6/18/2022

Lecture 4: Oligopoly Market Structure and a

Monopolistic Market structure

MSc. Financial Mathematics

Chehara Lakshini Dias Amaratunga

Msc. Accounting and Finance, Univeristy of Adelaide, Australia
Bsc. Economics and Management, London School of Economics

Characteristics of an Oligopoly Market

structure
• Few firms

• Firms explicitly consider other firms when acting to maximise their profits.

• Firms in an oligopoly market structure recognise their mutual

interdependence.

• When firms make pricing , output or other decision, it must explicitly

recognise that it may provoke a reaction from other firms in industry. This
means that the firms must act strategically.
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Strategic Behaviour
• Given the possible conditions in which oligopolistists compete (
include those relating to demand , costs and the information held by
firms) and the range of possible decision variables firms can choose, it
is difficult to analyse strategic behaviour and there is no overall model
of oligopoly.

• Game theory however can be used to analyse the role of

commitments and the credibility of threats particularly important for
the development of theories of non- cooperative collusion and
strategic entry detterence.

Models of oligopoly
• A model of oligopoly was first of all put forward by Cournot. It is a
theory that explains the behaviour of the individual firm and relates
to non collusive oligopoly.

• In the cournet model it is assumed that an oligopolist thinks that his

rival will keep his output fixed regardless of what he might do. This
means that each oligopolist does not take into account the possible
reactions of his rivals in response to his actions.
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Cournot’s Duopoly Model

Assumptions under the Cournot model
• Identical firms sell homogeneous goods

• The costs of production are taken as zero and only the demand side of the market is analysed

• His model can be presented when the cost of production is positive

• The duopolists fully know the market demand for the mineral water because they can see every point
on the demand curve.

• The market demand for the product is assumed to be linear .

• Each duopolist believes that regardless of his actions and their effect upon the market price of the
product, the rival firm will keep its output constant , i.e , it will go on producing the same output which
it is presently producing. In determining output a firm will not take into account the reactions of its
rival in response to his variation in output and thus decides its level of output independently.

The market demand curve is MD.

Cournet Model The total output of both firms is OD. So if
both firms sell their output they will have
to sell the goods at 0 price so as to provide
Y a zero profit in the long run equilibrium
Price under perfect competition.
M
Assume that one producer starts business
and produces ON output his profit is ONKP.

Now if the other firm enters the market and

knows that ON is being produced by the
first firm , the best response of the second
P K firm is to regard KD as the demand confronting
E S it.
P’’
L Since MR is half of demand , the firm will produce
P’
G NH output ( ½ of ND). The total output is ON+NH.
The total profit is OHLP’.
H D
C N T MR B X
MR A Output
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Cournet Model
By firm 2 entering the market it has reduced
the profit of firm 1 .But firm 1 will assume that
firm 2 will continue to produce NH. The best that
firm 1 can do is to reduce output by ½ ( OD- NH).

The first firm starts by producing ON= ½ of OD and

continuously reduces his output until he produces OC.
The final output OC of producer A will be equal to
1/3 OD= ½ OT.
On the other hand producer B begins by producing
¼ of OD and continuously increases his output until he
produces CT. The final output will be equal to
1/3 OD (= ½ OT). Thus the two producers together will
produce a total output equal of 1/3 OD+ 1/3 OD= 2/3 OD=OT
0

Reaction function and Cournet Duopoly

• An output reaction function depicts the profit maximisng output of a firm
on the assumption that the other firm’s output remains constant.

• The profit maximisation output of the cournet duopoly is one half of the
difference between the other firms output and the market demand for
output at which price equals marginal cost. This is called the reaction
function of a firm.

• This is the output at which price equals marginal cost ( MC) and is the
maximum output which can be produced because any output beyond this
will cause the price to go below marginal cost and will therefore not be
worthwhile to produce.
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Reaction function and Cournet Duopoly

• Let the market demand function is Q= 100 – P and marginal cost is Rs.10. In order to determine the reaction functions of two
duopolist firms, we set price equal to the given marginal cost to determine market demand at price P= MC.
• P= 100 – Q
• P= MC
• 100- Q = 10
Q= 90
Firm A’s reaction curve : Qa= 90-Qb/ 2
Firm B’s reaction curve : Qb= 90- Qa/2
Qa= 30
Qb= 30
Q= Qa+ Qb= 60
P= 100- 60 = 40

Since in Cournet duopoly equilibrium each firm choses to produce an output level that maximises its profits , given the profit
maximising level of output of the other firm . it is generally called the Cournot Nash duopoly equilibrium.

Question
• Let the market for telecommunicaton equipment be represented by a
duopoly, where the two firms produce outputs q1 and q2
respectively. The inverse market demand function is represented by
P=100 – 2Q ( where Q= q1 + q2). The marginal cost that each firm
faces is 48.

1. What are the reaction functions of the Cournot duopolists?

2. Calculate each firm’s output and the market price at the Cournet
equilibrium.
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Chamberlin’s Oligopoly model

• Chamberlin made an important contribution to the explanation of
pricing and output under oligopoly. According to Chamberline
oligopolists behave quite intelligently as they recognise their
interdependence and learn from their experience when they find that
their action in fact causes the rivals to react and adjust their level of
output. This relisalisation of mutual dependence on the part of an
oligopolists leads to a monopoly output being produced jointly and
thus the charging of the monopoly price. In this way according to
Chamberlin, mazimisation of joint profits and stable equilibrium are
achieved by the oligopolistist even though they act in a non-collusive
manner. Given identical costs, they will also equally share these
monopoly profits.

Chamberline Model If firm 1 moves first they will produce OQ output

Price (1/2 of OD) which is the monopoly output and will
fix price equal to OP. If firm 2 enters, it produces
half of QD, which is QL. The aggregate output
M of both firms is OL and the price falls to OP’.
Now due to a fall in profit firm A , the Chamberline
Demand curve model assumes that the firm A will readjust its output.
Firm A learns from its experience that firms are
Interdependent and firm A selects to produce OH
E which is equal to QL of firm 2 which is half of the
P Monopoly output. The aggregate of both firms
will be equal to the monopoly output level. Thus
each producer producing half of monopoly output will
T K
result in maximisation of joint profit though they don’t
P’ enter into a formal agreement.

Q L D
0 H Output
MRa MRb
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The Stackelberg Model

• In the Stackelberg model, like in Cournot’s model, firms adjust their output to
maximise their profits. However the Cournot model assumes a duopoly that
adjusts their output independently and simultaneously assuming that the other’s
output will remain constant. i.e. each duopolist in Cournot model does not think
that his rival will react to his decision regarding output. In other words in the
Cournot’s model each firm does not recognise interdependence between each
other .
• The Stackelberg model differs from Cournot’s model in two respects .
• First, one firm recognises that its rival firm will take into account the quantity of output it
decides to produce.
• Second, in the Stackelberg duopoly model the two firms do not take their decisions
simultaneously; one firm fixes its output first that is moves first to produce a quantity of a
commodity and the other firm follows and produces its profit maximising output by taking
the output of the first mover as given and constant. The Stackelberg model shows that it is
advantageous for a firm to move first i.e. to become a leader so that others follow it.