Jennifer Carlise

2301892036
LD23

SUB TOPICS

Monopolistic Competition

Monopolistic competition is a market in which firms can enter freely, each producing its own
brand or version of a differentiated product. Amarket structure which combines elements of
monopoly and competitive markets. Essentially a monopolistic competitive market is one
with freedom of entry and exit, but firms can differentiate their products. Therefore, they
have an inelastic demand curve and so they can set prices. However, because there is
freedom of entry, supernormal profits will encourage more firms to enter the market leading
to normal profits in the long term.

Efficiency of firms in monopolistic competition

• Allocative inefficient. The above diagrams show a price set above marginal cost
• Productive inefficiency. The above diagram shows a firm not producing on the lowest
point of AC curve
• Dynamic efficiency. This is possible as firms have profit to invest in research and
development.
• X-efficiency. This is possible as the firm does face competitive pressures to cut cost
and provide better products.

Examples of monopolistic competition

• Restaurants – restaurants compete on quality of food as much as price. Product
differentiation is a key element of the business. There are relatively low barriers to
entry in setting up a new restaurant.
• Hairdressers. A service which will give firms a reputation for the quality of their hair-
cutting.
• Clothing. Designer label clothes are about the brand and product differentiation
• TV programmes – globalisation has increased the diversity of tv programmes from
networks around the world. Consumers can choose between domestic channels but
also imports from other countries and new services, such as Netflix.

There are several potential disadvantages associated with monopolistic competition,

including:

1. Some differentiation does not create utility but generates unnecessary waste, such as
excess packaging. Advertising may also be considered wasteful, though most is
informative rather than persuasive.
2. As the diagram illustrates, assuming profit maximisation, there is allocative
inefficiency in both the long and short run. This is because price is above marginal cost
in both cases. In the long run the firm is less allocatively inefficient, but it is still
inefficient.
The makings of monopolistic competition

Differentiated Products

A firm can try to make its products different from those of its competitors in several ways:
physical aspects of the product, location from which the product is sold, intangible aspects of
the product, and perceptions of the product. Products that are distinctive in one of these
ways are called differentiated products.

Physical aspects of a product include all the phrases you hear in advertisements: unbreakable
bottle, nonstick surface, freezer-to-microwave, non-shrink, extra spicy, newly redesigned for
your comfort. The location of a firm can also create a difference between producers. For
example, a gas station located at a heavily travel intersection can probably sell more gas,
because more cars drive by that corner. A supplier to an automobile manufacturer may find
that it is an advantage to locate close to the car factory. Intangible aspects can differentiate
a product, too. Some intangible aspects may be promises like a guarantee of satisfaction or
money back, a reputation for high quality, services like free delivery, or offering a loan to
purchase the product. Finally, product differentiation may occur in the minds of buyers. For
example, many people could not tell the difference in taste between common varieties of
beer or cigarettes if they were blindfolded but, because of past habits and advertising, they
have strong preferences for certain brands. Advertising can play a role in shaping these
intangible preferences.

Perceived Demand for a Monopolistic Competitor

A monopolistically competitive firm perceives a demand for its goods that is an intermediate
case between monopoly and competition. Figure 1 offers a reminder that the demand curve
as faced by a perfectly competitive firm is perfectly elastic or flat, because the perfectly
competitive firm can sell any quantity it wishes at the prevailing market price. In contrast, the
demand curve, as faced by a monopolist, is the market demand curve, since a monopolist is
the only firm in the market, and hence is downward sloping.

The demand curve faced by a perfectly competitive firm is perfectly elastic, meaning it can
sell all the output it wishes at the prevailing market price. The demand curve faced by a
monopoly is the market demand. It can sell more output only by decreasing the price it
charges. The demand curve faced by a monopolistically competitive firm falls in between.

The demand curve as faced by a monopolistic competitor is not flat, but rather downward-
sloping, which means that the monopolistic competitor can raise its price without losing all
of its customers or lower the price and gain more customers. Since there are substitutes, the
demand curve facing a monopolistically competitive firm is more elastic than that of a
monopoly where there are no close substitutes. If a monopolist raises its price, some
consumers will choose not to purchase its product—but they will then need to buy a
completely different product. However, when a monopolistic competitor raises its price,
some consumers will choose not to purchase the product at all, but others will choose to buy
a similar product from another firm. If a monopolistic competitor raises its price, it will not
lose as many customers as would a perfectly competitive firm, but it will lose more customers
than would a monopoly that raised its prices. At a glance, the demand curves faced by a
monopoly and by a monopolistic competitor look similar—that is, they both slope down. But
the underlying economic meaning of these perceived demand curves is different, because a
monopolist faces the market demand curve and a monopolistic competitor does not. Rather,
a monopolistically competitive firm’s demand curve is but one of many firms that make up
the “before” market demand curve. Are you following? If so, how would you categorize the
market for golf balls? Take a swing, then see the following Clear It Up feature.

Pricing Power

The monopolistically competitive firm decides on its profit-maximizing quantity and price in
much the same way as a monopolist. A monopolistic competitor, like a monopolist, faces a
downward-sloping demand curve, and so it will choose some combination of price and
quantity along its perceived demand curve.

As an example of a profit-maximizing monopolistic competitor, consider the Authentic

Chinese Pizza store, which serves pizza with cheese, sweet and sour sauce, and your choice
of vegetables and meats. Although Authentic Chinese Pizza must compete against other pizza
businesses and restaurants, it has a differentiated product.
To maximize profits, the Authentic Chinese Pizza shop would choose a quantity where
marginal revenue equals marginal cost, or Q where MR = MC. Here it would choose a quantity
of 40 and a price of $16.

Determines How Much to Produce and at What Price

The process by which a monopolistic competitor chooses its profit-maximizing quantity and
price resembles closely how a monopoly makes these decisions process. First, the firm selects
the profit-maximizing quantity to produce. Then the firm decides what price to charge for
that quantity.

Step 1. The monopolistic competitor determines its profit-maximizing level of output. In this
case, the Authentic Chinese Pizza company will determine the profit-maximizing quantity to
produce by considering its marginal revenues and marginal costs. Two scenarios are possible:

• If the firm is producing at a quantity of output where marginal revenue exceeds

marginal cost, then the firm should keep expanding production, because each
marginal unit is adding to profit by bringing in more revenue than its cost. In this way,
the firm will produce up to the quantity where MR = MC.
• If the firm is producing at a quantity where marginal costs exceed marginal revenue,
then each marginal unit is costing more than the revenue it brings in, and the firm will
increase its profits by reducing the quantity of output until MR = MC.

In this example, MR and MC intersect at a quantity of 40, which is the profit-maximizing level
of output for the firm.

Step 2. The monopolistic competitor decides what price to charge. When the firm has
determined its profit-maximizing quantity of output, it can then look to its perceived demand
curve to find out what it can charge for that quantity of output. On the graph, this process
can be shown as a vertical line reaching up through the profit-maximizing quantity until it hits
the firm’s perceived demand curve. For Authentic Chinese Pizza, it should charge a price of
$16 per pizza for a quantity of 40.

Once the firm has chosen price and quantity, it’s in a position to calculate total revenue, total
cost, and profit. At a quantity of 40, the price of $16 lies above the average cost curve, so the
firm is making economic profits. From Table 1 we can see that, at an output of 40, the firm’s
total revenue is $640 and its total cost is $580, so profits are $60. In Figure 2, the firm’s total
revenues are the rectangle with the quantity of 40 on the horizontal axis and the price of $16
on the vertical axis. The firm’s total costs are the light shaded rectangle with the same
quantity of 40 on the horizontal axis but the average cost of $14.50 on the vertical axis. Profits
are total revenues minus total costs, which is the shaded area above the average cost curve.
Although the process by which a monopolistic competitor makes decisions about quantity
and price is similar to the way in which a monopolist makes such decisions, two differences
are worth remembering. First, although both a monopolist and a monopolistic competitor
face downward-sloping demand curves, the monopolist’s perceived demand curve is the
market demand curve, while the perceived demand curve for a monopolistic competitor is
based on the extent of its product differentiation and how many competitors it faces. Second,
a monopolist is surrounded by barriers to entry and need not fear entry, but a monopolistic
competitor who earns profits must expect the entry of firms with similar, but differentiated,
products.

Equilibrium in the short run and the long run

Equilibrium in the Short Run

The short-run equilibrium of a monopolistic competitive organization is the same as that of
an organization under monopoly. In the short run, an organization under monopolistic
competition attains its equilibrium where marginal revenue equals marginal cost and sets its
price according to its demand curve. This implies that in the short run, profits are maximized
when MR=MC.

In the picture, AR is the average revenue curve, MR represents the marginal revenue curve,
SAC curve denotes the short run average cost curve, while SMC signifies the short run
marginal cost. It can be seen that MR intersects SMC at output OM where price is OP’ (which
is equal to MP). This is because P is the, point on AR curve, which is price. From the picture
above, it can be interpreted from that the organization is earning supernormal profit.
Supernormal profit per unit of output is the difference between the average revenue and
average cost. Average revenue at equilibrium point is MP and average cost is MT. Therefore,
PT is the supernormal profit per unit of output. In the present case, supernormal profit would
be measured by the area of rectangle P’PTT’ (which is output multiplied by supernormal profit
per unit of output).

On the other hand, when marginal cost is greater than marginal revenue, organizations would
incur losses, as shown in picture below:

The picture shows the condition of losses in the short run under monopolistic competition.
Here, OP’ is smaller than MT, which implies that average revenue is smaller than average cost.
TP is representing the loss that has incurred per unit of output. Therefore total loss is depicted
from rectangle T’TPP’.

Equilibrium in Long Run:

In the preceding sections, we have discussed that in the short run, organizations can earn
supernormal profits. However, in the long run, there is a gradual decrease in the profits of
organizations. This is because in the long run, several new organizations enter the market due
to freedom of entry and exit under monopolistic competition. When these new organizations
start production the supply would increase and the prices would fall. This would automatically
increase the level of competition in the market. Consequently, AR curve shifts from right to
left and supernormal profits are replaced with normal profits.
In the long run, the AR curve is more elastic than that of in the short run. This is because of
an increase in the number of substitute products in the long- run. The long-run equilibrium of
monopolistically competitive organizations is achieved when average revenue is equal to
average cost. In such a case, organizations receive normal profits.
The picture below shows the long-run equilibrium position under monopolistic competition:

In the picture, P is the point at which AR curve touches the average cost curve (LAC) as a
tangent. P is regarded as the equilibrium point at which the price level is MP (which is also
equal to OF) and output is OM. In the present case average cost is equal to average revenue
that is MP. Therefore, in long run, the profit is normal. In the short run, equilibrium is attained
when marginal revenue is equal to marginal cost. However, in the long run, both the
conditions (MR=MC and AR=AC) must hold to attain equilibrium.

Monopolistic Competition and Efficiency

The long-term result of entry and exit in a perfectly competitive market is that all firms end
up selling at the price level determined by the lowest point on the average cost curve. This
outcome is why perfect competition displays productive efficiency: goods are being produced
at the lowest possible average cost. However, in monopolistic competition, the end result of
entry and exit is that firms end up with a price that lies on the downward-sloping portion of
the average cost curve, not at the very bottom of the AC curve. Thus, monopolistic
competition will not be productively efficient. In a perfectly competitive market, each firm
produces at a quantity where price is set equal to marginal cost, both in the short run and in
the long run. This outcome is why perfect competition displays allocative efficiency: the social
benefits of additional production, as measured by the marginal benefit, which is the same as
the price, equal the marginal costs to society of that production. In a monopolistically
competitive market, the rule for maximizing profit is to set MR = MC—and price is higher than
marginal revenue, not equal to it because the demand curve is downward sloping. When P >
MC, which is the outcome in a monopolistically competitive market, the benefits to society
of providing additional quantity, as measured by the price that people are willing to pay,
exceed the marginal costs to society of producing those units. A monopolistically competitive
firm does not produce more, which means that society loses the net benefit of those extra
units. This is the same argument we made about monopoly, but in this case to a lesser degree.
Thus, a monopolistically competitive industry will produce a lower quantity of a good and
charge a higher price for it than would a perfectly competitive industry.
Oligopoly competition

In oligopolistic markets, the products may or may not be differentiated. What matters is that
only a few firms account for most or all of total production. In some oligopolistic markets,
some or all firms earn substantial profits over the long run because barriers to entry make it
difficult or impossible for new firms to enter. Oligopoly is a prevalent form of market structure.
Examples of oligopolistic industries include automobiles, steel, aluminium, petrochemicals,
electrical equipment, and computers. Managing an oligopolistic firm is complicated because
pricing, output, advertising, and investment decisions involve important strategic
considerations. Because only a few firms are competing, each firm must carefully consider
how its actions will affect its rivals, and how its rivals are likely to react.

Suppose that because of sluggish car sales, Ford is considering a 10-percent price cut to
stimulate demand. It must think carefully about how competing auto companies will react.
They might not react at all, or they might cut their prices only slightly, in which case Ford
could enjoy a substantial increase in sales, largely at the expense of its competitors. Or they
might match Ford’s price cut, in which case all of the firms will sell more cars, but might make
much lower profits because of the lower prices. Another possibility is that some firms will cut
their prices by even more than Ford to punish Ford for rocking the boat, and this in turn might
lead to a price war and to a drastic fall in profits for the entire industry. Ford must carefully
weigh all these possibilities. In fact, for almost any major economic decision that a firm
makes—setting price, determining production levels, undertaking a major promotion
campaign, or investing in new production capacity—it must try to determine the most likely
response of its competitors. These strategic considerations can be complex. When making
decisions, each firm must weigh its competitors’ reactions, knowing that these competitors
will also weigh its reactions to their decisions. Furthermore, decisions, reactions, reactions to
reactions, and so forth are dynamic, evolving over time. When the managers of a firm
evaluate the potential consequences of their decisions, they must assume that their
competitors are as rational and intelligent as they are. Then, they must put themselves in
their competitors’ place and consider how they would react.

Equilibrium in an oligopolistic market

In oligopoly competition, a firm sets the selling price partly based on the behaviour of its
competing firms. When a market is in equilibrium, all firms are not changing their price or
output level. The decisions made by the firms are said to be in equilibrium if no one can
increase their income by one-sided action, given that the other firms does not alter their
decision. One of the main assumptions about the theory of economical equilibrium and
spatial price equilibrium is that the supply of products takes place in a totally competitive
market where no firm can obtain actual profit and, given the equilibrium prices, the quantity
produced is exactly equal to the quantity demanded. Nevertheless, this concept of perfectly
competitive markets is a bit unrealistic for most of markets such as oil and coal. This
assumption also ignores the existence of local monopolies, where a firm has certain power
over demand in a particular region, obtaining significant income this way. In the problem of
equilibrium in an oligopoly market, consider that there is a set F of firms (|F| finite) that try
to maximize their own individual profits. Each firm has knowledge about the demand and
tries to maximize its own profits, evaluating the strategy (production level) of other firms.
The Cournot Model

Cournot model is an oligopoly model in which firms produce a homogeneous good, each firm
treats the output of its competitors as fixed, and all firms decide simultaneously how much
to produce. A simple model of duopoly first introduced by the French economist Augustin
Cournot in 1838. Suppose the firms produce a homoge- neous good and know the market
demand curve. Each firm must decide how much to produce, and the two firms make their
decisions at the same time. When making its production decision, each firm takes its
competitor into account. It knows that its competitor is also deciding how much to produce,
and the market price will depend on the total output of both firms.

Reaction curve is a relationship between a firm’s profit-maximizing output and the amount it
thinks its competitor will produce. Cournot equilibrium is an Equilibrium in the Cournot model
in which each firm correctly assumes how much its competitor will produce and sets its own
production level accordingly. Note that this Cournot equilibrium is an example of a Nash
equilibrium (and thus it is sometimes called a Cournot-Nash equilibrium). Remember that in
a Nash equilibrium, each firm is doing the best it can given what its competitors are doing. As
a result, no firm would individually want to change its behaviour. In the Cournot equilibrium,
each firm is producing an amount that maximizes its profit given what its competitor is
producing, so neither would want to change its output.

Reaction Curve and Cournot Equilibrium

Firm 1’s reaction curve shows how much it will produce as a function of how much it thinks
Firm 2 will produce. Firm 2’s reaction curve shows its output as a function of how much it
thinks Firm 1 will produce. In Cournot equilibrium, each firm correctly assumes the amount
that its competitor will produce and thereby maximizes its own profits. Therefore, neither
firm will move from this equilibrium.
Duopoly example

The demand curve is P = 30 - Q, and both firms have zero marginal cost. In Cournot equilibrium,
each firm produces 10. The collusion curve shows combinations of Q1 and Q2 that maximize
total profits. If the firms collude and share profits equally, each will produce 7.5. Also shown
is the competitive equilibrium, in which price equals marginal cost and profit is zero.

Advantages of Cournot Competition

The model produces logical results, with prices and quantities that are between monopolistic
(i.e. low output, high price) and competitive (high output, low price) levels. It also yields a
stable Nash equilibrium, an outcome from which neither player would like to deviate
unilaterally. Some of the model’s assumptions may be somewhat unrealistic in the real world.
Firstly, the Cournot classic duopoly model assumes that the two players set their quantity
strategy independently of each other. This is unlikely to be the case in a practical sense. When
only two producers are in a market, they are likely to be highly responsive to each other’s
strategies rather than operating in a vacuum. Secondly, Cournot argues that a duopoly could
form a cartel and reap higher profits by colluding. But game theory shows that a cartel
arrangement would not be in equilibrium since each company would tend to deviate from
the agreed output—for proof, one need look no further than The Organization of the
Petroleum Exporting Countries (OPEC). Thirdly, the model's critics question how often
oligopolies compete on quantity rather than price. French scientist J. Bertrand in 1883
attempted to rectify this oversight by changing the strategic variable choice from quantity to
price. The suitability of price, rather than quantity, as the main variable in oligopoly models
was confirmed in subsequent research by a number of economists. Finally, the Cournot model
assumes product homogeneity with no differentiating factors. Cournot developed his model
after observing competition in a spring water duopoly.
First mover advantage – The Stackelberg Model

The Stackelberg Model is an oligopoly model in which one firm sets its output before other
firms do.The Stackelberg leadership model is a strategic game in economics in which the
leader firm moves first and then the follower firms move sequentially. It is named after the
German economist Heinrich Freiherr von Stackelberg who published Market Structure and
Equilibrium (Marktform und Gleichgewicht) in 1934 which described the model. First-mover
advantage refers to when firms get a higher payoff in which it is a leader than a follower. It
can be assumed that Marginal Cost is equal to zero, then firm A sets its output first and then
firm B will make an output decision based on firm A output.

Price competition

Price competition is one of many ways that a product or service can compete in the
marketplace. In price competition, two products which are substantially similar are judged by
prospective consumers on their respective pricing, with the purchase made mostly on the
basis of which is cheaper. There are different types of price competition, some of which are :

• Penetration pricing
• Predatory pricing
• Umbrella pricing
• Premium pricing
• Loss leader pricing

Price competition with homogeneous products – The Bertrand Model

It describes interactions among firms (sellers) that set prices and their customers (buyers)
that choose quantities at the prices set. The model was formulated in 1883 by Bertrand in a
review of Antoine Augustin Cournot's book Recherches sur les Principes Mathématiques de
la Théorie des Richesses (1838) in which Cournot had put forward the Cournot model.
Cournot argued that when firms choose quantities, the equilibrium outcome involves firms
pricing above marginal cost and hence the competitive price. In his review, Bertrand argued
that if firms chose prices rather than quantities, then the competitive outcome would occur
with price equal to marginal cost. The model rests on very specific assumptions. There are at
least two firms producing a homogeneous (undifferentiated) product and cannot cooperate
in any way. Firms compete by setting prices simultaneously and consumers want to buy
everything from a firm with a lower price (since the product is homogeneous and there are
no consumer search costs). If two firms charge the same price, consumers' demand is split
evenly between them. It is simplest to concentrate on the case of duopoly where there are
just two firms, although the results hold for any number of firms greater than one.

Price competition with differentiated products

Oligopolistic markets often have at least some degree of product differentiation. Market
shares are determined not just by prices, but also by differences in the design, performance,
and durability of each firm’s product. In such cases, it is natural for firms to compete by
choosing prices rather than quantities.
Example of Nash Equilibirum in Price :

Here two firms sell a differentiated product, and each firm’s demand depends both on its
own price and on its competitor’s price. The two firms choose their prices at the same time,
each taking its competitor’s price as given. Firm 1’s reaction curve gives its profit-maximizing
price as a function of the price that Firm 2 sets, and similarly for Firm 2. The Nash
equilibrium is at the intersection of the two reaction curves: When each firm charges a price
of $4, it is doing the best it can given its competitor’s price and has no incentive to change
price. Also shown is the collusive equilibrium: If the firms cooperatively set price, they will
choose $6. The Nash equilibrium is at the point where the two reaction curves cross; you
can verify that each firm is then charging a price of $4 and earning a profit of $12. At this
point, because each firm is doing the best it can given the price its competitor has set,
neither firm has an incentive to change its price. Now suppose the two firms collude:
Instead of choosing their prices independently, they both decide to charge the same price—
namely, the price that maximizes both of their profits. You can verify that the firms would
then charge $6, and that they would be better off colluding because each would now earn a
profit of $16. Finally, suppose Firm 1 sets its price first and that, after observing Firm 1’s
decision, Firm 2 makes its pricing decision. Unlike the Stackelberg model in which the firms
set their quantities, in this case Firm 1 would be at a distinct disadvantage by moving first.
(To see this, calculate Firm 1’s profit-maximizing price, taking Firm 2’s reaction curve into
account.) Why is moving first now a disadvantage? Because it gives the firm that moves
second an opportunity to undercut slightly and thereby capture a larger market share.

Competition versus collusion: the prisoners’dilemma

Noncooperative game : Game in which negotiation and enforcement of binding contracts are
not possible. Payoff matrix: Table showing profit (or payoff) to each firm given its decision
and the decision of its competitor. Prisoners’ dilemma : game theory example in which two
prisoners have been accused of collaborating in a crime. They are in separate jail cells and
cannot communicate with each other. Each has been asked to confess. If both prisoners
confess, each will receive a prison term of five years. If neither confesses, the prosecution’s
case will be difficult to make, so the prisoners can expect to plea bargain and receive terms
of two years. On the other hand, if one prisoner confesses and the other does not, the one
who confesses will receive a term of only one year, while the other will go to prison for 10
years. If you were one of these prisoners, what would you do—confess or not confess? If they
could both agree not to confess (in a way that would be binding), then each would go to jail
for only two years. But they can’t talk to each other, and even if they could, can they trust
each other? If Prisoner A does not confess, he risks being taken advantage of by his former
accomplice. After all, no matter what Prisoner A does, Prisoner B comes out ahead by
confessing. Likewise, Prisoner A always comes out ahead by confessing, so Prisoner B must
worry that by not confessing, she will be taken advantage of. Therefore, both prisoners will
probably confess and go to jail for five years. The problem is that your competitor probably
won’t choose to set price at the collusive level. Why not? Because your competitor would do
better by choosing a lower price, even if it knew that you were going to set price at the
collusive level. Oligopolistic firms often find themselves in a prisoners’ dilemma. They must
decide whether to compete aggressively, attempting to capture a larger share of the market
at their competitor’s expense, or to “cooperate” and compete more passively, coexisting with
their competitors and settling for their current market share, and perhaps even implicitly
colluding. If the firms compete passively, setting high prices and limiting output, they will
make higher profits than if they compete aggressively. Like our prisoners, however, each firm
has an incentive to “fink” and under- cut its competitors, and each knows that its competitors
have the same incentive. As desirable as cooperation is, each firm worries—with good
reason—that if it competes passively, its competitor might decide to compete aggressively
and seize the lion’s share of the market. Both firms do better by “cooperating” and charging
a high price. But the firms are in a prisoners’ dilemma, where neither can trust its competitor
to set a high price.

Implications of the prisoners’ dilemma for oligopolistic pricing

The laws of supply and demand hold that demand for a good falls as the price rises, as well
prices rise when demand increases, and vice versa. Either way, most goods and services are
expected to respond to the laws of demand and supply. However, with certain goods and
services, this does not always happen due to price rigidity. Price stickiness rigidity is the
resistance of market price(s) to change quickly despite changes in the broad economy that
suggest a different price is optimal. "Sticky" or rigidity is a general economics term that can
apply to any financial variable that is resistant to change. When applied to prices, it means
that the prices charged for certain goods are reluctant to change despite changes in input
cost or demand patterns. Price rigidity would occur, for instance, if the price of a once-in-
demand smartphone remains high at say $800 even when demand drops significantly. Price
rigidity can also be related to wage stickiness. Price rigidity, or sticky prices, refers to the
tendency of prices to remain constant or to adjust slowly despite changes in the cost of
producing and selling the goods or services. This rigidity means that changes in the money
supply have an impact on the real economy, inducing changes in investment, employment,
output, and consumption.

When prices cannot adjust immediately to changes in economic conditions or in the

aggregate price level, there is an inefficiency in the market—that is, a market disequilibrium.
The presence of price stickiness is an important part of macroeconomic theory since it can
explain why markets might not reach equilibrium in the short run or even, possibly, the long
run. A kinked demand curve occurs when the demand curve is not a straight line but has a
different elasticity for higher and lower prices.
One example of a kinked demand curve is the model for an oligopoly. This model of oligopoly
suggests that prices are rigid and that firms will face different effects for both increasing price
or decreasing price. The kink in the demand curve occurs because rival firms will behave
differently to price cuts and price increases. The point of kinked demand curve is that a few
firms dominate the industry and firms wish to maximize profits. An example of a kinked
demand, one possibility is the market for petrol. It is homogenous and consumers are price
sensitive. If one petrol station increased the price there would be a shift to other petrol
stations. However, if one petrol station cuts price, other firms may feel obliged to follow suit
and also cut price – therefore a price cut would be self-defeating for the first firm.

Cartel

• Producers in a cartel explicitly agree to cooperate in setting prices and output levels.
• Cartels are often international

Conditions for Cartel Success

Why do some cartels succeed while others fail? There are two conditions for cartel success.
First, a stable cartel organization must be formed whose members agree on price and
production levels and then adhere to that agreement. Unlike our prisoners in the prisoners’
dilemma, cartel members can talk to each other to formalize an agreement. This does not
mean, however, that agreeing is easy. Different members may have different costs, different
assessments of market demand, and even different objectives, and they may therefore want
to set price at different levels. Furthermore, each member of the cartel will be tempted to
“cheat” by lowering its price slightly to capture a larger market share than it was allotted.
Most of- ten, only the threat of a long-term return to competitive prices deters cheating of
this sort. But if the profits from cartelization are large enough, that threat may be sufficient.

The second condition is the potential for monopoly power. Even if a cartel can solve its
organizational problems, there will be little room to raise price if it faces a highly elastic
demand curve. Potential monopoly power may be the most important condition for success;
if the potential gains from cooperation are large, cartel members will have more incentive to
solve their organizational problems.

Analysis of cartel pricing

Cartel pricing can thus be analyzed by using the dominant firm model discussed earlier. We
will apply this model to two cartels, the OPEC oil car- tel and the CIPEC copper cartel.13 This
will help us understand why OPEC was successful in raising price while CIPEC was not.

Analyzing OPEC
Total demand TD is the total world demand curve for crude oil, and Sc is the competitive (non-
OPEC) supply curve. The demand for OPEC oil DOPEC is the difference be- tween total demand
and competitive supply, and MROPEC is the corresponding marginal revenue curve. MCOPEC
is OPEC’s marginal cost curve; as you can see, OPEC has much lower production costs than do
non-OPEC producers. OPEC’s marginal revenue and marginal cost are equal at quantity
QOPEC, which is the quantity that OPEC will produce. We see from OPEC’s demand curve that
the price will be P*, at which competitive supply is Qc.

Analyzing CIPEC
CIPEC, which consists of four copper-producing countries: Chile, Peru, Zambia, and Congo
(formerly Zaire), that collectively account for less than half of world cop- per production. In
these countries, production costs are lower than those of non-CIPEC producers, but except
for Chile, not much lower. CIPEC’s marginal cost curve is therefore drawn only a little below
the non- CIPEC supply curve. CIPEC’s demand curve DCIPEC is the difference between total
demand TD and non-CIPEC supply Sc. CIPEC’s marginal cost and marginal revenue curves
intersect at quantity QCIPEC, with the corresponding price P*. Again, the competitive price
Pc is found at the point where CIPEC’s demand curve intersects its marginal cost curve. Note
that this price is very close to the cartel price P*.

As the examples of OPEC and CIPEC illustrate, successful cartelization re- quires two things.
First, the total demand for the good must not be very price elastic. Second, either the cartel
must control nearly all the world’s supply or, if it does not, the supply of noncartel producers
must not be price elastic. Most international commodity cartels have failed because few
world markets meet both conditions.

EXERCISES:
1. Consider two firms facing the demand curve P = 50 - 5Q, where Q = Q1 + Q2. The firms’
cost functions are C1(Q1) = 20 + 10Q1 and C2(Q2) = 10 + 12Q2.

a. Suppose both firms have entered the industry. What is the joint profit-maximizing level
of output? How much will each firm produce? How would your answer change if the firms
have not yet entered the industry?

b. What is each firm’s equilibrium output and profit if they behave noncooperatively? Use
the Cournot model. Draw the firms’ reaction curves and show the equilibrium.

c. How much should Firm 1 be willing to pay to purchase Firm 2 if collusion is illegal but a
takeover is not?

a)

If the firms collude, they face the market demand curve, so their marginal revenue curve is:
MR = 50 − 10Q.
Set marginal revenue equal to marginal cost (the marginal cost of Firm 1, since it is lower than
that of Firm 2) to determine the profit-maximizing quantity, Q:
50 − 10Q = 10, or Q = 4.
Substituting Q = 4 into the demand function to determine price:
 P = 50 − 5(4) = $30.
The question now is how the firms will divide the total output of 4 among themselves. The
joint profit-maximizing solution is for Firm 1 to produce all of the output because its marginal
cost is less than Firm 2’s marginal cost. We can ignore fixed costs because both firms are
already in the market and will be saddled with their fixed costs no matter how many units
each produces. If Firm 1 produces all 4 units, its profit will be
1 = (30)(4) − (20 + (10)(4)) = $60.
The profit for Firm 2 will be:
2 = (30)(0) − (10 + (12)(0)) = −$10.
Total industry profit will be:
T = 1 + 2 = 60 − 10 = $50.
Firm 2, of course, will not like this. One solution is for Firm 1 to pay Firm 2 $35 so that both
earn a profit of $25, although they may well disagree about the amount to be paid. If they
split the output evenly between them, so that each firm produces 2 units, then total profit
would be $46 ($20 for Firm 1 and $26 for Firm 2). This does not maximize total profit, but
Firm 2 would prefer it to the $25 it gets from an even split of the maximum $50 profit. So
there is no clear-cut answer to this question.
If Firm 1 were the only entrant, its profits would be $60 and Firm 2’s would be 0.
If Firm 2 were the only entrant, then it would equate marginal revenue with its marginal cost
to determine its profit-maximizing quantity:
50 − 10Q2 = 12, or Q2 = 3.8.
Substituting Q2 into the demand equation to determine price:
P = 50 − 5(3.8) = $31.
The profits for Firm 2 would be:
2 = (31)(3.8) − (10 + (12)(3.8)) = $62.20,
and Firm 1 would earn 0. Thus, Firm 2 would make a larger profit than Firm 1 if it were the
only firm in the market, because Firm 2 has lower fixed costs.

b)

In the Cournot model, Firm 1 takes Firm 2’s output as given and maximizes profits. Firm 1’s
profit function is
 1 = (50 − 5Q1 − 5Q2 )Q1 − (20 + 10Q1 ), or
 1 = 40Q1 − 5Q12 − 5Q1Q2 − 20.
Setting the derivative of the profit function with respect to Q1 to zero, we find Firm 1’s
reaction function:
  1 Q 
= 40 − 10Q1 − 5Q2 = 0, or Q1 = 4 −  2  .
 Q1  2 

Similarly, Firm 2’s reaction function is Q2 = 3.8 − 

Q1 
.
 2 

To find the Cournot equilibrium, substitute Firm 2’s reaction function into Firm 1’s reaction
function:
 1  Q 
Q1 = 4 −   3.8 − 1  , or Q1 = 2.8.
 2  2 
Substituting this value for Q1 into the reaction function for Firm 2, we find
Q2 = 2.4.
Substituting the values for Q1 and Q2 into the demand function to determine the equilibrium
price:
P = 50 − 5(2.8 + 2.4) = $24.
The profits for Firms 1 and 2 are equal to
1 = (24)(2.8) − (20 + (10)(2.8)) = $19.20, and
2 = (24)(2.4) − (10 + (12)(2.4)) = $18.80.
The firms’ reaction curves and the Cournot equilibrium are shown below.

c) To determine how much Firm 1 will be willing to pay to purchase Firm 2, we must compare
Firm 1’s profits in the monopoly situation versus it profits in an oligopoly. The difference
between the two will be what Firm 1 is willing to pay for Firm 2.

From part a, Firm 1’s profit when it sets marginal revenue equal to its marginal cost is $60.
This is what the firm would earn if it was a monopolist. From part b, profit is $19.20 for Firm
1 when the firms compete against each other in a Cournot-type market. Firm 1 should
therefore be willing to pay up to $60 - 19.20 = $40.80 for Firm 2.
2. A monopolist can produce at a constant average (and marginal) cost of AC = MC = $5. It
faces a market demand curve given by Q = 53 - P.

a. Calculate the profit-maximizing price and quantity for this monopolist. Also calculate its
profits.

b. Suppose a second firm enters the market. Let Q1 be the output of the first firm and Q2
be the output of the second. Market demand is now given by Q1 + Q2 = 53 - P.

Assuming that this second firm has the same costs as the first, write the profits of each firm
as functions of Q1 and Q2.

c. Suppose (as in the Cournot model) that each firm chooses its profit-maximizing level of
output on the assumption that its competitor’s output is fixed. Find each firm’s “reaction
curve” (i.e., the rule that gives its desired output in terms of its competitor’s output).

d. Calculate the Cournot equilibrium (i.e., the values of Q1 and Q2 for which each firm is
doing as well as it can given its competitor’s output). What are the resulting market price
and profits of each firm?

e. Suppose there are N firms in the industry, all with the same constant marginal cost, MC
= $5. Find the Cournot equilibrium. How much will each firm produce, what will be the
market price, and how much profit will each firm earn? Also, show that as N becomes large,
the market price approaches the price that would prevail under perfect competition.

a)

First solve for the inverse demand curve, P = 53 - Q. Then the marginal revenue curve has
the same intercept and twice the slope:
MR = 53 − 2Q.
Marginal cost is a constant $5. Setting MR MC, find the optimal quantity:
53 − 2Q = 5, or Q = 24.
Substitute Q 24 into the demand function to find price:
P = 53 − 24 = $29.
Assuming fixed costs are zero, profits are equal to

 = TR − TC = (29)(24) − (5)(24) = $57

b)

When the second firm enters, price can be written as a function of the output of both firms:
P = 53 - Q1 - Q2. We may write the profit functions for the two firms:
 1 = PQ1 − C (Q1 ) = (53 − Q1 − Q2 )Q1 − 5Q1 , or  1 = 48Q1 − Q12 − Q1Q2
and
 2 = PQ2 − C (Q2 ) = (53 − Q1 − Q2 )Q2 − 5Q2 , or  2 = 48Q2 − Q22 − Q1Q2 .

c) Under the Cournot assumption, each firm treats the output of the other firm as a constant
in its maximization calculations. Therefore, Firm 1 chooses Q1 to maximize 1 in part b with
Q2 being treated as a constant. The change in 1 with respect to a change in Q1 is

 1 Q
= 48 − 2Q1 − Q2 = 0, or Q1 = 24 − 2 .
 Q1 2
This equation is the reaction function for Firm 1, which generates the profit- maximizing
level of output, given the output of Firm 2. Because the problem is symmetric, the reaction
function for Firm 2 is
Q1
Q2 = 24 − .
2
d) Solve for the values of Q1 and Q2 that satisfy both reaction functions by substituting Firm
2’s reaction function into the function for Firm 1:
 1  Q 
Q1 = 24 −   24 − 1  , or Q1 = 16.
 2  2 
By symmetry, Q2 = 16.
To determine the price, substitute Q1 and Q2 into the demand equation:
P = 53 − 16 − 16 = $21.
Profit for Firm 1 is therefore
i = PQi − C(Qi) = i = (21)(16) − (5)(16) = $256.
Firm 2’s profit is the same, so total industry profit is 1 + 2 = $256 + $256 = $512.

e) If there are N identical firms, then the price in the market will be
P = 53 − (Q1 + Q2 + + QN ).
Profits for the ith firm are given by
 i = PQi − C (Qi ),
 i = 53Qi − Q1Qi − Q2Qi − − Qi2 − − QN Qi − 5Qi .
Differentiating to obtain the necessary first-order condition for profit maximization,
 i
= 53 − Q1 − Q2 − − 2Qi − − QN − 5 = 0 .
 Qi
Solving for Qi,
1
Qi = 24 − (Q1 + + Qi −1 + Qi +1 + + QN ).
2
If all firms face the same costs, they will all produce the same level of output, i.e., Qi = Q*.
Therefore,
1
Q* = 24 − ( N − 1)Q*, or 2Q* = 48 − ( N − 1)Q*, or
2
48
( N + 1)Q* = 48, or Q* = .
( N + 1)

Now substitute Q = NQ* for total output in the demand function:

 48 
P = 53 − N  .
 N +1
Total profits are
T = PQ − C(Q) = P(NQ*) − 5(NQ*)
or
  48    48   48 
 T = 53 − N   (N )   − 5N   or
 N +1 
 N +1
  N +1  
  48    48 
 T =  48 − ( N )   ( N )  
  N + 1   N +1
or
 N +1− N   N   N 
 T = (48)   (48)   = (2, 304)  
 N +1   N +1  ( N + 1) 
Notice that with N firms
 N 
Q = 48  
 N +1
and that, as N increases (N → )
Q = 48.
Similarly, with
 N 
P = 53 − 48  ,
 N +1
as N → ,
P = 53 − 48 = 5.
Finally,
 N 
 T = 2,304  2 
,
 ( N + 1) 
so as N → ,
T = $0.
In perfect competition, we know that profits are zero and price equals marginal cost. Here,
T = $0 and P = MC = 5. Thus, when N approaches infinity, this market approaches a
perfectly competitive one.

3. Two firms compete in selling identical widgets. They choose their output levels Q1 and
Q2 simultaneously and face the demand curve
P = 30 - Q
where Q = Q1 + Q2. Until recently, both firms had zero marginal costs. Recent
environmental regulations have increased Firm 2’s marginal cost to $15. Firm 1’s
marginal cost remains constant at zero. True or false: As a result, the market price will
rise to the monopoly level.

Surprisingly, this is true. However, it occurs only because the marginal cost for Firm 2 is $15
or more. If the market were monopolized before the environmental regulations, the
marginal revenue for the monopolist would be
MR = 30 − 2Q.
Profit maximization implies MR = MC, or 30 - 2Q = 0. Therefore, Q = 15, and (using the
demand curve) P = $15.
The situation after the environmental regulations is a Cournot game where Firm 1’s marginal
costs are zero and Firm 2’s marginal costs are $15. We need to find the best response
functions:
Firm 1’s revenue is
PQ1 = (30 − Q1 − Q2 )Q1 = 30Q1 − Q12 − Q1Q2 ,
and its marginal revenue is given by:
MR1 = 30 − 2Q1 − Q2 .
Profit maximization implies MR1 = MC1 or
Q2
30 − 2Q1 − Q2 = 0  Q1 = 15 − ,
2
which is Firm 1’s best response function.
Firm 2’s revenue function is symmetric to that of Firm 1 and hence
MR2 = 30 − Q1 − 2Q2 .
 Profit maximization implies MR2 = MC2, or
Q1
30 − 2Q2 − Q1 = 15  Q2 = 7.5 − ,
2
which is Firm 2’s best response function.
Cournot equilibrium occurs at the intersection of the best response functions. Substituting
for Q1 in the response function for Firm 2 yields:
 Q 
Q2 = 7.5 − 0.5 15 − 2 .
 2 
Thus Q2 = 0 and Q1 = 15. P = 30 − Q1 − Q2 = $15, which is the monopoly price.

4. Suppose the airline industry consisted of only two firms: American and Texas Air Corp.
Let the two firms have identical cost functions, C(q) = 40q. Assume the demand curve for
the industry is given by P = 100 - Q and that each firm expects the other to behave as a
Cournot competitor.

a. Calculate the Cournot-Nash equilibrium for each firm, assuming that each chooses the
output level that maximizes its profits when taking its rival’s output as given. What are
the profits of each firm?

b. What would be the equilibrium quantity if Texas Air had constant marginal and average
costs of $25 and American had constant marginal and average costs of $40?

c. Assuming that both firms have the original cost function, C(q) = 40q, how much should
Texas Air be willing to invest to lower its marginal cost from 40 to 25, assuming that
American will not follow suit? How much should American be willing to spend to reduce

its marginal cost to 25, assuming that Texas Air will have marginal costs of 25 regardless of
American’s actions?

a)
First, find the reaction function for each firm; then solve for price, quantity, and profit. Profit
for Texas Air, 1 , is equal to total revenue minus total cost:
 1 = (100 − Q1 − Q2 )Q1 − 40Q1 , or
 1 = 100Q1 − Q12 − Q1Q2 − 40Q1 , or  1 = 60Q1 − Q12 − Q1Q2 .
The change in 1 with respect to Q1 is
 1
= 60 − 2Q1 − Q2 .
 Q1
Setting the derivative to zero and solving for Q1 gives Texas Air’s reaction function:
Q1 = 30 − 0.5Q2.
Because American has the same cost structure, American’s reaction function is
Q2 = 30 − 0.5Q1.
Substituting for Q2 in the reaction function for Texas Air,
Q1 = 30 − 0.5(30 − 0.5Q1), or Q1 = 20.
By symmetry, Q2 = 20. Industry output, QT , is Q1 plus Q2, or
QT = 20 + 20 = 40.
Substituting industry output into the demand equation, we find P = $60. Substituting Q1, Q2,
and P into the profit function, we find
1 = 2 = 60(20) − 202 − (20)(20) = $400.

b)
By solving for the reaction functions under this new cost structure, we find that profit for
Texas Air is equal to
 1 = 100Q1 − Q12 − Q1Q2 − 25Q1 = 75Q1 − Q12 − Q1Q2 .
The change in profit with respect to Q1 is
 1
= 75 − 2Q1 − Q2 .
 Q1
Set the derivative to zero, and solve for Q1 in terms of Q2,
Q1 = 37.5 − 0.5Q2.
This is Texas Air’s reaction function. Since American has the same cost structure as in part a,
American’s reaction function is the same as before:
Q2 = 30 − 0.5Q1.
To determine Q1, substitute for Q2 in the reaction function for Texas Air and solve for Q1:
Q1 = 37.5 − (0.5)(30 − 0.5Q1), so Q1 = 30.
Texas Air finds it profitable to increase output in response to a decline in its cost structure.
To determine Q2, substitute for Q1 in the reaction function for American:
Q2 = 30 − (0.5)(30) = 15.
American has cut back slightly in its output in response to the increase in output by Texas
Air.
Total quantity, QT, is Q1 = Q2, or
QT = 30 + 15 = 45.
Compared to part a, the equilibrium quantity has risen slightly.

c)
Recall that profits for both firms were $400 under the original cost structure. With constant
average and marginal costs of $25, we determined in part b that Texas Air would produce
30 units and American 15. Industry price would then be P = 100 − 30 − 15 = $55. Texas Air’s
profits would be
(55)(30) − (25)(30) = $900.
The difference in profit is $500. Therefore, Texas Air should be willing to invest up to $500 to
lower costs from 40 to 25 per unit (assuming American does not follow suit).
To determine how much American would be willing to spend to reduce its average costs,
calculate the difference in American’s profits, assuming Texas Air’s average cost is $25.
First, without investment, American’s profits would be:
(55)(15) − (40)(15) = $225.
Second, with investment by both firms, the reaction functions would be:
Q1 = 37.5 − 0.5Q2 and
Q2 = 37.5 − 0.5Q1.
To determine Q1, substitute for Q2 in the first reaction function and solve for Q1:
Q1 = 37.5 − (0.5)(37.5 − 0.5Q1), which implies Q1 = 25.
Since the firms are symmetric, Q2 is also 25.
Substituting industry output into the demand equation to determine price:
P = 100 − 50 = $50.
Therefore, American’s profits when both firms have MC = AC = 25 are
2 = (50)(25) − (25)(25) = $625.
The difference in profit with and without the cost-saving investment for American is $400.
American would be willing to invest up to $400 to reduce its marginal cost to 25 if Texas Air
also has marginal costs of 25.

5. The dominant firm model can help us understand the behavior of some cartels. Let’s
apply this model to the OPEC oil cartel. We will use isoelastic curves to describe world
demand W and noncartel (competitive) supply S. Reasonable numbers for the price
elasticities of world demand and noncartel supply are -1/2 and 1/2, respectively. Then,
expressing W and S in millions of barrels per day (mb/d), we could write

W = 160 P-1/2 and S = 31/3 P1/2

Note that OPEC’s net demand is D = W - S.

a. Draw the world demand curve W, the non-OPEC supply curve S, OPEC’s net demand
curve D, and OPEC’s marginal revenue curve. For purposes of approximation, assume
OPEC’s production cost is zero. Indicate OPEC’s optimal price, OPEC’s optimal production,
and non-OPEC production on the diagram. Now, show on the diagram how the various
curves will shift and how OPEC’s optimal price will change if non-OPEC supply becomes
more expensive because reserves of oil start running out.
b. Calculate OPEC’s optimal (profit-maximizing) price. (Hint: Because OPEC’s cost is zero,
just write the expression for OPEC revenue and find the price that maximizes it.)

c. Suppose the oil-consuming countries were to unite and form a “buyers’ cartel” to gain
monopsony power. What can we say, and what can’t we say, about the impact this action
would have on price?

1
a) OPEC’s initial net demand curve is D = 160P −1/ 2 − 3 P1/ 2 . Marginal revenue is quite difficult
3
to find. If you were going to determine it analytically, you would have to solve OPEC’s net
demand curve for P. Then take that expression and multiply by Q (=D) to get total revenue as
a function of output. Finally, you would take the derivative of revenue with respect to Q. The
MR curve would look approximately like that shown in the figure below.
OPEC’s optimal production, Q*, occurs where MR = 0 (since production cost is assumed to be
zero), and OPEC’s optimal price, P*, is found from the net demand curve at Q*. Non-OPEC
production, QN, can be read off the non-OPEC supply curve, S, at price P*.

Now, if non-OPEC oil becomes more expensive, the supply curve S shifts to S. This shifts
OPEC’s net demand curve outward from D to D , which in turn creates a new marginal
revenue curve, MR, and a new optimal OPEC production level of Q, yielding a new higher
price of P . At this new price, non-OPEC production is QN. The new S, D, and MR curves are
dashed lines. Unfortunately, the diagram is difficult to sort out, but OPEC’s new optimal
output has increased to around 30, non-OPEC supply has dropped to about 10, and the
optimal price has increased slightly.

b)
Since costs are zero, OPEC will choose a price that maximizes total revenue:
 Max  = PQ = P (W − S )
 1  1
 = P 160P −1/ 2 − 3 P1/ 2  = 160P1/ 2 − 3 P 3/ 2 .
 3  3
To determine the profit-maximizing price, take the derivative of profit with respect to price
and set it equal to zero:
  1  3 
= 80 P −1/ 2 −  3   P1/ 2 = 80 P −1/ 2 − 5P1/ 2 = 0.
P  3  2 
Solving for P,
80
5P1/ 2 = , or P = $16.
P1/ 2
At this price, W = 40, S = 13.33, and D = 26.67 as shown in the first diagram.

c) If the oil-consuming countries unite to form a buyers’ cartel, then we have a monopoly
(OPEC) facing a monopsony (the buyers’ cartel). As a result, there are no well-defined demand
or supply curves. We expect that the price will fall below the monopoly price when the buyers
also collude, because monopsony power offsets some monopoly power. However, economic
theory cannot determine the exact price that results from this bilateral monopoly because
the price depends on the bargaining skills of the two parties, as well as on other factors such
as the elasticities of supply and demand.

6. Suppose the market for tennis shoes has one dominant firm and five fringe firms. The
market demand is Q = 400 - 2P. The dominant firm has a constant marginal cost of 20. The
fringe firms each have a marginal cost of MC = 20 + 5q.

a. Verify that the total supply curve for the five fringe firms is Qf = P - 20

b. Find the dominant firm’s demand curve.

c. Find the profit-maximizing quantity produced and price charged by the dominant firm,
and the quantity produced and price charged by each of the fringe firms.

d. Suppose there are ten fringe firms instead of five. How does this change your results?

e. Suppose there continue to be five fringe firms but that each manages to reduce its
marginal cost to MC = 20 + 2q. How does this change your results?

a) The total supply curve for the five firms is found by horizontally summing the five marginal
cost curves, or in other words, adding up the quantity supplied by each firm for any given
price. Rewrite each fringe firm’s marginal cost curve as follows:
 MC = 20 + 5q = P
5q = P − 20
P
q= −4
5
Since each firm is identical, the supply curve is five times the supply of one firm for any given
price:
P 
Q f = 5  − 4  = P − 20.
 5 

b) The dominant firm’s demand curve is given by the difference between the market demand
and the fringe total supply curve:
QD = 400 − 2 P − ( P − 20) = 420 − 3P.

c) The dominant firm will set marginal revenue equal to marginal cost. The marginal revenue
curve has the same intercept and twice the slope of the linear inverse demand curve, which
is shown below:
QD = 420 − 3P
1
P = 140 − QD
3
2
MR = 140 − QD .
3
Now set marginal revenue equal to marginal cost to find the profit-maximizing quantity for
the dominant firm, and the price charged by the dominant firm:
2
MR = 140 − QD = 20 = MC
3
QD = 180, and P = $80.
Each fringe firm will charge the same $80 price as the dominant firm, and the total output
produced by the five fringe firms will be Q f = P − 20 = 60. Each fringe firm will therefore
produce 12 units.

d) We need to find the new fringe supply curve, dominant firm demand curve, and dominant
firm marginal revenue curve as above. The new total fringe supply curve is Q f = 2P − 40. The
new dominant firm demand curve is QD = 440 − 4P. The new dominant firm marginal revenue
Q
curve is MR = 110 − . The dominant firm will produce where marginal revenue is equal to
2
marginal cost which occurs at 180 units. Substituting a quantity of 180 into the demand curve
faced by the dominant firm results in a price of $65. Substituting the price of $65 into the
total fringe supply curve results in a total fringe quantity supplied of 90, so that each fringe
firm will produce 9 units. Increasing the number of fringe firms reduces market price from
$80 to $65, increases total market output from 240 to 270 units, and reduces the market
share of the dominant firm from 75% to 67% (although the dominant firm continues to sell
180 units).
e)
Follow the same method as in earlier parts of this problem. Rewrite the fringe marginal cost
curve as
P
q= − 10.
2
The new total fringe supply curve is five times the individual fringe supply curve, which is also
the fringe marginal cost curve:
5
Qf = P − 50.
2
The new dominant firm demand curve is found by subtracting the fringe supply curve from
the market demand curve to get QD = 450 − 4.5P.
The new inverse demand curve for the dominant firm is therefore,
Q
P = 100 − .
4.5
The dominant firm’s new marginal revenue curve is
2Q
MR = 100 − .
4.5
Set MR = MC = 20. The dominant firm will produce 180 units and will charge a price of
180
P = 100 − = $60.
4.5
5
Therefore, price drops from $80 to $60. The fringe firms will produce a total of (60) − 50 = 100
2
units, so total industry output increases from 240 to 280. The market share of the dominant
firm drops from 75% to 64%.