistic versus Perfect Competition

Excess Capacity in Monopolistic Competition

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC

P
P = MC P = MR
(demand
curve)

MR Demand

0 Quantity Efficient Quantity 0 Quantity produced = Quantity

produced scale Efficient scale

Excess capacity

102
Copyright©2003 Southwestern/Thomson Learning
Excess Capacity in Monopolistic Competition

Excess capacity
103
 Markup in Monopolistic Competition

 Markup Over Marginal Cost

 For a competitive firm, price equals marginal
cost.
 For a monopolistically competitive firm, price
exceeds marginal cost.
 Because price exceeds marginal cost, an extra
unit sold at the posted price means more profit
for the monopolistically competitive firm.

104
 Markup in Monopolistic Competition
(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price

MC MC
ATC ATC

Markup
P
P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

0 Quantity Efficient Quantity 0 Quantity produced = Quantity

produced scale Efficient scale

Excess capacity

105
Copyright©2003 Southwestern/Thomson Learning
Monopolistic competition and
efficiency
 As the number of firms rises, a
monopolistically competitive firm’s demand
curve becomes more elastic.
 As the number of firms in a market expands,
the market approaches a perfectly
competitive market.
 Thus, economic inefficiency may be smaller
when there is a large number of firms in a
monopolistically competitive market.
106
Product differentiation and advertising

 Monopolistically competitive firms may

receive short-run economic profit from
successful product differentiation and
advertising.
 These profits are, however, expected to
disappear in the long run as other firms
copy successful innovations.

107
 Advertising
 When firms sell differentiated products and charge
prices above marginal cost, each firm has an
incentive to advertise in order to attract more buyers
to its particular product.
 Critics of advertising argue that firms advertise in
order to manipulate people’s tastes; advertising
impedes competition by implying that products are
more different than they truly are.
 Defenders argue that advertising provides
information to consumers; it increases competition
by offering a greater variety of products and prices.
108
 Brand Names
 Critics argue that brand names cause
consumers to perceive differences that do not
really exist.

 Economists have argued that brand names may be

a useful way for consumers to ensure that the
goods they are buying are of high quality.
 providing information about quality.

 giving firms incentive to maintain high quality.

109
 Monopolistic Competition and the Welfare of
Society
 The product-variety externality due to entry:
 Because consumers get some consumer surplus
from the introduction of a new product, entry of
a new firm conveys a positive externality on
consumers.
 The business-stealing externality due to entry:
 Because other firms lose customers and profits

from the entry of a new competitor, entry of a

new firm imposes a negative externality on
existing firms.
110
 Monopolistic Competition: Summary

 A monopolistically competitive market is

characterized by three attributes: many firms,
differentiated products, and free entry.
 The equilibrium in a monopolistically competitive
market differs from perfect competition in that
each firm has excess capacity and each firm
charges a price above marginal cost.
 The product differentiation inherent in
monopolistic competition leads to the use of
advertising and brand names.
111
4.4 Price Determination in
Oligopoly Market

112
 The “competition continuum”
Market power of firms

Perfect Monopolistic
Oligopoly Monopoly
competition competition
Many firms Many firms A few A single
with a with producers producer
homogeneous differentiated with high
product products market
power
 Oligopoly

 Characterized by a few dominant firms.

 Products may be homogeneous or
differentiated.
 Difficult entry.
 The behavior of any one firm in an
oligopoly depends to a great extent on
the behavior of others. Recognized
mutual interdependence
 Oligopoly
 E.g. Auto industry, cigarete industry, packed
water, bus services, pvt schools, ...
 Apart from the few producers instead of one, this is
not much different from the monopoly
 A duopoly is an oligopoly with only two members.
 Compared to the monopoly case, each firm has an
extra element to consider: The behaviour of its
competitors
 Because a firm’s output influences market prices,
competitors will react
 This will lead to strategic behaviour
115
 RANGE OF OLIGOPOLY OUTCOMES

 When firms in an oligopoly individually

choose production to maximize profit, they
produce quantity of output greater than the
level produced by monopoly and less than
the level produced by competition.
 The oligopoly price is less than the monopoly
price but greater than the competitive price
(which equals marginal cost).
116
 Oligopoly Models
 All kinds of oligopoly have one thing in
common:
 The behavior of any given oligopolistic firm depends
on the behavior of the other firms in the industry
comprising the oligopoly.
 Comprehensive theory of oligopoly would have
to take into account how rivals would react to
any price or production change.
 As a result, there is no satisfactory
comprehensive theory of oligopoly.
 1. The Collusion Model
 A group of firms that gets together and makes
price and output decisions jointly is called a
cartel.
 A simple solution for the market price and
quantity is possible if the firms decide to
cooperate. This cooperative equilibrium is called a
cartel.
 OPEC is a good example: an organisation of
independent producers, producing the same
goods, who decide to coordinate their strategies,
so as to limit their output and increase prices.
 1. The Collusion Model…
 Overt cartels – the terms of agreement are generally
known.
 Covert cartels – the terms of agreement are known only
to the participants. This is especially when cartels are
prohibited by legislation relating to competition.
 In cartels:
 The good news for the firms: Firms practise monopoly
pricing and get monopoly profits. This means the
simple monopoly model is enough
 The “bad” news for the firms:

 This practise is illegal in most countries, and

 There is an incentive to cheat.
 1. The Collusion Model…
 While it pays for firms to collude, in order to earn positive
profits, it also pays to cheat on the collusive agreement.
 If one firm cuts its price to slightly below the others, it
could gain a lot of business.
 Cartels are likely to break down in the longrun. Producers
have an incentive to cheat by producing in excess of their
quota and by undercutting the agreed price.

120
 1. The Collusion Model…
 So usually, firms will not cooperate, and a more complex
model is needed...
 When firms in an oligopoly do not cooperate, there is a
non-cooperative equilibrium
 Compared to the monopoly and the cooperative cartel
case, it becomes difficult to characterise the market
equilibrium (equilibrium price and quantity)
 If a firm changes its output (price), this changes the market price,
and the profits of competitors. They will react to this change in
profits by changing their output (price).
 The optimal strategy of a firm depends on the strategies of
its competitors. There are as many types of equilibria as
there are combinations of strategies.
 2. The Cournot Model
 Is the simplest model of a duopoly: each firm
considers the output of its competitor as given

 The 2 firms simultaneously choose their

output, and consider that the current output of
their competitor will not change (not very
realistic...)
 The profits of the two firms is given by:

1  p  q1  q2   q1  c1  q1 


 2  p  q1  q2   q2  c2  q2 


The cost of production

depends only on the
The market price however, firm’s output
depends on the aggregate
output q1 + q2
 For simplicity, we re-write them as:

1  F1  q1 , q2 


 2  F2  q1 , q2 

 As for all firms, the maximum profit condition is
given by the first order condition  i qi  0
  1 F1  q1 , q2 
  0
 q1 q1

  2  F2  q1 , q2   0
 q q2
 2
 These first order conditions can be rearranged to
give a system of equations known as reaction
functions
q1  f1  q2  A reaction function tells you the

q2  f 2  q1  quantity q1 that maximises the
profits of firm 1 given the
quantity q2 produced by firm 2
 2. The Cournot Model…
 The essence is that each firm bases its
output decision assuming an output level
for the other firm in the market.
 The model captures interdependence in a
non-cooperative setting.

125
Convergence to Equilibrium

Q1 .Firm 1 thinks Firm 2 will

produce nothing so chooses
to produce quantity A.
. Firm 2 observes this and
chooses to supply B.
.Firm 1 sees that Firm 2 is
producing B and reacts by
A
producing C. And so on.
C Z .Ultimately end up at Z.

Q2
0 B
126
If Firm 2 makes the same conjectures then we
get the following:
Q1

Firm 2’s Reaction

Curve; Q2=f (Q1)

Cournot Equilibrium

Firm 1’s
Reaction Curve;
Q1=f (Q2)

0 Q2
127
A numerical example
 Assume market demand to be
P = 30 - Q
where Q= Q1 + Q2
ie industry output constitutes firm 1 and firm 2’s
output respectively
 Further, assume Q1 = Q2

 and average (AC) and marginal cost (MC)

AC = MC = 12

128
 To find the profit maximising output of Firm 1
given Firm 2’s output we need to find Firm 1’s
marginal revenue (MR) and set it equal to MC. So,
 Firm 1’s Total Revenue is
R1 = (30 - Q) Q1
R1 = [30 - (Q1 + Q2)] Q1
= 30Q1 - Q12 - Q1Q2
 Firm 1’s MR is thus
MR1 =30 - 2Q1 - Q2
129
 If MC=12 then
Q1 = 9 -1 Q2
2
This is Firm 1’s Reaction Curve.
 If we had begun by examining Firm 2’s profit
maximising output we would find its reaction
curve, i.e.
Q2 = 9 - 1 Q1
2
130
 We can solve these 2 equations and find
equilibrium quantity and price.
 Solving for Q1 we find
Q1 = 9 - 1 (9 - 1 Q1)
2 2
Q1 = 6
 Similarly,
Q2 = 6
and P = 18
131
 Q1
Q2= 9 - 1 Q1
2
18

Cournot
Equilibrium

Q1= 9 - 1 Q2
9
2

0 Q2
6 9 18

132
 3. The Kinked Demand Curve Model
 It is also called Sweezy’s kinked demand curve model
 The kinked demand model is a model of oligopoly in
which the demand curve facing each individual firm
has a “kink” in it. The kink follows from the assumption
that:
1. If a firm raises prices, other firms won’t follow and the
firm loses a lot of business. So demand is very
responsive or elastic to price increases.
2. If a firm lowers prices, other firms follow and the firm
doesn’t gain much business. So demand is fairly
unresponsive or inelastic to price decreases.
 The Kinked Demand Curve
$

P*

D
Q* quantity

134
 The Kinked Demand Curve
and the MR Curve

P*
MR

D
Q* quantity

135
 The MC curve intersects the MR curve
in the vertical segment.
$
MC
P*
MR

D
Q* quantity

136
 If costs shift up slightly, but MC still intersects
MR in the vertical segment, there will be no
change in price

$ MC’
MC
P*

D
Q* MR quantity

137
 The ATC curve can be added to the graph. To
show positive profits, part of ATC curve must lie
under part of the demand curve.

$
MC ATC
P*

D
Q* MR quantity

138
 Profit = TR - TC

$
MC ATC
P* profit
ATC*

D
Q* MR quantity

139
 To show a firm with a loss, the ATC curve
must be entirely above the demand curve.

ATC
$
ATC* loss MC AVC
P*

D
Q* MR quantity

140
 To show a firm breaking even, the ATC curve must
be tangent to the demand curve at the kink.

$
MC ATC
ATC*= P*

D
Q* MR quantity

141
 4. The Price-Leadership Model
 Price-leadership is a form of oligopoly in which one
dominant firm sets prices and all the smaller firms in the
industry follow its pricing policy.
 Assumptions of this model:
1. The industry is made up of one large firm and a number of
smaller, competitive firms;
2. The dominant firm maximizes profit subject to the constraint of
market demand and subject to the behavior of the smaller
firms;
3. The dominant firm allows the smaller firms to sell all they want
at the price the leader has set.
 4. The Price-Leadership Model…
 Outcome of the price-leadership model:
1. The quantity demanded in the industry is split between the
dominant firm and the group of smaller firms.
2. This division of output is determined by the amount of market
power that the dominant firm has.
3. The dominant firm has an incentive to push smaller firms out of
the industry in order to establish a monopoly.
 Predatory Pricing: The practice of a large, powerful firm
driving smaller firms out of the market by temporarily
selling at an artificially low price is called predatory
pricing. Such behavior became illegal in some countries.
 5. Game Theory Model
 Game theory analyzes oligopolistic behavior as a complex
series of strategic moves and reactive countermoves
among rival firms. In game theory, firms are assumed to
anticipate rival reactions.
 In a typical game, we found:
 Strategies: player’s plan of moves and counter-moves
 Pay-offs: possible outcomes of strategies given the rival’s counter
strategies
 The pay-off matrix: a table which illustrates all the pay-offs
 Dominant strategy: player’s best strategy given the rival’s
counter strategies
 Payoff Matrix for Advertising Game
B’s STRATEGY
A’s STRATEGY Do not advertise Advertise

A’s profit = $50,000 A’s loss = $25,000

Do not advertise
B’s profit = $50,000 B’s profit = $75,000

A’s profit = $75,000 A’s profit = $10,000

Advertise
B’s loss = $25,000 B’s profit = $10,000

• The strategy that firm A will actually choose depends on

the information available concerning B’s likely strategy.
• Regardless of what B does, it pays A to advertise. This is
the dominant strategy, or the strategy that is best no
matter what the opposition does.
The Prisoners’ Dilemma
Mr Y
Mr X Do not confess Confess
Mr X: 1 year Mr X: 7 years
Do not confess
Mr Y: 1 year Mr Y: free
Mr X: free Mr X: 5 years
Confess
Mr Y: 7 years Mr Y: 5 years

• Both Mr X and Mr Y have dominant strategies: to confess.

Both will confess, even though they would be better off if
they both kept their mouths shut.
• When all players are playing their best strategy given what
their competitors are doing, the result is called Nash
equilibrium.
 The Prisoners’ Dilemma
 Cooperation is difficult to maintain, because cooperation is not
in the best interest of the individual player.
 Both end up confessing and gets 8 yrs of prison, though
cooperation (not confessing) is better with only 1 yr prison
period
 Often people (firms) fail to cooperate with one another
even when cooperation would make them better off.
 Self-interest makes it difficult for the oligopoly to maintain a
cooperative outcome with low production, high prices, and
monopoly profits.
 A Nash equilibrium is a situation in which economic actors
interacting with one another each choose their best strategy
given the strategies that all the others have chosen. 147
 An Oligopoly Game

Iraq’s Decision

High Production Low Production

Iraq gets $40 billion Iraq gets $30 billion

High
Production

Iran gets $40 billion Iran gets $60 billion

Iran’s
Decision Iraq gets $60 billion Iraq gets $50 billion

Low
Production

Iran gets $30 billion Iran gets $50 billion

148
Copyright©2003 Southwestern/Thomson Learning
 6. Bertrand model
 In the Bertrand model, we have two firms that set
prices (instead of quantities), without knowing the
price that the other firm has set.
 This can be thought of as a closed bid auction.
 The one that has made the lowest bid wins the
contract, and in the case that they have made the
same bid they get to split it in two.

149
7. Stackelberg model

150
151
152
153
154
155
 8. Contestable Markets
 A market is perfectly contestable if entry
to it and exit from it are costless.
 In contestable markets, even large
oligopolistic firms end up behaving like
perfectly competitive firms. Prices are
pushed to long-run average cost by
competition, and positive profits do not
persist.
 Oligopoly is Consistent with
a Variety of Behaviors
 The only necessary condition of oligopoly is that firms are
large enough to have some control over price.
 Oligopolies are concentrated industries. At one extreme is
the cartel, in essence, acting as a monopolist. At the other
extreme, firms compete for small contestable markets in
response to observed profits. In between are a number of
alternative models, all of which stress the interdependence
of oligopolistic firms.
Profit possibilities

short run: positive profits, losses, or breaking even.

long run: positive profits, or breaking even.
 Non-price competition
 Oligopolists may engage in non-price
competition
 Especially where a price war might force price
down to such a low level that losses would
result.
 Non-price competition may include product
differentiation by means of advertising,
packaging, styling or after-sale service.

158
 Is Oligopoly Efficient?
 In oligopoly, price usually exceeds marginal
cost.
 So the quantity produced is less than the
efficient quantity.
 Oligopoly suffers from the same source and
type of inefficiency as monopoly.

159
 Oligopoly and Economic Performance

 Oligopolies, or concentrated industries, are likely

to be inefficient for the following reasons:
 They are likely to price above marginal cost. This
means that there would be underproduction from
society’s point of view.
 Strategic behavior can force firms into deadlocks that
waste resources.
 Product differentiation and advertising may pose a real
danger of waste and inefficiency.
 Measures of industry concentration
 Concentration ratio–percentage of total industry sales
accounted for by the four largest firms in the industry
 When four firms control 40 or more of the market, the
industry is considered oligopolistic
 The Herfindahl-Hirschman Index (HHI) helps to show
dominance of major firm
 sum of the squared percentage market share of all firms in the
industry
 greater weight is given to larger firms
 larger the index number, the greater the market power within an
industry
 Summary
Equilibrium for an Oligopoly
 Possible outcome if oligopoly firms pursue their
own self-interests:
 Joint output is greater than the monopoly

quantity but less than the competitive industry

quantity.
 Market prices are lower than monopoly price

but greater than competitive price.

 Total profits are less than the monopoly

profit.
162
 Summary
 Oligopolists maximize their total profits by
forming a cartel and acting like a
monopolist.
 The prisoners’ dilemma shows that self-
interest can prevent people from
maintaining cooperation, even when
cooperation is in their mutual self-interest.

163
 Summary
Properties of Monopoly, Oligop., Monop. Comp., and Competition

164