• Industry structure is characteristics that shape the

competitive strategy for a group of firms producing

products that are close substitutes for each other
• Usually, the most important characteristics of
industry structure include
– The number and size distribution of firms
– The existence and height of barriers to entry and
exit, and
– The degree of product differentiation.
• Structural analysis provides a framework for
identifying a firm's strengths and weaknesses in
relation to its competitors.
 2.1. Oligopoly model
• The models of perfect competition and pure
monopoly were unable to explain many aspects of
business conduct in the real world, such as
– product differentiation,
– advertising,
– price wars,
– Collusion etc.
• Imperfect competition lies between the two extreme
markets
• These are Monopolistic Competition and oligopoly
• In this chapter we focus on oligopoly
• Characteristics of Oligopoly Model
– Few firms
– Homogeneous or heterogeneous products
– Interdependence of decisions
– Barriers to entry

• Oligopoly model is classified into two

– Non-collusive models (uncoordinated decision)
– Collusive models (coordinated decision )
2.1.1. Non-collusive models


• The non-collusive models are the following
– Models of output determination in duopoly
– Models of price determination in duopoly
– The kinked demand curve
 1) Models of Output Determination
• Here the firms make decision of how much to produce
to maximize profit, given output of the other firm
• Then based on the determined quantity price is set by
the market
• Interdependence: firms know that their decision affects
its rival and vice versa through price
• Zero Conjectural Variation: When a firm decides the
profit maximizing quantity it expects the other firm to
maintain its output at its current level. It is assumption
of no change in output of the competitor. Firms are
naïve that they do not learn from past mistake
• Independent action: firms make their decision
independently without knowing decision of the other
Cournot Duopoly model
• Let say there are only two firms (A and B)
• Each firm set quantity that maximize its profit given
quantity of the other firm
• Isoprofit function is a function that shows different
combination of quantity supplied by a firm and its
conjectured quantity of the other firm that yields the
firm equal profit
• Here market demand and price depend on how much
the firm and its competitors produce
P  b  aQ where Q  q A  qB
• However the costs of the firms can be different
TC A  cq A and TCB  dqB
12/26/2022 8
T h e iso p ro fit fu n ctio n o f F irm A
 A  TRA  TC A
 A  PqA  TC A
 A   b  a Q  q A  cq A
 A   b  a  q A  q B   q A  cq A

The isoprofit function of Firm B

 B  TRB  TC B
 B  PqB  TC B
 B   b  a Q  q B  cq B
 B   b  a  q A  q B   q B  d q B
Reaction Functions
• Firm A’s reaction function shows, for each value of q B
(assumed fixed) the profit-maximizing value of q A .
• Firm B’s reaction function shows, for each value of q A
(assumed fixed) the profit-maximizing value of q B
• Reaction function is the derivative of the isoprofit
function with respect to respective quantities equated
to zero
 A  B
A  0 and  B  0
q A q B
• The reaction curves are downward sloping due to that
qA and qB are strategic substitutes:
12/26/2022 10
• Strategic substitute is if one firm alters its output, the
other firm reacts by adjusting its output in the
opposite direction without change in profit
• Strategic substitutes mutually offset one another.
• When quantity supplied of one increase for the other
firm it decreases
• Cournot – Nash equilibrium: Profit maximizing
quantities of the two firms are set where the reaction
curves of the two firms are equal.
• At equality point expectation of each firm is realized

12/26/2022 11
Quantity of firm B

Reaction function of firm A

Reaction function of firm B

Quantity of firm A
• Example:
• Let there are two sugar producing firms supplying
homogeneous sugar. If market demand function is
P  5800  Q where Q  qA  qB
and if they have the following costs
TCA  1000qA  1000qB  TCB

12/26/2022 13
• What is the isoprofit functions of the two firms?
 A  TRA  TC A
 A  Pq A  TC A
 A   5800  Q  q A  1000q A
 A  5800  (q A  qB ) q A  1000q A
 A  4800q A  q A2  q A qB

 B  TRB  TCB
 B  PqB  TCB
 B   5800  Q  qB  1000qB
 B  5800  (q A  qB ) qB  1000qB
 B  4800qB  q A qB  qB2
12/26/2022 14
• What are the reaction Functions of the two firms?
 A
 4800  2q A  qB  0
q A
1
q A  2400  qB reaction function of firm A
2

 B
 4800  qA  2qB  0
qB
1
qB  2400  qA reaction function of firmB
2

12/26/2022 15
• Given the reaction functions of example above what
is the quantity supplied by each firm at equilibrium?
• Cournot – Nash equilibrium is where the reaction
functions intersect
1
q A  2400  qB reaction function of firm A
2
1
qB  2400  q A reaction function of firm B
2
• Solving simultaneously
q A  1, 600 and qB  1, 600
Note: If the firms cooperate, they could produce lower output
that results in higher profit (but not good for the society)
12/26/2022 16
• Show the reaction curves and equilibrium
graphically
qB
4800 Reaction curve of firm A

2400
1600
Reaction curve of firm B

1600 2400 4800 qA

12/26/2022 17
• Based on the Cournot Nash equilibrium model,
what is the market price at equilibrium?

P  5800  Q where Q  qA  qB
P  5800  1600  1600 P  2, 600
• Based on the Cournot Nash equilibrium what are
the profit of the two firms?
 A  Pq A  TC A or
 A  4800q A  q A2  q A qB
 A  4800(1600)  (1600) 2  (1600)(1600)
 A  2,560, 000
12/26/2022 18
 B  PqB  TCB or
 B  4800qB  q AqB  qB2
 B  4800(1600)  (1600)(1600)  (1600)2
 B  2,560, 000

qSince the firms have equal costs,

• the quantity they supply at equilibrium are equal
• Profits they get are also equal
 Criticism of Cournot model
• It is based on a naive and unrealistic assumption that
each firm believes its rival will not change its output
(the zero conjectural variation assumption). In
practice firms learn from past experience and the
other firm does react and does also change its output.
• It ignores the possibility that firms may seek
cooperative or collusive solutions, in order to
maximise their joint profits.
• It focuses on output-setting, and ignoring price-
setting decisions. Price adjustments in the Cournot
model are the consequence of output decisions, rather
than being primary courses of action.
12/26/2022 20
 Chamberlin’s Joint Profit Maximization
• Chamberlin departs from the zero conjectural
variation assumption.
• The firms recognize their interdependence when
making their output decisions
• The firms can understanding each other (without
collusion) and coordinate their decisions
• By doing so if they reduce their out put
simultaneously, they can earn the same profit
supplying less quantity
• Π=PQ-TC

12/26/2022 21
• They coordinate their decision and resulted in
monopoly solution (not collusion)
• Then the firms can share the monopoly profit
proportionally among themselves
• If the two firms cheat by increasing output they result
in the Cournot- Nash equilibrium
• Chamberlin’s solution is always liable to break down,
if either or both firms succumb to the temptation to
act unilaterally and ignore their interdependence.

12/26/2022 22
• Example
• In the above example what are the joint profit
function?
P  5800  Q where Q  qA  qB
TCA  1000qA and TCB  1000qB
• Now the firms understand each other and monopolize
the market (without talking with each other)
• Each calculate the joint profit

12/26/2022 23
   TR  TCA  TCB
  PQ  TCA  TCB
   5800  Q  Q  1000qA  1000qB
  (5800  q A  qB )(q A  qB )  1000q A  1000qB
  4800q A  4800qB  q2A  2q A qB  qB2
( joint profit function)

12/26/2022 24
• What are the joint profit maximization
reaction of the two firms?

  4800q A  4800qB  q2A  2q A qB  qB2


 4800  2q A  2qB  0
q A
q A  2400  qB

 4800  2qB  2q A  0
qB
qB  2400  q A

12/26/2022 25
• If we solve the two new reaction curves
simultaneously we get infinite solutions
• The specific solution depends on the market share of
each firm
• Let say the two firms share the market equally
(qA=qB)

q A  2400  qB qB  2400  q A Less than the

Nash-equilibrium
q A  2400  q A qB  2400  qB
quantity
2q A  2400 2qB  2400
q A  1200 qB  1200

12/26/2022 26
• If we show the new reaction curves graphically the
two reaction curves overlap

• The new reaction curves

1200

1200
• What is the joint profit model equilibrium
price?

P  5800  Q where Q  q A  qB
P  5800  1200  1200 
P  3, 400

Which is higher than

the Nash-equilibrium
price

12/26/2022 28
• What is the joint profit?
  4800q A  4800qB  q A2  2q A qB  qB2
  4800(1200)  4800(1200)  1200 2

2
 2(1200)(1200)  1200
Greater than the
  5, 760, 000  joint profit Nash-equilibrium
profit
• What is the profit of each firm?
  5, 760, 000
 5, 760, 000
A  B    2,880, 000
12/26/2022
2 2 29
 Stackelberg’s Solution:
the Leader–Follower Model
• Let one firm is a leader
• Firm A leader (L) and Firm B follower (F)
• Suppose, the zero conjectural variation assumption is
dropped for firm A, but retained for firm B.
• B continues to select its profit-maximizing output by
treating A’s output as fixed at its current level.
• But A learns to recognize that B behaves in this
manner.
• A therefore learns to take B’s behaviour into account
whenever A makes its own output decisions.
12/26/2022 30
• Firm A knows that firm B makes decision based on
Firm A’s output
• So it simply satisfies its expectations
• It is by including reaction of firm B into isoprofit
function of firm A
• A is the first mover and B is follower
• Firm A earns a higher profit than at Cournot Nash
equilibrium profit, while B earns a lower profit.
• A is rewarded, and B is punished, for the fact that A
has insight into B’s behaviour, while B does not have
corresponding insight into A’s behaviour.
• A is rewarded for its first-mover advantage.
12/26/2022 31
 • Example:
• Let there are two firms supplying sugar. If market
demand function is
P  5800  Q where Q  qA  qB
and their costs are
TCA  1000qA and TCB  1000qB
A) What are the isoprofit functions of the two firms?
 A  TRA  TC A  B  TRB  TCB
 A  Pq A  TC A  B  PqB  TCB
 A  5800  (q A  qB ) q A  1000q A B  5800  (q A  qB ) qB  1000qB
 A  4800q A  q A2  q A qB  B  4800qB  q A qB  qB2
12/26/2022 32
B) What are the reaction function of the two firms?
 A
 4800  2 q A  qB  0
q A
1
q A  2400  qB reaction function of firm A
2

 B
 4800  q A  2 qB  0
qB
1
qB  2400  q A reaction function of firm B
2

12/26/2022 33
C) If firm A is a leader what is the profit function of
firm A?
Insert the reaction function of firm B into the isoprofit
function of firm A and maximize
1
 A  4800q A  q  q A qB and qB  2400  q A
2
A
2
 1 
 A  4800q A  q A  q A  2400  q A 
2

 2 
 A  2400q A  (1 2)q 2A

12/26/2022 34
D) What are the firms’ profit maximizing quantities?
 A  2400qA  (1 2) qA2
d A
 2400  q A  0
dq A
q A  2400 and
1
qB  2400  q A
2
1
qB  2400  (2400)
2
qB  1200

12/26/2022 35
 Firm A as a leader equilibrium

1200

2400
E) What is the equilibrium price?

P  5800  Q where Q  q A  qB
P  5800  (2400  1200)
P  2, 200
F) What are the profits of the two firms?
 A  Pq1  TC1
 A  2400q A  (1 2)q A2
 A  2400(2400)  (1 2)(2400) 2

 A  2,880, 000
12/26/2022 37
 B  4800qB  qA qB  q
2
B

 B  4800(1200)  2400 x1200  1200 2

 B  1, 440, 000
 2) Bertrand Duopoly Model:
Model of Price Determination
• Here the firms make decision of how much to charge to
maximize profit, given price of the other firm
• Then based on the determined price, quantity is set by
the market
• Interdependence: firms know that their decision affects
their rivals and vice versa
• Zero Conjectural Variation : a firm determines its price
assuming price of its rival is given and doesn’t change
• Independent action: firms make their decision
independently without knowing decision of the other

12/26/2022 39
• Bertrand criticizes Cournot’s emphasis on output-
setting.
• Bertrand argues that price, rather than output, is the
key decision variable for most firms.
• In Cournot’s model, the firms decide their output
levels and then allow the market price to adjust
accordingly.
• In the Bertrand model each firm sets its own price,
and then sells as much output as it can at the chosen
price.
• Bertrand uses a zero conjectural variation assumption
concerning prices:
12/26/2022 40
• Assume that the two firms produce similar products
• Let the two firms produce cane sugar and sweet
potato sugar
• A price cut by one firm allows it to gain some, but not
all, of its rival’s customers, due to brand loyalty
• Firms set price based on the zero conjecture variation
of price
• If firm A decreases price, firm B also decreases price
and vice versa

12/26/2022 41
• These leads to the derivation of reaction curves
• Measuring PA on the horizontal line and PB on the
vertical line reaction curves can be shown graphically
• Why the reaction functions are upward sloping?
• PA and PB are strategic compliments: If one firm
alters its price, the other firm reacts by adjusting its
price in the same direction.
• Strategic complements mutually reinforce one
another
• The point at which the two firms’ reaction functions
intersect corresponds to equilibrium

12/26/2022 42
• The point at which the two firms’ reaction functions
intersect corresponds to the point at which both firms
maximise their own profits subject to a zero
conjectural variation assumption, that the other firm
will maintain its price at the current level.
Example: Let the demand of the firms are
qA  6000  2 pA  2 pB and qB  4000  2 pB  2 pA

and if their costs are

TCA  1000qA and TCB  2000qB

12/26/2022 44
A) Formulate the profit function of the firms
 A  p A q A  TC A
 A  p A (6000  2 p A  2 p B )  1000 q A
 A  p A (6000  2 p A  2 p B )  1000(6000  2 p A  2 p B )
 A  6, 000, 000  8000 PA  2 PA2  2 PA PB  2000 PB

 B  p B q B  TC B
 B  p B (4000  2 p B  2 p A )  2000 q B
 B  p B (4000  2 p B  2 p A )  2000(4000  2 p B  2 p A )
 B  8, 000, 000  8000 p B  2 p B2  2 p A p B  4000 p A

12/26/2022 45
B) Find the reaction function of the firms
 A   6, 000, 000  8000 PA  2 PA2  2 PA PB  2000 PB
 A
 8000  4 PA  2 PB  0
PA PB
1
PA  2000  PB
2

For example if firm A

thinks, firm B charges PA
PB=2000, then it charges PA=3000

12/26/2022 46
 B   8, 000, 000  8000 PB  2 P  2 PA PB  4000 PA
B
2

 B
 8000  4 PB  2 PA  0
 PB
1 PB
PB  2000  PA
2

For example if firm B PA

thinks, firm A charges
PA=1000, then it charges PB=2500
 C) What are the equilibrium PA and PB?
1 1 PB
PA  2000  PB and PB  20  PA
2 2
4000
1 1 
PA  2000   2000  PA 
2 2 
PA  4000 and PB  4000
4000 PA
D) What are the equilibrium QA and QB?
q A  6000  2 PA  2 PB and q B  4000  2 PB  2 PA
q A  6000  2(4000)  2(4000) q B  4000  2(4000)  2(4000)
q A  6000 q B  4000
Note: If the firms cooperate, they could charge higher price
that results in higher profit
 E) What are the profit of the two firms?
 A  pAqA  TCA  B  pBqB  TCB
 A  4000(6000) 1000(6000)  B  4000(4000)  2000(4000)
 A  18,000,000  B  8,000,000
 3) The Kinked Demand Curve

• In many oligopolistic markets current prices are rigid

(inflexible)
• Each firm in an oligopoly may be reluctant to initiate
either a price increase or price cut, for the following
reasons:
vIf a firm increases its price, rivals will not increase so the
firm loses more of its customers (elastic demand dd)
vIf a firm decreases its price, rivals will also decrease their
prices so the firm cannot get expected more customers
(inelastic demand DD)
12/26/2022 50
• If all firms think in this way, prices throughout the
industry tend to be inflexible or rigid, because no
firm wishes to be the first to implement a price
change in either direction.
• In figure below, P2 is the firm’s current price.
• What is the firm’s perceived demand function?
• For prices > P2, the demand of the firm is dd
• For prices < P2, the demand of the firm is DD
• So it is kinked at P2 and perceived demand curve is
dAD

12/26/2022 51
 D

d
P3 A
P2
P1
d

Q1 Q2 Q3Q4 Q5