CHAPTER- FOUR

MARKET STRUCTURES AND BUSINESS

DECISIONS
Market Structures and Business Decisions
Learning Objectives

What is the market Structure?

How does competition affect

business decisions in d/nt market
structures?

Perfect competition; monopoly;

oligopoly; monopolistic competition

Measurement of market
structures

Market strategies in d/nt

market structures.
 1Market 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
Types:
◦ Perfectly competitive
◦ Pure monopoly
◦ Monopolistic competition
◦ Oligopoly
4.1 PERFECT COMPETITION
 Characteristicsof 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.
 4.1. Perfect Competition
 It simply represents a situation where
competition is at a maximum; it is therefore
sometimes referred to as pure competition or
atomistic competition.
 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.
Demand curve facing a single firm
 No individual firm can affect the market
price
 Demand curve facing each firm is perfectly
elastic
Revenue of a Competitive Firm
 Total revenue for a firm is the selling price times
the quantity sold.
 TR = (P X Q)
 Marginal revenue is the change in total revenue
from an additional unit sold.
 MR = ∆TR/ ∆Q=P
 For competitive firms, marginal revenue equals
the price of the good.
 Total, Average, and Marginal Revenue
for a Competitive Firm
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
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
Profit--maximizing level of output
Profit
Economic Profits > 0
Economic loss
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.
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.
Loss if shut down
 Break--even price
Break
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.
P < AVC
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
The Firm’s Short-
Short-Run Decision to Shut Down
 Short--run supply curve
Short
A perfectly
competitive firm
will produce at
the level of output
at which P = MC,
as long as P >
AVC.

The portion of
the marginal-cost
curve that lies
above average
variable cost is
the competitive
firm’s short-run
supply curve.
 Problem Perfectly competitive industry supply

TC=250000+200Q+0.02Q2
MC=200+0.04Q

B. Calculate the quantity supplied at industry prices of $200, $500, and $1000 per ton.

P=MC=200+0.04Q

0.04Q=-200+P

Therefore, the firms supply curve is Q=-5000+25P

P=$200: Q=-5000+25x200=0

P=$500: Q=-5000+25x500=7,500

P=$1,000: Q=-5000+25x1,000=20,000
Exercise
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
Long--run equilibrium
Long
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
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
The Competitive Firm’s Long
Long--Run Supply Curve
 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.
 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.
 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.
 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.
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.
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.
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.
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.
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
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
 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.
Local monopoly
 Local monopoly –a monopoly that exists in a local
geographical area (e.g., local newspapers)
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
Demand Curves for Competitive and Monopoly Firms
Monopoly’s Revenue
 Total Revenue= P *Q = TR
 Average Revenue=TR/Q = AR = P
 Marginal Revenue=∆TR/ ∆ Q = MR
Monopoly’s Marginal Revenue
 A monopolist’s marginal revenue is always
less than the price of its good.
 The demand curve is downward sloping.
 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.
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
A Monopoly’s Profit
 Profit equals total revenue minus total costs.
 Profit = TR-TC
 Profit = (TR/Q-TC/Q)*Q
 Profit = (P-ATC) * Q
Monopolist’s Profit
 The monopolist will receive economic profits as
long as price is greater than average total cost.
Zero-profit monopolist
Monopolist receiving economic loss
Monopolist that shuts down in the short run
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.
Exercises
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.
 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.
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
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
 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.
 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 MRs 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.
Price Discrimination Exercise:
 Assume the following for price discriminating
monopolist aimed at maximizing profit.
 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 (Q1and Q2), equilibrium
prices (P1and P2), profit (π), and elasticities (ε1and
ε2).
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?
 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 MC1is less than MC2, the monopolist would
increase his profit by increasing the production
in plant1 and decreasing it in plant2, until the
condition of MC1= MC2=MR is satisfied.
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= 10Q1and C2= 0.25Q22. Find
equilibrium levels of price and outputs to be
produced in the two plants, and the maximum
level of profit.
Dumping
 If firms practice price discrimination by
charging d/nt prices in d/nt 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.
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.
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.
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.
 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.
 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.
 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.
 Monopolists can raise their profits by charging different
prices to different buyers based on their willingness to
pay. …price discrimination.
4.3. Monopolistic Competition
 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
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
 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.
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.
Demand curve facing a monopolistically competitive firm
Short-run equilibrium in a monopolistically competitive industry

Economic profits
lead to entry and
a reduction in the
demand facing a
typical firm.
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.
firms‟ demand curves shift to the left.
 Incumbent firms
 Demand for the incumbent firms‟ products fall, and
their profits decline.
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.”
Short-run equilibrium with economic losses

Economic losses
lead to exit and a
rise in the
demand facing a
typical firm.
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.
 Long-run equilibrium
Exit continues until economic profit equals zero for a typical
firm.
Short-Run and Long-Run Equilibrium
for a Monopolistic Competitor Short-Run Losses
Short-Run Profits

Long-Run Equilibrium

Firms will enter and exit

until economic profits
become zero.
Monopolistic Competitor 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.
Monopolistic competition vs. perfect competition
 There are two noteworthy differences between
monopolistic and perfect competition -excess
capacity and markup.
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.
Excess Capacity in Monopolistic Competition
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.
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.
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.
 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.
 They also argue that it impedes competition by
implying that products are more different than
they truly are.
 Defenders argue that advertising provides
information to consumers.
 They also argue that advertising increases
competition by offering a greater variety of
products and prices.
 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.
Monopolistic Competition & 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.
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 & each firm charges a price above
marginal cost.
 The product differentiation inherent in
monopolistic competition leads to the use of
advertising and brand names.
4.4 OLIGOPOLY MARKET AND STRATEGIC
BEHAVIOUR
 Oligopoly
 A small number of firms produce most
output (a few producers)
 A standardized or differentiated product
 Recognized mutual interdependence, &
 difficult entry.
 E.g. Auto industry, cigarette industry,
packed water, bus services, pvt schools,
 A duopoly is an oligopoly with only two
members.
RANGE OF OLIGOPOLY OUTCOMES
 Monopoly power depends, in part, on how
firms interact in the market
 Collusion leads to monopoly power and
higher profits
 Competition leads to lower profits
 Tension between competition & collusion
 Oligopolists are pulled in 2 d/nt directions
 Non-collusive vs. collusive oligopoly
 If all the firms agree to limit their output ,
the price is high, but then firms have an
incentive to expand output by cheating.
 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).
Theory of 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.
 There is a tension between cooperation and self-
interest.
 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.
CARTELS
 Cartel is when a group of oligopolists engage in
collusion to make agreements relating to the
prices to be charged and/or the level of output
to be produced
 E.g. OPEC
 The objective of a collusive oligopoly is to act
like a monopolist –earning the maximum
profits.
 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.
 cartels
 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 long-run. Producers have
an incentive to cheat by producing in excess of their quota and
by undercutting the agreed price.
Sweezy’s kinked demand curve model of oligopoly
 Developed by Paul M. Sweezy (1939): “Demand under
Conditions of Oligopoly” and Robert Hall & Charles Hitch (1939):
“Price Theory and Business Behavior”
Assumptions:
 1. If a firm raises prices, other firms won’t follow & 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 & the firm
doesn’t gain much business.
 So demand is fairly unresponsive or inelastic to price
decreases.
 The Kinked Demand Curve
The Kinked Demand Curve

Other firms are assumed to match

price decreases, but not price
increases.
There is little evidence suggesting
that this model describes the behavior
of oligopoly firms.
Game theory models are more
commonly used.

The Kinked Demand Curve and the MR

Curve The MC curve intersects the MR curve in the vertical segment
 If costs shift up slightly, but MC The ATC curve can be added to the
still intersects MR in the vertical graph. To show positive profits, part of
segment, there will be no change ATC curve must lie under part of the
in price demand curve.
 To show a firm with a loss, the ATC curve
Profit = TR -TC must be entirely above the demand curve.
To show a firm breaking even, the ATC curve
must be tangent to the demand curve at the
kink.

Profit Possibilities for the Oligopolist

short run: positive profits, losses, or breaking even.
long run: positive profits, or breaking even.
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.
Strategic Behavior: Game Theory
• Game theory:- a study of strategic interactions
among rational players
 The study of alternative strategies that oligopolists
may choose to adopt, depending on their
assumptions about their rivals’ behavior.
• Strategy is an action plan that leads to
successful achievement of the goal.
• Game theory has been used in business and
economics to analyze interactions between
market rivals.
• In all game theoretic models the basic entity is a
player.
• A player may be interpreted as an individual or
as a group of individuals making a decision.
GAME THEORY AND ITS APPLICATION
 Game theory is the study of how people behave
in strategic situations.
 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
 Prisoners’ Dilemma
• There are two players suspected of
committing a crime
• Each player wants to maximize his own
payoff (less number of years in jail)
• Communication between two players is
not allowed and both players move
simultaneously
• There are two possible strategies: deny
any wrong doing and confess to the
police
 The Prisoners‟ Dilemma
 The dominant strategy is the best strategy for
a player to follow regardless of the strategies
chosen by the other players.
 Cooperation is difficult to maintain, because
cooperation is not in the best interest of the
individual player.
• For both players “Confess” is a dominant strategy
• Both players end up worse-off at the equilibrium:
dilemma
 Both end up confessing and gets 8 yrs of prison,
though cooperation (not confessing) is better with
only 1 yr prison period
 The prisoners’ dilemma provides insight into the
difficulty in maintaining cooperation.
 Often people (firms) fail to cooperate with one
another even when cooperation would make them
better off.
 GAME THEORY IN OLIGOPOLY
 Because the number of firms in an
oligopolistic market is small, each firm must
act strategically.
 Each firm knows that its profit depends not
only on how much it produces but also on
how much the other firms produce.
Oligopolies as a Prisoners’ Dilemma
 Self-interest makes it difficult for the oligopoly to
maintain a cooperative outcome with low
production, high prices, and monopoly profits.
 High production is a dominant strategy in the
above example.
 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.
PUBLIC POLICY TOWARD OLIGOPOLIES
 Cooperation among oligopolists is undesirable
from the standpoint of society as a whole because
it leads to production that is too low and prices
that are too high.
 The Cournot Model
 The essence is that each firm bases its output
decision assuming an output level for the other firm
in the market.
 Each firm takes the output of its rivals as given (fixed),
and chooses its best response to it
 Each firm maximizes its profit given what it believes
the other firm will produce
 Non-price competition
 Simultaneous output decisions by all firms
 The model captures interdependence in a non-cooperative
setting.
 Each firm has a Reaction Function.
 Firm 1’s reaction curve shows how much it will
produce as a function of how much it thinks Firm 2 will
produce.
 Firm 2’s reaction curve shows how much it will
produce as a function of how much it thinks Firm 1 will
produce
Illustration: Assume a case of two firms (Firm 1 & Firm 2) selling
homogeneous products and facing same cost functions
-firms face inverse linear demand function
P=100-Q, where Q= Q1 +Q2,
MC=MC1=MC2=$10
1) Calculate the reaction functions of both firms.
2) Compute Cournot Equilibrium, (Q*1, Q*2)

Sol’n: 1) TR1(Q1, Q2)=PQ1

=(100-Q) Q1 →(100- Q1-Q2)Q1
So the MR of firm 1 will be:
MR1=100-2Q1-Q2
Given Q2, firm 1 maximizes its profits by setting MR1=MC:
100-2Q1-Q2=10
Q*1(Q2)=45-1/2Q2 → firm 1’s Reaction function
2) Firm 2’s Reaction function can also be derived in the same
manner.
Firm 2’s Reaction function: Q*2(Q1)=45-1/2Q1
3) Cournot Equilibrium
By solving the two Reaction Functions
simultaneously, we can compute the
equilibrium levels of output
Given, Q1=45-1/2Q2 and Q2=45-1/2Q1,
we have, Q1=45-1/2(45-1/2Q1)
Q1=Q2=30.
Therefore, Cournot equilibrium is (Q*1,
Q*2)=(30,30)
A numerical example
 Assume market demand to be
 P = 30 – Q where Q= Q1 + Q2
 i.e 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
 To find the profit maximizing 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
 Firm1’s MR is thus
 MR1 =30 - 2Q1 - Q2
Oligopoly Summary
 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.
 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.