Chapter One

Price and output determination under monopoly market structure

1.1. Definition
A monopoly is a market structure where there is only one firm that produces and sells a
particular commodity or service and there are no close substitutes available. Since the monopoly
is the seller in the market, the industry is a single firm industry and it has no direct competitors.
However it does not necessarily mean that it is a guarantee to get an abnormal profit. Monopoly
power only guarantees that the monopolist can make the best of whatever demand and cost
conditions exist without fear of the entrant of new competing firms.
1.2. Source and Types of Monopoly
The rise and existence of monopoly is related to the factors, which prevents the entry of new
firms. The different barriers to entry that are the causes of monopoly are described below.

i. Legal Restrictions: A monopoly, which are created for the interest of the public. For
example the public utility sectors such as water supply, postal, telegraph and telephone
services, radio and TV services, generation and distribution of electricity such monopolies
are known as public monopolies.
ii. Control over key raw materials: some firms may get monopoly power if they possess
certain scarce & key raw materials that are essential for the production of certain goods or if
the supply of a commodity is localized in a single place. This type of monopoly is known as
raw material monopoly. For example India possesses manganese mines; the extraction of
diamonds is controlled by South Africa.
iii. Efficiency: A primary and technical reason for growth of monopolies is economies of scale.
The most efficient plant (probably large size firm), which can produce at minimum cost,
could eliminate the competitors by cutting down its price for a short period and can acquire
monopoly power. Monopolies created through efficiency are known as natural monopolies.
iv. Patent rights: - The government has granted firms a patent right, for producing a commodity
of specified quantity and character so that firms will have exclusive rights to produce the
specified commodity. Such monopolies are called patent monopolies.
1.3. Common characteristics of monopoly
Monopoly markets share the following common characteristics.
1. Single seller and many buyers
There is a single seller who sells the product to many buyers.
2. Absence of close substitutes
A product produced by a monopolist has no close substitute. So that consumers have no
alternative choices to substitute one product for another.
3. Price maker
The monopolist is a price maker. Facing a down ward sloped demand curve for its product, the
monopolist can change its product price by changing the quantity of the Product supplied. For
example, the monopolist can increase the price of its product by decreasing the quantity of
supply.
4. Barrier to entry
In monopoly, new competitors cannot freely enter in to the market due to some barriers which
can be economical, technical, legal or other type of barriers.
1.4. Demand, Marginal Revenue and cost curves under Monopoly
A monopoly firm faces a down ward sloping demand curve. It implies given the demand curve, a
monopoly firm has the option to choose between prices to be charged or output to be sold. But he
cannot simultaneously control both the price and the level of output. He can either decide the
level of output, and leave the price of the output to be determined by consumer demand or he can
fix the price and leave the level of output to be decided by the demand for the product at that
price. One of the fundamental differences between a monopolist and a competitor is therefore
the demand (AR) and marginal revenue curves they face. In the case of perfectly competitive
market MR = AR=P=D. But in the case of down ward sloping demand curve of monopoly
marginal revenue curve falls twice as much as the fall of average revenue curves i.e. the slope of
MR is twice as steep as the average revenue curve. The following figure illustrates this
relationship
 D

D=AR=P

MR
Quantity
0
T M
Fig: 1.1: AR and RM curves for Monopoly
DM is the demand curve and DT is the marginal revenue curve, which bisects the quantity
demanded OM. Thus the distance OT = TM
This can be shown mathematically as follows:
Assume linear demand function of the monopolist is given as:

1. The demand function

P = a - bx where a = constant, x=quantity demanded
2. The total revenue is calculated as follows :
TR = Px
= (a - bx)x = ( substituting P = a -bx)
TR = ax -bx2
3. The Average revenue can be determined
R Px
= =P=a−bx
AR = x x
Thus the demand curve is also the AR curve of the monopolist with slope = -b
4. The marginal revenue (the first derivative of R)
2
dR d (ax−bx )
=
dx dx
=a-2bx
 That is the MR is a straight line with the same intercept (a) as the demand curve, but
twice as steep ( i.e slope = -2b)
Note: - the general relation between P and MR is found as follows
R = Px
dx( P ) d ( p) x
MR= + dp dx
dx dx MR=P+ x
dx (But dp is negative due to the inverse relation
xd ( p )
MR=P+
dx

between demand & price)

dp dp
MR=P−X ⇒
dx P = MR+x dx
Thus the marginal revenue is smaller than price at all levels of output.

The nature and shape of cost curves confronting a monopolist are similar to those faced by a
perfectly competitive firm. Because cost depends on the production function and input prices,
irrespective of whether a firm is a monopoly or perfectly competitive.

Since total revenue curve of the monopolist firm has an inverse U- shape. The total revenue of a
monopolist firm first increases with the quantity of sales (over the elastic range of the demand
curve), reaches its maximum (when the demand curve is unitary elastic), and finally decreases
when quantity of sales increases (over the inelastic range of the demand curve) the following
figure illustrates this fact.

Ep>1
P

Ep=1
P1
Ep<1
Q
Q1 DD

TR
 TR
Q
Q1
Fig: 1.2 the shape of total revenue curve and its relationship with the price elasticity of demand.
When Ep>1 TR and Q have positive relation, at a point where Ep=1, TR curve reaches its
maximum and when EP<1, TR and Q have negative relation.
The MR curve of monopolist firm is down ward sloping (decreases with quantity of sales). The
fact that the monopolist must lower the price to increase its sales causes the MR to be less than
price except for the first unit. This is so because when the firm reduces the commodity price to
sell one more unit all units which would have been sold at the original higher price will now be
sold at the new (lower) price. The following table may help you better understand this fact.
Price Quantity TR AR MR
6 0 0 - -
5 1 5 5 5
4 2 8 4 3
3 3 9 3 1
2 4 8 2 -1
1 5 5 1 -3
The above table shows that as output increases the TR first increases, reaches its maximum
(when the firm sells the third unit) and then starts to fall.
The MR is less P except for the first unit. For example, when the firm decreases the price from$5
to $4 marginal revenue decreases from $5 to $3. That is, at the second unit MR ($3) is less than
the P ($4).
This is because, when the market price is $5, the firm will sell one unit and will get a TR of $5
and the MR of this first unit is $5. When the price decreases to $4, both the first and the second
unit are sold at $4 and the firm receives total revenue of $8. Now, the MR that the firm obtains
from the second unit is only $3. Hence for a down ward sloping demand curves (in monopoly)
the MR of the firm is less than the market price. Note that the AR of a monopolist is always
identical to the P or demand curve.
The following figure illustrates the relationship between price elasticity of demand and MR
 P

Ep>1
P1
MR

Ep=1
Ep<1
DD

Fig: 1.3 the relationship between MR and P. The MR of a monopolist lies below the commodity
price for each unit sold (except the first unit) and it is negative over the inelastic range of the
demand curve.

1.4 Short Run Equilibrium of Monopoly

A monopolist, like a perfectly competitive firm, can incur losses in the short run. Unlike the case
of the perfectly competitive firm, the monopolist’s short run supply curve cannot be derived
from its short run marginal cost curve (the supply curve of the monopolist is indeterminate).
Under monopoly, the firm is a price maker and has a power to alter the level of output. Thus,
profit maximization under monopoly involves determination of the price and output
combination that yields the maximum possible profit of the firm. Price- output combination that
yields the monopolist maximum profit can be determined in two ways:
1. Total approach: In this approach the profit maximizing unit of output is defined as that level
of output where the positive difference between TR and TC is maximal or the negative
difference between TR and TC is minimal.
TR, TC TC

TR*

TR

PROFIT Q
Q1 Q2 Q3

Q
Q1 Q2 Q3
MR

Fig 1.4 Short –run equilibrium of the monopolist Total approach: The TR of the monopolist has
an inverse U shape because the monopolist must lower the commodity price to sell additional
units. The Short run Total Cost has the usual shape. The total profit is maximized at Q2, where
the positive difference between the TR and STC is the greatest. Profit is negative for output
levels below Q1 and above Q3 .In this approach the profit maximizing price is given by the
ratio of TR* to Q2.
2. Marginal approach
In this approach the profit maximizing level of output is that level of output at which marginal
cost curve cuts the marginal revenue curve from below. The equilibrium (profit maximum) price
is the price corresponding to the equilibrium price from the demand curve.
Consider the following figure:
 a
P1

P2 SMC
d
P3

b
E
c
DD or AR

Q1 Q2 Q3
MR

Fig. 1.5 Short-run equilibrium of the monopolist: marginal approach. Equilibrium output is
Q2, where MC and MR curves intersect each other and MC curve is up ward sloping.
Equilibrium price is the price corresponding to the equilibrium quantity, Q2 (i.e. p2).
Note that, a monopolist charges a price which exceeds the MC of production, unlike the case of
the perfectly competitive firm. Now, how can we be sure that Q 2 is the profit maximizing unit of
output? To answer this question, note that in the total approach the level of profit at a given level
of output is the vertical distance between the TR and TC (i.e, ∏ = TR - TC.)
In the marginal approach, however, the level of profit at a given level of output is not the
distance between the MR and MC curves. Rather it is the area between marginal revenue and
marginal cost curves starting from the origin up to the given level of output. Symbolically, the
level of profit say at Q2 level of output is:
∏ at Q2 = TR at Q2 – TC at Q2 ---------------------------- Total approach
Q2

∫ ( MR−MC )dQ
∏ at Q2 = 0 ------------------------- Marginal approach

Given the level of profit as the area between the MR and MC, let’s come back to our question
above.
In the above figure, we have said that the equilibrium price is Q2 and the level of profit is the
area between that part of MR and MC curves between the origin and Q2 (area abE).
Mathematically, the profit maximizing condition of MR = MC and MC is increasing can be
shown as follows.
∏ = TR – TC
∏ is maximized when dπ
=0
dQ
Dπ dTR dTC
That is, = − =0
dQ dQ dQ
 MR – MC = 0
 MR = MC ………………………….. First order condition
The second order condition of profit maximization is

d2 π
<0
dQ 2
That is, d 2 π d 2 TR d 2 TC
= − <0
dQ 2 dQ 2 dQ 2 dTR
dMR dMC
2
d TR
=
(
d
dQ ) dMR
=
− <0 (Because dQ
2 dQ dQ
and the same for MC)
dQ dQ Slope of MR- slope of MC<0
Slope of MC > slope of MR ------- the second order condition
Numerical example
Suppose the monopolist faces a market demand function given by P=40-Q. The firm has a fixed
cost of $ 50 and its variable cost is given as TVC=Q2 determine:
a) the profit maximizing unit of output and price
b) the maximum profit
Solution
Given: p=40-Q
TFC=50
TVC= Q2
a) equilibrium condition is MR=MC, and slope of MC>slope of MR.
TR=P.Q = (40-Q) Q =40Q- Q2
TC=TFC+TVC =50 + Q2
Now,
2
dTR d (400−Q )
MR= = =40−2 Q
dQ dQ
 2
dTC d (50+Q )
MC= = =2 Q
dQ dQ
MR=MC 40-2Q=2Q
40=4Q
Q=10

dTR
Second order condition: slope of MR= =−2
dQ
dMC
Slope of MC= =2
dQ
dMC dMR The second order condition is
Thus, the profit maximizing level of > output is 10 and the profit
dQ dQ met
maximizing price is obtained by substituting the profit
maximizing quantity (10) in the demand function.
Thus, P = 40 – Q
P = 40 – 10 = 30
b) The maximum profit is the level of profit obtained from selling 10 units at $ 30 each.
∏ = TR – TC
But TR = P.Q
= $ 30 * 10 = $ 300
TC = 50 + Q2 = 50 + 102 = $ 150
The maximum ∏ is thus $ 300 - $ 150 = $ 150.

1.6. Absence of unique supply Curve under Monopoly

Under Perfect competition, you remember that firms have unique supply curve. That is there is
unique supply price for each unit of output supplied. In monopoly supply price is not unique. A
given quantity could be supplied at different prices and different quantities can be sold at the
same price, depending on market demand and marginal revenue. Hence there is no one to one
correspondence between P and Q under monopoly. Consider the following figures.
 P
P
Fig.6.5

MC

MC
P1
P E1
P
E2
D D1

D
D1 MR1
Q Q Q1 Q
MR
Q* MR1 MR
Panel-1
In this panel, the same quantity Q* is sold at Panel-2
different prices depending on the market In this panel, initially equilibrium is E1
demand. If the market demand is D1 and the (where MR1=MC) and equilibrium
MR curve is MR1, equilibrium occurs when P&Q1. when the demand for monopolist
MR1 cuts MC curve and the equilibrium price product decreases to D the new
and quantity are P1 and Q*. If the market equilibrium becomes E2 where the new
demand for the monopolist product decreases MR=MC At the new equilibrium, price is
to D, the monopolist can still sell the same the same, but the monopolist sell only Q
quantity Q* by lowering the price. So, there is amount of output i.e. the monopolist sells
no unique (or one to one correspondence) lower quantity at the original price when
between P&Q, as the same Q* is matched with the dd decreases.
two different price, P&P1

Therefore, there is no unique supply curve under monopoly.

1.7 Long – run Equilibrium under Monopoly

The monopolist firm can get a positive profit even in the long run because there are entry barriers
that discourage new firms to enter the industry, attracted by the positive profit.
A monopolist maximizes its long run profit when it produces and sells that output level where
LMC = MR , slope of LMC being greater than the slope of MR at the point of intersection, and
the optimal plant size is the one whose SAC curve is tangent to the LAC at the point
corresponding to long run equilibrium output.
 Let’s illustrate the equilibrium situation graphically.

SMC1
P1
C SAC1 LAC

SMC2 LMC

Pe SAC2

MR
DD

Q
Q1 QE

Fig 1.6 Suppose initially the monopolist builds the plant size having the costs SAC1 and SMC1
the equivalence of SMC1 and MR leads into producing and marketing output levels Q1 and P1,
making a unit profit of P1 – C, since the monopolist is making a positive profit, it decide to
continue its operation and looks for a more profitable plant size in the long run. This long run
plant is attained when LMC = MR, and the corresponding output level and price are Qe and Pe
respectively.

Finally, it should be noted that there is no certainty in the long run that the monopolist will reach
the optimal plant size (minimum LAC), as in perfectly competitive case. The monopolist may
reach optimal plant size or even may exceed the optimal size if the market demand allows him
(or if there is enough demand which absorb that level of output).
1. The multi- plant monopolist
In monopoly Production takes place in two or more different plants whose operating costs can
differ. To minimize transport cost, to approach the consumers or for different reasons a
monopolist may establish more than one plant in different areas. The operating costs of these
plants can also vary due to many reasons such as variation in prices of raw materials, wage of
labors etc.

Numerical example
Suppose Ethiopian Electric Light and Power Corporation (EELPC) is a multi-plant monopolist
having two plants, Tekeze plant (plant1) and Fincha plant (Plant2). The operating costs of the
two plants are given as follows:
Tekeze Plant: TC1 = 10 Q12 , where Q1 - Amount of electric power produced in Tekeze (p1)
And
Fincha plant: TC2 = 20 Q22 where Q2 – amount of electric power produced in Fincha (p2)

EELPC estimates the demand for electric power by the following function
P= 700 – 5Q where P is price (total in million birr) per Giga watt and
Q is the total amount of Giga watt sold and Q = Q1 + Q2
Note that a Giga watt of electric power, whether it comes from Fincha or Tekeze plant worth
equal price
a) What level of output (electric power) should EELPC produce and what price per Kilowatt
should it charge to maximize its profit?
b) How much of the total output should be produced in each plant?
Solution
a) The equilibrium condition is:
MR = MC1
MR = MC2
TR = P.Q
= (700 – 5Q) Q = 700Q-5Q2
dTR
MR = dQ = 700- 10Q, where Q = Q1+Q2
Thus, MR = 700 – 10 Q1 – 10 Q2

dTC 1
=20Q 1
MC1 = dQ 2
 dTC 2
MC2 = dQ 2 = 40 Q2
Now the equilibrium occurs when:
700 – 10Q1- 10Q2 = 20Q1 and
700 – 10Q1 – 10Q2 = 40Q2
Re-arranging the above equations we get the following simultaneous equation.
30Q1 + 10Q2 = 700
10Q1 + 50Q2 = 700
Solving the above equations simultaneously, we get
Q1 = 20 giga watts
Q2 = 10 giga watts
The profit maximizing level of output is, thus, Q1+Q2
= 30 giga watt
To determine the equilibrium price we substitute the total output (30) in the demand function:
Accordingly, P = 700 – B (30)
= 550 mill birr
b) The Tekeze plant should produce 20 giga watts and the Fincha plant should produce 10 giga
watts
Price Discrimination
Price discrimination refers to the charging of different prices for the same good. But not all price
differences are price discrimination. If the costs of offering a certain uniform commodity
(service) to different group of customers are different (say due to difference in transport costs),
price of the commodity may differ for each group owing to this cost difference. But this cannot
be considered as price discrimination. A firm is said to be price discriminating if it is charging
different prices for the same commodity without any justification of cost differences.
By practicing price discrimination, the monopolist can increase its total revenue and profits.

Miscellaneous questions
1. Discus the factors responsible for existence of pure monopoly
2. How monopolies maximize its profit in the short run?
 144
Q=
3. Suppose the monopolist faces the market demand function given by P2
.The AVC of the firm is given as AVC = Q ½ and the firm has a fixed cost of $ 5
a. determine equilibrium P&Q
b. determine the maximum profit
 CHAPTER TWO
MONOPOLISTIC COMPETITION

Monopolistic competition is a market structure with many buyers and sellers. Product
differentiation is the major characteristic of monopolistically competitive market structure.
A monopolistically competitive market combines the characteristics of competitive and monopoly
markets.

2.1 Assumptions of Monopolistic Competition

The assumptions of the monopolistic competition are the same as those of perfect competition, with
an exception of price taker and homogeneity of products (i.e. products are closely substitute, but
they not perfectly substitutes for one another).
Specifically, the following are some of the basic assumptions of a monopolistic competition
market:
1. There are large number of sellers and buyers in the group.
2. The products of the sellers are differentiated, but they are close substitutes of one another.
3. There is free entry and exit of firms in the group.
4. The goal of the firm is profit maximization.
5. The prices of factors and technology are given.
6. The firm is assumed to behave as if it knows its demand and cost curves with certainty.
7. The long run consists of a number of identical short run periods, which are assumed to be
independent of one another, in the sense that decisions in one period do not affect future periods
and will not be affected by past decisions. The optimum decision for one period is the optimum
decision for any other period, Thus by assumption, maximization of short run profit implies long
run profit maximization.
8. Heroic Assumptions: Both demand and cost curves of all products are uniform throughout the
group. This requires that consumer’s preference be evenly distributed among the different
sellers, and that differences between the products be such as not to give rise to differences in
costs. This assumption is made in order to be able to show the equilibrium of the firm and the
group on the same diagram. But this assumption leads to a model that is very restrictive, because
it excludes the inclusion of the firm in the group which has similar products but different cost of
production. Chamberlin himself recognized that the ‘heroic’ assumptions are unrealistic and he
relaxes them at a later stage.

2.2 Product Differentiation and the Demand Curve

Product differentiation is any feature of a product of sellers that makes buyers to prefer one
product or sellers to that of another. It leads to different consumer’s preference. It is also the
basis for establishing a downward sloping demand curve. Chamberlin suggested that the
demand for a product is not only determined by the price but also by the style of the product, the
services associated with it and the selling activities of the firm. Thus, Chamberlin introduced
two additional policy variables in the theory of the firm: the product itself and selling costs.
Hence, the demand curve shifts if:
1. The style, services, or the selling strategy of the firm changes,
2. Competitors change their price, output, services or selling policies of a product,
3. Tastes, incomes, prices or selling policies of products from other industries change,
Product differentiation is intended to distinguish the product of one producer from that of the
other producer in the ‘industry’ (in the group). It can be real differentiation or fancied
(artificial) differentiation.

Real differentiation: exists when the inherent characteristics of the products have slight
differences (slight difference in quality, durability), in the specification of products (terms of
credit, transportation, guarantee, location of the firm), which determine the convenience with
which a product is accessible to the consumer. Example: chemical differences existing in
shampoos or conditioners.

Fancied differentiation: is established by advertising or differences in packaging or differences

in design (color or shape) or simply by brand name.

N.B: In any case, the aim of product differentiation is to make the product unique in the mind of
the consumers. And the effect of product differentiation leaves firms under monopolistic
competition with some degree of monopoly power. Because of this the firm is not a price taker.

Monopolistic competition has less power than pure monopoly and more power than perfectly
competitive market structure over the price of its product. The power of the firm over price is
limited because of the existence of other competitors. Product differentiation creates brand
loyalty and gives rise to a negatively sloped demand curve.

Cost of the Firm:

Cost structure of a firm under monopolistic competition is similar to that of any other firm
(perfectly competitive and monopoly firm). The AVC, MC, ATC are all U- shaped implying
that there is only single level of output which can be optimally produced.
There is another cost, the cost of selling activities, which is introduced in the theory of the firm
by Chamberlin. The recognition of product differentiation provides the rationale for the selling
expenses incurred by the firm. With advertising and other selling activities the firm seeks to
Selling Cost
Average
differentiate more his product from the products of other firms in the group. Chamberlin assumes
that advertising will shift the demand and will make the demand less elastic.
Total cost = Production cost + Selling cost.
o

Like any other costs the average selling cost is U-shaped. That means there are economies and
diseconomies of selling cost as output increases.
Average Selling Cost Curve
Q

Initially, expansion of output will not require an equi-proportional increase in selling costs, and
this leads to a fall in the average selling expenditure. However, beyond a certain level of output,
the firm will have to spend more per unit in order to attract customers from other firms. The U
shaped average selling cost, added to U shaped average production cost, yields a U shaped ATC
curve.
2.3 The Concept of Industry and Product Group
In perfectly competitive market, firms included in an industry are easy to determine because they
produce same product. But product differentiation creates difficulty in the analytical treatment
of the industry. Firms under monopolistic competition do not constitute an industry because they
produce differentiated products. Hence, for this market structure, the concept of industry needs
redefinition. Chamberlin uses the concept of ‘product group’, which includes products which are
‘closely related’. The products should be close technological and economic substitutes.
Technological substitutes are products which can technically cover the same want. For
example, Motor cars are all used for transportation, all powder soaps are used for washing
purpose. On the other hand, Economic substitutes are products which cover same want and
have similar prices. Products with different cost structure are not economic substitutes.
An operational definition of the ‘product group’ is the demand of each single product be
highly elastic and that it shifts appreciably when the price of other products in the group changes.
In other words, products forming the group or ‘industry’ should have high price and cross-
elasticity’s. But, ‘how much high the elasticity’s should be?’ is not indicated.
Product differentiation allows each firm to charge different prices and practically there will not
be unique equilibrium price but an equilibrium cluster of prices, reflecting the preferences of
consumers for the products of the various firms in the group. When the market demand shifts or
cost conditions change in a way affecting all firms, then the entire cluster of prices will rise or
fall simultaneously. This more realistic market situation emerges from Chamberlin’s analysis
after the relaxation of his ‘heroic assumptions’.

2.4. Equilibrium of the Firm

The product differentiation gives rise to a negatively sloped demand curve. The demand curve is
more elastic because of the assumption of large number of firms. Since the firm is one of the
very large numbers of sellers if it reduces its price, the increase in its sales will produce loss of
sales distributed more or less equally over all the other firms, so that each one of them will suffer
a negligible loss in customers, not sufficient to induce them to change their own price.
Therefore, the individual demand curve, DD. is a planned sales curve, drawn on the assumption
that the competitors will not react to changes in the particular firm’s price.
D Planned sale

D Q
 In order to be able to analyze the equilibrium of the firm and of the industry on the same diagram
Chamberlin made two ‘heroic assumption’, namely that firms have identical costs, and
consumers’ preferences are evenly distributed among the different products. That is, although
the products are differentiated, all firms have identical demand and cost curves. Under these
assumptions the price in the market will be unique.
Short run equilibrium
In the short run the Chamberlinial firm acts like a monopolist. The firm, given its demand and
cost curves, maximizes its profit by producing at which marginal cost is equal to marginal
revenue (MC=MR).
A firm will obtain excess profit if Pe>ATC and loss if Pe<ATC.
Example
Assume a firm engaging in selling its product and promotional activities in monopolistic competition
face short run demand and cost functions as Q d=20-0.5P and C= 4Q2-8Q+15, respectively. Having
this information.
A. Determine the optimal level of output and price in the short run.
B. Calculate the economic profit (loss) the firm will obtain (incur).
 Solution
A. Q=20-0.5P B.∏=TR-TC or Q (P-ATC)
Q-20= -0.5P= P=40-2Q = PQ–(4Q2-8Q+15)
R=PQ= (40-2Q) Q =32(4) - (4(4) 2-8(4)+15)
=40Q-2Q2 =128 - 47 =81
MR=∂R= 40-4Q
∂Q
C=4Q2-8Q+15 and MC=∂TC=8Q-8
∂Q
MR=MC, 40-4Q=8Q-8 48=12Q then Q=4
*P=40-2Q P=40-2(4) P=40-8=32
Long run equilibrium
In order to be able to analyze the equilibrium of the firm and of the industry on the same diagram
Chamberlin made two ‘heroic assumption’, namely that firms have identical costs, and
consumers’ preferences are evenly distributed among the different products. That is, although
the products are differentiated, all firms have identical demand and cost curves. Under these
assumptions the price in the market will be unique.
Chamberlin develops three models of equilibrium.
Model 1: Equilibrium with new firms entering the industry
Assumption: Each firm is in short run equilibrium with excess profit.

LM
d

dE

Pm C
LAC

Pe E
A B

d|E d|
Qe Qm Q

MR2 MR1

The firm in the short run is in equilibrium at point C where MC = MR. At equilibrium point a
given firm attains abnormal profit, area of PmCBA. The excess profit attracts firms to come in
to the market with competing brands. The result of new entry is a downward shift of the demand
curve dd’, since the market is shared by a larger number of sellers. The process will continue
until the dd curve is tangent to the average cost curve at its equilibrium. I.e. until the abnormal
profit is eliminated and excess profit is wiped out. In the final equilibrium of the firm, the price
will be Pe and the ultimate demand curve will be dd|E. In the long run the equilibrium occurs at
P=LAC, at this point there will be neither entry nor exit, and the equilibrium is stable.
Model 2: Equilibrium with price competition
In this model, the number of firms in the industry is assumed to be compatible with long run
equilibrium, so that neither entry nor exit will take place. But the ruling price in the short run is
assumed to be higher than the equilibrium price.

d D
LMC
P0
d |1

Actual Sales curve or share of the Market Curve

P1
d||1 LAC

P2
d |2 d

e d|1
Pe

d ||1
D
d |e

X0 X1X2Xe MR Xol

The analysis of this case is done by the introduction of a second demand curve, labeled DD’,
which shows the actual sales of the firm at each price after accounting for the adjustments of the
prices of other firms in the group. DD’ is sometimes called actual sales curve or share of the
market curve. It is a locus of points of shifting dd curves as competitors change their price.
Assume the firm is at a non-equilibrium position Po and Xo. The firm, in an attempt to
'
maximize its profit, lower the price to P 1 expecting to sell X o . This level of sales is not
actually realized because all other firms faced by the same demand and cost condition have an
incentive to act in the same way simultaneously. Thus, all firms acting independently reduce
their price simultaneously to P1. As a result, the dd curve shifts downward and the firm instead
'
Xo
of selling expected quantity sales actual quantity X1 (which is less than the expected
quantity)on the shifted dd curve dd’ along the share curve DD’.
According to Chamberlin, the firm suffers from myopia and does not learn from pas experience
and may further reduce price expecting that the others will not react. Thus the firm lowers its
price again in an attempt to reach equilibrium, but instead of the expected sales Xo the firm
achieves actual sales of X2, because all other firms act identically, though independently. The
process stops when the dd’ curve has shifted so far to the left as to be tangent to the LAC curve.
Equilibrium is determined by the tangency of dd’ and the LAC. At the point of tangency the DD |
curve cuts the dd| curve. Obviously it will pay no one firm to cut the price beyond that point,
because its costs of producing the larger output would exceed the price at which this output could
be sold in the market.
In the long run the equilibrium occurs at P=LAC, at this point there will be neither entry nor exit,
and the equilibrium is stable.
Model 3: Equilibrium through Entry and Price Competition.
Chamberlin suggests that in the real world adjustment towards long run equilibrium takes place
through both entry/exit and price competition. Price adjustments are shown along the dd | curve
while entry/exit cause shifts in the DD’ curve. Equilibrium is stable if the dd | curve is tangent to
the AC curve and expected sales are equal to actual sales, i.e., DD | curve cuts dd| curve at the
point of tangency of dd’ & LAC.
 D|
D* D LMC

d
e2
P

C d| A
LAC
P1 B
d* e1

d||
E d
P*
d|
D| D* D

d*

d||
4
X X1 X2 X* 4 MR*

Let’s start from e1 where there is an abnormal profit. This excess profit attracts other firms to
enter into the market. When they enter in to the market, the market will be shared by larger
number of firms then DD (market share curve) keeps on shifting left ward until it becomes
tangent to LAC, DD|.
Although, firms earn normal profit, e2 does not constitute stable equilibrium, because the firm
believes that dd is its demand curve. By taking dd as its sales planning function the firm will feel
that it can expand sales and earn excess profit by reducing price to P1. But all the firms will be
doing the same thing simultaneously. As price is reduced by all firms dd shifts down to dd | and
each firm realizes a loss of area CABP1 instead of positive profit.
The firm is still in myopia assumption, now also he believes that he can obtain positive profit
by cutting its price. However, all the firms do the same. One might think that the process would
stop when dd becomes tangent to the LAC, dd*. This would be so if the firm could produce X*.
However, there are so many firms and the share of the firm is only X2. The firm still on the
myopia assumption believes that it can reach X* if he reduces to P*. However, all firms do the
same and dd* falls below the LAC with ever increasing losses. At this time, the financially
weakest firms will leave the market. So that the surviving firms will have a higher market share
then DD| will move to the right with dd |. Exit will continue until the dd becomes tangent to the
LAC curve and the market share curve, DD, cuts the dd curve at the point of tangency, point E.
Equilibrium is then stable at point E with normal profits earned by all firms and no entry or exit
taking place. The equilibrium price is P*, which is unique and each firm have a share equal to
OX* at E, expected share is equal to actual sale.
Criticism of Chamberlin’s Large Group Model
1. The assumption of product differentiation is incompatible with the assumption of
independent action and free entry.
2. It is hard to accept the myopic behavior of business men implied by the model. For sure
some firms learn from their past mistakes.
3. The concept of industry was destroyed by the recognition of product differentiation.
Heterogeneous products cannot be added to give industry.
4. The model assumes large number of firms & high cross price elasticity’s among the
products in the industry but the model does not objectively define the number of firms
and the magnitude of elasticity required to have monopolistic market structure.
Despite his critics Chamberlin’s contribution to the theory of pricing is:
a) Introduction of product differentiation and selling strategy as two additional policy
variables in the decision process of the firm. These factors are the basis for the non-price
competition which is a typical form of competition in the real world.
b) Introduction of the share of the market demand curve as a tool of analysis.
2.6 Excess Capacity and Welfare Loss
Under perfectly competitive firm MC = MR = LAC = P = AC at the minimum point of LAC and
resources are efficiently allocated. On the other hand, under monopolistic competition MC = MR
and P = AC, but P > MC (because P > MR). As a result price will be higher and output will be
lower in monopolistic competition as compared to the perfectly competitive market.
In monopolistically competitive market structure there are too many firms in the industry each
producing less than the optimal (at a higher cost) because of:
 1. The tangency of the long run average cost and demand occurs at the falling point of the
average cost curve.
2. Firms incur selling cost which is not presented in perfectly competitive market structure.
Therefore, firms in monopolistically competitive market structure have an excess
capacity measured by the difference between the ideal output (Y F) corresponding to the
minimum cost level on the LAC curve and the output actually obtained in the long run
(YE).

P LMC
d

y
Capacit
Excess
PE LAC
PF

d
YE YF Y
MR
Chamberlin argues that the excess capacity and misallocation of resources is valid only if one
assumes that the demand curve of each individual firm is horizontal. If demand is downward
sloping and firms enter into active price competition and entry is free in the industry. Y F cannot
be considered as a socially optimal level of output. Consumers desire a variety of products. And
product differentiation reflects the desire of consumers to pay higher price for differentiated
product. Therefore, the difference between the actual output YE and the minimum cost output YF
is not a measure of excess capacity but rather a measure of the “social cost of producing and
offering the consumers a greater variety of output.”
 P D| D
LAC
d
P

d
D|
D

Y Y E YF Y
Excess Capacity Social Cost

Chamberlin’s argument is based on the assumption of active price competition and free entry.
He argues that the equilibrium output will be very close to the minimum cost output, because
firms will be competing along their individual dd curves which are very elastic.

Chamberlin divides the competition into two, price and non-price competition. If firms avoid
price competition and instead enter into a non-price competition there will be an excess capacity
in each firm and inefficient product capacity in the industry and that is an inexhaustible economy
of scale for the firms in the industry. Chamberlin argues “excess capacity in monopolistically
competitive market structure comes because of the non-price competition coupled with free
entry”. Excess capacity is the difference between YE and Y.

In summary, if the market is monopolistically competitive the output is lower than society would
ideally like it to be (that is, price is higher than MC, but the socially desired P = MC cannot be
achieved without destroying the whole private enterprise system.
Question:
1. Assume a firm engaging in selling its product and proportional activities in monopolistic
completion face short run demand and cost function of AR=40−2 Q∧TC=4 Q2−8 Q+15
respectively. Then:
A. Determine the optimum level of output and price in the short run
B. Calculate the optimum profit (loss) the firm will earn (incur)
2. If the inverse demand function of a monopolist firm be given by p=30−5 Q and also its average

20
cost be: ATC= + 4 Q−6 . Then:
Q
A. Compute the optimum level of output and price in the short run
B. Calculate the optimum profit
 CHAPTER THREE
OLIGOPOLY MARKET STRUCTURE

3.1. Definition
Oligopoly is a market organization in which there are few firms that produce identical or closely
substituted products (i.e. Identical or differentiated). Oligopoly is said to exist when there are more
than one seller in the market, but their number is not so large so as to make the contribution of each
firm negligible. Nevertheless, in principle, the criterion is whether firms take in to account their
rivals’ actions in deciding upon their own action or not. In other words, the essence of oligopoly is
recognized interdependence among firms. For example, Coca-Cola considers the actions and likely
future responses of Pepsi when it makes its decisions (whether concerning product design, price
advertising, or other factors).
It is difficult to fix up definite number of sellers. Any way, if each seller has command over a sizable
proportion of the total market supply then there exists oligopoly in the market. That means if one
seller increases (decreases) its supply; the market price may decrease (increase) because the supply
of this seller constitutes a significant proportion in the total market supply.
DUOPOLY is a special case of oligopoly in which there are only two firms in the industry.
3.2. Causes of Oligopoly
There are many cause of oligopoly market. Some of them are:
1. Economies of scale: low costs cannot achieved in some industries unless a few firms are
producing output that account for substantial percentages of the total market demand .That means
the average cost of production reach minimum only when the output produced in large amount by a
few firms. As result, the number of firms in such type of industry should be reduced in order to
make use of the advantage of economies of scale in production. Economies of scale in sales
promotion and advertising may also promote oligopoly.
2. Barriers to entry: - there are varieties of barrier that did not allow the entry of some firms in to
the industry. This barrier may be technological, skill, cost, and size of the market in relation to
economies of scale, patent right and different activities of government such as licensing and
marketing quota.
3. Collusion (merger of small firms): Small firms collide to get market power and overcome their
competitor‘s pressure. If they gain market power, firms set higher price and restricts output supply
that maximizes their profit. Such firms develop to oligopoly while other removed from the market.
3.3. Characteristics of Oligopoly Market
The basic characteristics of oligopolistic market structure are the following:
A. Keen (or intense) competition between firms: The number of firms is small enough that each
seller takes into account the actions of other firms in its pricing and output decisions. In other
words, each firm keeps a close watch on the activities of the rival firms and prepares itself with a
number of aggressive and defensive marketing strategies.
B. Interdependence: the nature and degree of competition makes firms interdependent in respect of
decision making.
C. Barrier to entry: in oligopoly market firms are small enough in number implies there is barrier
for new firms to enter into the market. Some common barriers to entry are economies of scale,
patent rights, and control over important inputs by existing firms.
D. Nature of the Product: The firms under oligopoly may produce homogeneous products or
differentiated products. Accordingly, we may have “oligopoly without product differentiation”
(or pure oligopoly) and “oligopoly with product differentiation”.
E. There is selling Costs: In view of the intense competition and interdependence of the firms under
oligopoly, the firms compete with each other through various sales-promotion measures like
price cutting, discounts, door-to-door campaigns, advertisement, etc. Therefore, selling costs and
advertisement are very important under oligopoly market structure.
F. Firms have some power to set price
G. Indeterminate Demand Curve: An important feature of oligopoly is that the demand curve faced
by an oligopolistic firm is indeterminate. An oligopolistic firm cannot ignore the reactions of
rival firms in view of the interdependence of the firms. Any change in price by one firm may
result in price changes by the rival firms. As a result, the demand curve faced by an oligopolistic
firm keeps on shifting.
In general unpredictable action and reaction will make it difficult to analyze oligopoly market. Firms
may come ‘in collusion with each other’ or ‘may try to fight each other on the death (i.e. Oligopoly
firms may cooperate (collude) or may not cooperate (no- collusion) in some activities with respect to
their businesses depending on their interest and agreement). So accordingly we can classify
oligopoly market structure as:
1. Non-collusive Oligopoly
2. Collusive Oligopoly
1. Non- Collusive Oligopoly
Non-collusive oligopoly is a condition in which firms operate independently to determine the
optimal level of price and output. That is firms in the industry will not go in to contractual agreement
to cooperate in making optimal decision. Under such cases, negotiation and enforcement of binding
agreement is not possible even though each firms make some expectation (assumption) about the
reaction of its rivalry in response to its action or observe the decision of its rivalry while setting
profit maximizing level of output and price. If firms do not cooperate, their decision-making process
is analyzed using the non- collusive model. Under this model we have the following models.
1. The Cournot's duopoly model 2. The 'kinked- demand' model
3. Bertrand Duopoly model 4. Stackleberg Duopoly model
1 .The kinked demand model
The kinked demand model, developed by Paul Sweezy in 1939, explains why prices are rigid in
some oligopoly market. The model assumes that oligopolies often have strong desire to keep stable
price. Even under the condition when cost and demand changes, firms are reluctant to change their
prices. If costs fall or market demand declines, they fear that the lower prices send the wrong
message to their competitors and initiate price war among them. If costs and demand rises, they do
not increase price because they are afraid that their competitors may not raise their price.
According to this model therefore, demand curve facing each firm in oligopoly market is kinked at
prevailing market price (Chamberlin‘s intersection of individual and market demand) reflecting the
following behavioral pattern of oligopolists. Rivalry firms expected to follow decrease in price but
ignore price increase. That means if a firm increases its price, due to increase cost of production or
increase demand for its product, it would loss most of its customer and cause total revenue to
decrease. This is because other firms in the industry would not follow the increase in price. As result,
given that the product produced in the industry is homogenous, consumer preference shifts from the
other hand oligopolists could not increase its market share by lower intend to maintain prices
constant even under the condition where their demand and cost changes. The equilibrium of the firm
is defined by the kink at point E.
 D
P d
MC1
E MC2
Pk

A d
D
B
MRd

Q
Figure: 1 Qk MR

As shown in the above figure an oligopolists firm faces two demand curves for different ranges of
prices. Above Pk the relevant demand curve for the firm is dE. Because if the firm increases its
price, it would lose some of its customer to firm that maintained their previous price. The firm will
then face a demand curve given by dE, which is very elastic. On the other hand, if the firm decreases
its price below Pk form the intention of increasing their market share, they will not able to increase
their market share, since other firms also decrease their price in order to keep up their customers.
Therefore, below Pk the relevant demand curve of the firm is ED. This implies the demand curve
facing oligopolies is not straight line, rather kinked at a certain price. Thus, their demand curve is
kinked at the intersection point of market and individual demand curve to reflect the rigidity of
prices. Now let us see how their marginal revenue curve derived and how they undertake optimal
decision. Normally, marginal revenue curve derived from demand curve. So, the marginal revenue
curve associated to kinked demand curve is discontinues at the level of output corresponds to the
kinked point. It has two segments as indicated in figure 1, dA and BMR. Segment dA corresponds to
the upper part of demand curve, while the segment BMR corresponds to the lower part of demand
curve and the kink point on demand curve corresponds to the discontinuous portion of marginal
revenue curve. The point of kink defines equilibrium of the firm since at any point to the left of the
kink, MC is below MR, while to the right of the kink; MC is larger than MR. Thus profit of the firm
maximized at the point of the kink. However, this equilibrium is not necessary defined by the
intersection of MC and MR curve. So long as MC passes through segment AB, the firm maximizes
its profit by producing Qk and charging pk level of price. This level of price and output is
compatible with wide range of cost.
To sum up, the kinked demand model have three possible ways in which rival firms may react:
I. Rival firms follow the changes in price, both price hike and price cut
II. Rival firms do not follow the changes in price, both price hike and price cut
III. Rival firms follow the price cut changes but not follow price hike change
It is important to note here that a kinked demand curve model does not explain how equilibrium
price and output determined like other models rather, explain why price once set remain fixed.
2. Cournot’s model
Augustin Cournot was the first French economists who develop a formal cournot duopoly model in
1838. He illustrates the model assuming two firms having identical cost facing linear market demand.
Given these assumptions, each firms known that the market price will depend on the total output of both
firms. Thus to maximize their profit each of the cournot duopolies simultaneously decides, how much to
produce by taking its rivals‘ output constant at existing level regardless of what output it decides to
produce . Thus, each firm takes the other firms output level as given and chooses its own output level to
maximize profit. The level of output that it chooses will, of course depend on how much it thinks its
rival will produce. In other words, each firm recognizes that its own decision about output i y will affect
its revenue through affecting market price but any one firm has output decisions do not affect those of

∂p ∂ yj
any other firm. That is, each firm recognizes that ≠ 0but assume that ¿ 0 , for j≠ i
∂ yi ∂ yi
The following assumptions of the model help to precede our analysis of the model:
a) There are only two firms, A and B each owing a mineral water wells
b) Both operate their wells at zero marginal cost of production (MC=0)
c) Both face a down ward sloping straight line demand curve; and
d) Each seller acts on the assumption that its competitor will not react to its decision to change its output
and price.
Cournot started his illustration by assuming that there are two firms (firm-A and firm-B), each
producing mineral water at zero cost and face linear demand curve DD as shown in figure 2.2. . Each
firm also acts on the naïve assumption that its competitor will not change its output when deciding its
profit maximizing level of output. Assume that firm A is the first to start producing and selling mineral
water assuming that firm B produce nothing. Firm-A therefore thinks that its effective demand curve is
 the market demand because the firm thinks that it will be the sole producer of mineral water. So to find
the profit maximizing level of output and price, we use the marginal principle (MR=MC). Since it is
assumed that cost of production equals to zero MC is also zero. Therefore profit maximization condition
of the firm reduced to MR= 0. This point corresponds to point A level of output that is half of the total
market demand. Now firm-B assume that firm-A will keep its output fixed point A and define CD‘as its
relevant demand curve to determine its profit maximizing level of output and applying the same
marginal principle rule. Firm-B produces half of the market which is not supplied by firm-A.

P D’

C C=d=1
PA

PB F
k
O A B D’ MC

MRA MRB

Figure 2: Graphical Presentation of Price and output determination under Cournot’s Duopoly
In the first period
 The equilibrium output level of firm A is at point A (OA amount) where MR A=MC. Firm A faces
DD curve denoted by D’D’. At the midpoint of D’D’ that is at point C, the elasticity of DD is unity
and TR of the firm is the maximum. With zero cost and hence MC, maximum TR implies
maximum profit. That is, the area given by OACPA.
 Further let us assume that B enters into the market and faces the DD curve given by CD’. It is this
time that the Cournot assumption comes into picture. Now firm B assumes that firm A will keep its
output fixed at OA and hence considers that its own DD curve as CD’. Hence, firm B will produce

1 1
AB amount where MRB=MC (i.e. ½ of AD’, which is not supplied by firm A, or 1/4= ( 2 . 2 ¿of
the total market DD, OD’), and will sell it at price P B. Clearly, at the midpoint of firm B’s DD
curve that is at point F the elasticity of DD is unity and therefore TR of firm B is the maximum.
The profit of firm B is given by area OBFPB.
 In the second period

1
(
 Firm-A assumes, firm B will produce fixed level of output as before 4 of the total market), it will

produce half of BD’ which is not supplied by firm B. That is, since B covered 1/4 th of the total

1 1 3
market, A will supply in the second period
2
1
( - ) = = 0.375 of the total market demand
4 8
(OD’).
 Assuming A will keep on producing 3/8 of the market, firm B will react to the latest decision made

by firm A by producing ½ of the unsupplied section of the market. That is, ½(1-3/8) =
5/16=0.3125.
In the third period

 Once again firm A continues to assume that firm B will keep on (not change) its quantity supply at

5/16 and thus will decide to produce ½ of the remainder of the market in the third period. That is,
½ (1-5/16) = 11/32 = 0.34375. Similarly, firm B will assume as firm A and will supply ½ of the
remainder of the market. That is ½(1-11/32) = 21/64 = 0.3125.
 This action and reaction pattern continues because firms have naïve behavior (assumption) of
never learning from their past pattern of reaction from their rival. Thus, gradually A’s sales
decreases while that of B’s increases. However, eventually equilibrium is reached where each firm
supply (produce) 1/3 of the total market DD. Thus, the action and reaction ends (settles) and
together they supply 2/3 (1/3+1/3) of the total DD.
 Each firm maximizes its profit in each period but the industry profit is not maximized. That is,
each firm’s profit and hence their joint profit would have been higher if they have recognized their
interdependence after their failure in forecasting the correct reaction of their rival. Recognizing
their interdependence or forming open collusion would lead them to act as a monopolist, produce
 ½ of the market DD jointly, sell that output at a profit maximizing P, and sharing the market
equally. That is, each can produce ¼ of the market instead of 1/3.
SUMMERY
Equilibrium level of output for firm A and firm B at different successive period:
Firm A Firm B

 1st period=1/2 1/2(1-1/2)=1/4

 2nd period=1/2(1-1/4)=(1/2-1/8)=3/8 ½(1-3/8) or (1/4+1/16)=5/16

 3rd period= ½ (1-5/16) or (1/2-1/8-1/32)=11/32 ½(1-11/32) or (1/4+1/16+1/64)=21/64
 4th period=1/2(1-21/64) or (1/2-1/8-1/32-1/128) ½(1-43/128) or (1/4+1/16+1/64+1/256)
=43/128 … = 58/256 …

 We observe that the output of A declines while that of B increases gradually. Therefore, for n
period we have
=1/2-1/8-1/32-1/128 … =1/4+1/16+1/64+1/256 …
=1/2-(1/8+1/8(1/4) +1/8(1/4)2+1/8(1/4)3+…) = (1/4+1/4(1/4) +1/4(1/4)2+1/4(1/4)3+…)

a r a r

 Applying the summation formula for an infinite geometric series:

S= a where, S is sum, a is 1st term, and r is ratio.
1- r
We obtain [Product share of firm A in equilibrium]

 For A = ½ - ⅛ =1/3 => For B= 1/4= 1/3

1-1/4 1-1/4
 Each firm in the long run (during n period) supplies 1/3 of the market (together they will supply 2/3
level of the output). Consequently, the Cournot equilibrium is stable equilibrium. In other word,
output OD’ is under perfect competition, half of OD’ (i.e.OA) is under monopoly and 2/3 of OD’ is
 output under duopoly using the Cournot’s model. The price level in the Cournot models is lower
than the monopoly priced but above the pure competitive price.
 NB: if there are three firms in the industry, each will supply ¼ of the market (¾ of the output under
perfect competition) according the Cournot’s model. If there are four firms, each will supply 1/5 of
the market (4/5 of the output under perfect competition) and so on. In general, if there are n firms in

1 n
the industry, each will supply of the market and the industry output will be . Clearly as
n+1 n+1
more firms exist in the industry, the higher the total quantity supplied and hence the lower the
price.
Note that: The Cournot game is also called an output game as the strategies of firms are their
outputs. Firms are using their outputs as a weapon to win the tough competition among the firms.

 Mathematical Derivation of the Cournot model: It is based on the following assumptions
1. Each firm maximizes profit by assuming the output of the other is constant (ignoring their
interdependence or naïve assumption).
2. The duopolies face the same demand function (curve).
3. The MRs of the duopolies need not be the same. This is because if the duopolies are of
unequal size, the one with the larger output or smaller MC will have smaller MR. This
implies that in the short run the duopolies will supply different output levels but sell at
the same price since they supply identical products it is the total output that determines
price.
4. The duopolies have different cost function.
5. In the long run, however, each firm will supply 1/3 of the market
Let the market demand is given by X = a – b Px for two oligopoly firms (Duopolists)
Where Market Demand = X = X1 + X2, X1 = output of firm 1
X2 = output of firm 2
While C1 = f (X1) and C2 = f (X2)
Profit maximizing rule of the firms are
1st order condition: 1 = TR1 – TC1; 1 = TR1 - TC1
X1 X1 X1
2 = TR2 – TC2; 2 = TR2 - TC2
 X2 X2 X2
2nd t order condition: 21 = 2TR1 - 2TC1 < 0 ; 2TR1 < 2TC1
2 2 2 2 2
 X1  X1  X1  X1  X1

22 = 2TR2 - 2TC2 < 0 ; 2TR2 < 2TC2

2 2 2 2 2
 X2  X2  X2  X2  X2

 Example: Assume that the market demand and cost functions of the duopolies are given as:
P =100 - 0.5Q, where Q = q1+q2
TC1= 5q1
TC2 = 0.5q22. Then answer the follow questions
A. Determine the short run equilibrium output of each duopoly ignoring their
interdependence (with naive assumption)
B. What is the short run market price?
C. Find the demand functions of the duopolies (the reaction curves or graphic solution of
Cournot’ model and draw) and show the short run output levels.
D. Calculate the short run profits of each duopoly and the industry profit.
E. Verify the economic profit of each duopoly graphically
F. Explain the relationship between output and MR in the short run.
G. Calculate the long run equilibrium output of each duopoly, market price, and
economic profits of each firm and the industry profit as a whole
Solution:
A. 1st find TR1 = Pq1
= (100 – 0.5 (q1+q2)) q1
= 100q1 –0.5q12 – 0.5q1q2
2nd find MR1 = ∂TR1 = 100 –q1 – 0.5q2
∂q1
3rd find MC1 = ∂TC1 = 5
∂q1
4th equate MR1 = MC1
100 – q1 – 0.5q2 = 5
100 – 5 - q1 – 0.5q2 = 0
 95 – q1 – 0.5q2 = 0
95 = q1 + 0.5q2 -------------------------------------------- (1)
5th find TR2 = Pq2
= (100 – 0.5 (q1+q2)) q2
= 100q2 – 0.5q22 – 0.5q2q1
6th find MR2 = ∂TR2 = 100 – q2 – 0.5q1
∂q2
7th find MC2 = ∂TC2 = q2
∂q2
8th equate MR2 = MC2
100 – q2 – 0.5q1 = q2
100 – q2 – q2 – 0.5q1 = 0
100 – 2q2 – 0.5q1 = 0
100 = 2q2 +0.5q1 --------------------------------------- (2)
9th The profit maximizing (loss minimizing) output of q 1 and q2 can be solved from the two equations
using simultaneous equation method. That is
q1 + 0.5q2 = 95
(0.5q1 + 2q2 = 100) (–2)
q1 + 0.5q2 = 95
-q1 – 4q2 = -200
-3.5q2 = -105
q2 = 105/3.5 = 30, substituting this in any one of the above equation gives the value of
q1. That is
q1 + 0.5q2 = 95
q1 + 0.5 (30) = 95
q1 = 95 – 15 = 80
Q = q1 + q2 = 80 +30 = 110
B. Market price: P = 100 – 0.5Q, where q1 + q2
= 100 – 0.5 (80 + 30)
= 100 – 0.5 (110)
= 100 – 55 = 45
 C. The demand functions (reaction curves) of the duopolies are obtained by solving for q 1 and
q2 from the two equations as follows.
95 = q1 + 0.5q2
q1 = 95 – 0.5q2, is the demand function for firm 1. Hence,
 If q2 = 0, then q1 = 95 and if q1 = 0, then q2 = 190
100 = 2q2 + 0.5q1
2q2 = 100 – 0.5q1
q2 = 50 – 0.25q1, is the demand function for firm 2. Hence,
 If q1 = 0, then q2 = 50 and if q2 = 0, then q1 = 200. The reaction curves (graphic solution of
Cournot’s model) is

q2

190
Firm 1’s reaction curve

50
30
Equilibrium

Firm 2’s reaction curve

80 95 200 q1

 At the equilibrium each firm maximizes their own profit. But the industry profit is not maximized.
Why firms choose these sub optimal output? The reason is that, the Cournot pattern of behavior
implies that the firms do not learn from past experience, each expects the other to remain at a given
position. Each firm acts independently. That is, each does not know (recognize) the other will
behave (hold) the same assumption.
D. The economic profits of each duopoly
Π1 = Pq1 – TC1 Π2 = Pq2 – TC2
= 45(80) – 5(80) = 45 (30) – 0.5 (30) 2
= 3600 – 400 = 3200 =1350 – 450 = 900
Π= 3200 + 900 = 4100 is the total industry profit due to naïve assumption
 E. The relevant curves to show profits graphically are
-The market DD curve
-The MR curve derived from the market DD curve
-Each firm’s MC and ATC curves

P P MC2

100 MC1 100 ATC2

ATC1

45 45

30

5 15

Q
Q
80 100 200 30 100 200

Π1 = q1 (P – ATC1) Π2 = q2 (P – ATC2)
= 80 (45 – 5) = 30 (45 – 15)
= 80 (40) = 30 (30)
= 3200 =

F. Firm 1 has lower MR than firm 2 because q1 > q2 (80 > 30)
MR1 = 100 – q1 – 0.5q2 MR2 = 100 – q2 – 0.5q1
= 100 – 80 – 0.5 (30) = 100 – 30 – 0.5(80)
= 100 – 80 – 15 = 100 – 30 – 40
=5 = 30
MR1 < MR2 because MC1 < MC2 and q1 >q2
G. The long run equilibrium output and price are calculated from the MR functions using
simultaneous equation method. That is
q1 + 0.5q2 = 100
 (0.5q1 + q2 = 100) (-2)
q1 + 0.5q2 = 100
-q1 – 2q2 = -200
-1.5q2 = -100
q2 = 100/1.5 = 66.7, substituting this in any of the above MR will give us q 1 in the long
run. That is
q1 + 0.5q2 = 100
q1 = 100 –0.5 (66.7)
q1 = 100 – 33.3 = 66.7
=> P = 100 – 0.5Q
P = 100 – 0.5 (66.7 +66.7)
P = 100 – 66.7 = 33.3
=> Π1 = Pq1 – TC1 Π2 = Pq2 – TC2
= 33.3 (66.7) – 5(66.7) = 33.3 (66.7) – 0.5 (66.7) 2
= 2221.11 – 333.5 = 2221.11 – 2224.45
= 1887.61 = -3.34
Π = Π1 + Π2 = 1887.61 + (-3.34) = 1884.27 is total industry profit in the long run. Note that, each
firm’s and industry profits are higher in the short run than in the long run.

3. THE STACKELBERG MODEL (Quantity leadership)

 This model often used to describe industries in which there is a dominant firm or a natural leader.
For example, IBM is often considered to be a dominant firm in the computer industry. A
commonly observed pattern of behavior is for the smaller firms in the computer industry to wait
for IBM’s announcements of new products and then adjust their own product decisions
accordingly. In this case we might want to model the computer industry with IBM playing the role
of a Stackleberg leader and the other firms in the industry being Stackleberg follower.
 Suppose that firm 1 is the leader and that it chooses to produce q1. Firm 2 responds by choosing a
quantity q2. Each firm knows that the equilibrium price in the market depends on the total output
produced. That is by substituting Q (q1 +q2) in the inverse demand function (curve).
 What output should the leader choose to produce to maximize profits? The answer depends on how
the leader thinks the followers will react to its choice. Presumably, the leader should expect that
 the follower will also attempt to maximize profits as well, given the choice made by the leader. In
order for the leader to make a sensible decision about its own product, it has to consider the
follower’s profit maximization problem as its own.
 Numerical example: Consider the example we have used to describe Cournot’s model. That is,
P = 100 – 0.5Q, where Q=q1 + q2, TC1 = 5q1, and TC2 = 0.5q22. Given this,
A.Find the equilibrium q1, q2, market price, Π1 and Π2
-Firm 1 being Stackelbrg’s sophisticated leader and firm 2 the follower
-Firm 2 being Stackelbrg’s sophisticated leader and firm 1 the follower
B.From the view point of profit obtained is it better for the firms to be a leader or a follower?
Solution:
A. The reaction (DD) functions or curves are found by taking the partial derivatives w.r.t. q1
and q2 and equating to zero.
Π1= Pq1 – TC1= (100 –0.5 (q1+q2)) q1 –5q1
= 100q1 – 0.5q12 – 0.5q1q2 – 5q1
= 95q1 – 0.5q12 - 0.5q1q2
Π2 = Pq2 – TC2 = (100 – 0.5 (q1+q2) q2 –0.5q22
= 100q2 – 0.5q1q2 – 0.5q22 – 0.5q22
= 100q2 – 0.5q1q2 – q22
 The partial derivatives w.r.t. q1 and q2
 ∂ Π1= 95 – 0.5q2 – q1
 ∂q1
 ∂ Π1= 100 – 0.5q1 – 2q2
 ∂q1
 The reaction (DD) function are
 q1= 95 – 0.5q2 --- firm 1 reaction (DD) function
 q2= 50 – 0.25q1 --- firm 2 reaction (DD) function
 Stackelbrg’s solution with firm 1 being the sophisticated leader. Firm 1 will substitute
firm 2’s reaction (DD) function in its own profit equation to produce an output that will
maximize profit as if it were a monopoly. That is
Π1= Pq1 – TC1
= 95q1 – 0.5q12 – 0.5q1q2, substituting firm 2’s DD function
 = 95q1 – 0.5q12 – 0.5q1 (50 – 0.25q1)
= 95q1 – 0.5q12 – 25q1 + 0.125q12
= 70q1 – 0.375q12
 The first order condition of the profit function w.r.t. q1
 ∂Π1= 70 – 0.75q1
∂q1
= 70= 0.75q1
= q1 = 70/0.75 = 93.333
Π1= 70q1 – 0.375q12
= 70 (93.333) – 0.375 (93.333) 2
= 6533.333 – 3266.666 = 3266.66
 Firm 2 will substitute firm 1’s output in its own DD as a follower. That is
 q2 = 50 – 0.25q1
= 50 – 0.25 (93.333)
= 50 – 23.333 = 26.666
Π2 = 100q2 – q22 – 0.5q1q2
= 100 (26.666) – 26.6662 – 0.5 (93.333) (26.666)
= 2666.66 – 711.1 – 0.5 (2488.8)
= 2666.7 – 711.1 – 1244.4 = 711.1
 P = 100 – 0.5 Q
= 100 – 0.5 (93.33 + 26.666)
= 100 – 0.5 (120)
= 100 – 60 = 40
 Stackelbrg’s solution with firm 2 being the sophisticated leader. It will substitute firm
1’s DD function in its own profit function to produce an output that will maximize its
profit as it were a monopoly. That is
 Π2 =Pq2 – TC2
 Π2 = 100q2 – q22 – 0.5q1q2, substituting firm 1’s DD function
= 100q2 – q22 – 0.5q2 (95 – 0.5q2)
= 100q2 – q22 – 47.5q2 + 0.25 q22
= 52.5q2 – 0.75q22
  The first order condition of Π2 w.r.t.q2 gives
 ∂ Π2 = 52.5 – 1.5q2
∂q2
= 52.5 = 1.5q2
= q2 = 52.5/1.5 = 35
Π2 = 52.2q2 – 0.75q22
= 52.2 (35) – 0.75 (35) 2
= 1837.5 – 0.75 (1225)
= 1837.5 – 918.75 = 918.75
 As a follower firm 1 will substitute the output produced by firm 2 on its DD function.
That is
 q1 = 95 – 0.5 q2
= 95 – 0.5 (35)
= 95 – 17.5 = 77.5
 Π1 = 95q1 – 0.5q12 – 0.5q1q2
= 95 (77.5) – 0.5 (77.5) 2 – 0.5 (35) (77.5)
= 7362.5 – 3003.125 –1356.25
= 3003.125
 P = 100 – 0.5 (35 + 77.5)
= 100 – 0.5 (112.5)
= 100 – 56.25 = 43.75
B. As can be seen from the profits as a leader and follower, both
are better off as a leader.
4. THE BERTRAND’S MODEL (simultaneous price setting): This model assumed a model of
competitive bidding and hence is the opposite of the Cournot’ model.
 The Cournot’s model described that firms were choosing their quantities and letting the market
determines the price. Another approach is to think of firms as setting their prices and letting the
market determines the quantity sold. This model is known as the Bertrand model.
 What does the Bertrand model looks like? The answer is that when firms are selling identical
(homogenous) products and have significant effect on the price, the Bertrand equilibrium is a
 competitive equilibrium for they engaged in strategic interaction. That is the Bertrand
equilibrium is where price equals MC. How?
 First, we note that price can never be less than MC. As a result, either firm would increase its
profits by producing less output. So let us consider the case where P >MC. Suppose that both

firms are selling at some P >MC. Consider the position of firm 1. If it lowers its price by any

small amount ε and if the other firm keeps it price at P , all the consumers will prefer to
purchase from firm 1. By cutting its price by an arbitrary small amount, form 1 can steel all the
consumers from firm 2.

 If firm 1 really believes that firm 2 will charge a price P that is greater than MC, it will

always pay firm 1 to cut its price to P - ε. But firm 2 can reason the same way. Thus, any price
higher than MC cannot be equilibrium. The only equilibrium is then the competitive equilibrium.
 This result seems paradoxical when you first encounter it. You may wonder how can we get a
competitive price if there are only two firms that produce identical products in the market? If we
think of the Bertrand model as a model of competitive bidding it makes more sense. Suppose that
one firm “bids” for the consumers’ business by quoting a price above MC. Then the other firm
can always make a profit by undercutting this price with a lower price. It follows that the only
price that each firm cannot rationally expects to be undercut is a price equal to MC. Thus, it is
often observed that competitive bidding among firms that are unable to collude can result in
prices that are much lower than it can be achieved by other means. This phenomenon is simply
an example of Bertrand competition.
 Numerical Example: Given P = 100 – 0.5Q, where Q = q 1+q2, TC1= 5q1, TC2 = 0.5q22 find the
Bertrand’s equilibrium.
 Solution:
Firm 1 Firm 2
P = MC1 P = MC2
P=5 P = q2
5 = 100 – 0.5Q
-95 = -0.5Q
Q = 95/0.5 = 190
 Check that P = MC1 = MC2
 100 – 0.5 (q1 + q2) = 5 100 – 0.5 (q1 + q2) = q2
95 – 0.5q1 – 0.5q2 100 – 0.5q1 –1.5q2
95 = 0.5q1 + 0.5q2 100 = 0.5q1 + 1.5q2
 Solving the two equations simultaneously
 95 = 0.5q1 + 0.5q2
(100 = 0.5q1 +1.5q2) –1
95 = 0.5q1 + 0.5q2
-100 = -0.5q1 – 1.5q2
-5 = -q2, q2 = 5
95 = 0.5q1 + 0.5 (5)
95 = 0.5q1 + 2.5
0.5q1 = 95 – 2.5
0.5q1 = 92.5, q1 = 92.5/0.5 = 185 and Q = 5+185 = 190
 P = 100 – 0.5Q
= 100 – 0.5 (5 + 185)
= 100 – 0.5 (190)
= 100 – 95 = 5, is the price which cannot be undercut because it is equal to MC1 and MC2.

2. COLLUSIVE OLIGOPOLY:
One way of avoiding the uncertainty that may arise from interdependence of firms in oligopoly
market is to enter in to collusive agreement (that is to adopt more strategic cooperation).
Firm enter in to such collusive agreement in order to cultivate the advantage of increasing profit,
decreasing uncertainties and to create better opportunity to prevent other‘s entry to the industry.
There are two main types of collusive oligopoly. These are

1. CARTELS: A cartel is a formal organization of firms producing the same product. It is formed to
coordinate the policies of member firm so as to increase their joint profit by limiting the scope of
competition among them. It also reduces uncertainty arising from their mutual interdependence and act
as a monopoly.
NB: Cartels imply direct agreements among the competing oligopolists with the aim of reducing the
uncertainty arising from their mutual interdependence. Based on this objective, the general purpose of cartels
is to centralize certain managerial decisions and functions of individual firms with a view to promoting
commons benefits. There is one typical example of cartels i.e., OPEC (Oil and Petroleum Exporting
Countries). These countries (or oil producing firms) form the organization called OPEC and this OPEC acts
as decision maker and all firms are governed under it.
2. Price Leadership
Price leadership is another form of collusion. In this form of coordination one firm sets the price and the
others followed (adopt) it. Price leadership is more widespread than cartel.
NB: unlike firms in cartel, which agree explicitly to cooperate in setting price and output, firms
in price leadership collusive oligopoly, agree to cooperate implicitly in making decisions about
price and output without any formal discussion. They enter in to such agreement voluntarily to
avoid any uncertainty about the competitor reaction. In such type of model, one firm implicitly
recognized as the leader and set price. The other remaining firm, the follower take price as given
and adopt the price set by the leader firm even though its profit did not maximized.

There are various forms of price leadership .The most common types of leadership are price leaderships by a
low- cost firm and price leadership by a large (dominant) firm.