Micro New

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Micro new
Microeconomics (Haramaya University)
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Pure Monopoly Market
1.1 Definition and source of monopoly
Definition of monopoly
Monopoly is defined as: a market situation in which a single seller sells a product or provides a
service for which there is no close substitute. In monopoly there are no similar products whose
prices or sales will influence the monopolist price or sales. In another words, cross elasticity
between monopolist product and other commodities is zero or low. Since there is a single seller
in monopoly market structure, the firm is at the same time the industry.
Common characteristics of monopoly
Monopoly market structures share the following characteristics in common.

1-Single seller and many buyers
There is a single seller in the market (industry) 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
Under perfectly competitive market, we have said that, both sellers and buyers are price takers.
However, the monopolist is a price maker or price setter. 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 and vice-versa.
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.
Sources of Monopoly Power

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1. Ownership of strategic or key inputs: A firm may own or control the entire supply of a raw
material required for the production of a commodity. Such firms are not willing to sell the raw
materials to another firm.
2. Exclusive knowledge of production technique.
Most beverage (soft drink) companies such as East Africa Beverage Company have maintained
monopoly power over supply of their products (Coca Cola, Fanta and Sprite) partly due to
exclusive knowledge of the ingredient chemicals required for the production of their product.
3. Patents, Copyrights and Trademarks
A patent is a legal protection which prevents original inventions from being copied, and once a
patent is granted it is protected by law for a period of time. Copyright protects written work like
plays, books, music, and films which are all protected from copying by copyright laws.
Trademarks can be names of logos, and sometimes shapes. The Coca-Cola bottle, for example, is
actually a trade mark and it is illegal to copy it without permission of the company.
Protection of patents, copyrights, and trademarks come from a country’s legal system and from
international agreements. In countries where we have these laws, owners of the indicated
intellectual property rights will have some monopoly power on their products or services.
4. Government Franchise and License

Another source of monopoly is government franchise. Franchise is a promise by the government
for a firm to prohibit the establishment of another firm (by another person) that produces the
same product or offers the same service as the original one.
For example, when the first Bank in Ethiopia, Abyssinia Bank was established, Emperor Minilik
has promised for the Egyptian firms (the owner of the Bank) that they will monopolize the
Banking service in Ethiopia for 50 years. Telecommunication service and hydroelectric power
supply are other examples of monopoly in Ethiopia.
5. Economies of scale may operate (i.e. the long run average cost may fall)
Another cause for the emergence of monopoly is economies of scale in production. A firm is
said to have economies of scale if its long run average cost is declining. In such a situation, when
the incumbent firm observes that new firms are entering into the market, it will produce large

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amount of output to minimize its unit cost of production and will charge a lower price than the
new firms to deter entry. Such a monopoly is called natural monopoly.
Aside from the cases of monopoly mentioned above, pure monopoly is rare and most
governments discourage pure monopoly because monopoly is deemed to create inefficiency.
For example, had it been the case that the telecommunication services are not monopolized in
our country, their prices would have been lower. But though pure monopoly is rare, the pure
monopoly model is useful for analyzing situations that approach pure monopoly and for other
types of imperfectly competitive markets (i.e. monopolistic competition and oligopoly).
1.2. The demand and revenue curves of the monopoly firm

A monopolist firm is at the same time the industry and thus, it faces the negatively sloped
market (industry) demand curve for the commodity. In other words, because a monopolist is
the sole seller of a commodity, it faces a down ward sloping demand curve. This means, to sell
more units of the commodity, the monopolist must lower the commodity price. Conversely, if
the monopolist decides to raise the price of the product, it will reduce the quantity of supply
without worrying about the competitors. The monopolist who charged lower prices would
capture a large share of the market (customers) at the expense of him. So the monopolist can
manipulate the price of its commodity by changing the quantity of supply. To sell more units of
the commodity, the monopolist will charge lower price and vice-versa. Hence, the demand
curve facing the monopolist is negatively sloped, showing the inverse relationship between
market price and quantity demanded.
P
P1
dd
P2 Q
Q1 Q2
Fig.1.1 the demand curve of the monopolist

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The demand curve facing the monopolist firm is down wards sloping. At price p1, the firm sells
only Q1 outputs. To sell more units of the product the firm should reduce its price.
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. Note that the AR of a monopolist is always identical to the P or
demand curve.
In general, the MR curve of a monopolist firm is negatively sloped. The MR will be positive
over the elastic range of the demand curve (because TR is increasing over this range), zero when
the price elasticity of demand is unitary ( because the TR is at its maximum level) and will have
a negative sign over the inelastic range of the demand curve( because TR is decreasing).The
following figure illustrates the relationship between price elasticity of demand and MR
P
Ep>1
P1
Ep=1
Ep<1
DD
Q
MR
Fig: 1.2The relationship between MR and P.

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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.Mathematically, it can be shown
that MR is less (steeper) than the AR or demand curve.
Suppose a monopolist’s demand curve is given by P = a – bQ

dTR d (aQ−bQ 2)
MR= = =a−2 bQ
2
TR = P.Q = (a - bQ) = aQ – bQ hence dQ dQ
Thus, MR = (a – 2bQ) has a slope which equals twice the slope of demand (average revenue)
curves. This implies that MR is less than AR or demand or price.
Example 1
Consider that the monopolist firm faces a demand function which given as Q= 48-2P, then based
on the given find
a. Total revenue function
b. Marginal revenue function and
c. Price elasticity at Q=24
Solution
To find the solution for the above functions first we should convert the demand function which
given as a function of price to quantity.
Q = 48-2P  2P= 48 - Q P = 24-1/2Q
a. TR=P∗Q=(24−1/2Q )Q=24 Q−1/2 Q 2

2
dTR d (24 Q−1/2 Q )
MR= = =24−Q
b. dQ dQ
As we can observe from the P and MR functions we can conclude that MR is less than P
except at zero level of output at which both of them becomes 24.
ΔQ P dQ P
e p= ∗ = ∗
c. As we know ΔP Q dP Q
dQ
Therefore first we should find the value dP and value of P at Q=24

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dQ d( 48−2 P)
= =−2
dP dP and at Q=24, P=24-1/2(24) =24-12=12
dQ P 12
e p= ∗ =−2∗ =−1
dP Q 24
This means the price elasticity of demand is unitary.
1.3. Monopoly supply in the short run

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.
P
MC
MC
P1 P E1
P
E2
D D D2 D1
D1 Q Q2 Q1 Q
Q* MR1 MR MR2 MR1
Fig 1.3 supply curve of the monopoly
Panel-1 Panel-2
In this panel, the same quantity Q* is sold at In this panel, initially equilibrium is E1
different prices depending on the market demand. (Where MR1=MC) and equilibrium P&Q1.
If the market demand is D1 and the MR curve is When the demand for monopolist product
MR1, equilibrium occurs when MR1 cuts MC decreases to D the new equilibrium becomes
curve and the equilibrium price and quantity are E2 where the new MR2=MC. At the new
P1 and Q*. If the market demand for the equilibrium, price is the same, but the
monopolist product decreases to D, the monopolist monopolist sell only Q amount of output i.e.
6 the
can still sell the same quantity Q* by lowering the the monopolist sells lower quantity at
price. So, there is no unique (or one to one original price when the dd decreases.
correspondence) between P&Q, as the same Q* is Therefore, there is no unique supply curve
matched with two different price, P&P1
Downloaded under monopoly.
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1.4. Short run and Long run Equilibrium of the monopolist
1.4.1. Short run and Long run Equilibrium
Profit maximization under monopoly involves determination of both price and output
combination that yields the firm the maximum possible profit. Price and output combination that
maximizes the monopolist profit can be determined in the similar fashion as that of the perfectly
competitive firm. That is, price- output combination that yields the monopolist the maximum
profit can be determined either using total approach or marginal approach
A. 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. The equilibrium price can be determined by dividing the TR corresponding to the
equilibrium output level to the equilibrium output.
B. Marginal approach
In this approach there are two condition of profit maximization. These are:
1) MC = MR. This means the slope of cost curve is the same as the slope of revenue curve.
2) Slope of MC is must be > slope of MR i.e. MC curve cuts MR curve from below.
P MC
AC
Pm G
A
R H
A
A
C E E
AR
=D
MR D= 7
dd
O Qm Q
Q ==
dd
mDownloaded by Faturmen Jemal (faturmenj2020@gmail.com)
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= dd
Figure 1.4: Short-run equilibrium of the monopolist
At point E,MR=MC and MC cuts MR from below, and hence it is equilibrium point for the
monopolist. This equilibrium point determines monopoly output Qm. In order to determine
monopoly price, trace up through the equilibrium point to the demand or AR line to point G and
correspond to the price axis. Therefore, monopoly price is Pm.
Revenue R = P x Q = area ofOQmGPm. andCost C = AC x Q = area of rectangle OQmHA.
π =R−C = area of rectangle AHGPm. The shaded area is, therefore, profit for the monopolist.
The monopolist may get a positive profit or incurred a loss depends on the value of AR and short
run AC at the equilibrium point. When AR>AC, the monopolist get a positive profit; if AR=AC
the firm get neither profit nor loss while if AR<AC, the firm incurred a loss.
Mathematically, the profit maximizing conditionsare same to perfect competitive market:

MR = MC ………………………….. First order condition and
Slope of MC > slope of MR ---------- second order condition
Example 2
Suppose the monopolist faces a market demand function given by P=40-Q. The firm has a fixed
cost of Birr 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 and 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
2 2
dTR d (400−Q ) dTC d (50+Q )
MR= = =40−2 Q MC= = =2 Q
dQ dQ dQ dQ 8

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Now,
At equilibrium MR=MC 40-2Q=2 →40=4Q → Q=10
dMC dMR
Second order condition >
dQ dQ
dMR dMC
Slope of MR= =−2 Slope of MC= =2
dQ dQ
Since both first and second order conditions are satisfied, the profit maximizing level of output is
10 units and the profit maximizing price is obtained by substituting the profit maximizing
quantity (10) in the demand function. .Hence, P = 40 – Q = 40 – 10 = Birr 30.
b) The maximum profit is the level of profit obtained from selling 10 units at Birr 30 each.
∏ = TR – TC But TR = P.Q = Birr 30 * 10 = Birr 30 and TC = 50 + Q2 = 50 + 102 = Birr 150
The maximum ∏ is thus Birr 300 - Birr 150 = Birr 150.
Example 3
Ethio-telecom is the sole provider of a telephone service in Ethiopia. The demand function for its
service is P = (8300 – Q)/2.1 and its total cost function is TC = 2200 + 480Q + 20Q2 where P is
price in Birr. Based on the given information, calculate the maximum possible profit that the
monopolist can achieve.
Solution
The corporation will maximum its profit when MC = MR
Total Revenue (TR) = Price x Quantity = (8300–Q)/2.1*Q = 3952Q – 0.476Q2
dTR d 3952 Q−0. 476 Q 2

MR= = =3952−0 . 952Q
dQ dQ
2
dTC d (2200+480 Q+20 Q )
MC= = =480+40 Q
dQ dQ
At profit maximizing point MC = MR
480 + 40Q = 3952 – 0.952Q 40.952Q = 3472  Q = 84.8
At Q = 84.8, P = 3952 + 0.476(84.8) = 3,912. Thus the price should be Br. 3912.
The firms monthly profits () is given by TR – TC

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= 80(3,914) – [2200+480(80) +20(80)2] = Br.144520.

Therefore the maximum profit that the monopolist can achieved will be 144,520 Birr.
1.4.2 Long – run Equilibrium under Monopoly

The monopolist’s long run condition is different from the perfectly competitive firms’ long run
situation in respect of the entry of new firms into an industry. In perfectly competitive market,
there is free entry in the long run. Nevertheless, entrance is barred by several factors in
monopoly. Moreover, we have seen that a perfectly competitive firm can earn only normal profit
in the long run. The monopolist firm can, however, get a positive profit even in the long run
because there are entry barriers that discourage new firms to enter to the industry.
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 with price and quantity ofPe and Qe respectively.
Fig 1.5 Long run Equilibrium of the Monopoly Firm
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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).
1.5 The multi- plant monopolist

We have seen that a monopolist maximizes its profit by producing that level of output where MR
equals MC. For many firms, however, 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. we call such firm a multi-plant monopolist.
In short, the condition of equilibrium in multi- plant monopolist is: MR = MC of multi plant
monopolist and to allocate the total output among each plant, the condition must satisfy:
MC1 = MR = MC or MC2 = MR = MC of multi plant monopolist. In short it can be given as
MR = MC1 =MC2
Example 4
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:
Plant 1: TC1 = 10 Q12 and where Q1 - Amount of electric power produced in Tekeze
Plant 2: TC2 = 20 Q22 Q2 – amount of electric power produced in Fincha
EELPC estimates the demand for electric power by the following function i.e. 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, based on the given answer the following questions accordingly
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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 and 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 dTC 2
=20Q 1
MC1 = dQ 2 and 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 and 10Q1 + 50Q2 = 700
Solving the above equations simultaneously, we get
Q1 = 20 giga watts and 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 Fincha plant should produce 10 giga watts
1.6 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
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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.
Necessary conditions for price discrimination

1- There should be effective separation of markets for different classes of consumers, so
that buyers of low price market cannot resale the commodity in high price market.
A market is said to be effectively separated if one of the following points is met:
 Geographical variation with high transport cost so that the inter market price margin is
unable to cover the transport expense.E.g. Domestic Vs international markets.
 Exclusive use of the commodity. For some services resale is inherently difficult. For
example you cannot resale Doctor’s services, Entertainment shows.
 Lack of distribution channels
2- The price elasticity of demand should be different in each sub market.
 For example, a movie theatre knows that college students and old people differ in their
willingness to pay for a ticket and can exercise discrimination by charging the college
students a higher price.
3- Lastly, the market should be imperfectly competitive.
 The seller of the product should have some monopoly power (it should not be price taker)
to practice price discrimination.
Degrees (types) of price discrimination

The degree of price discrimination refers to the extent to which a seller can divide the market and
can take advantage of it in extracting the consumer Surplus. In economics literature, there are
three degrees of price discrimination. These are discussed one by one here under.
1.6.1 First degree price discrimination (Perfect price discrimination)

This is a price discrimination in which the monopolist attempts to entirely take away the
consumers surplus. Ideally, a firm would like to charge each customer the maximum price that
the customer is willing and able to pay for each unit bought. We call this maximum price the
consumer’s reservation price and obviously, the consumers’ reservation prices are different due
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to the differences in their economic status or the value they attach to a commodity. Note that the
consumer’s willingness to pay reservation price for a given commodity varies with the quantities
of the commodity the consumers own. The LDMU implies that a consumer’s willingness to pay
for successive units of a commodity declines because the marginal utilities of these successive
units decline. Hence, in the first degree price discrimination differs across customers and a given
customer may pay more for the initial units than for others (successive units).
First degree price discrimination is the limiting case of price discrimination, the monopolist, in
this case, individually negotiate with each buyer and sell each unit of the output at the
corresponding price given on the demand curve of the consumer, then receiving the entire of
consumer’s surplus.
For example, a doctor who knows his patients’ paying capacity charges high price for the
richest patients’ and low price for the poor patients for identical services. This is practiced to
increase revenue. If the doctor fixes the price at the richest patients’ level, no poor will
afford to pay and the doctor will not get revenue from the poor. On the other hand, the
doctor would not fix the price at the poorest patients’ level for all patients because he
knows that the rich can pay more and he will exploit the rich. Lawyers also practice the
same discrimination for identical legal service.
Perfect price discrimination is efficient as it maximizes the total welfare, where welfare is
defined as the sum of consumer surplus and producer surplus. That is, there is no welfare loss
associated with first degree price discrimination equilibrium. The problem with perfect price
discrimination is that it hurts consumers because the monopolist will take the entire of the
consumer surplus. The other problem with perfect discrimination is that it involves high
transaction costs; it is too difficult and costly to gather information about each customer’s price
sensitively.
1.6.2 Second degree price discrimination (block pricing)

Many firms are unable to determine which customers have the highest reservation prices. Such
firms may know, however, that most customers are willing to pay more for the first unit than for
successive units. This is due to the fact the typical customer’s demand curve is down ward
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sloping. Such a firm can discriminate price by letting the price each customer pays vary with the
number of units the customer buys. The act of charging different prices for different quantities of
purchases is called second degree price discrimination or sometimes called quantity
discrimination. In second degree price discrimination, the price various only with quantity: all
customers pay the same price for a given quantity. In second degree price discrimination, the
monopolist attempts to take the major part of the consumer surplus instead of the entire of it.
Block pricing can feasibly be implemented where:
 The number of consumers is large and price rationing can be effective
 The demand curves of all customers are identical and
 A single rate is applicable for a large number of buyers.
Graphically, block pricing can be explained as follows:

A monopolist that practices second degree price discrimination charges the price OP1, for the
first OQ, units, OP2 for the next Q1 Q2 units and OP3 for Q2 Q3 units. By doing so, the
monopolist will increase its total revenue by extracting the major part the consumer surplus.
P1 A
B
P2
P3 C
DD
Q1 Q2 Q3
Fig.1.6 Second price degree price discrimination
The monopolist receives a price OP1, for each unit sold to a given customer for the first OQ,
units, OP2 for the next Q1 Q2 units and OP3 for the next Q2 Q3 units. By so doing, the
monopolist will receive total revenue of OP, A B C . If the monopolist charges a uniform price of
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OP3, its total revenue will only be OP3 EQ3. Hence, block pricing will enable him receive large
total revenue than uniform pricing.
Note that not all quantity discounts are a form of price discrimination. Sometimes selling in large
quantities may reduce the unit costs of sales and as a result a firm may charge a relatively lower
per unit price for large sales than small sales. Such an action cannot be regarded as price
discrimination.
1.6.3 Third degree price discrimination (multi-market price discrimination)
An action of charging different prices in different markets is called third degree price
discrimination. All units of the good sold to customer with in a group (in one market) are sold at
a single price, but prices will differ among the different groups or markets.
For simplicity, let us assume that there are only two markets. To maximize profits, the
monopolist must produce the level of output (defined by MC=MR) and sell that output in the
two markets in such a way that the marginal revenue of the last unit sold in each market is the
same. This will require the monopolist to sell the commodity at higher p rice in the market with
the less elastic demand. The equilibrium condition for a third degree price discriminating
monopolist is: MC=MR1=MR2.
Example 5
Suppose Ethiopian Airlines (EAL) flies only one route: from Addis Ababa to Dubai. EAL knows
that two different types of people fly to Dubai. Type A consists of rich merchants flying to Dubai
for business purposes with demand for flight of
QA = 260-0.4PA. Type B consists of poor ladies flying to Dubai in search of jobs ( such as house
maid) whose total demand is QB = 240-0.6PB.
Assume that EAL has a running cost of $30,000 plus $100 per passenger and it has decided to
charge different prices for the two groups of passengers.
a. How many tickets should EAL sell to each group?
b. How much price should EAL charge each group?
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c. Suppose now that EAL is prohibited by the Ethiopian government to exercise such
discrimination. How many tickets should the EAL sell to maximize its profit and at what price?
Solution
Given
TC = 30,000 + 100Q
Where Q = QA+QB
QA = 260 – 0.4PAPA = 650 – 2.5QA………..…. Merchants inverse demand function:
5
PB=400− QB
QB = 240 – 0.6 PB. 3 …………….Ladies inverse demand function
a) The equilibrium condition is that
dTC
=100
MC=MRA = MRBBut MC = dQ then we should find MRA and MRB
dTR A
, and 2
MRA = dQ A TRA = QA.PA = 650QA – 2.5 Q A
10
QB
Thus, MRA = 650 – 5QA. Likewise MRB = 400 - 3
The equilibrium condition is thus presented as:
10
100 = 650 – 5QA and 100 = 400 - 3 QB
Solving the above equations simultaneously, we get QA = 110 and QB = 90
Therefore, EAL should sell 110 tickets of A type and 90 tickets of B type passengers.
b) Substituting the above quantities in their respective demand functions, we get
5 5
(90 )
PA = 650 – 2.5 QA = 650 – 2.5 (110) = $ 37 and PB = 400 - 3 QB = 400 - 3 = $ 250
Hence, the EAL should charge $ 375 for the merchant and $ 250 for the leady passengers.
C) If EAL decides to charge a uniform price, the equilibrium price will be obtained first by
deriving the market demand function and then by using the usual method (MC = MR)
Market demand (Q) = QA + QBQ = 260 – 0.4 PA + 240 – 0.6 PB
Since PB = PA = P, thus the market demand becomes = 500 – P orP = 500 – Q
TR = P.Q = 500 Q – Q2 hence MR = 500 – 2Q
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Given MC = 100, Equilibrium occurs when MC = MR, i.e.

100 = 500 – 2Q Q = 200, and P = 500 – Q = $300
That is, EAL should sell 200 tickets at a price of $ 300 each to maximize its profit.
1.7 Social costs of monopoly: The dead weight loss

In a competitive market, price equals MC of production. Monopoly power, on the other hand,
implies that price exceeds MC. Because monopoly power results in higher prices and lower
quantities produced, we would expect it to make consumers worse off and the firm better off.
Consider the following figure. Suppose DD represents the market demand curve, MR represents
the corresponding marginal revenue.Here, we use consumers’ and producers’ surplus as a
measure of welfare of each. Consumer surplus is the area between the demand curve and
equilibrium price and producer surplus is the area between the equilibrium price and marginal
cost curve.
- A perfect competitor’s equilibrium occurs when MC =P=MR at Ec with PC &QC. Here
the consumer’s surplus is the area above the dropped line Pc Ec and below the demand
curve i.e. area of the rectangle Pc F Ec while producer’s surplus is area below the
dropped line PcEc and above the MC curve.
- A monopolist equilibrium occurs when MC = MR i.e. at Emwith Pm and Qm
respectively. Hence, in monopoly lower quantity is sold at higher price. The new
consumers’ welfare is the area above the dropped line PmD and below the demand curve
(i.e. area of the rectanglePmFD) whereas the producers surplus becomes the area below
the dropped line PmD and above MC curve to the left of Qm (i.e. the area GPmDEm)
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Fig.1.7 the Dead Weight Loss of the Monopolist
Thus monopoly power reduces the consumers’ surplus by the amount which equals area A+B;
but increases the producers’ surplus by the area A-C. The net welfare effect (loss) is obtained by
deducting the welfare loss of consumers from the welfare gain of producers. i.e
Net welfare = Welfare gain by producers – Welfare loss by consumers
= A-C – (A+B) = A-C – A-B = -C –B or – (C +B)
Thus monopoly results in a welfare loss which is given by the area (C+B). This area is called
dead weight loss. It is gained neither by producers nor by consumers. The other disadvantage
(Social cost) of monopoly is that is discourages innovations. Monopolist may feel secure and
have no incentive to innovate new product (technology) since there are no competitors.
2. Monopolistic Competitions
2.1 Assumptions monopolistic Competitive
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Monopolistic competition is a market structure with many buyers and sellers in which product
differentiation exists and in which there are elements of both monopoly and perfect
competition.
Assumptions of Monopolistic Competition
Chamberlin’s model of monopolistic competition works under many of the assumptions of pure
competition.
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 knew 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.
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.
2.2. Product Differentiation, Demand and Cost 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,
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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. On the other hand, fancied differentiation is
established by advertising or differences in packaging or differences in design (color or shape) or
simply by brand name. Product differentiation leaves firms under monopolistic competition with
some degree of monopoly power. Because of this the firm is not a price – taker.
Panel A Panel B
DD curve for a monopoly Panel C
DD curve for a firm DD curve for a firm in
In perfect comp. mkt firm and the industry
monopolistic comp mkt
P
P P
d curve
d curve d curve
Q Q Q
Figure 2.1 demand curves of different market structures
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
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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 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.
Like any other costs the average selling cost is U-shaped. That means there are economies and
diseconomies of selling cost as output increases.
Cost
Average Selling Cost Curve
Q
o
Figure 2.2 selling cost of monopolistic competitive firm
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 this
makes the average selling cost to be U shaped. The U shaped average selling cost, added to U
shaped average production cost, yields a U shaped ATC curve.
2.3. The Concept of Product Group and Industry

In perfectly competitive market, firms included in an industry are easy to determine because they
all produce same product. But product differentiation creates difficulty in the analytical
treatment of the industry. Strictly speaking, firms under monopolistic competition do not
constitute an industry because they produce differentiated products.
PRODUCT GROUP: It refers to a group of sellers in an industry, supplying different brand of

commodities or services, but are very much (closely) related and hence consumers are unable to
differentiate them based on some state of quality, such as shape, test, colour etc. For instance, within
automobile industry cars with brand name Fiat and Lada, Corolla DX and Toyota DX are alike in
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their shape many people cannot differentiate them precisely simply by looking them distant without
getting close and search for some clues, such as looking at their brand names.
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.
INDUSTRY: The concept industry refers to broader classification and hence consists of several
product groups. If all firms in a monopolistic competition market produce very close products as the
brewery industry or supply very close service as the banking and insurance industry in Ethiopia all
the firms in can be regarded as product group and industry. On the other hand, if all firms in an
industry produce highly differentiated products, we say there is no product group. Thus, product
group is a sub set of industry.
2.4. Equilibrium of Monopolistic Competitive Firms
2.4.1 Short Run Equilibrium

The short run MR (derived from the perceived demand curve) that will be equated with the MC
curve in order to find the optimal-profit maximization (loss minimization)-output and price and the
MC curve must be rising..
Numerical Example 1
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 TC= 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).
C. Show the economic profit (loss) of the firm graphically.
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Solution
A. Q=20-0.5P B.∏=TR-TC or Q (P-ATC)
Q-20= -0.5P = (40Q-2Q2) – (4Q2-8Q+15) or 4(32-11.75)
*P=40-2Q =(40(4)-2(4) 2) - (4(4) 2-8(4)+15) or 4(20.25)
TR=PQ = (160-64) – (64-32+15) or 81
= (40-2Q) Q =128 - 47 or 81
=40Q-2Q2 =81=81
dTR
MC
MR= dQ = 40-4Q P
TC=4Q2-8Q+15
32 ATC
∂TC
MC= ∂Q =8Q-8
MR=MC 24
11.75 Q=20-0.5P or P=40-2Q
40-4Q=8Q-8
MR=40-4Q
48=12Q
Q=4 4 Q
*P=40-2Q C. Graphical illustration of economic profit of the firm

P=40-2(4)
P=40-8=32
2.4. 2 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.
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The firm in the short run is in equilibrium at point C where MC = MR. See the graph above. 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 P e and the ultimate demand curve will be dd ’. 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.
Figure 2.4 Long-run Equilibrium Monopolistic competitive firms with price competition
Model 2: Equilibrium with price competition
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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.
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
'
Xo
maximize its profit, lower the price to P 1 expecting to sell . 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 (whish is less than the expected
quantity)on the shifted dd curve dd’ along the share curve DD.
Actual Sales curve or share of the Market Curve
dD
P0LMC
d|1
P1
d||1
LAC
P2
d|||e d
Pe d|1
D d||1
e d|||e
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X0 X1X2XeMR Xol
Figure 2.5 Long-run Equilibrium with price competition
According to Chamberlin, the firm suffers from myopia and does not learn from past 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 d|||e d|||e and the LAC. At the point of tangency the
DD curve cuts the d|||e d|||e 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.
Model 3: Equilibrium through Entry and Price Competition.
D|
D* D LMC
d
P e2
C A
d|
P1 B
d* e1 LAC
d|| d
P* E
D d|
D| D*
d*
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d||
X X1 X2 X* MR* Q
Figure 2.6 Long-run Equilibrium with 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.
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.
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 demand shifts down to d |d|
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 frim 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.
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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 can not be added to give industry.
4. The model assumes large number of firms & high cross price elasticities 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 are:
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.
2.5 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 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
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PE LAC
PF
YE MR YF Y
Figure 2.7 Monopolistic Competitive Excess Capacities

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
D| LAC
D d
Y YE YF Y
Excess Capacity Social Cost
Figure 6.8 chamberlain’s Excess Capacity
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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 shown in figure 2.8 above.
3. Oligopoly Market
Introduction
Definition
The term oligopoly has been derived from Greek words, oligo meaning ‘few’ and polein
meaning ‘sellers’ from this; oligopoly means a market with few sellers. Oligopoly can
synonymously be used for competition among few firms. Markets are said to be oligopolistic
whenever a small number of large firms supply the dominant share of an industry’s total
output. How few should be the sellers' to make an industry or market oligopolistic is not easy to
define numerically. It is rather difficult task to fix a definite number of sellers for the market to
be oligopolistic in its form. The number of sellers depends on the size of the market. Given the
size of the market, if number of sellers is such that each seller has command over a sizable
proportion of the total market supply, then there exists oligopoly in the market.
Firms in an oligopoly market trade products that may be identical/homogenous or

differentiated/heterogeneous. If the firms in an industry produce a standardized or identical
product the industry is called pure oligopoly. The most common examples of virtually uniform
products marketed under conditions of oligopoly include steel, aluminum, cement, fuel oil, etc.
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If a few firms dominate the market for differentiated product, the industry is called a
differentiated oligopoly. The most visible differentiated oligopolies involve the production of
automobiles, tooth paste, cereal, cigarettes, TV sets, computers, refrigerators, soft drinks, beer,
etc.
In oligopoly market entry is difficult or impossible for new firms to the market. Barrier to entry
may arise as a result of
1. Scale of economics and large capital requirement than
other markets except monopoly,
2. Patents or access to technology or raw materials may
exclude potential competitors,
3. Pricing and advertizing strategies of firms and the like
DUOPOLY is a special case of oligopoly in which there are only two firms in the industry. The
duopoly case allows as capturing many of the important features of firms engaging in strategic
interaction without the notational complication involved in models with a large number of firms.
Also, we will limit ourselves investigation of the case in which each firm is producing an identical
product. This allows us to avoid the problems of product differentiation and focus only on strategic
interaction.
If one firm reduces its price it will attract consumers and increases its sells, leading to a substantial
loss of sales by other firms in the industry. The other firms may or may not reduce their price, but
the firm that reduces price can no longer assume other firms do not notice his/her action. The
outcome of his/her decision depends on the reaction of other firms. The outcomes (consequences)
of price changes by the firm under consideration are uncertain. Firm under oligopoly market may
1. Spend a lot of time to guess each other’s action or reaction
2. Be bitter rivals of each other, competing by price changes (price war may be
started)
3. Tacitly (informally or implicitly) agree to compete by advertising but not by
price changes
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4. Form a collusion or cooperation (some kind of agreement) rather than

competing. Therefore, there are many solutions to oligopoly problem. This means that there
is no unique solution like that of perfect competition, Monopoly and monopolistic
competition.
The Distinguishing Features of Oligopoly

So as to enrich your understanding of what oligopoly means let us discuss the distinguishing
features of oligopolistic market from other markets as follows:
1. Keen competition: - The fact that there are only few sellers in the market brings the
firms (oligopolies) in to keen competition. Under oligopoly, the number of sellers is so
small (or few) that any move by one seller immediately affects the rival sellers. As a
result each firm is curious enough about the acts of the rival firms in order to react in an
aggressive or defensive way. To an oligopolistic business is ‘constant struggle of life’ that
urges action and reactions or moves and counter moves. Such kind of competition is not
found in the other forms of market. So, fierce (keen) competition is key characteristics of
the oligopoly market structure.
2. Interdependence: - Each firm closely and carefully watches the moves of its rival firms’
as it is affected by the competing firms’ act. So, a typical firm’s decisions are
interdependent with the decision of other firms since the typical firm knows that its
decision (action) results in reaction.
One of the characteristics of oligopolistic market structure, which is interdependence among

the firms, makes the behavior of the firms uncertain or unpredictable. Hence, it becomes
extremely difficult to formulate model that could explain the behavioral pattern of oligopolistic
firms. Under the oligopoly market, various behaviors can be observed that some firms collude
to undertake optimum decision regarding price and output setting. While some act
independently without collusion and in some other cases the collusion may not last long and
some other situations. Thus, we find no nice, neat and clear-cut equilibrium position toward
which all firms tend to move-just like we find for the previously discussed market structures:
perfectly competitive, monopoly, and monopolistic competition. Accordingly, our survey of the
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oligopoly will consist a series of models developed by various economists based on different
behavioral assumptions and competitive conditions.
Types of Oligopoly Market

A. Non-Collusive Oligopoly: here firms do not enter in to any form of collusive agreement.
 The Cournot’s Duopoly model (1838)
 The Kinked demand (Sweezy’s) model (1839)
 The Stackelberg’s model (1920)
 The Bertrand’s Duopoly model (1883)
B. Collusive Oligopoly: here firms enter in to collusive
 Cartels
 Price leadership.
3.1 Non Collusive Oligopoly
3.1.1 The Kinked Demand Curve Model

This model developed by Paul M. Sweezy in his analysis of price stability in oligopolistic
market. The kinked demand curve model seeks to establish that once a price-quantity
combination is determined, an oligopoly firm will not find it profitable to change its price even
in response to the small changes in the cost of production. The kinked demand curve model
developed to explain why prices often remain stable in oligopoly markets, even when costs rise.
Consider a firm in an oligopolistic market structure which behaves that:

1. If it raises price above the ongoing market price, none of its rivals will follow suit. But, the
firm will lose a considerable part of its consumers. Hence, the demand curve confronting the
firm is very elastic above the ongoing price.
2. If it reduces its price, its competitors will follow suit, matching the price cut. That is to say
all rivals will reduce their prices. So the share of the competitors in the market demand
remains unchanged. Therefore, for price reduction below the ongoing market price, the
relevant curve for decision making is the proportional demand curve (D).
In short, oligopolies rivals will ignore a price rise and follow a price cut. This in turn cause
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1. The oligopoly’s DD curve to be kinked. That is CED.

2. His/her MR curve to have a vertical break or gap.
3. Furthermore, since any shift in MC between MC1 and MC2 will cut
the vertical segment (dashes) of the MR curve, no change in either Pkor Qkwill occur.
P
C
MC1
E MC2
Pk
A
d
D
B
Qk MR
Q
Figure 3.1: The kinked demand curve in oligopoly market
The equilibrium of the firm is defined by the kink because at any point to the left of the kink, MC
lies below MR which implying output must increase while to the right of the kink, MC lies above
MR implying output must decrease. Thus, total profit is maximized at the point of the kink by the
intersection of d and D curves at point E.
The discontinuous segment AB on the MR curve implies that there is a range within which cost may
change without affecting the equilibrium price (Pk) and output (Qk) of the firm. So long as the MC
passes through the segment AB the firm maximizes profits by producing Qk and selling at Pk.
Hence, oligopoly price is said to be very sticky, changing only infrequently (rarely).
The kinked demand model has the following limitations;

1. The model implies that price rigidity (stickiness) coincides with quantity rigidity (stickiness).
In reality this may not be the case. For example, in our country the price of Coca Cola and
Pepsi are rigid for the last many years but the SS of the products has been increasing from
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time to time due to aggressive promotion. In other word, the model ignores the impact of
non-price competition (advertising and sales promotion) in increasing output sold.
2. The analysis does not explain how the ongoing price gets to be Pk or why firms in oligopoly
market are reluctant to deviate existing price that yields them higher (substantial) profits.
3. The model explains only as to how the kink occurs but doesn’t explain where it occurs.
3.1.2 Cournot’s Duopoly Model

This model is the pioneering oligopoly (or duopoly) model formally developed in 1838 by
French economist, AugustinCournot. In his model, he put forth some basic assumptions, and
after logically deducing the assumptions he conclude about the behavior of duopolists.
Basic Assumptions:
1. There are only two firms, A & B in the market; each owning mineral water wells;
2. Both operate their wells at zero marginal cost.
3. Both face a downward sloping straight-line demand curve.
4. Each firm acts on the assumption that its competitor will not react to its decision to change
in its output and price. This assumption is the behavioral assumption of Cournot.
Conclusion:
Deducing the assumptions logically, Cournot has concluded that each firm attains equilibrium by
ultimately selling one-third of the market, and charging the same price. And one-third of the
market remains unsupplied.
The Analysis:
Tabular Illustration of the Cournot Model:
Table 3.1: Tabular Illustration of the Cournot Model
Period Firm ‘A’ Firm ‘B’ Unsupplied Portion of the Market
1st ½(1) = ½ ½ (½)=1/4 1/4
2nd ½ (1-¼) = ⅜ ½(1-3/8)=5/16 5/16
3rd ½ (1- 5/16 ) = 11/32 ½ (1-11/32) = 21/64 43/64
: : : :
: : : :
: : : :
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Nth ½ (1 – 1/3)= ⅓ ½
(1- 1 /3) = 1/3 1
/3
As you can see it from the table, the process of adjustment continues and ultimately a point will
be attained, where any further changes gets back to the original position that is the equilibrium
point for the duopolists. If firm ‘A’ at period N+1 wants to adjust price and output in search for
better position, it assumes that firm ‘B’ continues to supply 1/3rd of the market so the relevant
market demand for ‘A’ is 2/3rd of the market and attempts to optimize given this. To optimize
profit, firm ‘A’ should offer half of the available market demand (½ ( 2/3) = 1/3) that is one-third of
the market which is the same as firm A’s position at period N. Hence, any further attempt of
adjustment result in no change in the firm’s position hence is equilibrium position.
Example
Suppose that there are only two firms, A and B, and with the demand curve of P = 120 – Q and
retain the condition of no cost. Assume that firm A is the first to start producing and selling
mineral water. In order to maximize his / her profit, he/ she sells quantity 60 where his/her
MC=0=MR, at price 60 birr. As a result his /her total profit is 3600 Birr. The elasticity of
market demand at this level of output is equal to unity and the total revenue of the firm is the
maximum which is equal to 3600 birr.
Then firm B will take A's output as given and seek the output that maximizes B's profits in the
remainder of the market, so B's demand curve begins at R of the following figure. The output of
firm B is found to be 30. The price in the market is 120 – (30 + 60) = 30 birr. Taking this
segment as the relevant demand curve, firm B maximizes profit by selling 30 units at price 30
Birr. The maximum profit will be 900 birr which is equal to the maximum of the total revenue.
Note that firm B supplies only 30 = ¼ of the market demand (120 – 60) ½ = 60 X ½ = 30 units.
Let us now relax the assumption of zero marginal cost and see the equilibrium of a duopoly
market (Cournot’s equilibrium) based on the reaction-curves approach. Reaction curve is a curve
that shows the relationship between a firm’s profit maximizing output and the amount it thinks
its competitor will produce. For instance, if we have two firms (A&B), firm A’s reaction
function (curve) shows how much output A must produce in order to maximize its own profit for
every specific level of output of its rival (B).
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Example:
Assume that the market demand and cost functions of the duopolies are P =100 - 0.5Q,
Where Q = q1+q2, TC1= 5q1, TC2 = 0.5q22. Based on the given answer the following questions
accordingly.
A. Determine the short run equilibrium output and price of each duopoly ignoring their
interdependence (with naive assumption)
B. Find the demand functions for each duopolies
C. Calculate the short run profits of each duopoly and the industry profit.
D. Verify the profit level of each duopoly graphically
Solution
The same to the precious market structures here also the equilibrium of the cournot duopoly exists
when the marginal revenue and the marginal cost becomes equal.
A. To determine the short run equilibrium output and price of each duopoly first we should find the
marginal revenue and marginal cost of each firm
TR1 = Pq1 = (100 – 0.5 (q1+q2))q1 = 100q1 –0.5q12 – 0.5q1q2
∂TR
From this total revenue we can find marginal revenue as MR1 =
∂ q1 = 100 –q – 0.5q
1 2
∂TC 1
From the total cost we can find marginal cost as MC1 = ∂ q1 =5
Equate MR1 = MC1100 – q1 – 0.5q2 = 5 100 – 5 - q1 – 0.5q2 = 0
95 – q1 – 0.5q2 = 0  95 = q1 + 0.5q2 ------------------------------ (1)
TR2 = Pq2 = (100 – 0.5 (q1+q2)) q2 = 100q2 – 0.5q22 – 0.5q2q1
∂TR 2 ∂TC 2
MR2 = ∂ q2 = 100 – q2 – 0.5q1 and MC2 = ∂q 2 = q2
Equate MR2 = MC2100 – q2 – 0.5q1 = q2 100 – q2 – q2 – 0.5q1 = 0
100 – 2q2 – 0.5q1 = 0 100 = 2q2 +0.5q1 --------------------------- (2)
The profit maximizing (loss minimizing) output of q1 and q2 can be solved from the two
equations using simultaneous equation method. That is
q1 + 0.5q2 = 95
(0.5q1 + 2q2 = 100) (–2)
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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 value of
q1. That is q1 + 0.5q2 = 95 q1 + 0.5 (30) = 95 q1 = 95 – 15 = 80
Q = q1 + q2 = 80 +30 = 110
Market price: P = 100 – 0.5Q, where q1 + q2
= 100 – 0.5 (80 + 30) = 100 – 0.5 (110) = 100 – 55 = 45
B. 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.
100 = 2q2 + 0.5q1 q2 = 50 – 0.25q1, is the demand function for firm 2.
C. 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
The total industry profit naïve assumption calculated as
Π = Π1+Π2 = 3200 + 900 = 4100
D. To verify the profit level of each duopoly graphically we should find the two intercepts of
the firms demand functions as follow
q1 = 95 – 0.5q2,  If q2 = 0, then q1 = 95 and if q1 = 0, then q2 = 190
This implies firm1 reaction function cross the x-axis at q1=95 and the y axis at q2=190
q2 = 50 – 0.25q1, If q1 = 0, then q2 = 50 and if q2 = 0, then q1 = 200.
This implies that firm1 reaction function cross the x-axis at q1=200 and the y axis at q2=50
Therefore the reaction curves (graphic solution of Cournot’s model) is given as follow
q2
Firm 1’s reaction curve
190
Equilibrium
Firm 2’s reaction curve
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50
30 q1
80 95 200
Criticism of Cournot Model:

The Cournot model has been criticized on the following ground:
Cournot assumed the behavior of firms as they never learn from their past experience which is
far-cry from reality. In general, the behavioral assumption of Cournot is naïve
3.1.3 THE BERTRAND’S MODEL:

Dear students, this model assumed a model of competitive bidding and hence is the opposite of
the Cournot’ model (simultaneous price setting). Bertrand, a French Mathematician, criticized
cournot's model and developed his own model of duopoly in 1883. Bertrand's model differs
from cournot's model in respect of its behavioral assumption. While under cournot's model, each
seller assumes his rival's output to remain constant; under Bertrand's model each seller
determines his price on the assumption that his rival's price remains constant.
This model states 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. What do you think
the reason for such situation?
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, firm 1 can steal all the consumers from firm 2.
On the other way 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,
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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 we can 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 = q1+q2, TC1= 5q1, TC2 = 0.5q22 find the Bertrand’s equilibrium.
Solution:
Firm 1 Firm 2
Since TC1=5q1 MC1=5 TC2=0.5q22 MC2=q2
At equilibrium P = MC1 P = MC2
100 – 0.5Q = 5 100 – 0.5Q=q2, since Q=190
-95 = -0.5Q 100-0.5(190) = q2
Q = 95/0.5 = 190 q2=5
Its criticisms:
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 It is a static model which does not explain the time period involved in the action and
reaction process of price moves by the duopolists.
 It is a closed model which does not allow entry of firms. This assumption that entry of
firms is blocked makes the model unrealistic because price increases in the duopoly
market lead to entry of firms.
 The assumption that each duopolist can act without any price reaction from the other is
unrealistic. It is, in fact, a no- learning by-doing model.
3.1.4 THE STACKELBERG MODEL (Quantity leadership)

The German economist developed his leadership model of duopoly in 1930 based on the
assumption that each seller recognizes the interdependence of other's actions. His model is an
extension of cournot's model. In this model each seller determines the maximum profits he can
get both by being a leader and a follower. He/she will then choose to play whatever role brings
him/her greater profits. Stakelberg assumes that one of the duopolists (Say A) is sophisticated
enough to play the role of a leader and the other (say B) acts as a follower. The leading duopolist
A recognizes that his rival seller, B, has a definite reaction function which A uses into his own
profit function and maximizes his profits.
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 behaviour 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 Stackelberg
leader and the other firms in the industry being Stackelberg follower.
Suppose that firm 1 is the leader and that it chooses to produce q 1. 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
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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,
i. Find the equilibrium q1, q2, market price, Π1, and Π2
a. Firm 1 being Stackelbrg’s sophisticated leader and firm 2 the follower
b. Firm 2 being Stacklberg’s sophisticated leader and 1 the follower
ii. From the view point of profit obtained is it better for the firms to be a leader or a
follower?
Solution:
i. 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 ----------------------------- (1)
Π2 = Pq2 – TC2 = (100 – 0.5 (q1+q2) q2 –0.5q22
= 100q2 – 0.5q1q2 – 0.5q22 – 0.5q22 = 100q2 – 0.5q1q2 – q22 ---------------------------- (2)
The partial derivatives w.r.t. q1 and q2
∏1 ¿
∂
∂q 1
¿ = 95 – 0.5q2 – q1q1= 95 – 0.5q2 ---- firm 1 reaction (DD) function----------- (3)
∏2 ¿
∂
∂q 2
¿ = 100 – 0.5q1 – 2q2  q2= 50 – 0.25q1 --- firm 2 reaction (DD) function-------
(4)
a. Stakelberg’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 given in eq (4)
= 95q1 – 0.5q12 – 0.5q1 (50 – 0.25q1)
= 95q1 – 0.5q12 – 25q1 + 0.125q12
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= 70q1 – 0.375q12------------------------------------------------------------------------ (5)

The first order condition of the profit function w.r.t. q1
∏1 ¿
∂
∂q 1
¿ = 70 – 0.75q1 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)2 – 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
b. Stakelberg’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  52.5 = 1.5q2  q2 =52.5/1.5 = 35
∂q2
Π2 = 52.2q2 – 0.75q22 = 52.2 (35) – 0.75 (35) 2 = 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) = 3003.125
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P = 100 – 0.5 (35 + 77.5) = 100 – 0.5 (112.5) = 100 –56.25 = 43.75
As can be seen from the profits as a leader and follower, both are better off as a leader
3.2 COLLUSIVE OLIGOPOLY MODELS

Rationales for Collusion and Types of Collusion
Some of the factors that can be taken as rationales for collusion of an oligopoly firms are;
A. Collusion reduces the degree of competition between the firms and helps them act
monopolistically in their effort of profit maximization.
B. It reduces the oligopolistic uncertainty (risk) surrounding the market
C. It forms a kind of barrier to the entry of new firms.
3.2.1 CARTELS:
As it is indicated, the firms under oligopoly are independent in decision-making. However, their
actions are not unnoticed by the rivals and in this sense they are independent. In this situation,
best interest of the firms can be served through mutual cooperation rather than competition.
Cooperation in the market by the competing firms is called collusion.
Cartel is the most effective form (type) of collusion as seen in practice. Cartel is a formal
organization of the oligopoly firms in an oligopoly. It is a combination of firms whose object is to
limit the scope of competitive forces within a market. A cartel is a cooperation of firms whose
objective is to limit (reduce) the scope of competitive environment that arises due to mutual
interdependence of firms within the market and act as a monopoly.
A general purpose (objective) of cartels is to centralize certain managerial decisions and

functions of individual firms in the industry with a view to promoting common benefits.
Producers in a cartel explicitly agree to cooperate in setting prices and output levels. In other
words, formation of a cartel by the firms means creation of a single body to take pricing and
output decisions for the firms. Whether cartel may take form of open or secret collusion, Cartel
agreements are explicit and formal in the sense that agreements are enforceable on member firms
not following the cartel rules. In most countries cartels and cartel type agreements between the
firms in manufacturing and trade are illegal. Yet, Cartels in the broader sense of the term exist in
the form of trade associations, professional organizations and the like.
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Cartels are often international. For example, the OPEC Cartel is an international agreement
among oil-producing and exporting countries, which for over a decade succeeded in raising
world oil prices far above what they would have been otherwise. Others also succeeded, for
example during the mid 1970s the International Bauxite Association (IBA) quadrupled bauxite
prices, and a secretive international Uranium cartel pushed up Uranium prices. Some cartels had
longer successes. From 1928 through the early 1970s, a cartel called MercurioEuropeo kept the
price of Mercury close to monopoly levels, and an international cartel monopolized the
iodinemarket from 1878 through 1939. However, most cartels have failed to raise prices. An
International Copper Cartel operates to this day, but it has never had a significant impact on
copper prices. And cartel attempts to drive up the prices of tin, coffee, tea, and cocoa have also
failed. DeBeers is one of the largest cartels in trading Diamond.
Successful cartelization requires two things:
1. The total demand for the good must not be very price elastic.
2. Either the cartel must control nearly all the world's supply or if it does not the supply of
non-cartel producers must not be price elastic.
There are two forms of cartel. These are

a) Cartel aiming at joint profit maximization
b) Cartel aiming at sharing the market
A. CARTEL AIMING AT JOINT PROFIT MAXIMIZATION:

The aim of this particular form of cartel is to set prices and outputs together so as to maximize total
industry (joint) profit not profit of individual firms. In this cartel solution the firms act together to
restrict output so as not to “spoil” the market. They recognize the effect on joint profits from
producing more output in either firm. This situation is similar to the multi plant monopoly case that
seeks (wants) the maximization of his profit.
For simplicity we will consider two oligopoly firms (firm A and B) producing identical
(homogenous) products. The firms appoint a central agency (cartel) to which they delegate to:
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1) The total quantity and the price level at which each quantity should be sold so as to attain
maximum group (joint) profit
2) The allocation of production among the members of the cartel and
3) The distribution of the maximized joint profits among the participating members
The authority of the central cartel agency is complete. The central agency:
Has access to the cost figures of individual firms.
It calculates the market demand and the corresponding MR. Given the market demand, the
cartel (monopoly) solution output and price levels- that maximizes joint industry profit is
determined by equating MR = MC.
Next the central agency allocates the production among firm A and B by equating the MR to
individual firm’s MC. That is MR = MCA and MR = MCB.
 The first-order condition for maximization of the joint profit П requires the
allocation of output in such a way that the MC of each firm is equal.
∂Π ∂ R ∂ c1 ∂ R ∂C 1 MR = MC1= MC2
= − =0 = > =
∂ X1 ∂ X ∂ X1 ∂ X ∂ X1
 The Second-order condition for maximization of joint profit:
2 2
∂2 R ∂ C 1 ∂ 2 R ∂ C2
2
< 2
and 2
< 2
∂X ∂ X1 ∂X ∂ X2
Consider a numerical example for a profit-maximizing cartel

Suppose the market price of a homogeneous product which produced by to joint profit maximizing
cartel given as p = 100 – 0.5Q, where Q = q 1 +q2, and their costs as TC 1 = 5q1, and TC2 = 0.5q22 then
determine Q, q1, q2, P, and joint profit.
Solution:
First the central agency of the cartel computes the joint profit function as
П = П1 + П2 = TR1 – TC1 + TR2 – TC2 = (Pq1+Pq2) – (TC1 + TC2)= P (q1+q2) – (TC1+TC2)
= 100 – 0.5 (q1+q2) (q1+q2) – (5q1+0.5q22)
= 100q1+100q2 – 0.5q12 – 0.5q1q2 – 0.5q1q2 – 0.5q22 – 5q1 – 0.5q22
= 95q1+100q2 – 0.5q12 – q1q2 – q22
Find the partial derivative of the profit function w.r.t q1 and q2 and equate them to zero.
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∂ П =0 = 95 – q1 – q2 = 0 ∂ П = 100 – q1 – 2q2 = 0
∂ q1 ∂ q2
= q1+q2 = 95 -------- (1) = q1+2q2 = 100 --------- (2)
To obtain the level of output and price that maximizes joint profit, the central agency of the
cartel solves q1 and q2 using the above two equations simultaneously as follows
q1+q2 = 95
(q1+2q2 = 100) –1
q1+q2 = 95
-q1 – 2q2 = -100
-q2 = -5, q2 = 5. Substituting this in one of the two equations above will give us
q1+q2 = 95q1+ 5 = 95  q1 = 95 – 5 q1 = 90.
Then joint profit maximizing P = 100 – 0.5Q = 100 – 0.5 (95) = 100 – 47.5 = 52.5.
 The second order condition for maximization states the slope MR < slope of the MC
2 2
∂2 R ∂ C1 ∂2 R ∂ C2
2
=−1 < 2
=0 and 2
=−1 < 2
=1
∂X ∂X1 ∂X ∂ X2
Thus, Q = 95 and P = 52.5 are the output and price levels that maximizes joint profit.
Finally, the joint profit will be obtained by substituting the values of q1 and q2 in the above П
function or alternatively as follows
П = TR1+TR2 – TC1 – TC2= Pq1+Pq2 – TC1 – TC2= 52.5 (90) + 52.5 (5) – 5 (90) – 0.5 (5) 2
= 4725 + 262.5 – 450 – 12.5 = 4525.
Difficulties of a joint profit maximizing cartel

1. It is difficult to estimate demand curve accurately since each firm thinks that the demand
for its own product is more elastic than the market demand curve because its product is a
perfect substitute for the product of other firms.
2. An accurate estimation of industry's MC curve is highly improbable for lack of adequate
and correct cost data. If industry's MC is incorrectly estimated, industry output can be
only incorrectly determined. Hence joint profit maximization is doubtful.
3. Cartel negotiations take a long time. During the period of negotiation, the composition of
the industry and its cost structure may change. This may render the estimates irrelevant,
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even if they are correct. Besides, if the number of firms increase beyond 20 or so, cartel
formation becomes difficult, or even if it is formed, it soon breaks down.
4. If Cartel price, like monopoly price is very high, it may invite government attention and
interference. For the fear of government interference, members may not charge the cartel
price.
5. There are "Chiselers' who have a strong temptation to give secret concessions to their
customers. This tendency in the cartel members reduces the prospect of joint profit
maximization.
6. Another reason for not charging the cartel price is the fear of entry of new firms. The
high cartel price which yields monopoly profit may attract new firms to the industry. To
prevent the entry of new firms some, firms may, decide on their own not to change the
cartel price.
Yet another reason for not charging the cartel price is the desire to build a public image or
good reputation. Some firms may, to this end, decide to charge only a fair price and realize
only a fair profit.
B. CARTEL AIMING AT SHARING THE MARKET: This is the most common type of cartel.
The two methods of sharing the market are through
I. NON-PRICE COMPETITION:Under this kind of arrangement between firms, a uniform

price is fixed and each firm is allowed to sell as much as it can at the cartel price. The only
requirement is that firms are not allowed to reduce the price below the cartel price. The
Cartel price is a bargain price. While low-cost firms press for a low price, the high -cost firms
press for a higher price. But the cartel price is so fixed by mutual consent that all member
firms are able to make some profits. But the firms are allowed to compete with one another in
the market on a non-price basis. That is, they are allowed to change the style of their product,
innovation of new designs and promote their sales without reducing their price below the
level of cartel price. For example
b. Doctors charge the same price
c. Barbers charge the same price
d. Gasoline stations charge the same price
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e. Cinema halls charge the same price etc.
II. SHARING THE MARKET BY AGREEMENT ON QUOTAS: Here, cartel members agree
explicitly on the common price and quantity each member may sell in the market (national or
international). The best example of this cartel is OPEC.
If all firms have identical cost, a monopoly solution will emerge with the market being shared
equally. That is equal quotas will be allocated. This will happen if and only if firms have identical
costs. However, if costs are different, the quotas (shares) of the market will differ. Again, allocation
of quotas on the basis of cost is unstable. Therefore, the quotas will be decided by bargaining.
During the bargaining process to decide the quotas of members of the cartel, the main criterions are;
 Bargaining ability of a firm and its relative importance in the industry,
 The relative sales of the firm in some pre-cartel price,
 The production capacity of the firm,
 The geographical division of the market, and the like
The best example of this kind of agreement is what the Japanese, Malaysian, and Chinese companies
producing Sony products have agreed. Note that cartel models of collusive oligopoly are closed
models. That is they assume no entry. However, if entry is free, the inherent instability of cartel will
be intensified. This is because new entrant firms may charge lower prices in order to secure a
considerable share of the market. Besides, if either firm is not sure the other firm keeps track on
prices and production levels, price war and eventually the dissolution of the cartel is inevitable
It may be mentioned at the end that cartels do not necessarily create the conditions for price
stability in an oligopolistic market. Most cartels are loose. Cartel agreements are generally not
binding on the members. Cartels do not prevent the possibility of entry of new firms. On the
contrary, by ensuring monopoly profits, cartels in fact create conditions, which attract new firms
to the industry. Besides; 'Chiselers' and 'free riders' create conditions for instability in price and
output.
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3.2.2 Price Leadership

Collusion through price leadership is an imperfect form of collusion between oligopoly firms.
Price leadership is an informal position of a firm in an oligopolistic setting to lead other firms in
pricing. This leadership may emerge spontaneously due to technical reasons or out of tacit or
explicit, agreements between the firms to assign leadership role to one of them. The spontaneous
price leadership may be the result of such technical reason as size, efficiency, economies of scale
or firm’s ability to forecast market conditions accurately or a combination of these factors. The
three common types of price leaderships: - low-cost firm, dominant firm, and barometric Price.
A. Low Cost Price Leadership

Consider we have two firms (duopoly) that produce identical products at different costs but sell
their products at the same market price. However, firms may have equal or unequal share.
Assumptions to this model:
a. There are only two firms, firm 1 and firm 2. firm 2 is the low cost firm and firm 1 is the high
cost firm
b. The product produced by the two firms is identical (homogenous) products.
c. Each of the two firms have equal share in the market. In other words demand curve facing
each firm will be the same and will be half of the total market demand.
d. The two firms may have different costs but sell their products at the same market price.
e. The market industry demand curve for the product is known to both the firms.
P
MC1
P1 MC2
P2
D (market demand)
E
q1 q2MR Q = q2+q1 Q = 2(q2)
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Figure 3.3 the low cost firm equilibrium
Firm 2 have lower cost and hence it charges lower price, p2, and produce q2 to maximize profits.
Firm 1, with the highest cost, on the other hand would like to charge p 1 and produce q1. However,
firm 1 prefers to follow the leader because if it charges p 1 its sells will be zero implying no one will
pay a higher price for identical products. Therefore, the high cost firm 1 must be willing (satisfied)
to accept the price decision of the low cost firm. Thus, it changes P 2 and produces the same quantity
as firm 2, q2. The two together then produce output level, which is equal to q2 + q2 = 2q2. It is only in
this case the antitrust monopoly legislation, which forbids monopoly production will work. In short
the high cost firm must tolerate to the price and output level equal to the low cost firm to avoid the
uncertainty that may arise when firm 2, reduces price lower than p2.
Mathematical approach for the low-cost price leader

The market demand is defined by the function P = a-b(X) a-b(X1+X2)
Where X1= Output of firm A and X2= Output of firm B
The firms costs defined by the functions: C1= f1(X1) and C2=f2 (X2) Where C1< C2
The leader will be the low-cost firm, A. It assumes that the rival firm will produce an equal
amount of output to his own; i.e. X1=X2
With this assumption, the demand function relevant to the leader's decision is: P= a-2b (X1)
The low-cost leader will set the price, which maximizes his own profit.
π1= R1- C1= PX1 - C1
R1= (a-2bX1) X1-C1
The first-order condition for the maximization of π1 requires
∂ Π1 ∂ R1 ∂C 1 ∂ R1 ∂C 1 ∂ R1 ∂C 1
= − =0 = =0 ⇒ = ⇒ MR1 = MC 1
∂ X1 ∂ X1 ∂ X1 => ∂ X 1 ∂X1 ∂ X1 ∂ X1
The second - order condition requires.

∂2 Π 1 ∂ 2 R1 ∂2 C 1
2
<0⇒ 2
< 2
∂ X1 ∂ X1 ∂ X1
The solution of this problem yields the price P and output X 1 that the leader must produce in
order to maximize his profit. The follower would adoptthe same price and will produce an equal
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amount of output (X1=X2). Given that C2>C1, the follower does not maximize his profit. He
would prefer (under the above assumptions) a lower level of output and sell it at a higher price.
Numerical example:
Given P = 24 – 0.1Q, where Q = q1+q2 and q1 = q2, TC1 = 0.075q12, TC2 = 0.05q22,
a) Determine the output and price of low cost firm
b) Calculate the profit of the low cost firm
c) What is the profit maximizing price level the high firm would like to charge but that
doesn’t realize in the market
d) Compare the profits of the price taker at its own profit maximizing output and low cost
firm’s output
Solution
a) Since q1 = q2, 0.075q12> 0.05q22. This implies that firm 2 is a low cost price leader.
Hence,
П2 = Pq2 – TC2 P = 24 – 0.1Q, where q1 = q2
= (24 – 0.1(q1+q2)) q2 – 0.05q22 P = 24 – 0.1 (2q2)
= (24 – 0.1 (q2+q2)) q2 – 0.05q22 = 24 – 0.2q2
= (24 – 0.1 (2q2)) q2 – 0.05q22 = 24 – 0.2 (48)
= (24 – 0.2q2) q2 – 0.05q22 = 24 – 9.6 = 14.4
= 24q2 – 0.2q22 – 0.05q22 b) П2 = Pq2 –TC2
= 24q2 – 0.25q22
dП2= 0 = 24 – 0.5q2 = 0 = 14.4 (48) – 0.05 (48) 2
dq2
= q2 = 24/0.5 = 48 = 691.2 –115.2 = 576
c) П1 = Pq1 – TC1 d) П1= Pq1 – TC1
= (24 – 0.1(q1+q2)) q1 – 0.075q12 = 14.4 (43.63) – 0.075 (43.63) 2
= (24 – 0.1 (q1+q1)) q1 – 0.075q12 = 628.36 –142.77= 485.59 and
= (24 – 0.1 (2q1) q1 – 0.075q12 П1= Pq1 – TC1
= (24 – 0.2q1) q1 – 0.075q12 = 14.4 (48) – 0.1 (48)2
= 24q1 –0.2q12 – 0.075q12 = 691.2 – 230.4 = 460.8
= 24q1 – 0.275q12 though, 485.59>460.8 firm 1 will
produce 48 than 43.63
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dП1= 0 = 24 –0.55q1 = 0
dq1
q1= 24/0.55 = 43.63
Exercise: GivenP = 300 – 5X, where X = x1+x2, TC1= 0.5x12, TC2 = 3x22 answer the
questions above.
Answer: X1 = 14.29, P1 = 157.96, X2 =11.54, and P2 = 184.62
B. Price- Leadership by the Dominant Firm

This is a typical case of price leadership where there is one large dominant firm and a number of
small firms in the industry. The dominant firm fixes the price for the entire industry and the small
firms will sell as much product as they like and the remaining market is filled by the dominant
firm itself. The dominance of the large firm is indicated by the fact that it could possibly
eliminate all its rival firms by price-cutting. In that case, the large firm gains the status of a
monopoly, which may invite legal problems. The dominant firm therefore compromises with the
existence of rural firms in the market. The smaller firms recognize their position and behave just
like a firm in a perfectly competitive market; i.e., the smaller firms assume that their demand
curve is a straight horizontal line.
Assumptions of the model:

- The oligopolistic industry consists of a large dominant firm and a number of small firms.
- The dominant firm sets the market price
- All other firms act like pure competitors, which act as price takers.
- The dominant firm alone is capable of estimating the market demand curve for the product.
- The dominant firm is in a position to predict supplies of other firms at each price set by it.
Given these assumptions, when each firm sells its product at the price set by the dominant firm,
its demand curve is perfectly elastic at that price. Thus its MR curve coincides with the
horizontal demand curve.
The problem confronting the dominant firm is to determine the price that will maximize its profit
while allowing the small firms to sell all they wish at that price. To do this, it is necessary to find
the demand curve for the dominant firm. It is assumed that the dominant firm knows the market
demand curve DD' and the MC curve of the small firms. The summation of the MC curves of the
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small firms is MCs. Since the small firms equate MC and price, MCs is also the collective supply
curve of the small firms.
P S small
MCL
PS D1
SSsm
B C
PL1
SSsmSSL1
P2 AD2
SSsmSSL2
D3
P3 dL
SSL3 DD MRL
Q qL q2 q3
Smaller firms Dominant firm
Figure 3.4The dominant firm price leader ship
Knowing the market DD and the SS of the smaller firms the dominant firm calculates its DD curve
as follows. At each price the dominant firm will be able to SS that section of the total market DD not
supplied by the smaller firms. That is, the DD for the product of the firm will be the difference
between the total dd (D) and the total SS of the smaller firms.
At ps, market DD is equal to the market SS of smaller firms. This is equal to P SD1 amount. The dd
for the product of the leader will be zero. As price falls below P S, the dd for the leader increases, for
instance, at P2, total market dd is P2D2 amount of which P2A is supplied by the smaller firms. The
share of the dominant is AD2. At P3, total market dd is P3D3 of which the share of smaller firms is
zero, while P3D3 (all) is the share of the dominant firm. Below P s the market dd coincides with the
leader dd curve.
Having derived the dd curve of the leader (dL) and given its MC, the dominant firm will set the price
p at which MRL = MCL and output is qL. At price PL1 the total market dd is P L1C of which PLB is the
share of smaller firms while BC is the share of the dominant firm. The dominant firm maximizes its
profit be equating its MR to MC, but the smaller firms or price taker may or may not attain the point
where MRS = MCS.
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Numerical example: Given Q = 120 – 0.2P, SSsm = 4.8P, and TCL = 4qL determine the supply, price,
and profit of the dominant (large) firm, finally, the supply of smaller (followers) firms.
Solution:
First we should derive the demand function of the dominant firm (qL) which is the difference of
the market demand (Q) and the small firms supply (SSsm)
qL (dL ) = Q – SSsm)= 120 – 0.2P – 4.8P = 120 – 5P qL – 120 = -5P  P = 24 - 0.2qL
TRL = p*qL= (24 – 0.2 qL) qL= 24qL-0.2qL2
ПL = TRL – TCL = 24qL-0.2qL2– 4qL = 20qL - 0.2qL2
Once we have derived the profit function of the dominant firm, it maximized its profit by
calculating the first order derivative of its profit with respect to qLandequate to zero.
dΠ L
=
qL 20 – 0.4qL = 0  20 = 0.4qLqL = 20/0.4 = 50
P = 24 – 0.2 qL = 24 – 0.2 (50) = 24 – 10 = 14, this is the equilibrium price
ПL = PqL – TCL = 14 (50) – 4 (50) = 700 – 200 = 500
Then the supply of smaller firms will (SSsm) = Q – dL. That is
SSsm = (120 – 0.2P) – 50 = (120 – 2.8) – 50 = 117.82– 50 = 67.2 or
SSsm= 4.8P=4.8*14=67.2
C. Price-Leadership by the Barometric Firm

The barometric price leadership is that in which there is no leader firm as such but one firm
among the oligopolistic firms with the wisest management which announces a price change first
which is followed by other firms in the industry. The barometric price leader may not be the
dominant firm with the lowest cost or even the largest firm in the industry. It is a firm, which acts
like barometer in forecasting changes in cost and demand conditions in the industry and
economic conditions in the economy as a whole. On the basis of a formal or informal tacit
agreement, the other firms in the industry accept such a firm as the leader and follow it in
marketing price changes for the product.
The barometric price leadership develops due to the following reasons:
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a) Most firms do not possess the expertise to calculate cost and demand conditions of the
industry. So they leave their estimation to one leader firm, which has the ability to do so.
b) Oligopolistic firms accept one among them as the barometric leader firm which possesses
better knowledge and predictive power about changes in direct costs or style and quality
changes and changes in the economic conditions as a whole
GAME THEORY AND STRATEGIC BEHAVIOR

4.1. INTRODUCTION
Consider the following questions: why do firms tend to collude in some markets and compete
aggressively in other markets? How do some firms manage to deter entry by potential
competitors? And how should firms make pricing decisions when demand or cost conditions are
changing, or new competitors are entering the market? To answer these questions, we will use
game theory to extend our analysis of strategic decision making by firms. The application of
game theory has been an important development in microeconomics. Game theory can help an
oligopoly firm to choose the best level of advertising, the best price to charge, the optimum level
of product differentiation, etc. that maximizes its benefit or profit after considering all possible
reactions of its competitors.
In this unit we will discuss how firms can make strategic moves that give them an advantage
over their competitors or the edge in a bargaining situation and we will briefly explore this
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interesting subject to give you a flavor or how it works and how it can be used to study economic
behavior in oligopolistic markets.
Game theory can be regarded as a multi-agent decision problem. It is an analysis of a decision

making process when there are more than one decision-makers where each agent’s payoff
possibly depends on the actions taken by the other agents.
Games are a convenient way in which to model the strategic interactions among economic
agents. Many economic issues involve strategic interaction.
 Behavior in imperfectly competitive markets, e.g. Coca-Cola versus Pepsi.
 Behavior in auctions, e.g. Investment banks bidding on Treasury bills.
 Behavior in economic negotiations, e.g. trade.
The payoff matrix of a game

The following are the basic elements of any game
Players: are parties involved in the game
A set of rules (Allowable actions and sequencing of actions by each player)
Strategies: all the actions that each player can take.
Payoffs: are outcomes for each player resulting from all combination of strategies by players.
The amount each player gets for every possible combination of the actions.
Informational structure (what players know at each point in the game).
The players may be individuals, firms (market) or entire nations (in military conflicts). All
players are characterized as having the ability to choose among a set of possible actions. Games
are often characterized by the number of players (that is, two-player, three-player, or n-player
games). An important assumption usually made in game theory (as in most of economics) is that
the specific identity of players is irrelevant. There are no “good guys” or" bad guys" in a game,
and players are not assumed to have any special abilities or shortcomings. Each player is simply
assumed to choose the course of action that yields the most favorable outcome.
A strategy is each course of action open to a player in a game. Each strategy is assumed to be a
well-defined, specific course of action. Usually the number of strategies available to each player
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will be few in number; many aspects of game theory can be illustrated for situations in which
each player has only two strategies available.
Payoffs are the final returns to the players of a game at its conclusion. Payoffs are usually
measured in levels of utility obtained by the players, although frequently monetary payoffs (say,
profit for firms) are used instead. B Naturally, players prefer payoffs that offer more utility to
those that offer less. In some games the payoffs are simply transfers among players-what one
player wins, the other losses. This type of game is zero-sum game.
Suppose that there are two people (A and B) are playing a simple game and each has two strategies
to play. Let the two strategies of A are top and bottom and that of B left and right. Their strategies
could represent economic choices like “raise price” or “lower price” and “don’t advertise” or
“advertise” or they could represent political choices like “declare war” or “don’t declare war”.
Player B
Left(don’t adv) Right(advertise)
Top(p) 1,2 0,1

Player A Bottom(p ) 2,1 1,0
Table 4.1 a pay off matrix of a game
From the viewpoint of person A, it is always better for him to play bottom. Since his/her payoff
from this choice (2 or 1) are always greater than their corresponding entries in top (1 or 0).
Similarly, it is always better for B to play left. Since (2 and 1) dominate (1 and 0). Thus, we
would expect that the equilibrium strategy for A is to play bottom and B to play left
4.2 The Dominant Strategy Equilibrium

A dominant strategy is the optimal (best) choice of strategy for each player no matter what the
other player does. Whatever choice B makes, player A will get a higher payoff if he/she plays
bottom, so it make sense for A to play bottom and bottom(decreasing price ) is thus the dominant
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strategy for A. And whatever choice A makes, B will get a higher payoff if he plays left, thus left (do
not advertise) is the dominant strategy for B. If there is a dominant strategy for each player, in the
same game, then we would predict that it would be the equilibrium outcome of the game. We call it
the dominant strategy equilibrium.
Firm B
Advertise Don't Adv.
Firm A Advertise 10, 5 15 , 0
Table 4.2 Payoff Don't Adv. 6,8 10 , 2 matrix for
advertising game
Every game may not have a dominant strategy for each player. Look this game
Firm B
Advertise Don't Adv.
Firm A Advertise 10, 5 15 , 0
Don't Adv. 6,8 20 , 2
Table 4.3 Payoff matrix for advertising game
Now firm A has no dominant strategy. Its optimal decision depends on what firm B does. If firm
B advertises, then firm A does best by advertising; but if firm B does not advertise, firm A also
does best by not advertising. Now suppose both firms must make their decisions at the same
time what should firm A do?
To answer this, firm A must put itself in firm B's shoes. What decision is best from firm B's
point of view, and what is firm B likely to do? The answer is clear: firm B has a dominant
strategy advertise, no matter what firm A does. Therefore, firm A can conclude that firm B will
advertise (and there by earn 10 instead of 6). The equilibrium is that both firms will advertise. It
is the logical outcome of the game because firm A is doing the best it can given firm B's
decision; and firm B is doing the best it can, given firm A's decision.
To determine the likely outcome of a game, we have been seeking "self-enforcing" or "Stable,"
strategies. Dominant strategies are stable but in many games, one or more players may not have.
Eliminating the dominated strategy
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Consider an entry game, played by Microsoft (the row player) and Ethiotech (the column player),
a small start-up company as another example for equilibrium in dominated strategies. Both
Microsoft and Ethiotech are considering entering a new market for an online service. The payoff
structure is given as follow;
Ethiotech
Enter Don’t
MS Enter (2, -2) (5, 0)

(0, 5) (0, 0)
Don’t
Table 4.4 An entry game
In this case, if both companies enter, Microsoft ultimately wins the market, and earns 2, and
Ethiotech loses 2. If either firm has the market to itself, they get 5 and the other firm gets zero. If
neither enters, both get zero. Microsoft has a dominant strategy to enter: it gets 2 when Ethiotech
enters, 5 when Ethiotech doesn’t, and in both cases does better when enters than not. In contrast,
Ethiotech does not have a dominant strategy: Ethiotech wants to enter when Microsoft doesn’t,
and vice-versa. That is, Ethiotech’s optimal strategy depends on Microsoft’s action, or, more
accurately, Ethiotech’s optimal strategy depends on what Ethiotech believes Microsoft will do.
Ethiotech can understand Microsoft’s dominant strategy, if it knows the payoffs of Microsoft.
Thus, Ethiotech can conclude that Microsoft is going to enter, and this means that Ethiotech
should not enter. Thus, the equilibrium of the game is for Microsoft to enter and Ethiotech not to
enter. This equilibrium is arrived at by the iterated elimination ofdominated strategies. First, we
eliminated Microsoft’s dominated strategy in favor of its dominant strategy. Microsoft had a
dominant strategy to enter, which means the strategy of not entering is dominated by the strategy
of entering, so we eliminated the dominated strategy. That leaves a simplified game in which
Microsoft enters:
Ethiotech
Enter Don’t
MS
Enter (2, -2) (5, 0)
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Table 4.5 elimination of a dominated strategy
In this simplified game, after the elimination of Microsoft’s dominated strategy, Ethiotech also
has a dominant strategy: not to enter. Thus, we iterate and eliminate dominated strategies again,
this time eliminating Ethiotech’s dominated strategies, and wind up with a single outcome:
Microsoft enters, and Ethiotech doesn’t. The iterated elimination ofdominated strategies solves
the game.
Three-by-three game
Dear student, iterative elimination of dominated strategies enables us to solve games in which
each player has more than two strategies. Let us take a game involving two players, each of
whom has three strategies to choose from. All that we have to do is to eliminate dominated
strategies from a player, then go to the other player and eliminate his dominated strategies from
the remaining strategies and payoffs after the first elimination and repeat the process until we end
up at the equilibrium. This three by three model is shown in Table 4.6
Column
Left Center Right
Top (-5, -1) (2, 2) (3, 3)
Row Middle (1, -3) (1, 2) (1, 1)
Bottom (0, 10) (0, 0) (0, -10) Table 4.6 a three-by-three game
The process of iterated elimination of

dominated strategies is illustrated by actually eliminating the rows and columns, as follows.
For the Row player, Top and Middle dominates Bottom and we can eliminate the Bottom Row as
a dominated strategy. This is because if the Row player expects the Column player to play Left,
she would choose Middle; if she assumes the Column player would play Center, she would go
for Top; and if she assumes the Column player will choose Right, she will choose Top again.
That is, no matter what the Column player does, the Row player will not choose Bottom as her
strategy. i.e, the Bottom strategy is dominated by Top and Middle and can be eliminated.
Column
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Left Center Right

Top (-5, -1) (2, 2) (3, 3)
Middle (1, -3) (1, 2) (1, 1)
Row
Bottom (0, 10) (0, 0) (0, -10)
Table 4.7 Eliminating a dominated strategy
After Bottom is eliminated, Left will be dominated by Center and Right for the Column player.
[Can you see why?] Good.
Column
Left Center Right

Top (-5, -1) (2, 2) (3, 3)
Middle (1, -3) (1, 2) (1, 1)
Row
Bottom (0, 10) (0, 0) (0, -10)
Table 4.8 eliminating another dominated strategy
At this stage too, the Row player’s dominant strategy is Top, so we can eliminate the middle
strategy.
Column
Left Center Right

Top (-5, -1) (2, 2) (3, 3)
Middle (1, -3) (1, 2) (1, 1)
Row
Bottom (0, 10) (0, 0) (0, -10)
Table 4.9 Eliminating a third dominated strategy
Finally, Column chooses Right over Center, yielding a unique outcome after the iterated
elimination of dominated strategies, which is (Top, Right).
Column
Left Center Right

Top (-5, -1) (2, 2) (3, 3)
Middle (1, -3) (1, 2) (1, 1)
Bottom (0, 10) (0, 0) (0, -10)
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Row
Table 4.10 Game solved
The iterated elimination of dominated strategies is a useful concept, and when it applies, the
predicted outcome is usually quite reasonable. Certainly it has the property that no player has an
incentive to change their behavior given the behavior of others. However, there are games where
it doesn’t apply, and these games require the machinery of a Nash equilibrium, named after the
Nobel laureate John Nash
Activity 4.1
1. In the table below show the dominant strategies of the Row player and that of the Column
player.
A. Column
Left Right
Up (3, 2) (11, 1)
Row
Down (4, 5) (8, 0)
B. Column
Left Right
Row Up (3, 3) (0, 0)

Down (4, 5) (8, 0)
2. What is the equilibrium of both games depicted in question number 1?
4.3 Nash Equilibrium

Dominant strategy equilibriums do not happen all the time. This is because we may not have
dominant strategy equilibrium when the optimal (best) choice of one depends on what he/she
thinks the other will do. If this is the case, we call the equilibrium Nash equilibrium. Nash
equilibrium can be interpreted as a pair of expectations about each person’s choice such that,
when the other person’s choice is revealed neither individual wants to change his/her behaviour.
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Nash equilibrium is a set of strategies (or actions) such that each player is doing the best it can
given the actions of its opponents. Since each player has no incentive to deviate from its Nash
equilibrium (Strategy), the strategies are stable.
Dominant strategies: I am doing the best I can no matter what you do.
You are doing the best you can no matter what I do.
Nash equilibrium: I am doing the best I can given what you are doing.
You are doing the best you can given what am doing.
How do we find Nash equilibrium (NE)?
Step 1: Imagine you are one of the players and you have your own actions
Step 2: Assume your “opponent” picks a particular action from alternative actions
Step 3: Determine your best strategy (strategies), given your opponent’s action
Underline any best choice in the payoff matrix
Step 4: Repeat Steps 2 & 3 for any other opponent strategies
Step 5: Repeat Steps 1 through 4 for the other player
Step 6: Any entry with all numbers underlined is Nash equilibrium of the game
A game may have no Nash equilibrium, may have one Nash equilibrium, or it can have multiple
Nash equilibria.
A. Game with no Nash equilibrium

Let us assume that there are two firms, firm A and firm B, in the market producing and selling the
same product. The strategy adopted by either firm will have an impact on the demand, hence on the
profit of the other firm. Firm A has two strategic choices: Fight and accommodate, and firm B have
two strategies: advertise and do not advertise. The following table represents the payoff matrix of the
two firms.
Player B
Advertise Don’t advertise
Player A Fight (5,4) (4,1)
Accommodat (7,3) (3,4)
e
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Table 4.11 payoff without Nash equilibrium
If firm A plays ‘fight’, firm B is better off by playing ‘advertise’, but if firm B plays ‘advertise’,
firm A is better off by playing ‘accommodate’. Hence, (advertise, accommodate) is not Nash
equilibrium. If firm B plays ‘do not advertise’, the best strategy for firm A is to play ‘fight’ but ‘do
not advertise’ is not the best strategy for firm B, if firm A plays ‘fight’. Hence, (fight, do not
advertise) is not Nash equilibrium. A similar calculation of all the other payoffs of a pair of strategies
reveals no Nash equilibrium.
Generally in this game there is no Nash equilibrium in the sense that there is no set of strategies by
each firm which imply one firm is better off given what the other is doing and vice versa.
B. Game with one Nash equilibrium
If we assume two firms: A and B, A with the strategies ‘advertise’ and ‘do not advertise’ and B with
the strategies ‘expand production’ and ‘cut production’. The payoff for each player is given in the
following table.
Player B
Expand Cut production
Player A production
Advertise (2,1) (0,0)
Do not advertise (0,0) (-1,2)
Table 4.12 Game
with one Nash Equilibrium
In the above table, the strategy (advertise, expand production) is a Nash equilibrium. If A chooses to
advertise, the best strategy for B is to expand production. And if B chooses to expand production
then optimal choice for A is to choose to advertise (since 2>0).
C. Game with multiple Nash equilibra

Consider the following payoff matrix:
Player B
Left Right
Top (1,2) (0,0)
Player A
Bottom (0,0) (1,2)
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Table 4.13 game with two Nash equilibria
Here when B chooses right, the payoffs to A are 0 or 1. This means that when B chooses right, A
would want to choose bottom, and when B chooses left, A would want to choose top. Thus, A’s
optimal choice depends on what he thinks B will do and vice versa. Therefore, we will say that a pair
of strategies is a Nash equilibrium If A’s choice is optimal given B’s choice, and B’s choice is
optimal given A’s choice. Remember that neither person knows what the other player will do when
he has to make his own choice of strategy. But each person may have some expectation about what
the other person’s choice will be.
 Therefore,
- If A choose top, then the best thing for B is to choose left, since the payoffs to B from
choosing left is 2 and from choosing right is 0. And if B chooses left, then A will be better off
by choosing top than bottom because (1>0). Thus (Top, left) is Nash equilibrium.
- Similarly, if A choose bottom, B will choose right and if B chooses right, A will choose
bottom. Thus (bottom, right) is also Nash equilibrium.
From the above we can conclude that the Nash equilibrium is a generalization of the Cournot
equilibrium for each firm chooses its output level taking the other firm’s choice as being fixed.
Activity 4.2 Find Nash equilibrium/equilibria for the following games.
A. Column
Left Right
Row Up (3, 2) (11, 1)

(4, 5) (8, 0)
Down
B. Column
Left Right
Row Up (3, 3) (0, 0)

(4, 5) (8, 6)
Down
C. Column
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Left Right
Up (0, 3) (3, 0)
(4, 0) (0, 4)
Down
4.4 MIXED STRATEGYEQUILIBRIUM

If we enlarge our definition of strategies, we can find a new sort of Nash Equilibrium where we
cannot get Nash equilibrium if we have pure strategy. Pure strategy is a strategy in which each
agent makes a specific choice and sticks to it. If the agents are allowed to randomize their
strategies - to assign a probability to each choice and to play their choices according to those
probabilities - we call this strategy a mixed strategy.
Nash equilibrium in mixed strategies refers to an equilibrium in which each agent chooses the
optimal frequency with which to play his strategies given the frequency choices of the other
agent. Every game with a finite number of players and a finite number of actions has at least one
Nash Equilibrium.
Consider the following payoff matrix for which no Nash equilibrium exists under pure strategy.
Player B
Left Right
Top 0,0 0, -1
Player A
Bottom 1,0 -1,3
Table 4.14 Game with two mixed strategy Nash Equilibrium
Suppose player B plays left with probability ‘b’ and Right with probability (1-b); player A plays
Top with probability ‘a’ and bottom with (1-a). Each player calculates his own expected payoff
given the probability with which the opponent plays the strategies.
The expected payoff of player A is:

i) Playing Top = 0(the probability that B plays left) +0(the probability that B plays
Right) (b) + 0(1-b) = 0.
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ii) Playing Bottom = 1(b) +-1(1-b) =2b-1 if he plays Bottom

A will be indifferent between playing Top and Bottom if the expected payoffs from both
strategies are equal i.e., if 0=2b-1  2b=1 b=1/2 ; (1-b) = ½
 A is indifferent between top and Bottom if b=1/2
 Plays Top frequently if b<1/2(because b<1/2 0>2b-1)
 A plays Bottom frequently if B>1/2 because b>1/2 0<2b-1
The expected payoff of player B is:

i) If the plays left =0(a) + 0(1-a) =0
ii) If he plays right = -1(a) +3(1-a) =3-4a.
B will be indifferent between playing left and Right if 0=3-4a 3=4a  a =3/4; (1-a) =1/4
 B is indifferent between left and right if a=3/4
 B plays Left frequently if a>3/4
 B plays Right frequently if a <3/4.
The Nash equilibrium is when A plays Top with probability3/4 and Bottom with 3/4 and B plays
Left with probability 1/2 and Right with1/2.
A. Mixed Strategies in Matching Pennies
Let us consider the matching pennies game once again.

Column
Head Tail
Row Head (1, -1) (-1, 1)
Tail (-1, 1) (1, -1)
Table 4.15 matching the pennies, once again
Suppose that Row believes Column plays Heads with probability p. Then if Row plays Heads,
Row gets 1 with probability p and -1 with probability (1-p), for an expected value of 2p – 1.
Similarly, if Row plays Tails, Row gets -1 with probability p (when Column plays Heads), and 1
with probability (1-p), for an expected value of 1 – 2p. This is summarized in the Table 3.16
Column
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Head Tail Row’s expected payoff

1p + -1(1-p)=2p-1
Head (1, -1) (-1, 1)
Row
Tail -1p + 1(1-p)=1-2p
(-1, 1) (1, -1)
Table 4.16 Matching the pennies with probabilities
If 2p – 1 > 1 – 2p, then Row is better off on average playing Heads than Tails. Similarly, if 2p – 1
< 1 – 2p, Row is better off playing Tails than Heads. If, on the other hand, 2p – 1 = 1 – 2p, then
Row gets the same payoff no matter what it does. In this case Row could play Heads, could play
Tails, or could flip a coin and randomize its play.
A mixed strategy Nash equilibriuminvolves at least one player playing a randomized strategy,
and no player being able to increase their expected payoff by playing an alternate strategy. A
Nash equilibrium without randomization is called a pure strategy Nash equilibrium.
Note that that randomization requires equality of expected payoffs. If a player is supposed to
randomize over strategy A or strategy B, then both of these strategies must produce the same
expected payoff. Otherwise, the player would prefer one of them, and wouldn’t play the other.
We computed the payoff to Row of playing Heads, which was 2p – 1, where p was the
probability Column played Heads. Similarly, the payoff to Row of playing Tails was 1 – 2p.
Row is willing to randomize if these are equal, which solves for p = ½ .
Now let q be the probability that Row would play Heads. Then if Column plays Heads, Column
gets -1 with probability qand 1 with probability (1-q), for an expected value of 1– 2q. Similarly,
if Column plays Tails, Column gets 1 with probability q(when Column plays Heads), and -1 with
probability (1- q), for an expected value of 2q – 1. This is summarized in the Table 4.17.
Column
Head Tail Row’s expected payoff
Head
(1, -1) (-1, 1) 1p + -1(1-p)=2p-1
Tail (-1, 1) (1, -1) -1p + 1(1-p)=1-2p

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Column’s -1q + 1(1-q) = 1q + -1(1-q)
expected pay 1 - 2q = 2q – 1
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Row
Table 4.17 Expected payoff of both players
If 1– 2q > 2q – 1, then Column is better off on average playing Heads than Tails. Similarly, if 1–
2q < 2q – 1, Column is better off playing Tails than Heads. If, on the other hand,1– 2q = 2q –1,
then Column gets the same payoff no matter what Column does. In this case Column could play
Heads, could play Tails, or could flip a coin and randomize its play.
Table 4.16 show that the payoff to Column of playing Heads is 1– 2q. Similarly, the payoff to her
of playing Tails is 2q – 1. Column is willing to randomize if these are equal, which solves for q =
½.
Remember that A Nash equilibrium in mixed strategies refers to an equilibrium in which each
agent chooses the optimal frequency with which to play his strategies given the frequency
choices of the other agent. In our game of matching pennies, this equilibrium results in Row
playing Head 50 per cent of the time and playing tail the remaining 50 per cent, and also Column
playing Head 50 per cent and Tail 50 per cent.
Since the Row’s expected payoff is 2p-1 (=1-2p) and p = ½, it is clear that Row’s expected
payoff is 0. Likewise, Column’s expected payoff is 0 [Please convince yourself this is so by
following the same argument we did to find the payoff of Row].
This mixed strategy Nash equilibrium is a Nash equilibrium in the sense that neither party can
improve their payoff, given the behavior of the other party. It may seem strange to play a game
by choosing actions randomly. But put yourself in the position of the Row player and think what
would happen if you followed a strategy other than just flipping coin or randomizing. Suppose,
for example, you decided to play heads. If Column knows this, she would play tails and you
would lose. Even if Column did not know your strategy, if the game was played over and over
again, she could eventually discern your pattern of play and choose a strategy that countered it.
Of course, you would then want to change your strategy – which is why this would not be a Nash
equilibrium in pure strategies in the first place. Only if you and your opponent both choose heads
or tails randomly with probability ½ would neither of you have any incentive to change
strategies.
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B. Mixed Strategies in Battle of the Sexes

Dear student, you are now familiar with the game of the battle of the sexes. In the previous topic
(mixed strategies in matching the pennies) we have shown that even if there is no Nash
equilibrium in pure strategies, there exists Nash equilibrium in mixed strategies. However, some
games have Nash equilibrium both in pure strategies and in mixed strategies. A case in point is
battle of the sexes. As you may remember, there are two Nash equilibria in pure strategies in
battle of the sexes. Now let us see if there also exists Nash equilibrium in mixed strategies in
such a game.
Woman
Baseball Ballet
Man Baseball (3, 2) (1, 1)

(0, 0) (2, 3)
Ballet
Table 4.18 The battle of the sexes, once again
This game’s two pure strategy Nash equilibria are (Baseball,Baseball) and (Ballet,Ballet). Is
there a mixed strategy? To compute a mixed strategy, let the woman go to the baseball game with
probability p, and the Man go to the baseball game with probability q. Table 3.22 contains the
computation of the mixed strategy payoffs for each player.
Woman
Baseball (p) Ballet (1-p) Man’s expected payoff
3p + 1(1-p)=1+2p
Baseball (q) (3, 2) (1, 1)
Man
0p + 2(1-p)=2-2p
Ballet (1-q) (0, 0) (2, 3)
Woman’s 2q + 0(1-q) 1q + 3(1-q)
Table
=2q =3-2q
expected pay off
4.19
Expected payoff of players in battle of the sexes
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A mixed strategy in the Battle of the Sexes game requires both parties to randomize (since a pure
strategy by either party prevents randomization by the other). The Man’s indifference between
going to the baseball game and the ballet requires 1+2p = 2 – 2p, which yields p = ¼ . That is,
the Man will be willing to randomize which event he attends if the Woman is going to the ballet
¾ of the time, and otherwise to the baseball game. This makes the Man indifferent between the
two events, because he prefers to be with the Woman, but he also likes to be at the baseball
game; to make up for the advantage that the game holds for him, the woman has to be at the
ballet more often.
Similarly, in order for the Woman to randomize, the Woman must get equal payoffs from going
to the game and going to the ballet, which requires 2q = 3 – 2q, or q = ¾ . Thus, the probability
that the Man goes to the game is ¾, and he goes to the ballet ¼ of the time. These are
independent probabilities, so to get the probability that both go to the game, we multiply the
probabilities, which yield 3/16. Table 4.19 fills in the probabilities for all four possible outcomes.
Woman
Baseball Ballet
Man Baseball 3/16 9/16
Ballet 1/16 3/16
Table 4.20 Probabilities of payoffs
Note that more than half the time, (Baseball, Ballet) is the outcome of the mixed strategy, and the
two people are not together. That is, the man would go to the baseball 3/4 th of the time and to the
ballet only 1/4th of the time while the woman goes to the baseball only 1/4th of the time and to the
ballet 3/4th of the time. This lack of coordination is a feature of mixed strategy equilibria
generally. The expected payoffs for both players are readily computed as well. The Man’s payoff
was 1+2p = 2 – 2p, and since p = ¼, the Man obtained 1 ½. [Using a similar calculation,
convince yourself that the woman also obtain 1 ½.] Thus, both do worse than coordinating on
their less preferred outcome. But this mixed strategy Nash equilibrium, undesirable as it may
seem, is a Nash equilibrium in the sense that neither party can improve their payoff, given the
behavior of the other party.
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In the Battle of the sexes, the mixed strategy Nash equilibrium may seem unlikely, and we might
expect the couple to coordinate more effectively. Indeed, a simple call on the telephone should
rule out the mixed strategy.
Exercise 4.3 Find Nash equilibrium in mixed strategies for the following game.
Column
Left Right
Row Up (0, 3) (3, 0)
(4, 0) (0, 4)
Down
4.5 THE PRISONER’S DILEMMA

Another problem of Nash equilibrium is that it doesn’t necessarily lead to Pareto efficient outcome.
Consider for example, the game depicted in the table 4.20. It refers to a situation where two
prisoners who were partners in a crime were being questioned in separate rooms. Each prisoner has
a choice of confessing (guilty) in the crime and there by implicating the other or denying (not
guilty) that he/she had participated in the crime.
 If only one prisoner confessed, then he would go free and the authority (judges) will
throw the book (sentenced) at the other prisoner, requiring him to spend 6 months in
prison.
 If both prisoner denied being involved, then both would be held for 1 month on a
technicality (labour work) and
 If both prisoners confessed they would be both held for 3 months. The payoff matrix for
this game is given as
The prisoner’s dilemma
Player B
Confess Deny
Confess -3,-3 0,-6
Player A
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Table 4.21 game prisoner’s dilemma
 Put yourself in the position of player A.

- If B decides to deny committing the crime, then you are certainly better off confessing, since
you will get off free.
- Similarly, if B confesses, then you will better off confessing since you will get a sentence of
3 months rather than a sentence of 6 months. Thus, whatever player B does, player A is
better off confessing. The same is true for plays B–he/she is better off confessing. Thus, the
unique Nash equilibrium for this game is for both to confess.
 In fact, both players’ confessing is not only a Nash equilibrium; it is dominant strategy
equilibrium since each player has the same optimal (best) choice independent of the other.
 However, if they could both just hang tight, they would each be better off. In other words, if
they both could be sure that the other would hold out and both could agree to hold out
themselves, they would get a payoff of -1, which would make each of them better off.
 The strategy (deny, deny) is not only Pareto efficient but also Pareto Optimal because there is no
other strategy choice that makes both players better off or either of them without making the
other worse off. Thus, the strategy (confess, confess) is Pareto inefficient for both.
The problem is that there is no way for the two prisoners to coordinate their action. If each could
trust the other, they could both be made better off. This applies to a wide range of economic and
political phenomena. Consider, for example, the problem of arms control. Interpret “confess” as
“deploy a new missiles” and the strategy of “deny” as “don’t deploy”. Note that the payoffs are
reasonable. If my opponent deploys his missile, I certainly want to deploy. But if there is no way to
make a binding agreement not to deploy a missile, we each end up deploying the missile and are
both made worse off, which is Pareto inefficient for both of us. However, if there had been a strong
binding agreement that forces us not to deploy a missile or absolute trust among us, both would
have been better off by reducing the likely hood of human and physical capital loss and using the
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money in activities that will enhance economic growth and is not only Pareto efficient but also
Pareto optimal for both of us.
Another good example is the problem of cheating in a cartel. Now interpret confess a “produce more
than your quota” and interpret deny as “stick to the original quota”. If one firm (A) thinks the other
firm (B) is going to stick to its quota, it will pay to it to produce more than its quota. And if A thinks
that B will overproduce, then A might as well, too.
The concept of the prisoner’s dilemma can be used to analyze the incentive to cheat in a cartel
(i.e., the tendency to secretly cut prices or to sell more than the allocated quota). Consider the
following payoff matrix.
Firm B
Cheat Don’t cheat

Firm A Chea 2,2 5,1
t
Don’t cheat 1,5 3,3
Table 4.22 game of a cartel oligopoly
The two firms adopt the dominant strategy of cheating and earn a profit of 2 units each. But by
not cheating each member of the cartel would earn the higher profit of 3. The carter members
then face the prisoner’s dilemma. Only if cartel members do not cheat will each share the higher
cartel profit of 3. A carter can prevent or reduce the probability of cheating by monitoring the
sales of each member and punishing cheaters. However, the larger the cartel and the more
differentiated the product, the more difficult it is for the cartel to do this and prevent cheating.
The prisoner’s dilemma provoked controversy as to what is a reasonable way to play the game. The
answer seems to depend on whether you are playing a one-shot game or the game is to be repeated
an indefinite number of time.
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4.6 REPEATED GAMES

In the above section the players met only once and played the prisoner’s dilemma game a single
time. However the situation is different if the game is to be played repeatedly by the same
player. In this case there are new strategic possibilities open to each player. If the other player
chooses to defeat in one round, then you can choose to defeat on the next round. Thus your
opponent can be punished for the bad behavior. In a repeated game each player has the
opportunity to establish reputation for cooperation and thereby encourage the other player to do
the same. Whether this kind will be possible depends on whether the game is to be played for a
fixed number of times or an infinite number of times.
If the game has fixed number of rounds ( say 10) then each player will defeat on every round
because if there is no way to enforce cooperation on the last round (10 th round) there will be no
way to enforce cooperation on the next last round (9th) round and so on. Players cooperate
because they hope that cooperation will include further cooperation in the future.
On the other hand, if the game is going to be repeated for an infinite number of times, a player
has an option of influencing other player’s behavior. If the opponent refuses to cooperate this
time you can refuse to cooperate next time. As long as both players care enough about future
payoffs, the treat of non-cooperation may be sufficient to convince players to choose the optimal
strategy. Therefore the winning strategy – the one with the highest payoff is the tit for tat that is
to do whatever the last player did in the last round.
Tit for tat is a highly effective strategy in game theory for the iterated prisoner’s dilemma. Based
on the English saying meaning ‘equivalent retaliation’ (tit for tat) an agent using this strategy will
initially cooperate, and then respond in kind to an opponent’s previous action. If the opponent
previously was cooperative, the agent is cooperative. If not, the agent is not.
This strategy is dependent on four conditions that have allowed it to become the most prevalent
strategy for the prisoner’s dilemma:
 Unless provoked, the agent will always cooperate
 If provoked, the agent will retaliate
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 The agent is quick to forgive
 The agent must have a good chance of competing against the opponent more than
once
When a game is to be played repeatedly there may be a chance to retaliate defectors by adopting
a simple strategy that may prove to be remarkably effective at keeping potential defectors in
check. The strategy is called tit for tat and works as follows:
The first time intact with someone, you cooperate. In each subsequent interaction you simply do
what the other person did in the previous interaction. Thus if your partner defected on you in the
first interaction then you would then defect on the next interaction with him. If he then
cooperates your move next time will be cooperate as well.
By tit for tat strategy it is meant that do whatever your rival does on the last round. It holds in a
game where players move simultaneously (or play strategies at the same time). Each player has
to choose his strategy knowing only the incentives facing his opponent, not the actual choice of
strategy.
4.7 Sequential Game and Entry Deterrence

Sequential Game
Games where players choose actions in a particular sequence are sequential move games, here
one player get to move first and the other player responds. Example of such type games include
the stackelberg model of oligopoly, one firm sets output before the other does; an advertizing
decision by one firm and the response by its competitor; entry deterring investment by an
incumbent firm the decision whether to enter the market by the potential competitor; or a new
government regulator policy and the investment and output response of the regulated firms. Here
players must look ahead in order to know what action to choose now. Many sequential move
games have deadlines/ time limits on moves.
Example of sequential game
Player B
Left Right
Top 1,9 1,9
Player
Botto 0,0 2,1
A 78
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Table 4.23 Sequential game
Note that when the game is set in this form, it has two Nash equilibria; (top, left) and (bottom,
right). However one equilibria is not really reasonable. When sequential game represent the
possible moves in a decision tree we call it extensive form of a game.
(1,9)
Left
Top PB Right (1, 9)
PA Left (0, 0)
Bottom PB
Right (2, 1)
Figure 4.1 an extensive form of sequential game
The way to analyze this (sequential) game is the backward induction method. Suppose that
player A has already made his choice and we are sitting in one branch of the game tree. If player
A has chosen top, then it doesn’t matter what player B does, and the playoff is (1,9). If player A
has chosen bottom, then the sensible thing for player B to do is to choose right, and the payoff is
(2,1). Now think about player A’s initial choice. If he chooses top, the outcome will be (1,9) and
thus he will get a payoff of 1. But if chooses bottom, he gets a payoff of 2. So the sensible thing
for him to do is to choose bottom. Thus, the equilibrium choices will be (B, R) with the payoff
(2,1).
From B’s point of view this is rather unfortunate since he ends up with a payoff 1 rather than 9.
What might he do about it? He can threaten to play left (L) if player a plays bottom (B). If
player A thought that B would actually carry out this threat, he would be well advised to play top.
Because top gives him 1, while bottom- if B carries out his threat-will only give him 0. In this
case, however, the threat is not credible (or it is an empty threat).
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Entry Deterrence
Dear student, do you remember the sources of monopoly from our Microeconomics I? Good.
The sources of monopoly power and monopoly profits include economies of scale, patents and
licenses, ownership of strategic inputs, exclusive knowledge of a production technique and so on.
However, firms themselves can sometimes deter entry of potential competitors.
To deter entry the incumbent/existing firm must convince any potential competitor that entry will
be unprofitable. To see how this might be done, put yourself in the position of an incumbent
monopolist facing a prospective entrant, firm X. The entrant will decide whether or not to come
into the market and the incumbent will of course would like to induce firm X to stay out of the
industry so as to continue to charge a high price and enjoy monopoly profits. That is the potential
entrant’s strategies are to enter or to stay out while the incumbent’s strategies are either to
accommodate the entrant (maintain high price in the hope that the entrant will do the same) or to
wage warfare (charge low price to make entry unprofitable). The payoffs from such a game are
depicted in Table 4.24.
Potential entrant
Enter Stay out
Incumbent
High price 100, 20 200, 0
Low price 70, -10 130, 0
Table 4.24 entry
deterrence
If the incumbent want to be “accommodating”, and hence continue charging high price and allow
entry, it will earn only Br 100 million profits since it has to share the market with the new
entrant. But if it successfully manages to deter entry and maintain its higher price, then it gets Br
200 million. Alternatively, the incumbent can increase its production capacity, produce more, and
lower its price – engage itself in a price war. In this case if the new entrant decides to come in,
the entrant will face a loss of Br 10 million. Finally if firm X stays out but the incumbent expand
its capacity and lower price nonetheless, its net benefit will be Br 130 million. Certainly this last
choice would not make much sense.
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If firm X thinks the incumbent will be accommodating and maintain a high price after it has
entered, it will find it profitable to enter and will do so. Suppose the incumbent threaten to
expand output and start a price war in order to keep X out. If X takes the threat seriously, it will
not enter the market because it can expect to lose Br 10 million. The threat, however, is not
credible. As Table 4.17 shows (and the potential competitor knows), once entry has occurred, it
will be in the best interest of the incumbent to accommodate and maintain a high price. Firm X’s
rational move is to enter the market; and the outcome will be the upper left hand corner of the
matrix.
But what if the incumbent makes an irrevocable commitment that will alter its incentives once
entry occurs – a commitment that will give it little choice but to charge a low price if entry
occurs? Suppose it invested in the extra capacity needed to increase output and engage in
competitive warfare should entry occur.Of course, if the incumbent maintain a high price
(whether or not X enters), this added cost will reduce its payoff. The payoff matrix is now
changed as depicted in Table 4.25.
Potential entrant
Incumbent Enter Stay out

High price 50, 20 150, 0
Low price 70, -10 130, 0
Table 4.25 entry deterrence – credible threat
As a result of its decision to invest in additional capacity, the incumbent’s threat to engage in
competitive warfare is completely credible. Because it has already have the additional capacity
with which to wage war, it will do better in competitive warfare than it would by maintaining a
high price. Because the potential competitor now knows that entry will result in warfare, it is
rational for it to stay out of the market. Meanwhile, having deterred entry, it can maintain a high
price and earn a profit of Br 150 million.
Can an incumbent monopolist deter entry without making the costly move of installing
additional production capacity? Here a reputation for irrationality can bestow a strategic
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advantage. Suppose the incumbent firm has such a reputation. Suppose also that by means of
vicious price-cutting, this firm has eventually has driven out every entrant in the past, even
though it incurred losses in doing so. Its threat might then be credible: The incumbent’s
irrationality suggests to the potential competitor that it might be better off staying away.
Of course, if the game described above were to be indefinitely repeated, then the incumbent
might have a rational incentive to engage in warfare whenever entry actually occurs. Why?
Because short-term loses from warfare might be outweighed by long-term gains from preventing
entry. Understanding this, the potential competitor might find the incumbent’s threat of warfare
credible and decide to stay out. Now the incumbent relies on its reputation of being rational –
far-sighted - to provide the credibility needed to deter entry. The success of this strategy depends
on the time horizon and the relative gains and losses associated with accommodation and
warfare.
To conclude, the attractiveness of entry depends largely on the way incumbents can be expected
to react. In general, once entry has occurred, incumbents cannot be expected to maintain output
at their pre-entry levels. Eventually, they may back off and reduce output, raising price to a new
joint profit maximizing level. Because potential entrants know this, incumbent firms must create
a credible threat of warfare to deter entry. A reputation for irrationality can help. Indeed, this
seems to be the basis for much of the entry-preventing behavior that goes on in actual markets.
The potential entrant must consider that rational industry discipline can break down after entry
occurs. By fostering an image of irrationality and violence, an incumbent firm might convince
potential entrants that the risk of warfare is too high.
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Microeconomics (Haramaya University)

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Pure Monopoly Market

1.1 Definition and source of monopoly

Common characteristics of monopoly

Monopoly market structures share the following characteristics in common.

Sources of Monopoly Power

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3. Patents, Copyrights and Trademarks

4. Government Franchise and License

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1.2. The demand and revenue curves of the monopoly firm

Fig.1.1 the demand curve of the monopolist

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Fig: 1.2The relationship between MR and P.

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Suppose a monopolist’s demand curve is given by P = a – bQ

a. Total revenue function

b. Marginal revenue function and

c. Price elasticity at Q=24

Q = 48-2P  2P= 48 - Q P = 24-1/2Q

a. TR=P∗Q=(24−1/2Q )Q=24 Q−1/2 Q 2

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1.3. Monopoly supply in the short run

1.4. Short run and Long run Equilibrium of the monopolist

1.4.1. Short run and Long run Equilibrium

Figure 1.4: Short-run equilibrium of the monopolist

Revenue R = P x Q = area ofOQmGPm. andCost C = AC x Q = area of rectangle OQmHA.

Mathematically, the profit maximizing conditionsare same to perfect competitive market:

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At equilibrium MR=MC 40-2Q=2 →40=4Q → Q=10

dTR d 3952 Q−0. 476 Q 2

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= 80(3,914) – [2200+480(80) +20(80)2] = Br.144520.

1.4.2 Long – run Equilibrium under Monopoly

Fig 1.5 Long run Equilibrium of the Monopoly Firm

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1.5 The multi- plant monopolist

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1.6 Price Discrimination

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Necessary conditions for price discrimination

Degrees (types) of price discrimination

1.6.1 First degree price discrimination (Perfect price discrimination)

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1.6.2 Second degree price discrimination (block pricing)

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Graphically, block pricing can be explained as follows:

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1.6.3 Third degree price discrimination (multi-market price discrimination)

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Given MC = 100, Equilibrium occurs when MC = MR, i.e.

1.7 Social costs of monopoly: The dead weight loss

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Fig.1.7 the Dead Weight Loss of the Monopolist

2.1 Assumptions monopolistic Competitive

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