Partial Equilibrium

Monopolistic Competition
Perfect Competition, Monopoly
and Oligopoly
 Figure 1: Taxonomy of Competition

Perfect
Competition Monopoly

Imperfect
More Competition Competition Less Competition

Monopolistic
Competition

Oligopoly

Collusive (1.e. Cartel)

Non-Collusive
 Characteristics of Perfect Competition

1. Many buyers and many sellers.

2. The goods offered for sale are largely the same.

3. Firms can freely enter or exit the market.

▪ Because of 1 & 2, each buyer and seller is a

“price taker” – takes the price as given.

FIRMS IN COMPETITIVE MARKETS 3

 MR = P for a Competitive Firm
▪ A competitive firm can keep increasing its output
without affecting the market price.
▪ So, each one-unit increase in Q causes revenue
to rise by P, i.e., MR = P.

MR = P is only true for

firms in competitive markets.

FIRMS IN COMPETITIVE MARKETS 4

 Profit Maximization
▪ What Q maximizes the firm’s profit?
▪ To find the answer, “think at the margin.”
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
▪ If MR > MC, then increase Q to raise profit.
▪ If MR < MC, then reduce Q to raise profit.

FIRMS IN COMPETITIVE MARKETS 5

 Profit Maximization
(continued from earlier exercise)

Q TR TC Profit MR MC
 Profit =
At any Q with
MR – MC
MR > MC,
0 $0 $5 –$5
increasing Q $10 $4 $6
raises profit. 1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2
5 50 45 5

FIRMS IN COMPETITIVE MARKETS 6

 MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR. Costs
So, increase Q
MC
to raise profit.

At Qb, MC > MR.

So, reduce Q
to raise profit. P1 MR
At Q1, MC = MR.
Changing Q
would lower profit. Q
Qa Q1 Qb

FIRMS IN COMPETITIVE MARKETS 7

 MC and the Firm’s Supply Decision
If price rises to P2,
then the profit- Costs
maximizing quantity
MC
rises to Q2.
P2 MR2
The MC curve
determines the
firm’s Q at any price. P1 MR
Hence,
the MC curve is the
firm’s supply curve. Q
Q1 Q2

FIRMS IN COMPETITIVE MARKETS 8

 Shutdown vs. Exit
▪ Shutdown:
A short-run decision not to produce anything
because of market conditions.
▪ Exit:
A long-run decision to leave the market.
▪ A key difference:
▪ If shut down in SR, must still pay FC.
▪ If exit in LR, zero costs.

FIRMS IN COMPETITIVE MARKETS 9

A Firm’s Short-run Decision to Shut Down
▪ Cost of shutting down: revenue loss = TR
▪ Benefit of shutting down: cost savings = VC
(firm must still pay FC)
▪ So, shut down if TR < VC
▪ Divide both sides by Q: TR/Q < VC/Q
▪ So, firm’s decision rule is:
Shut down if P < AVC

FIRMS IN COMPETITIVE MARKETS 10

 A Competitive Firm’s SR Supply Curve

The firm’s SR
supply curve is Costs
the portion of MC
its MC curve
If P > AVC, then
above AVC.
firm produces Q ATC
where P = MC.
AVC

If P < AVC, then

firm shuts down
(produces Q = 0). Q

FIRMS IN COMPETITIVE MARKETS 11

 The Irrelevance of Sunk Costs
▪ Sunk cost: a cost that has already been
committed and cannot be recovered
▪ Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
▪ FC is a sunk cost: The firm must pay its fixed
costs whether it produces or shuts down.
▪ So, FC should not matter in the decision to shut
down.

FIRMS IN COMPETITIVE MARKETS 12

 A Firm’s Long-Run Decision to Exit
▪ Cost of exiting the market: revenue loss = TR
▪ Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
▪ So, firm exits if TR < TC
▪ Divide both sides by Q to write the firm’s
decision rule as:

Exit if P < ATC

FIRMS IN COMPETITIVE MARKETS 13

A New Firm’s Decision to Enter Market
▪ In the long run, a new firm will enter the market if
it is profitable to do so: if TR > TC.
▪ Divide both sides by Q to express the firm’s
entry decision as:
Enter if P > ATC

FIRMS IN COMPETITIVE MARKETS 14

 The Competitive Firm’s Supply Curve

The firm’s
Costs
LR supply curve
is the portion of MC
its MC curve
above LRATC. LRATC

FIRMS IN COMPETITIVE MARKETS 15

ACTIVE LEARNING 2
Identifying a firm’s profit
A competitive firm
Determine
this firm’s Costs, P
total profit. MC

Identify the P = $10 MR

area on the ATC
graph that
$6
represents
the firm’s
profit.
Q
50
16
ACTIVE LEARNING 2
Answers
A competitive firm
Costs, P
Profit per unit MC
= P – ATC
P = $10 MR
= $10 – 6
profit ATC
= $4
$6

Total profit
= (P – ATC) x Q
= $4 x 50 Q
= $200 50
17
ACTIVE LEARNING 3
Identifying a firm’s loss
Determine A competitive firm
this firm’s Costs, P
total loss, MC
assuming
AVC < $3.
ATC
Identify the
area on the $5
graph that P = $3 MR
represents
the firm’s
Q
loss. 30
18
ACTIVE LEARNING 3
Answers
A competitive firm
Costs, P
Total loss MC
= (ATC – P) x Q
= $2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR

Q
30
19
 Market Supply: Assumptions
1) All existing firms and potential entrants have
identical costs.
2) Each firm’s costs do not change as other firms
enter or exit the market.
3) The number of firms in the market is
▪ fixed in the short run
(due to fixed costs)
▪ variable in the long run
(due to free entry and exit)

FIRMS IN COMPETITIVE MARKETS 20

 The SR Market Supply Curve
▪ As long as P ≥ AVC, each firm will produce its
profit-maximizing quantity, where MR = MC.
▪ Recall from Chapter 4:
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.

FIRMS IN COMPETITIVE MARKETS 21

 The SR Market Supply Curve
Example: 1000 identical firms
At each P, market Qs = 1000 x (one firm’s Qs)

One firm Market

P MC P S
P3 P3

P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (market)

10,000 20,000 30,000

FIRMS IN COMPETITIVE MARKETS 22
 Entry & Exit in the Long Run
▪ In the LR, the number of firms can change due to
entry & exit.
▪ If existing firms earn positive economic profit,
▪ new firms enter, SR market supply shifts right.
▪ P falls, reducing profits and slowing entry.
▪ If existing firms incur losses,
▪ some firms exit, SR market supply shifts left.
▪ P rises, reducing remaining firms’ losses.

FIRMS IN COMPETITIVE MARKETS 23

 The Zero-Profit Condition
▪ Long-run equilibrium:
The process of entry or exit is complete –
remaining firms earn zero economic profit.
▪ Zero economic profit occurs when P = ATC.
▪ Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
▪ Recall that MC intersects ATC at minimum ATC.
▪ Hence, in the long run, P = minimum ATC.

FIRMS IN COMPETITIVE MARKETS 24

Why Do Firms Stay in Business if Profit = 0?
▪ Recall, economic profit is revenue minus all costs
– including implicit costs, like the opportunity cost
of the owner’s time and money.
▪ In the zero-profit equilibrium,
▪ firms earn enough revenue to cover these costs
▪ accounting profit is positive

FIRMS IN COMPETITIVE MARKETS 25

 The LR Market Supply Curve
In the long run, The LR market supply
the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.

One firm Market

P MC P

LRATC
P=
long-run
min. supply
ATC

Q Q
(firm) (market)
FIRMS IN COMPETITIVE MARKETS 26
 SR & LR Effects of an Increase in Demand
A firm begins in …but then an increase
long-run to…driving
…leadingeq’m… SR profits to zero
Over time, profits
in induce
demand entry,
raises P,…
andfirm.
profits for the restoring long-run
shifting eq’m.
S to the right, reducing P…

P One firm P Market

MC S1

S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (market)
FIRMS IN COMPETITIVE MARKETS 27
Why the LR Supply Curve Might Slope Upward
▪ The LR market supply curve is horizontal if
1) all firms have identical costs, and
2) costs do not change as other firms enter or
exit the market.
▪ If either of these assumptions is not true,
then LR supply curve slopes upward.

FIRMS IN COMPETITIVE MARKETS 28

 1) Firms Have Different Costs
▪ As P rises, firms with lower costs enter the market
before those with higher costs.
▪ Further increases in P make it worthwhile
for higher-cost firms to enter the market,
which increases market quantity supplied.
▪ Hence, LR market supply curve slopes upward.
▪ At any P,
▪ For the marginal firm,
P = minimum ATC and profit = 0.
▪ For lower-cost firms, profit > 0.
FIRMS IN COMPETITIVE MARKETS 29
 2) Costs Rise as Firms Enter the Market
▪ In some industries, the supply of a key input is
limited (e.g., amount of land suitable for farming
is fixed).
▪ The entry of new firms increases demand for this
input, causing its price to rise.
▪ This increases all firms’ costs.
▪ Hence, an increase in P is required to increase
the market quantity supplied, so the supply curve
is upward-sloping.

FIRMS IN COMPETITIVE MARKETS 30

 CONCLUSION: The Efficiency of a
Competitive Market
▪ Profit-maximization: MC = MR
▪ Perfect competition: P = MR
▪ So, in the competitive eq’m: P = MC
▪ Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
▪ So, the competitive eq’m is efficient, maximizes
total surplus.
▪ In the next chapter, monopoly: pricing &
production decisions, deadweight loss, regulation.

FIRMS IN COMPETITIVE MARKETS 31

CHAPTER SUMMARY

▪ For a firm in a perfectly competitive market,

price = marginal revenue = average revenue.
▪ If P > AVC, a firm maximizes profit by producing
the quantity where MR = MC. If P < AVC, a firm
will shut down in the short run.
▪ If P < ATC, a firm will exit in the long run.
▪ In the short run, entry is not possible, and an
increase in demand increases firms’ profits.
▪ With free entry and exit, profits = 0 in the long run,
and P = minimum ATC.
32
 Monopolistic Competition

⚫ Characteristics
1. Many firms
2. Free entry and exit
3. Differentiated product

©2005 Pearson Education, Inc. Chapter 12 35

 Monopolistic Competition

⚫ The amount of monopoly power depends

on the degree of differentiation
⚫ Examples of this very common market
structure include:
Toothpaste
Soap
Cold remedies
Retail

©2005 Pearson Education, Inc. Chapter 12 36

 Monopolistic Competition

⚫ Two important characteristics

Differentiated but highly substitutable
products (cross-price elasticity of demand
large)
Free entry and exit (keeps profits down)

©2005 Pearson Education, Inc. Chapter 12 37

 A Monopolistically Competitive
Firm in the Short and Long Run
$/Q Short Run $/Q Long Run
MC MC

AC AC

PSR

PLR

DSR
DLR

MRSR
MRLR

QSR Quantity QLR Quantity

 A Monopolistically Competitive
Firm in the Short and Long Run

⚫ Short run
Downward sloping demand – differentiated
product
Demand is relatively elastic – good
substitutes
MR < P
Profits are maximized when MR = MC
This firm is making economic profits

©2005 Pearson Education, Inc. Chapter 12 39

 A Monopolistically Competitive
Firm in the Short and Long Run

⚫ Long run
Profits will attract new firms to the industry
(no barriers to entry)
The old firm’s demand will decrease to DLR
Firm’s output and price will fall
Industry output will rise
No economic profit (P = AC)
P > MC → some monopoly power

©2005 Pearson Education, Inc. Chapter 12 40

 Monopolistically and Perfectly
Competitive Equilibrium (LR)
Perfect Competition Monopolistic Competition
$/Q $/Q
Deadweight
MC AC loss MC AC

P
PC
D = MR

DLR

MRLR

QC Quantity QMC Quantity

 Monopolistic Competition and
Economic Efficiency

⚫ The monopoly power yields a higher

price than perfect competition. If price
was lowered to the point where MC = D,
consumer surplus would increase by the
yellow triangle – deadweight loss.
⚫ With no economic profits in the long run,
the firm is still not producing at minimum
AC and excess capacity exists.

©2005 Pearson Education, Inc. Chapter 12 42

 Monopolistic Competition and
Economic Efficiency

⚫ Firm faces downward sloping demand so

zero profit point is to the left of minimum
average cost
⚫ Excess capacity is inefficient because
average cost would be lower with fewer
firms

©2005 Pearson Education, Inc. Chapter 12 43

 Excess Capacity

⚫ The FIRM’s output is inefficiently low:

less than minimum ATC
⚫ Fewer total firms in the INDUSTRY would
increase the FIRM’s demand and allow
them to take advantage of economies of
scale and increase output

©2005 Pearson Education, Inc. Chapter 12 44

 Monopolistic Competition
⚫ If inefficiency is bad for consumers,
should monopolistic competition be
regulated?
 Market power is relatively small. Usually
there are enough firms to compete with
enough substitutability between firms –
deadweight loss small.
 Inefficiency is balanced by benefit of
increased product diversity – may easily
outweigh deadweight loss.

©2005 Pearson Education, Inc. Chapter 12 45

 9.1 Monopoly Profit Maximization

• Marginal Revenue: MR = ΔR/Δq

– A firm’s marginal revenue, MR, is the change in its revenue from selling
one more unit.
• Marginal Revenue and Price
– A competitive firm that faces a horizontal demand and Δq=1, panel a of
Figure 9.1, can sell more without reducing price. So, MR = ΔR = B = p1
• Marginal Revenue and Downward Demand
– A monopoly that faces a downward-sloping market demand and Δq=1,
panel b of Figure 9.1, can sell more if price goes down. So, MR = ΔR = R2-
R1 = B-C = p2 - C

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 9.1 Monopoly Profit Maximization

Figure 9.1 Average and Marginal Revenue

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 9.1 Monopoly Profit Maximization

• MR Curve for a Linear Demand

– The MR curve is a straight line that starts at the same point on the
vertical (price) axis as the demand curve but has twice the slope. In
Figure 9.2, the demand and MR curves have slopes –1 and -2,
respectively.
• MR Function: MR = p + (Δq/ΔQ) Q
– The monopolist MR function is lower than p because the last term is
negative.
– When inverse demand p = 24 – Q, MR = 24 – 2Q
• MR Function with Calculus: MR(Q)=dR(Q)/dQ
– When inverse demand p = 24 – Q, R(Q) = (24 – Q)Q = 24Q – Q2,
MR(Q)=24 – 2Q

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 9.1 Monopoly Profit Maximization

• MR & Price Elasticity of Demand

– The MR at any given quantity depends on the demand curve’s height (the
price) and shape.
– The shape of the demand curve at a particular quantity is described by
the price elasticity of demand, ε = (∆Q/Q)/(∆p/p) < 0 (percentage change
in quantity demanded after a 1% change in price).
• MR & Elasticity Relationship: MR = p (1 + 1/ε)
– This key relationship says MR is closer to price as demand becomes more
elastic.
– Where the demand elasticity is unitary, ε = –1, MR is zero.
– Where the demand curve is inelastic, –1 < ε ≤ 0, MR is negative.
– Where the demand cure is perfectly elastic, ε = -∞, MR is p.

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 9.1 Monopoly Profit Maximization

• Choosing Price or Quantity

– Any firm maximizes profit where its marginal revenue and marginal cost
are equal.
– Rule for monopoly maximization: MR(Q)=MC(Q)
– A monopoly can adjust its price or its quantity to maximize profit.
• Monopolist Sets One, Market Decides the Other
– Whether the monopoly sets its price or its quantity, the other variable is
determined by the downward sloping market demand curve.
– The monopoly faces a trade-off between a higher price and a lower
quantity or a lower price and a higher quantity.
• Either Maximize Profit
– Setting price or quantity are equivalent for a monopoly. We will assume it
sets quantity.

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 9.1 Monopoly Profit Maximization

• Two Steps to Maximize Profit: 1st, Output Decision

– Profit is maximized where marginal profit equals zero, or
MR(Q)=MC(Q)
– In panel a of Figure 9.3, this occurs at point e, Q=6, p=18, π=60.
This is the maximum profit in panel b.
– At quantities smaller than 6 units, the monopoly’s MR > MC, so
its marginal profit is positive. By increasing its output, it raises its
profit.
– At quantities greater than 6 units, the monopoly’s MC > MR, so
its marginal profit is negative. By reducing its output, it raises its
profit.
– A monopoly’s profit is maximized in the elastic portion of the
demand curve. In panel a of Figure 9.3, the elasticity of demand
at point e is –3.
– A profit-maximizing monopoly never operates in the inelastic
portion of its demand curve.

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 9.1 Monopoly Profit Maximization

Figure 9.3
Maximizing Profit

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 9.1 Monopoly Profit Maximization

• Two Steps to Maximize Profit: 2nd, Shutdown Decision

– A monopoly shuts down to avoid making a loss in the short
run if its price is below its average variable cost at its
profit-maximizing (or loss minimizing) quantity (Chapter
7).
– Figure 9.3 illustrates a short run case. At the profit-
maximizing output, the average variable is less than the
price (Q=6, AVC = 6, p = 18). So, the monopoly chooses
to produce and it makes a positive profit (p > AC).
– In the long run, the monopoly shuts down if the price is
less than its average cost.

9-53 © 2014 Pearson Education, Inc. All rights reserved.

 9.1 Monopoly Profit Maximization
• Using Calculus, Output Decision: dπ(Q) / dQ = 0
– By setting the derivative of the profit function with respect to Q
equal to zero, we have an equation that determines the profit-
maximizing output.
– dπ(Q)/dQ = dR(Q)/dQ – dC(Q)/dQ = MR – MC = 0
– In Figure 9.3, , MR = 24 – 2Q = 2Q = MC. So, Q=6. Substituting
Q = 6 into the inverse demand function (Equation 9.2), p = 24 –
Q = 24 – 6 = 18.
• Using Calculus, Shutdown Decision
– At Q = 6, AVC = Q2/Q = 6, which is less than the price. So, the
monopoly does not shut down.
– At Q = 6, AC = (6 + 12/6) = 8, which is less than the price. So,
the monopoly makes a profit.

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 9.1 Monopoly Profit Maximization

• Effects of a Demand Curve Shift: Competitive Market Case

– The effect of a shift in demand on a competitive firm’s output depends
only on the shape of the marginal cost curve.
– The new equilibrium (P = MC) occurs along the marginal cost curve, and
for every equilibrium quantity, there is a single corresponding equilibrium
price.
• Effects of a Demand Curve Shift: Monopoly Case
– The effect of a shift in demand on a monopoly’s output depends on the
shapes of both the marginal cost curve and the demand curve.
– The new equilibrium (MR = MC) may occur at new levels of prices and
quantities, or two different prices for the same quantity, or the same
price for two different quantities.

9-55 © 2014 Pearson Education, Inc. All rights reserved.

 9.2 Market Power

• Market Power & the Shape of the Demand Curve

– If the monopoly faces a very inelastic demand curve (steep) at the profit-
maximizing quantity, it would lose few sales if it raises its price.
– However, if the demand curve is very elastic (flat) at that quantity, the
monopoly would lose substantial sales from raising its price by the same
amount.
• Profit-Maximizing Price: p = [1/(1+1/ε)] MC
– The monopoly’s profit-maximizing price is a ratio times the marginal cost
and the ratio depends on the elasticity.
– If ε = -1.01, only slightly elastic, the ratio is 101 and p = 101 MC
– If ε = -3, more elastic, the ratio is only 1.5 and p = 1.5 MC
– If ε = - ∞, perfectly elastic, the ratio shrinks to 1 and p = MC

9-56 © 2014 Pearson Education, Inc. All rights reserved.

 9.2 Market Power

• The Lerner Index or Price Markup: (p - MC)/p

– The Lerner Index measures a firm’s market power: the larger the
difference between price and marginal cost, the larger the Lerner Index.
– This index can be calculated for any firm, whether or not the firm is a
monopoly.
• Lerner Index and Elasticity: (p – MC)/p = - 1/ε
– The Lerner Index or price markup for a monopoly ranges between 0 and
1.
– If ε = -1.01, only slightly elastic, the monopoly markup is 0.99 (99%)
– If ε = -3, more elastic, the monopoly markup is 0.33 (33%)
– If ε = - ∞, perfectly elastic, the monopoly markup is zero

9-57 © 2014 Pearson Education, Inc. All rights reserved.

 9.2 Market Power

• Sources of Market Power

– Availability of substitutes, number of firms and proximity of competitors
determine market power.
• Less Power with …
– Less power with better substitutes: When better substitutes are
introduced into the market, the demand becomes more elastic (Xerox
pioneered plain-paper copy machines until …)
– Less power with more firms: When more firms enter the market, people
have more choices, the demand becomes more elastic (USPS after FedEx
and UPS entered the market).
– Less power with closer competitors: When firms that provide the same
service locate closer to this firm, the demand becomes more elastic
(Wendy’s, Burger King, and McDonald’s close to each other).

9-58 © 2014 Pearson Education, Inc. All rights reserved.

 9.3 Market Failure & Monopoly
Pricing
• Monopoly and DWL Figure 9.5 Deadweight
– Market Failure: non-optimal Loss of Monopoly
allocation of goods & services
with economic inefficiencies
(price is not marginal cost)
– A monopoly sets p > MC
causing consumers to buy less
than the competitive level of
the good. So society suffers a
deadweight loss.
– In Figure 9.5, the monopolist’s
maximizing q and p are 6 and
$18. The competitive values
would be 8 and $16.
– The deadweight loss of
monopoly is –C – E. Potential
surplus that is wasted because
less than the competitive
output is produced.

9-59 © 2014 Pearson Education, Inc. All rights reserved.

 9.4 Causes of Monopoly
1. Cost Based Monopolies
– Two cost structures facilitate the creation of a monopoly:
– A firm may have substantially lower costs than potential rivals:
cost advantage.
– A firm may produce any given output at a lower cost than two or
more firms: natural monopoly.
• Cost Advantage
– A low-cost firm is a monopoly if it sells at a price so low that
other potential competitors with higher costs would lose money.
No other firm enters the market.
– The sources of cost advantage over potential rivals are diverse:
superior technology, better way of organizing production, control
of an essential facility, or control of a scarce resource.

9-60 © 2014 Pearson Education, Inc. All rights reserved.

 9.4 Causes of Monopoly
• Natural Monopoly
– One firm can produce the total
Figure 9.6 Natural
output of the market at lower cost Monopoly
than two or more firms could:
– C(Q) < C(q1) + C(q2) +  +
C(qn), where Q = q1 + q2 + …
+ qn is the sum of the output
of any n firms where n ≥ 2
firms.
– Economies of scale explain this
outcome: a natural monopoly has
the same strictly declining average
cost curve (Figure 9.6)
– When just one firm is the cheapest
way to produce any given output
level, governments often grant
monopoly rights to public utilities
of water, gas, electric power, or
mail delivery.

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 9.4 Causes of Monopoly
2. Government Creation of Monopoly
– Governments grant a license, monopoly rights, or patents
• Barriers to Entry
– Governments create monopolies either by making it difficult for new firms
to obtain a license to operate or by explicitly granting a monopoly right to
one firm, thereby excluding other firms.
– By auctioning a monopoly to a private firm, a government can capture the
future value of monopoly earnings. However, for political or other
reasons, governments frequently do not capture all future profits.
• Patents
– A patent is an exclusive right granted to the inventor of a new and useful
product, process, substance, or design for a specified length of time. The
length of a patent varies across countries, although it is now 20 years in
the United States.

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 9.5 Advertising

• Advertising and Net Profit

– A successful advertising campaign shifts the monopolist
market demand curve outward and makes it less elastic. In
Figure 9.7, D2 is to the right and less elastic than D1.
• Deciding Whether to Advertise
– Do it only if firm expects net profit (gross profit minus the
cost of advertising) to increase. In Figure 9.7, gross profit
is B.
• How Much to Advertise
– Do it until its marginal benefit (gross profit or marginal
revenue) equals its marginal cost

9-63 © 2014 Pearson Education, Inc. All rights reserved.

 9.5 Advertising

Figure 9.7 Advertising

9-64 © 2014 Pearson Education, Inc. All rights reserved.

 9.5 Advertising

• Using Calculus: π (Q,A) = R (Q,A) – C (Q) - A

– Profit is revenue minus cost. Advertising, A, is a fixed cost and affects
revenue, R, R(Q, A) = p(Q, A)Q. The monopoly maximizes its profit by
choosing Q and A.
• First Order Condition: ∂π (Q,A) / ∂Q = 0
– ∂R (Q,A) /∂Q – ∂C (Q) /∂Q = 0
– The monopoly should set its output so that MR = MC
• First Order Condition: ∂π (Q,A) / ∂A = 0
– ∂R (Q,A) /∂A – 1 = 0
– The monopoly should advertise to the point where its marginal revenue or
marginal benefit from the last unit of advertising, R/A, equals the
marginal cost of the last unit of advertising, $1.

9-65 © 2014 Pearson Education, Inc. All rights reserved.

 9.6 Networks & Behavioral
Economics
• Network Externalities
– A good has a network externality if one person’s demand depends on the
consumption of a good by others.
– If a good has a positive network externality, its value to a consumer
grows as the number of units sold increases. A telephone and fax are
classical examples.
– For a network to succeed, it has to achieve a critical mass of users—
enough adopters that others want to join.
– A customer can get a direct benefit from a larger network, or an indirect
benefit from complementary goods that are offered when a product has a
critical mass of users (apps for a smart phone).
• Network Externalities & Behavioral Economics
– Bandwagon effect: A person places greater value on a good as more and
more other people possess it
– Snob effect: A person places greater value on a good as fewer and fewer
other people possess it

9-66 © 2014 Pearson Education, Inc. All rights reserved.

 9.6 Networks & Behavioral
Economics
• Network Externalities & Monopoly
– Because of the need for a critical mass of customers in a market with a
positive network externality, we sometimes see only one large firm
surviving.
– The Windows operating system largely dominates the market—not
because it is technically superior to Apple’s operating system or Linux—
but because it has a critical mass of users.
– But having obtained a monopoly, a firm does not necessarily keep it.
• Managerial Implication: Introductory Pricing
– Managers should consider initially selling a new product at a low
introductory price to obtain a critical mass. By doing so, the manager
maximizes long-run but not short-run profit.

9-67 © 2014 Pearson Education, Inc. All rights reserved.

 Managerial Solution

• Managerial Problem
– Drug firms have patents that expire after 20 years and Congress
expects drug prices to fall once generic drugs enter the market.
However, evidence shows, prices went up after the expiration.
– Why can a firm with a patent-based monopoly charge a high
price? Why might a brand-name pharmaceutical's price rise after
its patent expires?
• Solution
– When generic drugs enter the market after the patent expires,
the demand curve facing the brand-name firm shifts to the left,
and rotates to become less elastic at the original price.
– Price sensitive consumers switch to the generic, but loyal
customers prefer the brand-name drug (familiar and secure
product for them).
– Elderly and patients with generous insurance plans fit this group.

9-68 © 2014 Pearson Education, Inc. All rights reserved.

 Figure 9.2 Elasticity of Demand and
Total, Average, and Marginal Revenue

9-69 © 2014 Pearson Education, Inc. All rights reserved.

 Figure 9.4 Effects of a Shift of
the Demand Curve

9-70 © 2014 Pearson Education, Inc. All rights reserved.

 Table 9.2 Elasticity of Demand,
Price, and Marginal Cost

9-71 © 2014 Pearson Education, Inc. All rights reserved.

Monopoly with Linear Demand
• Suppose that the market for frisbees
has a linear demand curve of the form
Q = 2,000 - 20P
or
P = 100 - Q/20
• The total costs of the frisbee producer
are given by
TC = 0.05Q2 + 10,000
Monopoly with Linear Demand
• To maximize profits, the monopolist
chooses the output for which MR = MC
• We need to find total revenue
TR = PQ = 100Q - Q2/20
• Therefore, marginal revenue is
MR = 100 - Q/10
while marginal cost is
MC = 0.01Q
Monopoly with Linear Demand
• Thus, MR = MC where
100 - Q/10 = 0.01Q
Q* = 500
P* = 75
• At the profit-maximizing output,
TC = 0.05(500)2 + 10,000 = 22,500
AC = 22,500/500 = 45
 = (P* - AC)Q = (75 - 45)500 = 15,000
Monopoly with Linear Demand
• To see that the inverse elasticity rule
holds, we can calculate the elasticity of
demand at the monopoly’s profit-
maximizing level of output
Q P  75 
eQ,P =  = −20  = −3
P Q  500 
Monopoly with Linear Demand
• The inverse elasticity rule specifies that
P − MC 1 1
= =
P eQ,P 3

• Since P* = 75 and MC = 50, this

relationship holds
 Monopoly and Resource
Allocation
• To evaluate the allocational effect of a
monopoly, we will use a perfectly
competitive, constant-cost industry as a
basis of comparison
– the industry’s long-run supply curve is
infinitely elastic with a price equal to both
marginal and average cost
 Monopoly and Resource
Allocation
Price If this market was competitive, output would
be Q* and price would be P*
Under a monopoly, output would be Q**
and price would rise to P**
P**

P* MC=AC

D
MR
Q** Q* Quantity
 Monopoly and Resource
Allocation
Price Consumer surplus would fall

Producer surplus will rise

P** Consumer surplus falls by more
than producer surplus rises
P* MC=AC There is a deadweight
loss from monopoly
D
MR
Q** Q* Quantity
Welfare Losses and Elasticity
• Assume that the constant marginal (and
average) costs for a monopolist are
given by C and that the compensated
demand curve has a constant elasticity:
Q = Pe
where e is the price elasticity of demand
(e < -1)
Welfare Losses and Elasticity
• The competitive price in this market will
be
Pc = C
and the monopoly price is given by
C
Pm =
1
1+
e
Welfare Losses and Elasticity
• The consumer surplus associated with
any price (P0) can be computed as
 
CS =  Q(P )dP =  P e dP
P0 P0


P e +1
P0e +1
CS = =−
e +1P e +1
0
Welfare Losses and Elasticity
• Therefore, under perfect competition
e +1
C
CSc = −
e +1
and under monopoly
e +1
 
 C 
 
 1+ 1 
 
CSm = −  e 
e +1
Welfare Losses and Elasticity
• Taking the ratio of these two surplus
measures yields
e +1
 
CSm  1 
= 
CSc  1 + 1 
 
 e
• If e = -2, this ratio is ½
– consumer surplus under monopoly is half
what it is under perfect competition
Welfare Losses and Elasticity
• Monopoly profits are given by
 
 C 
m = PmQm − CQm =  − C Qm
 1+ 1 
 
 e 
e e +1
 C     
−   C   C  1
m =  e     = −  
 1+ 1   1+ 1   1+ 1  e
     
 e  e  e
Welfare Losses and Elasticity
• To find the transfer from consumer surplus
into monopoly profits we can divide
monopoly profits by the competitive
consumer surplus
e +1
 
m 
 e + 1 1   e 
e

=  = 
CSc  e  1 + 1 
   1+ e 
 e
• If e = -2, this ratio is ¼
Monopoly and Product Quality
• The market power enjoyed by a monopoly
may be exercised along dimensions other
than the market price of its product
– type, quality, or diversity of goods
• Whether a monopoly will produce a
higher-quality or lower-quality good than it
would under competition depends on
consumer demand and the firm’s costs
Monopoly and Product Quality
• Suppose that consumers’ willingness to
pay for quality (X) is given by the inverse
demand function P(Q,X) where
P/Q < 0 and P/X > 0
• If costs are given by C(Q,X), the
monopoly will choose Q and X to
maximize
 = P(Q,X)Q - C(Q,X)
Monopoly and Product Quality
• First-order conditions for a maximum are
 P
= P (Q, X ) + Q − CQ = 0
Q Q
– Marginal revenue equals marginal cost for
output decisions
 P
=Q − CX = 0
X X
– Marginal revenue from increasing quality by 1
unit is equal to the marginal cost of making
such an increase
Monopoly and Product Quality
• The level of product quality that will be
opted for under competitive conditions is
the one that will maximize net social
welfare
Q*
SW =  P (Q, X )dQ − C (Q, X )
0

• Maximizing with respect to X yields

SW Q*
=  PX (Q, X )dQ − C X = 0
X 0
Monopoly and Product Quality
• The difference between the quality choice
of a competitive industry and the
monopolist is:
– the monopolist looks at the marginal
valuation of one more unit of quality
assuming that Q is at its profit-maximizing
level
– the competitve industry looks at the marginal
value of quality averaged across all output
levels
Monopoly and Product Quality
• Even if a monopoly and a perfectly
competitive industry chose the same
output level, they might opt for diffferent
quality levels
– each is concerned with a different margin
in its decision making
 Durable Goods
• The fact that durable goods are long-
lived may mean that the monopoly may
face current competition from goods
that it produced previously
• To the extent that used goods are
competitively priced and substitutable
for new goods, monopolistic behavior
will be severely constrained
 Price Discrimination
• A monopoly engages in price
discrimination if it is able to sell otherwise
identical units of output at different prices
• Whether a price discrimination strategy is
feasible depends on the inability of
buyers to practice arbitrage
– profit-seeking middlemen will destroy any
discriminatory pricing scheme if possible
• price discrimination becomes possible if resale is
costly
Perfect Price Discrimination
• If each buyer can be separately
identified by the monopolist, it may be
possible to charge each buyer the
maximum price he would be willing to
pay for the good
– perfect or first-degree price discrimination
• extracts all consumer surplus
• no deadweight loss
 Perfect Price Discrimination
Under perfect price discrimination, the monopolist
Price charges a different price to each buyer
The first buyer pays P1 for Q1 units
P1
P2 The second buyer pays P2 for Q2-Q1 units
MC
The monopolist will
continue this way until the
marginal buyer is no
longer willing to pay the
D good’s marginal cost

Quantity
Q1 Q2
Perfect Price Discrimination
• Recall the example of the frisbee
manufacturer
• If this monopolist wishes to practice
perfect price discrimination, he will want
to produce the quantity for which the
marginal buyer pays a price exactly
equal to the marginal cost
Perfect Price Discrimination
• Therefore,
P = 100 - Q/20 = MC = 0.1Q
Q* = 266
• Total revenue and total costs will be
666
2
Q* Q
TR =  P (Q )dQ = 100Q − = 55,511
0 40 0

TC = 0.05Q 2 + 10,000 = 32,178

• Profit is much larger (23,333 > 15,000)

 Market Separation
• Perfect price discrimination requires the
monopolist to know the demand function
for each potential buyer
• A less stringent requirement would be to
assume that the monopoly can separate its
buyers into a few identifiable markets
– follow a different pricing policy in each market
– this is known as third-degree price
discrimination
 Market Separation
• All the monopolist needs to know in this
case is the price elasticities of demand
for each market
– set price according to the inverse elasticity
rule
• If the marginal cost is the same in all
markets,
1 1
Pi (1 + ) = Pj (1 + )
ei ej
 Market Separation
• This implies that
1
(1 + )
Pi ej
=
Pj (1 + 1 )
ei
• The profit-maximizing price will be
higher in markets where demand is less
elastic
 Market Separation
If two markets are separate, a monopolist can maximize
profits by selling its product at different prices in the two
markets
Price The market with the less
P1
elastic demand will be
charged the higher price
P2

MC MC

D D
MR MR

Quantity in Market 1 Q1* 0 Q2* Quantity in Market 2

 Third-Degree Price
Discrimination
• Suppose that the demand curves in two
separated markets are given by
Q1 = 24 – P1
Q2 = 24 – 2P2
• Suppose that marginal cost is constant
and equal to 6
• Profit maximization requires that
MR1 = 24 – 2Q1 = 6 = MR2 = 12 – Q2
 Third-Degree Price
Discrimination
• The optimal choices are
Q1 = 9
Q2 = 6
• The prices that prevail in the two
markets are
P1 = 15
P2 = 9
 Third-Degree Price
Discrimination
• The allocational impact of this policy can be
evaluated by calculating the deadweight
losses in the two markets
– the competitive output would be 18 in market 1
and 12 in market 2
DW1 = 0.5(P1-MC)(18-Q1) = 0.5(15-6)(18-9) = 40.5
DW2 = 0.5(P2-MC)(12-Q2) = 0.5(9-6)(12-6) = 9
 Third-Degree Price
Discrimination
• If this monopoly was to pursue a single-
price policy, it would use the demand
function
Q = Q1 + Q2 = 48 – 3P
• So marginal revenue would be
MR = 16 – (2/3)P
• Profit-maximization occurs where
Q = 15
P = 11
 Third-Degree Price
Discrimination
• The deadweight loss is smaller with one
price than with two:
DW = 0.5(P-MC)(30-Q) = 0.5(11-6)(15) = 37.5
 Discrimination Through
Price Schedules
• An alternative approach would be for
the monopoly to choose a price
schedule that provides incentives for
buyers to separate themselves
depending on how much they wish to
buy
– again, this is only feasible when there are
no arbitrage possibilities
 Two-Part Tariff
• A linear two-part tariff occurs when
buyers must pay a fixed fee for the right
to consume a good and a uniform price
for each unit consumed
T(Q) = A + PQ
• The monopolist’s goal is to choose A
and P to maximize profits, given the
demand for the product
 Oligopoly – Characteristics
⚫ Small number of firms
⚫ Product differentiation may or may not
exist
⚫ Barriers to entry
Scale economies
Patents
Technology access ($$)
Name recognition ($$)
Strategic action

©2005 Pearson Education, Inc. Chapter 12 110

 Oligopoly

⚫ Examples
Automobiles
Steel
Aluminum
Petrochemicals
Electrical equipment

©2005 Pearson Education, Inc. Chapter 12 111

 Oligopoly

⚫ Management Challenges
Strategic actions to deter entry
⚫ Threaten to decrease price against new
competitors by keeping excess capacity
Rival behavior
⚫ Because only a few firms, each must consider
how its actions will affect its rivals and in turn
how their rivals will react

©2005 Pearson Education, Inc. Chapter 12 112

 Oligopoly – Equilibrium

⚫ If one firm decides to cut their price, they

must consider what the other firms in the
industry will do
Could cut price some, the same amount, or
more than firm
Could lead to price war and drastic fall in
profits for all
⚫ Actions and reactions are dynamic,
evolving over time

©2005 Pearson Education, Inc. Chapter 12 113

 Oligopoly – Equilibrium
⚫ Defining Equilibrium
 Firms are doing the best they can and have no
incentive to change their output or price
 All firms assume competitors are taking rival
decisions into account
⚫ Nash Equilibrium
 Each firm is doing the best it can given what its
competitors are doing
⚫ We will focus on duopoly
 Markets in which two firms compete

©2005 Pearson Education, Inc. Chapter 12 114

 Oligopoly
⚫ The Cournot Model
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
Market price depends on the total output of
both firms
Firm will adjust its output based on what it
thinks the other firm will produce

©2005 Pearson Education, Inc. Chapter 12 115

 Firm 1’s Output Decision
P1 Firm 1 and market demand curve,
D1(0) D1(0), if Firm 2 produces nothing.

If Firm 1 thinks Firm 2 will produce

50 units, its demand curve is
shifted to the left by this amount.

If Firm 1 thinks Firm 2 will produce

75 units, its demand curve is
MR1(0) shifted to the left by this amount.
D1(75)

MR1(75)
MC1

MR1(50) D1(50)

12.5 25 50 Q1
©2005 Pearson Education, Inc. Chapter 12 116
 Oligopoly

⚫ The Reaction Curve

The relationship between a firm’s profit-
maximizing output and the amount it thinks
its competitor will produce
A firm’s profit-maximizing output is a
decreasing schedule of the expected output
of Firm 2
Different MC = different reaction functions

©2005 Pearson Education, Inc. Chapter 12 117

 Reaction Curves and Cournot
Equilibrium
Q1
Firm 1’s reaction curve shows how much it
100 will produce as a function of how much
it thinks Firm 2 will produce. The x’s
correspond to the previous model.

75
Firm 2’s Reaction
Curve Q*2(Q1)

Firm 2’s reaction curve shows how much it

50 x
will produce as a function of how much
it thinks Firm 1 will produce.

x
25 Firm 1’s Reaction
Curve Q*1(Q2) x

x
25 50 75 100 Q2

©2005 Pearson Education, Inc. Chapter 12 118

 Reaction Curves and Cournot
Equilibrium
Q1

100 In Cournot equilibrium, each

firm correctly assumes how
much its competitors will
produce and thereby
maximizes its own profits.
75
Firm 2’s Reaction
Curve Q*2(Q1)

50 x
Cournot
Equilibrium

x
25 Firm 1’s Reaction
Curve Q*1(Q2) x

x
25 50 75 100 Q2

©2005 Pearson Education, Inc. Chapter 12 119

 Cournot Equilibrium

⚫ Each firm’s reaction curve tells it how

much to produce given the output of its
competitor
⚫ Equilibrium in the Cournot model, in
which each firm correctly assumes how
much its competitor will produce and sets
its own production level accordingly

©2005 Pearson Education, Inc. Chapter 12 120

 Oligopoly

⚫ Cournot equilibrium is an example of a

Nash equilibrium (Cournot-Nash
Equilibrium)
⚫ The Cournot equilibrium says nothing
about the dynamics of the adjustment
process
 Since both firms adjust their output, neither
output would be fixed

©2005 Pearson Education, Inc. Chapter 12 121

 The Linear Demand Curve

⚫ An Example of the Cournot Equilibrium

Two firms face linear market demand curve
We can compare competitive equilibrium, the
equilibrium resulting from collusion, and
Cournot Equilibrium
Market demand is P = 30 - Q
Q is total production of both firms:
Q = Q 1 + Q2
Both firms have MC1 = MC2 = 0

©2005 Pearson Education, Inc. Chapter 12 122

 Oligopoly Example: Cournot

⚫ Firm 1’s Reaction Curve → MR = MC

Total Revenue : R1 = PQ1 = (30 − Q)Q1
= 30Q1 − (Q1 + Q2 )Q1
= 30Q1 − Q12 − Q2Q1

©2005 Pearson Education, Inc. Chapter 12 123

 Oligopoly Example

⚫ An Example of the Cournot Equilibrium

MR1 = R1 Q1 = 30 − 2Q1 − Q2
MR1 = 0 = MC 1
Firm 1' s Reaction Curve
Q1 = 15 − 1 2 Q2
Firm 2' s Reaction Curve
Q2 = 15 − 1 2 Q1

©2005 Pearson Education, Inc. Chapter 12 124

 Oligopoly Example

⚫ An Example of the Cournot Equilibrium

Cournot Equilibrium : Q1 = Q2
15 − 1 2(15 − 1 2Q1 ) = 10
Q = Q1 + Q2 = 20
P = 30 − Q = 10

©2005 Pearson Education, Inc. Chapter 12 125

 Duopoly Example
Q1
The demand curve is P = 30 - Q and
30 both firms have 0 marginal cost.
Firm 2’s
Reaction Curve

Cournot Equilibrium
15

10

Firm 1’s
Reaction Curve

10 15 30 Q2

©2005 Pearson Education, Inc. Chapter 12 126

 Best Response/Reaction Function
Best Response-
The point where (residual) marginal revenue equals
marginal cost gives ONE best response of firm i to its
rival's action.

Reaction Function-
The graph of all possible best responses to rival
actions

127
Chapter Thirteen
 Reaction Functions
q2

Reaction Function of Firm 1

q2* • Reaction Function of Firm 2

0 q1* q1 128
Chapter Thirteen
Cournot Equilibrium
Equilibrium: No firm has an incentive to
deviate in equilibrium; each firm is maximizing
profits given its rival's output

Each Firm’s output is a BEST RESPONSE to each

other firm’s output.

129
Chapter Thirteen
 Cournot Equilibrium Example
P = 100 - Q1 - Q2 MC = AC = 10
What is firm 1's profit-maximizing output when firm 2
produces 50?
Residual demand: P = (100 - Q1) – 50 = 50 - Q1
TR=PQ= 50Q1 - Q12
MR50 = ∂TR/ ∂Q1 = 50 - 2Q1
Since profit is maximized when MR=MC,
MR50 = MC
50 - 2Q1 = 10
40 = 2Q
20 = Q
130
Chapter Thirteen
 Cournot Equilibrium Example
P = 100 - Q1 - Q2 MC = AC = 10

What is the equation of firm 1's reaction function?

Residual demand: P = (100 - Q2) - Q1

TR= PQ1 = 100Q1 - Q2 Q1 - Q12
MRr = ∂TR/ ∂Q1 =100 - Q2 - 2Q1
MRr = MC  100 - Q2 - 2Q1 = 10
Q1r = 45 - Q2/2 firm 1's reaction function

•Similarly, Q2r = 45 - Q1/2

131
 Cournot Equilibrium Example
P = 100 - Q1 - Q2 MC = AC = 10
Q1r = 45 - Q2/2 Q2r = 45 - Q1/2

Calculate the Cournot equilibrium.

Q1 = 45 - Q2/2
Q1 = 45 - (45 - Q1/2)/2
Q1* = 30
Q2* = 30
P = 100 - Q1 - Q2 = 100 - 30 - 30 = 40
1* = 2* = TR – TC = (P-MC)Q*
1* = 2* = (40-10)(30) = 900 132
Chapter Thirteen
 Cournot Solving Steps

1) Calculate Residual Demand

2) Calculate (residual) MR
3) MR=MC to find reaction functions
4) Use reaction functions to solve for Q’s
5) Use Q’s to solve for P
-Remember that Q1+Q2=QM
6) Solve for 
7) Summarize

133
Chapter Thirteen
 How do firms achieve Cournot Equilibria?
q2 1) Each firm can calculate Reaction
Functions
2) Firm 2 will never produce over A
3) Knowing this, Firm 1 will never produce
under B
4) Knowing this, Firm 2 will never produce
over C
A 5) This reasoning continues until point Z

C
q2* • Z
Reaction Function of Firm 2

0 q1* q1
B 134
Chapter Thirteen
 Cournot vs. Monopoly vs. PC
Since Pcournot > MC, Cournot prices are higher than
perfect competition prices
➢ Cournot firms have market power
BUT, a Cournot market produces more than a
Monopoly, and at a lower price.
Each firm’s pursuit of individual self-interest does not
typically maximize the industry’s profits.
➢ Each firm wishes the other would decrease
quantity
➢Monopoly profits are possible if firms collude
135
(which is illegal)
 PC vs. Cournot vs. Monopoly
Consider the following outcomes using our above
example of P=100-Q:

The outcome changes greatly with number of firms.

136
 Cournot Equilibrium, Many Firms
P = a-bQ MC = c N identical firms
Find Cournot Equilibrium Quantity
Residual demand P = a-b(Q1 + Qother)
TR = PQ = aQ1-bQ12 – bQotherQ1
MR = ∂TR/ ∂Q = a-2bQ1 – bQother
Since profit is maximized when MR=MC,
MR = MC
a-2bQ1 – bQother = c
Q1=(a-c)/2b – (1/2)Qother Since Qother = (N-1) Q1,
Q1=(a-c)/2b – (1/2)[(N-1)Q1] Since Q1=Q*
1 a−c
Q* = ( )
( N + 1) b 137
 Cournot Equilibrium, Many Firms
P = a-bQ MC = c N identical firms
Find Cournot Equilibrium Market Price
Since there are N firms, N a−c
QM = ( )
( N + 1) b

P = a − bQM
N a−c
P = a −b ( )
( N + 1) b
a N
P= + c
( N + 1) ( N + 1)
138
 Cournot Solving Steps Multi-Firm

1) Calculate Residual Demand

2) Calculate (residual) MR
3) MR=MC to find reaction functions
New 3b) Remember that Qother = (N-1) Q1
4) Use reaction functions to solve for Q’s
5) Use Q to solve for P
-Remember that ∑Qi=QM
6) Solve for 
7) Summarize
139
Chapter Thirteen
 Outcome comparisons
Given the relationship P=a-bQ and MC=c,

140
Chapter Thirteen
 First Mover Advantage – The
Stackelberg Model
⚫ Oligopoly model in which one firm sets its
output before other firms do
⚫ Assumptions
One firm can set output first
MC = 0
Market demand is P = 30 - Q where Q is total
output
Firm 1 sets output first and Firm 2 then
makes an output decision seeing Firm 1’s
output

©2005 Pearson Education, Inc. Chapter 12 141

 First Mover Advantage – The
Stackelberg Model

⚫ Firm 1
Must consider the reaction of Firm 2
⚫ Firm 2
Takes Firm 1’s output as fixed and therefore
determines output with the Cournot reaction
curve: Q2 = 15 - ½(Q1)

©2005 Pearson Education, Inc. Chapter 12 142

 First Mover Advantage – The
Stackelberg Model

⚫ Firm 1
Choose Q1 so that:

MR = MC = 0
R1 = PQ1 = 30Q1 - Q - Q2Q12
1

Firm 1 knows Firm 2 will choose output

based on its reaction curve. We can use Firm
2’s reaction curve as Q2 .

©2005 Pearson Education, Inc. Chapter 12 143

 First Mover Advantage – The
Stackelberg Model

⚫ Using Firm 2’s Reaction Curve for Q2:

R1 = 30Q1 − Q12 − Q1 (15 − 1 2Q1 )

= 15Q1 − 1 2 Q1
2

MR1 = R1 Q1 = 15 − Q1

MR = 0 : Q1 = 15 and Q2 = 7.5

©2005 Pearson Education, Inc. Chapter 12 144

 First Mover Advantage – The
Stackelberg Model

⚫ Conclusion
Going first gives Firm 1 the advantage
Firm 1’s output is twice as large as Firm 2’s
Firm 1’s profit is twice as large as Firm 2’s
⚫ Going first allows Firm 1 to produce a
large quantity. Firm 2 must take that into
account and produce less unless it wants
to reduce profits for everyone.

©2005 Pearson Education, Inc. Chapter 12 145

 Stackelberg Oligopoly
Stackelberg model of oligopoly is a situation in which one
firm acts as a quantity leader, choosing its quantity first, with
all other firms acting as followers.

Call the first mover the “leader” and the second mover the
“follower”.

The second firm is in the same situation as a Cournot firm: it

takes the leader’s output as given and maximizes profits
accordingly, using its residual demand.

The second firm’s behavior can, then, be summarized by a

146
Cournot reaction function.
 Stackelberg Leader Choice
The Stackelberg leader knows the follower’s
reaction function, and can use that to choose
its production:
P = 100 - QL - QF MC = AC = 10

What is the equation of the follower’s reaction function?

Residual demand: P = (100 - QL) - QF

TR= PQF = 100QF - QF QL - QF2
MRFr = ∂TR/ ∂Q1 =100 - QL - 2QF
MRFr = MC  100 - QL - 2QF = 10
147
QFr = 45 - QL/2 follower’s reaction function
 Stackelberg Leader Choice
P = 100 - QL - QF MC = AC = 10
QFr = 45 - QL/2

Calculate the Stackelberg equilibrium.

P = 100 - QL - QF = 100 - QL – (45 - QL/2 )

P = 55 – QL/2
TR= PQL = 55QL – QL2/2
MRL = ∂TR/ ∂QL = 55 – QL
MRL = MC  55 – QL = 10
QL = 45
148
Chapter Thirteen
 Stackelberg Leader Choice
P = 100 - QL - QF MC = AC = 10
QFr = 45 - QL/2 QL = 45

Continue Calculating the Stackelberg equilibrium.

QFr = 45 - QL/2 = 45 - 45/2
QFr = 22.5

P = 100 - QL - QF = 100 - 45 – 22.5 = 32.5

L* = TR – TC = (P-MC)QL* = (32.5-10)45 = 1,012.5
F* = TR – TC = (P-MC)QF* = (32.5-10)22.5 = 506.25
149
Chapter Thirteen
 Stackelberg Leader Choice
With a Stackelberg leader, price is $32.50, with the leader
producing 45 units for a profit of $1,012.50 and the
following producing 22.5 units for a profit of $506.25.
Notice that:
1) Price is lower than the Cournot equilibrium
2) Leader profits are higher than the cournot
equilibrium
3) Follower profits are lower than the Cournot
equilibrium
➢ There is an advantage to moving first 150
 Stackelberg Solving Steps

1) Calculate Leader’s Residual Demand

2) Calculate Leaders (residual) MR
3) Leader’s MR=MC to find QL
4) Use QL to solve for QF
5) Use Q’s to solve for P
-Remember that QL+QF=QM
1) Solve for ’s
2) Summarize

151
Chapter Thirteen
 Oligopoly Example

⚫ Profit Maximization with Collusion

⚫ Collusion implies industry profits
maximized

R = PQ = (30 − Q)Q = 30Q − Q 2

MR = R Q = 30 − 2Q
MR = 0 when Q = 15 and MR = MC

©2005 Pearson Education, Inc. Chapter 12 152

 Profit Maximization w/ Collusion

⚫ Contract Curve
Q1 + Q2 = 15
⚫ Shows all pairs of output Q 1 and Q2 that
maximize total profits
Q1 = Q2 = 7.5
⚫ Less output and higher profits than the Cournot
equilibrium

©2005 Pearson Education, Inc. Chapter 12 153

 Duopoly Example
Q1
30 For the firm, collusion is the best
Firm 2’s outcome followed by the Cournot
Reaction Curve Equilibrium and then the
competitive equilibrium

Competitive Equilibrium (P = MC; Profit = 0)

15 Cournot Equilibrium

10 Collusive Equilibrium

7.5 Firm 1’s

Reaction Curve
Collusion
Curve
7.5 10 15 30 Q2

©2005 Pearson Education, Inc. Chapter 12 154

 Review: How to solve Cournot

⚫ Begin with Total Revenue function

Create by calculating P times Q1 and P is
from the demand function in terms of Q total
Must substitute Q1 + Q2 for Q
Result: TR function in terms of Q1 and Q2
Identify Marginal Revenue and set equal to
Marginal Cost
Solve this equality in terms of Q1 = fn. Of Q2

©2005 Pearson Education, Inc. Chapter 12 155

 13.2 Bertrand Oligopoly
(Homogeneous Products)
Cournot Oligopoly –Firms compete on QUANTITY
Bertrand Oligopoly –Firms compete on PRICES
-Goods must be homogeneous/identical

-A firm’s residual demand depends on the other

firm’s price:
➢ Zero demand at prices higher than the other
firm
➢ Market demand at prices lower than the other
firm
 Bertrand Oligopoly (homogeneous)

Assumptions:

• Firms set price*

• Homogeneous product
• Simultaneous
• Non-cooperative
*Definition: In a Bertrand oligopoly,
each firm sets its price, taking as
given the price(s) set by other firm(s),
so as to maximize profits.
157
Residual Demand Curve – Price Setting
Price
Market Demand

Firm 1’s Residual

Demand Curve
P2 •

0 Quantity
158
Chapter Thirteen
 13.2 Bertrand Oligopoly
(Homogeneous Products)
➢ Firm A must undercut firm B’s price to sell
anything
➢ This will force firm B to undercut Firm A
...
➢ This will continue until neither firm can
decrease price further, P=MC
➢ The Perfect Competition Result!
 Bertrand Equilibrium Example
P = 100 - QT MC = AC = 10

What is the Bertrand Equilibrium?

P = MC=10

P = 100 – QT
10 = 100 – QT
90 = QT

∏=TR-TC
∏=(P-MC)Q
∏=(10-10)90 = 0 160
 Bertrand vs. Cournot
Cournot – Long-Run Competition (Firms choose
output capacity)
Bertrand – Short-Run Competition (Firms have
excess output)
------------------------------------------------------------------
Cournot – Firms can quickly adjust their price, so
price competition is useless
Bertrand – Firms can only slowly adjust price, so
firms believe a price cut can temporarily
increase profits
 Price Competition

⚫ Competition in an oligopolistic industry

may occur with price instead of output
⚫ The Bertrand Model is used
Oligopoly model in which firms produce a
homogeneous good, each firm treats the
price of its competitors as fixed, and all firms
decide simultaneously what price to charge

©2005 Pearson Education, Inc. Chapter 12 162

 Price Competition – Bertrand
Model

⚫ Assumptions
Homogenous good
Market demand is P = 30 - Q where
Q = Q1 + Q2
MC1 = MC2 = $3
⚫ Can show the Cournot equilibrium if Q1 =
Q2 = 9 and market price is $12, giving
each firm a profit of $81.

©2005 Pearson Education, Inc. Chapter 12 163

 Price Competition – Bertrand
Model

⚫ Assume here that the firms compete with

price, not quantity
⚫ Since good is homogeneous, consumers
will buy from lowest price seller
If firms charge different prices, consumers
buy from lowest priced firm only
If firms charge same price, consumers are
indifferent who they buy from and each firm
will supply half the market

©2005 Pearson Education, Inc. Chapter 12 164

 Price Competition – Bertrand
Model

⚫ Nash equilibrium is competitive

equilibrium output since have incentive to
cut prices
⚫ Both firms set price equal to MC
P = MC; P1 = P2 = $3
Q = 27; Q1 & Q2 = 13.5
⚫ Both firms earn zero profit

©2005 Pearson Education, Inc. Chapter 12 165

 Price Competition – Bertrand
Model

⚫ Why not charge a different price?

If charge more, sell nothing
If charge less, lose money on each unit sold
⚫ The Bertrand model demonstrates the
importance of the strategic variable
Price versus output

©2005 Pearson Education, Inc. Chapter 12 166

 Bertrand Model – Criticisms

⚫ When firms produce a homogenous

good, it is more natural to compete by
setting quantities rather than prices
⚫ Even if the firms do choose the same
price, what share of total sales will go to
each one?
Probably not exactly half

©2005 Pearson Education, Inc. Chapter 12 167

 Competition Versus Collusion:
The Prisoners’ Dilemma

⚫ Nash equilibrium is a noncooperative

equilibrium: each firm makes decision
that gives greatest profit, given actions of
competitors
⚫ Although collusion is illegal, why don’t
firms cooperate without explicitly
colluding?
Why not set profit maximizing collusion price
and hope others follow?

©2005 Pearson Education, Inc. Chapter 12 168

 Competition Versus Collusion:
The Prisoners’ Dilemma

⚫ Competitor is not likely to follow

⚫ Competitor can do better by choosing a
lower price, even if they know you will set
the collusive level price
⚫ We can use a payoff matrix to better
understand the firms’ choices

©2005 Pearson Education, Inc. Chapter 12 169

 Payoff Matrix for Pricing Game
Firm 2
Charge $4 Charge $6

Charge $4 $12, $12 $20, $4

Firm 1

Charge $6 $4, $20 $16, $16

©2005 Pearson Education, Inc. Chapter 12 170

 Competition Versus Collusion:
The Prisoners’ Dilemma
⚫ We can now answer the question of why
firm does not choose cooperative price
⚫ Cooperating means both firms charging $6
instead of $4 and earning $16 instead of
$12
⚫ Each firm always makes more money by
charging $4, no matter what its competitor
does
⚫ Unless enforceable agreement to charge
$6, will be better off charging $4

©2005 Pearson Education, Inc. Chapter 12 171

 Competition Versus Collusion:
The Prisoners’ Dilemma

⚫ An example in game theory, called the

Prisoners’ Dilemma, illustrates the
problem oligopolistic firms face
Two prisoners have been accused of
collaborating in a crime
They are in separate jail cells and cannot
communicate
Each has been asked to confess to the crime

©2005 Pearson Education, Inc. Chapter 12 172

 Payoff Matrix for Prisoners’
Dilemma
Prisoner B
Confess Don’t confess

Confess
-5, -5 -1, -10

Prisoner A Would you choose to confess?

Don’t
confess
-10, -1 -2, -2

©2005 Pearson Education, Inc. Chapter 12 173

 Oligopolistic Markets

Conclusions
1. Collusion will lead to greater profits
2. Explicit and implicit collusion is possible:
1. Reputations
2. Short-lived gains from cheating
3. Face retaliation
3. Once collusion exists, the profit motive
to break and lower price is significant

©2005 Pearson Education, Inc. Chapter 12 174

 Price Rigidity

⚫ Firms have strong desire for stability

⚫ Price rigidity – characteristic of
oligopolistic markets by which firms are
reluctant to change prices even if costs
or demands change
Fear lower prices will send wrong message
to competitors, leading to price war
Higher prices may cause competitors to raise
theirs

©2005 Pearson Education, Inc. Chapter 12 175

 Price Rigidity

⚫ Basis of kinked demand curve model of

oligopoly
Each firm faces a demand curve kinked at
the current prevailing price, P*
Above P*, demand is very elastic
⚫ If P > P*, other firms will not follow
Below P*, demand is very inelastic
⚫ If P < P*, other firms will follow suit

©2005 Pearson Education, Inc. Chapter 12 176

 The Kinked Demand Curve
$/Q So long as marginal cost is in the
vertical region of the marginal
revenue curve, price and output
will remain constant.

MC’

P* MC

Q* Quantity

©2005 Pearson Education, Inc. Chapter 12 177

MR
 Price Rigidity
⚫ With a kinked demand curve, marginal
revenue curve is discontinuous
⚫ Firm’s costs can change without resulting
in a change in price
⚫ Kinked demand curve does not really
explain oligopolistic pricing
Description of price rigidity rather than an
explanation of it
How was price chosen to begin with?

©2005 Pearson Education, Inc. Chapter 12 178

 Price Signaling and Price
Leadership

⚫ Price Signaling
Implicit collusion in which a firm announces a
price increase in the hope that other firms will
follow suit
⚫ Price Leadership
Pattern of pricing in which one firm regularly
announces price changes that other firms
then match

©2005 Pearson Education, Inc. Chapter 12 179

 Cartels
⚫ Producers in a cartel explicitly agree to
cooperate in setting prices and output
⚫ Typically only a subset of producers are
part of the cartel and others benefit from
the choices of the cartel
⚫ If demand is sufficiently inelastic and
cartel is enforceable, prices may be well
above competitive levels
⚫ Most fail to maintain high prices

©2005 Pearson Education, Inc. Chapter 12 180

 Cartels
⚫ Examples of ⚫ Examples of
successful cartels unsuccessful cartels
 OPEC  Copper
 International Bauxite  Tin
Association  Coffee
 Mercurio Europeo  Tea
 Cocoa

©2005 Pearson Education, Inc. Chapter 12 181

 Cartels – Conditions for
Success

1. Stable cartel organization must be

formed – price and quantity settled on
and adhered to
 Members have different costs, assessments
of demand and objectives
 Tempting to cheat by lowering price to
capture larger market share

©2005 Pearson Education, Inc. Chapter 12 182

 Cartels – Conditions for
Success

2. Potential for monopoly power

 Even if cartel can succeed, there might be
little room to raise prices if it faces highly
elastic demand
 If potential gains from cooperation are
large, cartel members will have more
incentive to make the cartel work
 Low potential = low incentive to work out
organizational problems

©2005 Pearson Education, Inc. Chapter 12 183

 Cartels

⚫ To be successful:
Total demand must be fairly inelastic
Either the cartel must control nearly all of the
world’s supply or the supply of noncartel
producers must also be inelastic

©2005 Pearson Education, Inc. Chapter 12 184

 The Cartelization of
Intercollegiate Athletics

1. Large number of firms (colleges)

2. Large number of consumers (fans)
3. Very high profits

©2005 Pearson Education, Inc. Chapter 12 185

 The Cartelization of
Intercollegiate Athletics
⚫ NCAA is the cartel
Restricts competition
Reduces bargaining power by athletes –
enforces rules regarding eligibility and terms
of compensation
Reduces competition by universities – limits
number of games played each season,
number of teams per division, etc.
Limits price competition – sole negotiator for
all football television contracts

©2005 Pearson Education, Inc. Chapter 12 186

 The Cartelization of
Intercollegiate Athletics
⚫ Although members have occasionally
broken rules and regulations, has been a
successful cartel
⚫ In 1984, Supreme Court ruled that the
NCAA’s monopolization of football TV
contracts was illegal
Competition led to drop in contract fees
More college football on TV, but lower
revenues to schools

©2005 Pearson Education, Inc. Chapter 12 187

 13.3 Dominant Firm Model
The dominant firm model features:
1) A single company with an overwhelming
market share (a dominant firm), D
2) many small producers (competitive fringe),
each of whom has a small market share, F

The dominant firm faces market demand, and

residual demand that takes into account the
competitive fringe’s supply:
Dominant Firm
The dominant
firm’s residual
demand (DR)
is market
demand minus
competitive
fringe supply
(in terms of Q)

189
 Dominant Firm Example
P = 100 - QT SF: P =10+QF or QF =P - 10
MCD = AC = 10

What is the equation of the Dominant Firm’s Residual

Demand?
QR = QT – QF
QR = 100-P – (P-10)
QR = 110-2P
P = 55-QR/2

190
 Dominant Firm Example
P = 100 - QT SF: P =10+QF or QF =P - 10
MCD = AC = 10 QR = 90-2P (P = 55-QR/2)

Calculate Dominant Firm Quantities and Price

TRDR = PQD = 55QD-QD2/2
MRL = ∂TR/ ∂QL = 55 – QD
MRL = MC  55 – QD = 10
QD = 45
P = 55-QR/2
P = 55-45/2 = 32.5

191
 Dominant Firm Example
P = 100 - QT SF: P =10+QF or QF =P - 10
MCD = AC = 10 QR = 90-2P (P = 55-QR/2)

Calculate and check Competitive Fringe Quantities

SF: P =10+QF
32.5 = 10+QF
QF = 22.5

QT = QD + QF
QT = 45 + 22.5 = 67.5

P = 100 – QT
32.5 = 100 – 67.5 = 32.5 192
 Dominant Firm Example
P = 100 - QT SF: P =10+QF or QF =P - 10
MCD = AC = 10 QR = 90-2P (P = 55-QR/2)
QF = 22.5, QD = 45, P=32.5

Calculate market share and dominant firm profit

D: Market Share = QD/ QT = 45/67.5*100 = 66.6%
F: Market Share = QD/ QT = 22.5/67.5*100 = 33.3%

D* = TR – TC = (P-MC)QD* = (32.5-10)45 = 1,012.5

At a price of $32.50, the dominant firm produces
45 units for a profit of $1,012.50, and fringe
firms produce 22.5 total. 193
 Dominant Firm Solving Steps

1) Calculate Dominant Firm`s Residual Demand

2) Calculate Dominant Firm`s (residual) MR
3) Leader’s MR=MC to find QD
4) Use QD to solve for P
5) Use P to solve for QF
-Remember that QD+QF=QM
1) Solve for  and Market Share
2) Summarize

194
Chapter Thirteen
 Aside: Calculating SF
Recall:
➢ A competitive firm’s supply comes from its MC
curve
➢ Identical firms supply can be summed (through q)

Fringe Firm: MC=5+20q, 40 firms

Calculate Fringe Supply
MC=5+20q
q=(P-5)/20
QF=40(P-5)/20
QF=2P-10
195
 Growing Fringe:
As the size of the fringe grows, the price, and the
production and profits of the dominant firm
decreases (next slide):
There is therefore an incentive for the dominant
firm to practice limit pricing (illegal in Canada):

Limit Pricing – a strategy whereby the dominant firm

keeps its price below the level that maximizes its
current profit in order to reduce the rate of
expansion by the fringe 196
197