Imperfect Competition

Chavi Asrani
Imperfect Competition

Imperfectly Competitive Market Structures

Firms in market structures other than perfect competition face negatively sloped demand curves and
must administer their prices.
Monopoly

Monopoly: Market with only one seller.

Monopsony: Market with only one buyer.

Market power :Ability of a seller or buyer to affect the price of a good.

Number of Firms
When only a few firms account for most of the sales in a market, we say that the market is
highly concentrated. Note: in competitive market forms such as perfect competition and
monopolistic competition the market is highly fragmented

Barrier to entry Condition that impedes entry by new competitors.

Sometimes there are natural barriers to entry:

§ Patents, copyrights, and licenses
§ Economies of scale may make it too costly for more than a few firms to supply the entire
market.
§ In some cases, economies of scale may be so large that it is most efficient for a single
firm—a natural monopoly—to supply the entire market.
 Monopoly and Monopoly Power

§ Monopoly: A market structure in which a single firm serves an entire market for a product or service
§ Sole seller of a good in a market gives that firm greater market power than if it competed against
other firms.
Implication:
§ Market demand curve is the monopolist’s downward sloping demand curve.
§ However, a monopolist does not have unlimited market power
Monopoly
Note : Average Revenue and Marginal Revenue are different
Average revenue curve is also called the demand curve or the price line
Consider a firm facing the following demand curve: P = 6 - Q

MARGINAL REVENUE AVERAGE REVENUE

PRICE (P) QUANTITY (Q) TOTAL REVENUE (R) (MR) (AR)
$6 0 $0 — —
5 1 5 $5 $5
4 2 8 3 4
3 3 9 1 3
2 4 8 -1 2
1 5 5 -3 1
Average and marginal revenue

Demand Curve
P = 6 − Q.
Monopolist’s Output Decision
PROFIT IS MAXIMIZED WHEN MARGINAL REVENUE EQUALS MARGINAL COST

Q* is the output level at which

MR = MC

Q1—it sacrifices some profit because the

extra revenue that could be earned from
producing and selling the units between
Q1 and Q* exceeds the cost of producing
them.

Similarly, expanding output from Q* to

Q2 would reduce profit because the
additional cost would exceed the
additional revenue.
Shifts in Demand
A monopolist market has no supply curve.

No one-to-one relationship between price and quantity produced.

Monopolist’s output decision depends on:

Marginal cost
Shape of the demand curve.

Shifts in demand can lead to:

(i) changes in price with no change in output,

(ii) changes in output with no change in price,
(iii) changes in both price and output.
Shifts in demand
Shifting demand curve shows that a
monopolistic market has no supply
curve—i.e., there is no one-to-one
relationship between price and quantity
produced.
In (a), the demand curve D1 shifts to new
demand curve D2.
But the new marginal revenue curve MR2
intersects marginal cost at the same point
as the old marginal revenue curve MR1.
The profit-maximizing output therefore
remains the same, although price falls from
P1 to P2.
In (b), the new marginal revenue curve
MR2 intersects marginal cost at a higher
output level Q2.
But because demand is now more elastic,
price remains the same.
Production, Price, and Monopoly Power

Two questions!
1. How can we measure monopoly power in order to compare one firm with another?
(So far we have been talking about monopoly power only in qualitative terms.)
2. What are the sources of monopoly power, and why do some firms have more monopoly power
than others?
Sources of Monopoly/Market Power
§ Economies of scale: exist whenever long-run average costs decline as output increases.
§ Diseconomies of scale: exist whenever long-run average costs increase as output increases.
§ Economies of scope: exist when the total cost of producing two products within the same firm is lower than when the products are
produced by separate firms.
§ Cost complementarity: exist when the marginal cost of producing one output is reduced when the output of another product is
increased.
§ Patents & other legal barriers Firms under imperfect competition may earn positive economic profits, in the presence of barriers to
entry that prevents other firms from entering the market to reap a portion of those profits, thus super normal profits could continue
over time provided
§ Elasticity of market demand. Because the firm’s own demand will be at least as elastic as market demand, elasticity of market
demand limits the potential for monopoly power.
§ Number of firms in the market. If there are many firms, it is unlikely that any one firm will be able to affect price significantly.
§ Interaction among firms. Even if only two or three firms are in the market, each firm will be unable to profitably raise price very
much if the rivalry among them is aggressive, with each firm trying to capture as much of the market as it can.
Elasticity of Market Demand

If there is only one firm—a pure monopolist—its demand curve is the market demand curve.
In this case, the firm’s degree of monopoly power depends completely on the elasticity of market demand.
A particular firm’s elasticity depends on how the firms compete with one another, and the elasticity of market
demand limits the potential monopoly power of individual producers.

Since the demand for oil is fairly inelastic (at least in the short run), OPEC could raise oil prices far above marginal
production cost during the 1970s and early 1980s. Because the demands for such commodities as coffee, cocoa, tin, and
copper are much more elastic, attempts by producers to cartelize these markets and raise prices have largely failed. In
each case, the elasticity of market demand limits the potential monopoly power of individual producers.
Elasticity of Demand and Total Revenues
Price Revenue
Maximum revenues
Elastic 𝑃! ×𝑄!

Unitary

! Unitary 𝑅!
𝑃

Inelastic Elastic Inelastic

0 𝑄! Q 0 𝑄! Firm’s
MR output
 Monopoly

Marginal Revenue and Elasticity

§ The monopolist’s marginal revenue function is
"#$
§ 𝑀𝑅 = 𝑃
$

§ where 𝐸 is the elasticity of demand for the monopolist’s product and 𝑃 is the price charged.
§ For 𝑃 > 0
§ 𝑀𝑅 > 0 when 𝐸 < −1.
§ 𝑀𝑅 = 0 when 𝐸 = −1.
• 𝑀𝑅 < 0 when −1 < 𝐸 < 0.
Monopoly Output and Pricing Rule

§ A profit-maximizing monopolist should produce the output, 𝑄! , such that marginal

revenue equals marginal cost:
𝑀𝑅 𝑄! = 𝑀𝐶 𝑄!
§ Given the level of output, 𝑄! , that maximizes profits, the monopoly price is the price on
the demand curve corresponding to the 𝑄! units produced:

𝑃- = 𝑃 𝑄-
Marginal Revenue and Linear Demand

Given an linear inverse demand function

𝑃 𝑄 = 𝑎 + 𝑏𝑄
Marginal revenue is
𝑀𝑅 𝑄 = 𝑎 + 2𝑏𝑄
Costs, Revenues, and Profits Under Monopoly
𝐶 𝑄
Cost function
$
𝑅 = 𝑃 𝑄 ×𝑄
Revenue function

Slope of
𝑅 = 𝑀𝑅
Slope of
Maximum 𝐶 𝑄 = 𝑀𝐶
profit

0 Output
𝑄%
Profit Maximization Under Monopoly
Price 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 = MC
𝑃% − 𝐴𝑇𝐶 𝑄% ×𝑄% ATC

𝑃%
Profits
𝐴𝑇𝐶(𝑄% )

Demand

𝑄% Quantity
MR
 Monopoly

Marginal Revenue In Action

§ Suppose the inverse demand function for a monopolist’s product is given by 𝑃 = 10 − 2𝑄. What is
the maximum price per unit a monopolist can charge to be able to sell 3 units? What is marginal
revenue when 𝑄 = 3?

§ Answer:
§ The maximum price the monopolist can charge for 3 units is:
§ 𝑃 = 10 − 2 3 = $4.
§ The marginal revenue at 3 units for this inverse linear demand is:
§ 𝑀𝑅 = 10 − 2 2 3 = −$2.
Monopoly In Action

§ Suppose the inverse demand function for a monopolist’s product is given by 𝑃 = 100 − 2𝑄 and the
cost function is 𝐶 𝑄 = 10 + 2𝑄. Determine the profit-maximizing price, quantity and maximum
profits.

§ Answer:
§ Profit-maximizing output is found by solving: 100 − 4𝑄 = 2 ⟹ 𝑄! = 24.5.
§ The profit-maximizing price is: 𝑃! = 100 − 2 24.5 = $51.
§ Maximum profits are: 𝜋 = $51×24.5 − 10 + 2×24.5 = $1,190.50.
The Absence of a Supply Curve under Monopoly

§ Recall, firms operating in perfectly competitive markets determine how much output to produce based
on price (𝑃 = 𝑀𝐶).Thus, a supply curve exists in perfectly competitive markets.
§ A monopolist’s market power implies 𝑃 > 𝑀𝑅 = 𝑀𝐶.Thus, there is no supply curve for a
monopolist, a market served by firm’ s with market power.
Multiplant Decisions

§ Often a monopolist produces output in different locations.

§ Implications: manager has to determine how much output to produce at each plant.
§ Consider a monopolist producing output at two plants:
§ The cost of producing 𝑄" units at plant 1 is 𝐶 𝑄" , and the cost of producing 𝑄# at plant 2 is
𝐶 𝑄# .
§ When the monopolist produces a homogeneous product, the per-unit price consumers are
willing to pay for the total output produced at the two plants is 𝑃 𝑄 , where 𝑄 = 𝑄" + 𝑄# .
Multiplant Output Rule

§ Let 𝑀𝑅 𝑄 be the marginal revenue of producing a total of 𝑄 = 𝑄" + 𝑄# units of output. Suppose
the marginal cost of producing 𝑄" units of output in plant 1 is 𝑀𝐶" 𝑄" and that of producing 𝑄#
units in plant 2 is 𝑀𝐶# 𝑄# . The profit-maximizing rule for the two-plant monopolist is to allocate
output among the two plants such that:
§ 𝑀𝑅 𝑄 = 𝑀𝐶" 𝑄"
§ 𝑀𝑅 𝑄 = 𝑀𝐶# 𝑄#
 Implications of Entry Barriers

§ A monopolist may earn positive economic profits, which in the presence of barriers to entry prevents other
firms from entering the market to reap a portion of those profits.
§ Implication: monopoly profits will continue over time provided the monopoly maintains its market power.
§ Monopoly power, however, does not guarantee positive profits.
Can a Monopolist Earning Zero Profits ?
Price MC
ATC

𝑃! = 𝐴𝑇𝐶(𝑄! )

Demand

𝑄% Quantity
MR
Deadweight Loss of Monopoly
Price
The consumer and
producer surplus that
MC is lost due to the
%
𝑃
monopolist charging a
Deadweight loss
𝑃& price in excess of
marginal cost.

Demand
MR

𝑄% 𝑄& Quantity
Monopolistic Competition
§ An industry is monopolistically competitive if:
§ There are many buyers and sellers.
§ Each firm in the industry produces a differentiated product.
§ There is low barriers for entry and exit from the industry.
§ One of the key difference between monopolistically competitive and perfectly competitive markets is that
each firm produces a slightly differentiated product
§ Implication: products are close, but not perfect, substitutes; therefore, firm’s demand curve is
downward sloping under monopolistic competition.
Monopolistic Competition
Characteristics:
§ Firms compete by selling differentiated products that are highly substitutable for one another but
not perfect substitutes. In other words, the cross-price elasticities of demand are large but not infinite.
§ Low Barriers to entry and exit: It is relatively easy for new firms to enter the market with their own
brands and for existing firms to leave if their products or services become unprofitable
Implications of Product Differentiation under Monopolistic
Competition

The differentiated nature of products in monopolistically competitive markets implies that firms
in these industries must continually convince consumers that their products are better than their
competitors.
Implications of Product Differentiation under Monopolistic
Competition
§ Strategies monopolistically competitive firms could use to persuade consumers:
§ Comparative advertising: form of advertising where a firm attempts to increase the demand for
its brand by differentiating its product from competing brands
§ Brand equity
§ Niche marketing: a marketing strategy where goods and services are tailored to meet the needs
of a particular segment of the market.
§ Green marketing
§ Successful differentiation and branding strategies can make managers brand myopic, resting on
the brand’s past laurels and in doing so missing opportunities to enhance its brand
Optimal Advertising Decisions

§ How much should a firm spend on advertising to maximize profits?

§ Depends, in part, on the nature of the industry.
§ The optimal amount of advertising balances the marginal benefits and
marginal costs.
Profit-maximizing advertising-to-sales ratio is:

𝐴 𝐸8,:
=
𝑅 −𝐸8,;
Profit-Maximization under Monopolistic Competition

Price 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 = MC
𝑃∗ − 𝐴𝑇𝐶 𝑄∗ ×𝑄∗
ATC

𝑃∗
Profits
𝐴𝑇𝐶(𝑄∗ )

Demand

𝑄∗ Quantity
MR
Profit-Maximization Rule for Monopolistic Competition

§ To maximize profits, a monopolistically competitive firm produces where its

marginal revenue = marginal cost.
§ Profit-maximizing price is the maximum price per unit that consumers are
willing to pay for the profit-maximizing level of output.
§ Profit-maximizing output, 𝑄 ∗ , is such that 𝑴𝑹 𝑸∗ = 𝑴𝑪 𝑸∗ and the profit-
maximizing price is 𝑷∗ = 𝑷 𝑸∗ .
Long-Run Equilibrium under Monopolistic Competition
§ If firms in monopolistically competitive markets earn short-run
§ profits, additional firms will enter in the long run to capture some of those profits.
§ losses, some firms will exit the industry in the long run.
Effect of Entry on a Monopolistically Competitive Firm’s Demand

Price MC

ATC

𝑃∗ Due to entry of new

firms selling other brands

Demand1 Demand0

𝑄∗ Quantity of Brand X
MR1 MR0
Monopolistic Competition
§ In the theory of large-group monopolistic competition, many firms compete to
sell differentiated products.
§ Each may make pure profits in the short run. In the long run, freedom of entry
shifts its demand curve until it is tangent to the ATC curve, leading to excess
capacity and production at average costs above the minimum possible level.
Equilibrium of a Typical Firm in Monopolistic Competition

MC § Here the firm is in LR equilibrium at point EL.

£ per unit

§ Entry of new firms has pushed the existing

ATC
firm’s demand curve to the left until the curve is
EL
pL
tangent to the firm’s ATC curve at output qL.
pc § Price is pL, & total costs are just being covered.
D
Excess capacity is qC - qL.
MR § If the firm did produce at capacity, its costs
would fall from pL per unit of output to pC
qL qc
Output

[ii]. Long-run equilibrium

The Long-Run and Monopolistic Competition

§ In the long run, monopolistically competitive firms produce a level of output such
that:
§ 𝑃 > 𝑀𝐶
§ 𝑃 = 𝐴𝑇𝐶 > 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠
The excess capacity theorem

§ Each firm is producing its output at an average cost that is higher than it could achieve by producing
its capacity output.
§ In other words, each firm has unused or excess capacity.
§ This implies that firms typically invest in capacity that is not fully utilized
 Equilibrium in the Short Run and the Long Run
A MONOPOLISTICALLY COMPETITIVE FIRM IN THE SHORT AND LONG RUN
Long Run: These
profits attract new
Because the firm is the only
firms with competing
producer of its brand, it faces
brands. The firm’s
a downward-sloping demand
market share falls, and
curve.
its demand curve
Price exceeds marginal cost shifts downward.
and the firm has monopoly
power.
Part (b); price =
Short run: part (a), price >
average cost, so the
average cost, and the firm
firm earns zero profit
earns profits shown by the
even though it has
yellow-shaded rectangle.
monopoly power.
Note:

Under monopolistic competition an industry can be competitive, in the sense of

containing numerous competing firms and no pure profits, and yet contain unexploited
scale economies, in the sense that each firm is producing on the negatively sloped
portion of its average total cost curve.
Monopolistic Competition and Economic Efficiency

Comparison of
monopolistically
competitive equilibrium
and perfectly competitive
equilibrium

Under perfect competition, price = marginal cost.

The demand curve facing the firm is horizontal, so the zero-profit point occurs at the point of
minimum average cost.
Is monopolistic competition then a socially undesirable market structure that
should be regulated? The answer—for two reasons—is probably no:
1. In most monopolistically competitive markets, monopoly power is small.
Usually enough firms compete, with brands that are sufficiently substitutable, so that no single firm has
much monopoly power. Any resulting deadweight loss will therefore be small. And because firms’
demand curves will be fairly elastic, average cost will be close to the minimum.

2. Any inefficiency must be balanced against an important benefit from monopolistic competition:
product diversity.
Most consumers value the ability to choose among a wide variety of competing products & brands that
differ in various ways. The gains from product diversity can be large and may easily outweigh the
inefficiency costs resulting from downward-sloping demand curves.
Note:
Monopolistic competition
Market in which firms can enter freely, each producing its own brand or version of a
differentiated product.

Oligopoly
Market in which only a few firms compete with one another, and entry by new firms
is impeded.

Cartel
Market in which some or all firms explicitly collude, coordinating prices and output
levels to maximize joint profits.
 Market Structure

Perfect Competition Monopolistic Competition

Oligopoly
Many firms Many Firms Monopoly
Differentiated product/service
No Barrier to entry & exit Low Barrier to entry & exit One firm
Barrier to entry &exit
Identical products/service Differentiated products/service Barrier to entry & exit
Few Firms
P = MC P > MC P > MC
P > MC
Dead Weight Loss: No Dead Weight Loss: Yes Dead Weight Loss: Yes
Dead Weight Loss: Yes
Symmetric information E.g.: Restaurants, Movies, E.g.: Railways, Water
E.g.: Airlines, Telecom
E.g.: Agriculture Novel
Oligopoly

§ Oligopoly is imperfect competition market form, that is competition among the few; it
applies to an industry which contains only a few firms.
§ Each firm has enough market power to prevent it being a price taker, but each firm is subject
to enough inter-firm rivalry to prevent it considering the market demand curve as its own.
§ In contrast with a monopoly, which has no competitors, and with a monopolistically
competitive firm, which has many competitors, an oligopolistic firm faces a few competitors.
§ A special case of oligopoly is a duopoly, where there are just two firms competing.
Note

Where size confers a cost advantage, through economies of either scale or scope,
there may be room for only a few firms, even when the total market is quite large.
This cost advantage of size will dictate that the industry be an oligopoly, unless
government regulation prevents the firms from growing to their efficient size.
Conditions for Oligopoly

§ Oligopoly market structures are characterized by only a few firms, each of which is large
relative to the total industry.
§ Typical number of firms could be between 2 and 10.
§ Products can be identical or differentiated.
§ An oligopoly market composed of two firms is called a duopoly
§ Oligopoly settings tend to be the most difficult to manage since managers must consider the
likely impact of his or her decisions on the decisions of other firms in the market.
Oligopoly
Products may or may not be differentiated.

Only a few firms account for most or all of total production.

Some or all firms earn substantial profits over the long run because barriers to entry make it difficult or impossible for
new firms to enter.

Oligopoly is a prevalent form of market structure.

Examples:
Automobiles, steel, aluminum, petrochemicals, electrical equipment, and computers.

“natural” entry barriers

(i) Scale economies may make it unprofitable for more than a few firms to co-exist in the market;
(ii) Patents or access to a technology;
(iii) Need to spend money for name recognition and market reputation may discourage entry by new firms.
(iv) Incumbent firms may take strategic actions to deter entry.

Managing an oligopolistic firm is complicated:

Pricing, output, advertising, and investment decisions involve important strategic considerations, which can be highly
complex.
Strategic interaction: A firm’s demand depends on actions of
the rivals under oligopoly

Price
Demand if rivals
C match price changes

Demand if rivals do not

A
B match price changes
𝑃!

Demand2
Demand1

0 𝑄! Output
Sweezy Oligopoly

Sweezy oligopoly characteristics:

§ Few firms in the market serving many consumers
§ Firms produce differentiated products.
§ Each firm believes its rivals will cut their prices in response to a price reduction but
will not raise their prices in response to a price increase.
§ Barriers to entry exist.
Sweezy Oligopoly
Price

Sweezy Demand MC0

A
B
𝑃!
MC1
C Demand1
(rival holds price
constant)

E MR1
MR Demand2
(rival matches price change)

0 𝑄! F Output
MR2
Cournot Oligopoly

Cournot oligopoly characteristics

§ There are few firms in the market serving many consumers.
§ The firms produce either differentiated or homogeneous products.
§ Each firm believes rivals will hold their output constant if it changes its output.
§ Barriers to entry exist.
Cournot Oligopoly: Reaction Functions

§ Consider a Cournot duopoly. Each firm makes an output decision under the
belief that is rival will hold its output constant when the other changes its output
level.
§ Implication: Each firm’s marginal revenue is impacted by the other firms output
decision.
§ The relationship between each firm’s profit-maximizing output level is called a
best-response or reaction function.
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.
Cournot equilibrium is an example of a Nash equilibrium (and thus it is sometimes called a Cournot-Nash equilibrium).

In a Nash equilibrium, each firm is doing the best it can given what its competitors are doing.

As a result, no firm would individually want to change its behavior. In Cournot equilibrium, each firm is producing
an amount that maximizes its profit given what its competitor is producing, so neither would want to change its output.
Cournot Oligopoly:
Reaction Functions Formula

Given a linear (inverse) demand function

𝑃 = 𝑎 − 𝑏 𝑄" + 𝑄#
and cost functions, 𝐶" 𝑄" = 𝑐" 𝑄"
𝐶# 𝑄# = 𝑐# 𝑄#
the reactions functions are:

𝑎 − 𝑐" 1
𝑄" = 𝑟" 𝑄# = − 𝑄#
2𝑏 2
𝑎 − 𝑐# 1
𝑄# = 𝑟# 𝑄" = − 𝑄"
2𝑏 2
Cournot Reaction Functions

Quantity2

Firm 1’s Reaction Function

𝑄" = 𝑟" 𝑄(

𝑄( %)*)+),-
Cournot equilibrium
&)./*)0
𝑄( C
Firm 2’s Reaction Function
D A 𝑄( = 𝑟( 𝑄"
B

𝑄" &)./*)0 𝑄" %)*)+),- Quantity1

Cournot Oligopoly

§ Cournot Oligopoly Equilibrium A situation in which neither firm has an

incentive to change its output given the other firm’s output.

§ Cournot Oligopoly: Isoprofit Curves A function that defines the combinations

of outputs produced by all firms that yield a given firm the same level of profits.
Isoprofit Curves for Firm 1
1. Every point on a given isoprofit
curve yields Firm 1 the same level
of profits.
2. Isoprofits curves tat lie closer to
Firm 1’s monopoly output are
associated with higher profits for
that firm.
3. The isoprofit curves for Firm 1
reach their peak where they
intersect Firm 1’s reaction
function.
4. The isoprofit curves do not
interest one another.
Firm 1’s Best Response to Firm 2’s Output
Quantity2

𝑟" (Firm 1’s reaction function)

A B C
∗
𝑄( 𝜋" 1
𝜋" 2
𝜋" &
Firm 1’s profit increases as isoprofit
curves move toward 𝑄" %

𝑄" 1 𝑄" 2 𝑄" & 𝑄" % Quantity1

Firm 2’s Reaction Function and Isoprofit Curves
Quantity2
Monopoly
point for
firm 2

𝑄( %
Firm 2’s profit increases as isoprofit
curves move toward 𝑄( %

𝜋3 & 𝑟( (Firm 2’s reaction function)

2
𝜋(
𝜋" 1

Quantity1
Cournot Equilibrium
Quantity2
𝜋( &)./*)0

𝑄( % Cournot Equilibrium

𝑄( &)./*)0

𝜋" &)./*)0

𝑄" &)./*)0 𝑄" % Quantity1

Effect of Decline in Firm 2’s Marginal Cost on Cournot
Equilibrium
Quantity2
𝑟"

F
∗∗
𝑄(
Due to decline in
firm 2’s marginal cost

E
𝑄( ∗ 𝑟( 𝑟( ∗∗

𝑄" ∗∗ 𝑄" ∗ 𝑄" % Quantity1

Cournot Oligopoly: Collusion

§ Markets with only a few dominant firms can coordinate to restrict output to their
benefit at the expense of consumers.
§ Restricted output leads to higher market prices.
§ Such acts by firms is known as collusion.
§ Collusion, however, is prone to cheating behavior.
§ Since both parties are aware of these incentives, reaching collusive agreements
is often very difficult.
Incentive to Collude in a Cournot Oligopoly
Quantity2 𝜋( &)./*)0
𝜋( &),,.45)*

Collusion outcome
𝑄( %

𝑄( &),,.45)*
𝜋" &)./*)0
𝜋" &),,.45)*

𝑄" &),,.45)* 𝑄" % Quantity1

Incentive to Renege on Collusive Agreements in Cournot
Oligopoly
Quantity2
𝜋( &),,.45)*
𝜋("&6780

𝑄( %

𝑄( &),,.45)*

𝜋" &),,.45)*
𝜋" &6780

𝑄" &),,.45)* 𝑄" &6780 𝑄" % Quantity1

Stackelberg Oligopoly

Stackelberg oligopoly characteristics:

§ There are few firms serving many consumers.
§ Firms produce either differentiated or homogeneous products.
§ A single firm (the leader) chooses an output before all other firms choose their outputs.
§ All other firms (the followers) take as given the output of the leader and choose
outputs that maximize profits given the leader’s output.
§ Barriers to entry exist.
Stackelberg Equilibrium
Quantity Follower
𝜋( &)./*)0
𝑟 ?78@7/ 𝜋( 908:;7,<7/= A),,)B7/

𝑟 A),,)B7/
𝑄( %

908:;7,<7/= 𝜋" &)./*)0

𝑄( A),,)B7/

𝜋" 908:;7,<7/= ?78@7/

𝑄" % 𝑄" 908:;7,<7/= ?78@7/ Quantity Leader

Stackelberg Oligopoly: Equilibrium Output Formulae

Given a linear (inverse) demand function

𝑃 = 𝑎 − 𝑏 𝑄" + 𝑄#
and cost functions 𝐶" 𝑄" = 𝑐" 𝑄" and 𝐶# 𝑄# = 𝑐# 𝑄# .
The follower sets output according to the reaction function

𝑎 − 𝑐# 1
𝑄# = 𝑟# 𝑄" = − 𝑄"
2𝑏 2
The leader’s output is

𝑎 + 𝑐# − 2𝑐"
𝑄" =
2𝑏
Bertrand Oligopoly

Bertrand oligopoly characteristics

§ There are few firms in the market serving many consumers.
§ Firms produce identical products at a constant marginal cost.
§ Firms engage in price competition & react optimally to prices charged by
competitors.
§ Consumers have perfect information and there are no transaction costs.
§ Barriers to entry exist.
Bertrand Oligopoly: Equilibrium

§ Firms in this market undercut one another to capture the entire market leaving the rivals with no
profit. All consumers will purchase at the low-price firm
§ This “price war” would come to an end when the price each firm charged is equal marginal cost
§ In equilibrium, 𝑃" = 𝑃# = 𝑀𝐶
§ Socially efficient level of output
Cartels
§ Producers in a cartel explicitly agree to cooperate in setting prices & output levels.
§ If enough producers adhere to the cartel’s agreements, & if market demand is
sufficiently inelastic, the cartel may drive prices well above competitive levels.
§ Cartels are often international. Antitrust laws prohibit companies from colluding.
Furthermore, nothing prevents countries, or companies owned or controlled by
foreign governments, from forming cartels.
§ Example: OPEC cartel is an international agreement among oil-producing
countries which has succeeded in raising world oil prices above competitive levels.
Milk Cartel
The U.S. government has supported the price of milk since the
Great Depression & continues to do so today. The government,
however, scaled back price supports during the 1990s, and as a
result, wholesale prices of milk have fluctuated more widely. Not
surprisingly, farmers have been complaining.

In response to these complaints, in 1996 the federal government allowed milk producers in
the six New England states to cartelize. The cartel—called the
Northeast Interstate Dairy Compact—set minimum wholesale prices for milk, and was
exempt from the antitrust laws. The result was that consumers in New England paid more for
a gallon of milk than consumers elsewhere in the nation.
Studies have suggested that the cartel in the New England states has caused retail prices of
milk to rise by only a few cents a gallon. Why so little? The reason is that the New England
cartel is surrounded by a fringe of noncartel producers.
Congress ended the Northeast Interstate Dairy Compact in October 2001. Although
proponents of the Compact attempted to revive the cartel, opposition
in Congress has been strong. Nonetheless, milk production continues to benefit from federal
price supports
The dilemma of oligopoly

§ Oligopolistic behaviour is typically strategic behaviour.

§ In deciding on strategies, oligopolists face a basic dilemma between competing and
cooperating.
§ The firms in an oligopolistic industry will make more profits as a group if they
cooperate; however, any one firm may make more profits for itself if it goes it alone
while the others cooperate.
Oligopoly as a Game
§ Small-group interaction can be analysed using a game theory framework, which sets
out the available actions and the payoffs under various actions.
§ In a Nash equilibrium each firm is doing the best it can, given the choices that other
firms have made.
§ A co-operative solution is likely to be the one that maximizes joint profits, but each
firm will typically have an incentive to cheat, and explicit co-operation between firms
may be proscribed by competition law.
Contestable Markets

Contestable markets involve strategic interaction among existing firms and potential entrants
into a market.
A market is contestable if:
All producers have access to the same technology.
Consumers respond quickly to price changes.
Existing firms cannot respond quickly to entry by lowering price.
There are no sunk costs.
If these conditions hold, incumbent firms have no market power over consumers.

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Best of Luck !