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Given TC=5Q+20, TC = 5

Q
q1=55- p1 – The DD function in market 1
q2=70- 2p2 – The DD function in market 2
1.Determine q1, q2, p1, and p2 that maximises profit
2.Find the elasticity of DD in the two markets?
3.Calculate the total profit the monopolist will obtains from its sell in the two markets
4.Present the outputs and prices in the two markets in the back to back diagram
 Solution
1. For market 1  Inverse DD function
1st Find the inverse DD function q2=70-2q2
q1=55-p1 q2-70= -2q2
q1- 5 p2=35-0.5q2
p1=55-q1  TR2=p2q2
2nd Find TR1=p1q1 =(35-0.5q2) q2
(55-q1) q1 =35q2-0.5q22
 MR2= TR2
2
55q1-q1
3 Find MR1= TR1
rd
q2
q1 35-q2
=55-2q1  MR2=MC
4th Equate MR1=MC 35-q2=5
=55-2q1=5 -q2=5-35
-2q1=5-55 -q2= -30
-2q1= -50 q2=30
q1=25  Substitute q2=30 in the inverse DD fun.
5th Substitute q1=25 in the inverse DD fun. P2=35-0.5q2
p1=55-q1 P2=35-0.5 (30)
p1=55-25 P2=35-15
p1=30 P2=20
 For market 2

2. Price elasticity of DD in market 1

q1=55-p1 q2=70-2p2
1= q1 x p1 2=q2 x p2
p1 q1 p2 q2
-1 x 30 -2 x 20
25 30
-1.2=1.2 -1.33=1.33
The above result tells us that DD is more elastic in market 2. Therefore, the monopolist charge
lower price than market 1.
3.The profit of the monopolist
= (TR1 + TR2) – TC or
= (p1q1 + p2q2) – (5Q + 20), where Q is q1+q2
= 30 (25) + 20 (30) – (5 (25 + 30) + 20)
= 750 +600 – (5 (55) +20)
=1350 – (275 +20)
=1370 – 295
= 1055

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4.Back to back diagram

P

30

20

DD2
DD1
5 MC
MR1 MR2

q1=25 q2=30

 From the figure, the market with less elastic of DD curve (DD1) has higher price. This implies
that the monopolist will charge high price in the market in which quantity purchased is less
responsive to price changes. The necessary conditions for price discrimination are
1. The existence of different consumers (separate markets) with different price
elasticity
2. The ability of the monopolist to identify these consumers
3. No reselling of products should take place by consumers from lower price market to a
higher price market. For further reading, refer, Modern Microeconomics, A.
Koutsyiannis, PP 197.

6.3. MULTI P-LANT MONOPOLIST

 So far we have assumed that a monopolist own and produce an output by means of only one
plant. This is not all the case. It is possible for the monopolist to install more than one plant
and hence cost conditions may differ from one plant to another. The cost curves associated to
each plant are different. The problem faced by monopolist is the allocation of production
between plant 1 and 2. The monopolist maximises profit by equating MR equal to MC.
However, there is one MR and three MC curves when we assume the monopolist have two
plants. That is, MC1 for plant1, MC2 for plant 2, and MC common marginal cost (multi-plant
MC). The monopolist maximises profit by producing output level where each plant’s MC is
equal to MR.
 Consider the following table to examine how a monopolist with two plants having different cost
of production first determines total output and then decides how much to be produced sing
each plan.
Q P MR MC1 MC2 MC
1 5.00 - 1.92 1 2.04 3 1.92
2 5
2 4.50 4.00 2.00 2.14 2.00
4 8
3 4.10 3.30 2.08 2.24 2.04
4 3.80 2.90 2.16 6 2.34 10 2.08
7
5 3.55 2.55 2.24 2.44 2.14
6 3.35 2.35 2.32 9 2.54 2.16
7 3.20 1.30 2.40 2.64 2.24
8 3.08 2.24 2.48 2.74 2.24
9 2.98 1.18 2.56 2.84 2.32
10 2.89 2.08 2.64 2.94 2.34

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 The total output level that maximises the profit of the monopolist is 8, MR=MC. The
monopolist will produce 5 units using plant 1 while 3 units using plant 2. This, is because
profit is maximized when MR=MC1=MC2=MC.
 Mathematical example: Given, Q=200 - 2P, TC1=10q1 and TC2=0.25q22, find q1, q2, Q and
profit of the firm.
 Solution:
1st find the inverse fun
Q=200 – 2P 7th Apply simultaneous equ. for
Q – 200= -2P MR=MC1 and MR=MC2
P= 100 – 0.5Q, where Q is q1 +q2 100-q1-q2=10
2nd TR=PQ -(100-q1-q2=0.5q2)
= (100 – 0.5Q) Q 10- 0.5q2=0
2
= 100Q – 0.5Q 10=0.5q2
3rd MR= TR1 q2= 10/0.5=20
q1
=100 –Q 8th MR=MC1=100-q1-q2-10
4th MC1= TC1 = 100- q1-20-10
q1 q1=100-30
= 10 q1= 70
MC2=TC2 9th The profit of the monopolist
q2 Π=TR-TC
=0.5q2 =(TR)-(TC1+TC2)
5th Equate MR=MC1 =(100Q-0.5Q2)-(10q1+0.25q22)
100 – Q=10 =(100(90)-0.5(90)2)-(10(70)+0.25(20)2)
100 – q1 – q2 –10=0 =(9000-4050)-(700+100)
th
6 Equate MR=MC2 = 4950 - 800
100 – Q=0.5q2 = 4150
100-q1-q2=0.5q2

6.4. SOCIAL COST OF MONOPOLY

 Is the existence of a monopolist evil? The answer to this question is no and yes. No if the
monopolist charges different prices based on the marginal WTP, bulk discount, and elasticity
of DD. That is, as we have seen in the three types of price discrimination that a monopolist
charge higher and lower price for those who have high and low willingness to pay for its
product-discrimination across person, on the basis of bulk discount-discrimination across
product consumed, and elasticity of DD-across group of people in first, second, and third
degree price discrimination, respectively are Pareto efficient.
 We have seen in chapter 5 that a remarkable outcome of perfect competitive market is resource
allocation efficiency, which results to social welfare and increase in employment. This is
because at competitive equilibrium, the marginal utility of the consumed good (MU=DD)
equals price (P), which in turn equals the MC of producing the good. Hence, if MU=P (social
welfare) and P=MC (allocation efficiency), then MU=MC.
 An alternative way to understand the efficiency of competitive market is through the concept of
Consumers surplus. Consumers’ surplus is willing to pay (proportional DD curve) for and the
amount actually paid (prorata DD curve). In other words, it is the area to the left of the
perceived DD curve above the equilibrium price or since equilibrium represents the money not
spent by consumers who would have been willing to pay a price higher than equilibrium. In
short, it is the savings of the consumer for buying Qe at Pe.

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 Clearly, an economy is performing well when it generates much to the consumer surplus and
an efficient situation is one in which the maximum amount of consumers’ surplus is squeezed
out of the system.

P P

CS E CS E
Pe Pe

MU=DD=ƒ(Qd)
MU=DD= ƒ(Qd)

Qe Qe
Linear DD curve Non-linear DD curve
 The MC of goods represents supply. Equating the MC curve that passes through point E in the
above graphs shows producers’ surplus. Producers’ surplus is the area above the MC curve
but below the equilibrium Price (Pe). In other words, it indicates the difference between the
additional cost (MC) firms are willing to incur and what they actually incurred (Pe=MC). In
short, it is the money that suppliers would not have received if demand had been less than Qe.

P
MC=SS

CS
Pe
PS
DD

Qe
2
 Given Pd=25-Q and Ps=2Q+1 as demand and supply function, respectively calculate the
consumers’ and producers’ surplus.
 1st find the equilibrium Q and P 2
Pd=Ps
25-Q2=2Q+1 -2±10
2
25-1=2Q+Q 2
24=2Q+Q2 -2+10 and –2-10
Q2+2Q-24=0 2 2
2nd Use the quadratic formula to get Q Q=4 and Q= -6
-b±√b2-4ac 3rd find equilibrium P
2a Pd=25-Q2 or Ps=2Q+1
2
-2±√2 - (4(1)(-2) Pd=25-(4) 2 or Ps=2(4)+1
2(1) Pd= 25-16 or Ps=8+1
-2±√4+96 Pd=Ps=9
2
-2±√100

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4th Show the equilibrium Q and P graphically

25 SS

CS
9
PS
DD
1

Qe Qe
5th CS=  0
f (Qd )dQ -PeQe 6th PS=PeQe- 
0
f ( ps) dQ
4 4
=  0
(25  Q 2)dQ  9(4) =9(4)-  (2Q  1)dQ
0
3
=(25Q-Q /3)/ -36 4
0 =36-(2Q2/2+Q) 04
=25(4)-43/3-36 =36-(2(42/2)+4)
=100-64/3-36 =36-(32/2)+4)
=100-21.3-36 =36-20=16
=42.7
 Exercise
 Given the inverse DD and SS function as Pd=90-Q and Ps=(2Q+2) 2 find the CS for
Qd=30and Pe=40 and PS for Qs=5 and 42, respectively.
 Answer =CS is 1050 and PS is –76.7.
 These being the CS and PS in perfectly competitive market, the social cost of monopoly arises
due to the fact that a monopolist operates inefficiently as compared to perfect competition in
the sense that Pm>Pc and Qm<Qc. This is because a monopolist determines its Q and P by
equating MR=MC unlike sellers in perfect competition market that equate P=MC. As a result
some part of CS and PS obtained in perfectly competitive market are lost. To understand the
social cost (DWL) of monopoly, consider the graph below.

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P MC

Pm A

Pc B Ec

Em

DDm
MRm

Qm Qc Q

 The above graph shows the change in the CS and PS for a movement from competitive
(monopoly) to monopoly (competitive) output. The CS goes down (up) by area PcEcAPm. That
is, it goes down (up) by rectangle PcBAPm since consumers are not (now) getting all the units
they were buying before at a higher (cheaper) price; and it goes down by a triangle ABEc
since they loose (get) some surplus from the lower (extra) units that are being sold.
 The PS on the other hand, goes up (down) by area PcBAPm due to the higher (lower price) on
the units he was already selling. It goes down (up) by EmBEc due to looses (profits) on the
lower (extra) units it is now selling. The area PcBAPm is just a transfer from the consumers
(monopolist) to the monopolist (consumers) and hence one side of the market is made better off
while the other worse off, but the total surplus does not change as a result of the transfer.
However, the area ABEc and EmBEc represent the DWL due to monopoly behaviour (a true
increase in surplus-measure the value that the consumers and the producers place on the extra
output that has been produced).
 The DWL provides a measure of how much worse off people are paying the monopolist than
paying the completive price. The DWL due to monopoly like that of the DWL due to tax
increase measures the value of the lost output by valuing each unit of lost output at a price that
people are willing to pay for a unit. In other word, as we move from competitive to monopoly
output, the sum of the distance between the demand curve and the MC curve generates (gives)
the value of the lost output (Qc-Qm) due to monopoly behaviour. The total area between the
two curves is the DWL when moving from competitive to monopoly output.
 Numerical Example:
 Assume there is a tendency of moving from competitive to monopoly output. If the demand and
total functions are Q=100-2P and TC=14Q+2Q2, respectively
A. Determine Pc, Qc, Pm, and Qm.
B. Show the equilibrium Q and P you obtained in A above graphically.
C. Calculate the CS and PS under competitive and monopoly market structure.
D. Calculate part of CS transferred to the monopolist due to inefficiency of monopoly.
E. Calculate the social cost (net loos or DWL) of monopoly.
 Solution:
Equilibrium Q and P in perfectly competitive 50-14=4Q+0.5Q
market 36=4.5Q
A. P=MC Qc=8
50-0.5Q=14+4Q Pc=50-0.5Q or 14+4Q

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=50-0.5(8) or 14+4(8) PS=1/2(46-14) x 8

=50-4 or 14+32 =1/2(32) x 8
=46=46 =16 x 8=128
Equilibrium Q and P in monopoly market CS and PS under monopoly
TR=PQ CS =1/2(50-46.4) x 7.2
=(50-0.5Q) Q =1/2(3.6) x 7.2
=50Q-0.5Q2 =1.8 x 7.2=12.96
MR=∂TR=50-Q PS = ½((42.8-14) x (7.2))+((46.4-42.8)
∂Q x 7.2)
MC=∂TC=14+4Q =1/2((28.8) x (7.2))+(3.6 x 7.2)
∂Q =14.4(7.2)+ 25.92
MR=MC =103.68+25.92=129.6
50-Q=14+4Q The CS transferred to the monopolist and DWL
50-14=4Q+Q due to monopoly output
36=5Q D. Consumers’ loss due to monopoly =CS
Qm=7.2 under perfect –CS in monopoly
Pm=50-0.5Q 16-12.96
=50-0.5(7.2) 3.04
=50-3.6 =46.4 E. The amount of surplus transferred from
consumers to the monopolist is
MC=SS
B. (Pm-Pc) x Qm
Pm (46.4-46) x 7.2
Pc 0.4 x 7.2
2.88
DDm
DWL= CS not transferred + PS lost
MRm =1/2(((Pm-Pc) x (Qc-Qm)) + ½
((Pc-MC at Qm) x (Qc-Qm)
Qm Qc =1/2(46.4-46) x (8-7.2) + ½((46-
Consumers’ and producers’ surplus in perfect 42.8) x (8-7.2)
competition =1/2 ((0.4) x (0.8)) + ½ ((3.2) x
C. CS=1/2 (50-46) x 8 (0.8))
=1/2(4) x 8 =0.2(0.8) + 1.6(0.8)
=16 =0.16+1.28=1.44

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CHAPTER SIX
MONOPOLISTIC COMPETITION
 Monopolistic competition is the market structure whose characteristics lies between perfect
competition and monopoly.
7.1. BASIC ASSUMPTIONS (Chamberlain’s Heroic Assumptions)
1. There are relatively large number of sellers and buyers.
2. The products of the sellers are differentiated, but they are close substitute. In other
ward, many firms sell slightly differentiated (heterogeneous) products and hence the
cross elasticity of DD is large but not infinitive.
3. The effect of product differentiation is that any firm in a monopolistic competition
market has some degree of freedom in the determination of price for its product. That is
to say, the firm is not price taker for it has some degree of monopoly power over its
product, which it can exploit.
4. Entry to and exit from the market relatively to monopoly is easy. This is because, firms
can enter in to the market by having patent rights1 for their products, copy rights on
their brand names2 and trademarks, enhancing the difficulty and cost of being
successfully imitating their products (innovation). This in turn gives them the right to
become price marker depending on the quality of their products. The best examples for
monopolistic competition are the market for toothpastes, automobiles, TV sets, PCs,
soaps, tyres, breweries etc.
5. Due to product differentiation, in addition to price competition, there is also non-price
competition. That is, competition for potential consumers through advertising and sales
promotion (by/through arranging exhibitions, trade fair, acquiring certificate for
quality assurance, sponsorship etc).

1
A patent offers inventors the exclusive right to benefit from their invention for a limited period of time (in U.S.A
the life is 17 years). During that period, the holder of the patent have a monopoly on the invention; after the patent
expires, anyone is free to utilize the technology described in the patent. The longer the life of the patent, the more
gains can be accrued by the inventors, and the more incentive they have to invest in research and development (R &
D). However, the longer the monopoly is allowed to exist, the more DWL will be generated. The benefit from a long
patent life is that it encourages innovation; the cost is that it encourages monopoly. The optimal patent life is the
period that balances these two conflicting effects. In short, the reason for offering patent protection is to encourage
innovation. In the absence of a patent system, it is likely that individuals and firms would be unwilling to invest in R
& D, since competitors could copy any new discoveries that they make. Thus, a patent offers a kind of limited
monopoly. The problem of determining the optimal patent life has been examined by William Nordhaus of Yala
University in the book, innovation, Growth, and Welfare, Cambridge, mass: M.I.T. Press, 1969. Varian Hal
R.(1987), “Intermediate Microeconomics, A modern Approach, 3rd ed, W.W. Norton and Company Inc., 500 Fifth
avenue, New York, N.Y.10110, PP 409.
2
Patent rights and hence brand names and trademarks can be transferred to another manufacturer fully or partially
through sells based on some legal agreement. Why firms buy brand names is to take advantage of the famous name
consumers of a product are already familiar, assuring the capacity and commitment of the buyer to keep the standard
and quality of former product is what the seller of the band name scrutinises before entering into agreement. This is
because if the standard and quality of the buyer deviates much from the original product, consumers of the original
product may loose the brand loyalty they had for the product/s of the original producer and hence may endanger its
future existence in the market. If brand name is sold fully, then the legal agreement will state that the original
inventor of the product will not have the right to produce and market the product thereafter. However, if it is sold
partially it implies that the legal agreement that allow the brand name to be copied includes major component (parts)
of the buyer‟s product (which is going to use the same brand name) should be bought from the inventor company
/country. Besides, the agreement indicate that the new product should explicitly state that parts are from and is
licensed by the original company/country who owned solely the brand name for long period of time; and where
should the “sphere of influence”. The best example is the brand name “Sony” sold partially to Malaysia and China
to produce and sell Sony TV sets and CD players, respectively to Asia and Africa countries by Japan.

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6. The goal of each firm in monopolistic competition is profit maximisation. A firm is

assumed to know its DD and cost functions.

7.2. PRODUCT DIFFERENTIATION AND THE DD CURVE

 A typical characteristic of monopolistic competition market is product differentiation. As a
result, individual firms face a DD curve that is highly elastic (slightly negatively sloped), but
not perfectly elastic. This implies that
1. A firm in monopolistically competitive market has few rivals unlike perfect competitive
firm, which has significant rivals, and a monopoly firm, which has no rival.
P
P P

d curve d curve
DD curve

DD curve for a firm DD curve for a monopoly DD curve for a firm in

In perfect comp. mkt firm and the industry monopolistic comp mkt
2. The products of sellers are slightly differentiated. This means that the product of any
firm is similar (close), but not identical (perfect) substitute to the products of any other
firm in the industry. For example, in the case of toothpastes we have brands such as
Collegate, Aqua fresh, Choice, and President etc.

The patent right given to the manufacturers of the above-mentioned brands restricts
two or more manufacturers from producing identical toothpaste. However, all brands
of toothpastes are similar or close substitute to one another. Hence, a firm that
produces any toothpaste faces a slightly negatively sloped DD curve for its product-
implying that any manufacturer has monopoly power over its product, limited share in
the market and therefore has some degree of freedom in the determination of price for
its product.

 In general, the importance (significant) of product differentiation are then

1. It gives some advantage in the determination of price for its product to a firm in
monopolistic competition market. However, each firm faces keen (stiff, bottleneck)
competition from other firms that produce close substitutes. Therefore, the freedom a
firm to alter the price of its product is constrained (limited) to some extent. This is
because if a firm increases its price it will loose some but not all of its customers
(consumers of its product). On the contrary, if a firm decreases its price it will increase
its sales by attracting some but not all consumers of other firms’ products.
2.
3. Consumers do have special preferences for the products of a specific seller and within
limits will pay a higher price to satisfy those preferences. The reason why not a firm
looses or attract all consumers when price increases or decreases, respectively and
consumers are willing to pay a higher price for a product of a specific firm is due to
brand loyalty. This means that whatever the change in the price of other firms’
products people may not switch their consumption to other brands.

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The best example for this is the survey conducted regarding the DD for Sharp brand
products in Manchester (England) 1990’s. In 1990’s a Japanese company that produce
Sharp brand was the official sponsor of Manchester United Football Club. During that
decade, there was a decline in the prices of other brands of TV sets and refrigerators.
In spite of this, the survey conducted on Manchester United Football Club funs
confirmed that no significant reduction in the sales of the company was registered in
the city. This was because the funs keep on consuming the product of the firm (Sharp
brand) that sponsor and made the club financially strong and the best club in the world
after losing all of its players in an airplane accident occurred in 1980’s. This example
therefore best explains how brand loyalty due to non-price competition is stronger than
price reduction under monopolistic competition.

7.3. THE CONCEPT OF PRODUCT GROUP AND INDUSTRY

 PRODUCT GROUP:

It refers to a group of sellers in an industry, supplying different brand of commodities or

services, but are very much (closely) related and hence consumers are unable to differentiate
them based on some state of quality, such as shape, test, colour etc.

For instance, within automobile industry cars with brand name Fiat and Lada, Corolla DX
and Toyota DX are alike in their shape many people cannot differentiate them precisely simply
by looking them distant without getting close and search for some clues, such as looking at
their brand names. Similarly, though it typically represents an example of oligopoly market, in
the soft drink industry Mirinda and Fanta, Pepsi and Coca-Cola, 7 UP and Sprite-supplied by
Moha soft drink P.L.C and East Africa bottling P.L.S.C (Private Limited Share Company),
respectively are so close that a consume provided two glasses of these bundles without looking
when poured can hardly tell precisely which glass contains which bundle simply by testing or
looking the colours of the products in the two glasses. Therefore, the above bundles can be
categorised as 3 different product groups.

 INDUSTRY:
The concept industry refers to broader classification and hence consists of several product
groups. If all firms in a monopolistic competition market produce very close products as the
brewery industry or supply very close service as the banking and insurance industry in
Ethiopia all the firms in can be regarded as product group and industry. On the other hand, if
all firms in an industry produce highly differentiated products, we say there is no product
group. Thus, product group is a sub set of industry.

7.4. SHORTRUN AND LONGRUN EQUILIBRIUM OF FIRMS

A. SHORT RUN EQUILIBRIUM

 The shape of the proportional DD curve and cost conditions-MC and ATC-are the same as
firms under perfect competition. The difference between perfect and monopolistic competition
lies in the perceived DD curve (d). A firm in monopolistic competition market perceives its
demand curve to be less than perfectly elastic (not horizontal).

The reason is that the output of one firm is close but not perfect substitute for the output of
other firms that produce differentiated products. This implies that the firm perceives it must
reduce price to get more consumers. Accordingly, it is the short run MR (derived from the

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perceived demand curve) that will be equated with the MC curve in order to find the optimal-
profit maximization (loss minimization)-output and price.

ATC
P P MC

MC ATC
SRPe A C A

SRPe B

C B
E
SRD SRd E SRD
SR d
SRMR
SRMR

SRQe SRQe
Short run profit short run loss
 The three characteristics of short run equilibrium under monopolistic competition
SR D
1. Each firm determines output and price by equating MR and MC (point E).
2. D intersects d at the output chosen by the firm.
3. A firm will obtain excess profit if Pe>ATC and loss if Pe<ATC.
 Numerical Example
 Assume a firm engaging in selling its product and promotional activities in monopolistic
competition face short run demand and cost functions as Qd=20-0.5P and TC= 4Q2-8Q+15,
respectively. Having this information
A. Determine the optimal level of output and price in the short run.
B. Calculate the economic profit (loss) the firm will obtain (incur).
C. Show the economic profit (loss) of the firm. Note that the total shaded area must be
equal to the profit (loss) obtained in B above.

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 Solution
A. Q=20-0.5P B.∏=TR-TC or Q (P-ATC)
Q-20= -0.5P =(40Q-2Q2) –(4Q2-8Q+15) or 4(32-11.75)
*P=40-2Q =(40(4)-2(4) 2) - (4(4) 2-8(4)+15) or
4(20.25)
*TR=PQ =(160-64) – (64-32+15) or 81
=(40-2Q) Q =128 - 47 or 81
=40Q-2Q2 =81=81
*MR=∂TR= 40-4Q P.
∂Q MC
*TC=4Q2-8Q+15
*MC=∂TC=8Q-8
ATC
∂Q 32
*MR=MC
40-4Q=8Q-8
48=12Q 24 Q=20-0.5P or P=40-2Q
Q=4 11.75
*P=40-2Q
P=40-2(4) MR=40-4Q
P=40-8=32

 Exercise
 Given P=30-5Q and ATC=20/Q+4Q-6, answer the above questions A to C
 Q=2,P=20, and profit 16

B. LONG RUN EQUILIBRIUM

 There are three worthwhile observations about monopolistically competitive equilibrium in
the long run. One of them will be discussed under this heading while the other two under 1.5.
 In the long run, the tendency of a firm in monopolistic competition is to earn normal profit
(BEP, P=LAC-not P = min LAC). This is because we expect the short run economic profit of
firms to attract new rivals for entry is relatively easy than monopoly.

 As new firms enter in to the monopolistic competition market, supply of output in the market
increases. This in turn shifts the perceived demand curve faced by the typical firm to the
right; push price down, and the disappearance of economic profit (∏ will be equal to zero).
However, although profits are zero, the situation is not Pareto efficient. The reason is that
profits have nothing to do with efficiency question: when P is greater than MC, there is an
efficiency argument for expanding output.
 The long run equilibrium of a firm in monopolistic competition is defined by three conditions.
1. D must be tangent at the falling part of LAC (not at the minimum of LAC)
2. The proportional demand curve (D) must intersect both d and LAC at the tangency
3. No excess profit is obtained because P=LAC. Therefore, the long run equilibrium is
obtained at a point F where D=d=P=LAC.

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P LMC LAC

Pmc
F Ec
Pc
dmc
Emc

DDmc
Excess
Capacity MRmc

LRQmc LRQc Q

7.5. EXCESS CAPACITY AND WELFARE LOSS

(1) EXCESS CAPACITY:

The long run equilibrium of monopolistic competition also leads to excess capacity
measured by the difference between the ideal output (long run output of perfect
competition corresponding to the minimum LAC) and the actual output produced in the
long run by a firm under monopolistic competition. That is, firms will typically operate to
the left of output where LAC is minimised. This implies that there is misallocation of
resources for P is greater than the minimum of LAC.

 If there were fewer firms, each could operate at a more efficient scale of operation, which
could be better for consumers. However, if there were fewer firms there would also be
less product variety, and this would tend to make consumers worse off. Which of the two
effects dominates is a difficult question to answer.

 However, the extent of excess capacity depends on the condition of entry and degree of
price competition. If there is free entry and active price competition, the size of excess
capacity (restriction of output) will be small.

(2) WELFARE LOSS:

Another limitation of long run equilibrium of a firm in monopolistic competition is that P
>LMC implying welfare loss. To maximize social welfare, output should be increased
until P=LMC. However, this is not possible under monopolistic competition for the
perceived demand curve is downward sloping and P is greater than the minimum of LAC.

 The higher cost resulting from product differentiation would mean higher sales
(advertising and promotion) cost and price than perfect competition. Society however
may accept the higher price in order to have choice among the differentiated products.
In other words, consumers who desire product differentiation are willing to pay higher price.
Nevertheless, economists argue that though there is welfare loss under monopolistic
competition on the ground that P >MC, the welfare loss of under monopolistic competition

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should not be exaggerated (over emphasised) for it is much lower than the DWL of monopoly
and society have option to choose (entertain their preferences) among different brands.

P LMC
LAC

Pm A
B G

Pmc F
MRc=d
Pc
Ec

dmc
Emc

Em Dmc

MRmc
MRm

Excess
Capacity

LRQm LRQmc LRQc

Welfare loss under monopoly is given by the triangle AEmEc
Welfare loss under monopolistic competition is triangle FEmcEc. Therefore, AEmEc>
FEmcEc.

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CHAPTER SEVEN
OLIGOPOLY
INTRODUCTION
 OLIGOPOLY is a market organization in which there are few firms that produce identical or
closely substituted products (identical or differentiated). Oligopoly is said to exist when there
are more than one seller in the market, but their number is not so large so as to make the
contribution of each firm negligible. Firms thus, are situated mutually interdependence. That
is they behave as if any one firm’s action directly affect other rivals and is affected by the
action of others.
 In oligopoly market barrier to entry is difficult or impossible for new firms to enter the market.
Barrier to entry may arise as a result of
1. Scale of economics and large capital requirement than other markets except monopoly
2. Patents or access to technology or raw materials may exclude potential competitors.
Generally, the underlying reasons for the evolution of oligopoly are economic of scale
and the advance of mergers.
 DUOPOLY is a special case of oligopoly in which there are only two firms in the industry. The
duopoly case allows as to capture many of the important features of firms engaging in strategic
interaction without the notational complication involved in models with a large number of
firms. Also, we will limit ourselves investigation of the case in which each firm is producing an
identical product. This allows us to avoid the problems of product differentiation and focus
only on strategic interaction.
 If one firm reduces its price it will attract consumers and increases its sells, leading to a
substantial loss of sales by other firms in the industry. The other firms may or may not reduce
their price, but the firm that reduces price can no longer assume other firms do not notice
his/her action. The outcome of his/her decision depends on the reaction of other firms.
 The outcomes (consequences) of price changes by the firm under consideration are uncertain.
Firm under oligopoly market may
1. Spend a lot of time to guess each others action or reaction
2. Be bitter rivals of each other, competing by price changes (price war may be started)
3. Tacitly3 (informally or implicitly) agree to compete by advertising but not by price
changes
4. Form a collusion or cooperation (some kind of agreement) rather than competing.
Therefore, there are many solutions to oligopoly problem. This means that there is no
unique solution like that of perfect competition. Monopoly, and monopolistic competition.
 In general, oligopoly market is divided in to two. These are
I. Non collusive oligopoly
II. Collusive oligopoly. Following we will discuss models for oligopoly problems under
these two kinds of oligopoly.

8.1. NON-COLLUSIVE OLIGOPOLY: This implies that firms do not enter in to collusive agreement.
There are a number of non-collusive oligopoly models that give us stable solution to the
oligopoly problem that may arise. Example
1. The Cournot’s model (1838)
2. The Kinked demand (Sweezy’s) model (1839)
3. The Stackelberg’s model (1920)
4. The Bertrand’s model (1883)
5. The Chamberlain’s model (1883). For this course we will discuss only some of them.

3
Tacitly means understood without being expressed directly 9formally)

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8.1.1. COURNOT’S DUOPOLY MODEL

 Augustine Cournot (1838) assumed that there are only two firms each having (owning) a
mineral water well and operating at zero cost. Let one of the firms A and the other B. Both sell
their output in a market with a down wars sloping DD curve. Each firm acts on the assumption
that its competitors will not change its output and decides its own output so as to maximize
profit.
 Assume that firm A is the first to start producing and selling mineral water to maximize profit.
A will produce OA amount (1/2 of AD) and sell it at a price PA, where profits are at maximum
because at this point MR = MC = 0.

P D‟
‟

F C=d=1
PA

PB K

O MC
A B D’

MRA MRB

 In the first period

 The equilibrium output level of firm A is at point A (OA amount) where MR A=MC. Firm A
faces DD curve denoted by D’D’. At the mid point of D’D’ that is at point C, the elasticity of
DD at this level of output is unity and TR of the firm is the maximum. With zero cost and hence
MC, maximum TR implies maximum profit. That is, the area given by OACPA.
 Further let us assume that B enters into the market and faces the DD curve given by CD’. It is
this time that the Cournot assumption comes into picture. Now firm B assumes that firm A will
keep its output fixed at OA and hence considers that its own DD curve as CD’. Hence, firm B
will produce AB amount where MRB=MC (i.e. ½ of AD’, which is not supplied by firm A, or
1/4th of the total market DD, OD’), and will sell it at price PB. Clearly, at the mid point of firm
B’s DD curve that is at point F the elasticity of DD is unity and therefore TR of firm B is the
maximum. The profit of firm B is given by area OBFPB.
 In the second period
 Firm A who faced a competitor that is firm B will assume that firm B will keep on producing
that constant amount AB in the next period. Therefore, A will decide to produce ½ of BD’
(which is not supplied by firm B). That is, since B covered 1/4th of the total market, A will
supply in the second period ½ (1-1/4) = 3/8= 0.375 of the total market DD (OD’).
 Assuming A will keep on producing 3/8 of the market, firm B will react to the latest decision
made by firm A by producing ½ of the unsupplied section of the market. That is, ½(1-3/8)=
5/16=0.3125.

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 In the third period

 Once again firm A continues to assume that firm B will keep on (not change) its quantity
supply at 5/16 and thus will decide to produce ½ of the remainder of the market in the third
period. That is, ½ (1-5/16) = 11/32 = 0.34375. Similarly, firm B will assume as firm A and will
supply ½ of the remainder of the market. That is ½(1-11/32) = 21/64 = 0.3125.
 This action-reaction pattern continues because firms have naïve behaviour (assumption)4 of
never learning from their past pattern of reaction from their rival. Thus, gradually A’s sales
decreases while that of B’s increases. However, eventually equilibrium is reached where each
firm supply (produce) 1/3 of the total market DD. Thus, the action-reaction ends (settles) and
together they supply 2/3 (1/3+1/3) of the total DD.
 Each firm maximizes its profit in each period but the industry profit is not maximized. That is,
each firm’s profit and hence their joint profit would have been higher if they have recognised
their interdependence after their failure in forecasting the correct reaction of their rival.
Recognising their interdependence or forming open collusion would lead them to act as a
monopolist, produce ½ of the market DD jointly, sell that output at a profit maximizing P, and
sharing the market equally. That is, each can produce ¼ of the market instead of 1/3.
 SUMMERY
Firm A Firm B
 1st period=1/2 1//2(1-1/2)=1/4
nd
 2 period=1/2(1-1/4)=(1/2-1/8)=3/8 ½(1-3/8) or (1/4+1/16)=5/6
 3rd period= ½(1-5/16) or (1/2-1/8-1/32)=11/32 ½(1-11/32) or (1/4+1/16+1/64)=21/64
 4th period=1/2(1-21/64) or (1/2-1/8-1/32-1/128) ½(1-43/128) or (1/4+1/16+1/64+1/256)
=43/128 … = 58/256 …
 We observe that the output of A declines while that of B increases gradually. Therefore, for n
period we have
=1/2-1/8-1/32-1/128 … =1/4+1/16+1/64+1/256 …
2 3
=1/2-(1/8+1/8(1/4)+1/8(1/4) +1/8(1/4) +…)
=(1/4+1/4(1/4)+1/4(1/4)2+1/4(1/4)3+…)

a r a r

 Applying the summation formula for an infinite geometric series:

S = a where, s is sum, a is 1st term, and r is ratio.
1- r
 For A = ½ - ⅛ => For B= 1/4
1-1/4 1-1/4
=½ - ⅛ = 1/4
¾ 3/4
=½ - ⅛ (4/3) = ¼ (3/4)
= ½ - 4/24 = 4/12
=½ - 1/6=1/3 = 1/3
 Each firm in the long run (during n period) supplies 1/3 of the market (together they will supply
2/3 of the output under perfect competition) and sell at a common price, which is 2/3 of the
monopoly price. In other word, output OD’ is under perfect competition, half of OD’ (i.e.OA) is
under monopoly, and 2/3 of OD’ is output under duopoly using the Cournot’s model.

4
Naïve assumption is disproved trust (believe) that someone is telling the truth (doing good) or people‟s
intention in general and that life is simple and fair.

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 Thus, the Cournot’s case is stable and is one possible solution to the duopoly problem. However,
it is based on an extraordinary naïve assumption that each firm believes the other firm will not
change its output even after repeatedly observing changes.
 Observe that if there are three firms in the industry, each will supply ¼ of the market (¾ of the
output under perfect competition) according the Cournot’s model. If there are four firms, each
1/5 of the market (4/5 of the output under perfect competition) and so on. In general, if there are
n firms in the industry, each will supply 1/n +1 of the market and together n/n+1 of the output
that would have been supplied under perfect competition.
 Mathematical version of the Cournot model. It is based on the following assumptions
1. Each firm maximizes profit by assuming the output of the other is constant (ignoring
their interdependence or naïve assumption).
2. The duopolies face the same demand function (curve).
3. The MRs of the duopolies need not be the same. This is because if the duopolies are of
unequal size, the one with the larger output or smaller MC will have smaller MR.
This implies that in the short run the duopolies will supply different output levels but
sell at the same price since they supply identical products it is the total output that
determines price.
4. The duopolies have different cost function.
5. In the long run, however, each firm will supply 1/3 of the market
 Example: Assume that the market demand and cost functions of the duopolies are
P =100 - 0.5Q, where Q = q1+q2
TC1= 5q1
TC2 = 0.5q22. Given these answer the questions that follow
A. Determine the short run equilibrium output of each duopoly ignoring their
interdependence (with naive assumption)
B. What is the short run market price?
C. Find the demand functions of the duopolies (the reaction curves or graphic
solution of Cournot’ model and draw) and show the short run output levels.
D. Calculate the short run profits of each duopoly and the industry profit.
E. Verify the economic profit of each duopoly graphically
F. Explain the relationship between output and MR in the short run.
G. Calculate the long run equilibrium output of each duopoly, market price, and
economic profits of each firm and the industry profit as a whole
 Solution:
A. 1st find TR1 = Pq1
= (100 – 0.5 (q1+q2)) q1
= 100q1 –0.5q12 – 0.5q1q2
nd
2 find MR1 = ∂TR1 = 100 –q1 – 0.5q2
∂q1
rd
3 find MR1 = ∂TC1 = 5
∂q1
th
4 equate MR1 = MC1
100 – q1 – 0.5q2 = 5
100 – 5 - q1 – 0.5q2 = 0
95 – q1 – 0.5q2 = 0
95 = q1 + 0.5q2 -------------------------------------------- (1)
th
5 find TR2 = Pq2
= (100 – 0.5 (q1+q2)) q2
= 100q2 – 0.5q22 – 0.5q2q1
6th find MR2 = ∂TR2 = 100 – q2 – 0.5q1

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∂q2
th
7 find MC2 = ∂TC2 = q2
∂q2
th
8 equate MR2 = MC2
100 – q2 – 0.5q1 = q2
100 – q2 – q2 – 0.5q1 = 0
100 – 2q2 – 0.5q1 = 0
100 = 2q2 +0.5q1 --------------------------------------- (2)
th
9 The profit maximizing (loss minimizing) output of q1 and q2 can be solved from the
two equations using simultaneous equation method. That is
q1 + 0.5q2 = 95
(0.5q1 + 2q2 = 100) (–2)
q1 + 0.5q2 = 95
-q1 – 4q2 = -200
-3.5q2 = -105
q2 = 105/3.5 = 30, substituting this in any on of the above equation gives the
value of q1. That is
q1 + 0.5q2 = 95
q1 + 0.5 (30) = 95
q1 = 95 – 15 = 80
Q = q1 + q2 = 80 +30 = 110
B. Market price: P = 100 – 0.5Q, where q1 + q2
= 100 – 0.5 (80 + 30)
= 100 – 0.5 (110)
= 100 – 55 = 45
C. The demand functions (reaction curves) of the duopolies are obtained by solving for q1
and q2 from the two equations as follows.
95 = q1 + 0.5q2
q1 = 95 – 0.5q2, is the demand function for firm 1. Hence,
 If q2 = 0, then q1 = 95 and if q1 = 0, then q2 = 190
100 = 2q2 + 0.5q1
2q2 = 100 – 0.5q1
q2 = 50 – 0.25q1, is the demand function for firm 2. Hence,
 If q1 = 0, then q2 = 50 and if q2 = 0, then q1 = 200. The reaction curves (graphic
solution of Cournot’s model) is
q2

190
Firm 1‟s reaction curve

50 Equilibrium

30 Firm 2‟s reaction curve

q1
80 95 200

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 At the equilibrium each firm maximizes their own profit. But the industry profit is not
maximized. Why firms choose these sub optimal output? The reason is that, the Cournot
pattern of behaviour implies that the firms do not learn from past experience, each expects the
other to remain at a given position. Each firm acts independently. That is, each does not know
(recognise) the other will behave (hold) the same assumption.
D. The economic profits of each duopoly
Π1 = Pq1 – TC1 Π2 = Pq2 – TC2
= 45(80) – 5(80) = 45 (30) – 0.5 (30) 2
= 3600 – 400 = 3200 =1350 – 450 = 900
Π= 3200 + 900 = 4100 is the total industry profit due to naïve assumption
E. The relevant curves to show profits graphically are
-The market DD curve
-The MR curve derived from the market DD curve
-Each firm’s MC and ATC curves
P P MC2

100 MC1 100 ATC2

ATC1

45 45

30

5 15

80 100 200 Q 30 100 200 Q

Π1 = q1 (P – ATC1) Π2 = q2 (P – ATC2)
= 80 (45 – 5) = 30 (45 – 15)
= 80 (40) = 30 (30)
= 3200 = 900
F. Firm 1 has lower MR than firm 2 because q1 > q2 (80 > 30)
MR1 = 100 – q1 – 0.5q2 MR2 = 100 – q2 – 0.5q1
= 100 – 80 – 0.5 (30) = 100 – 30 – 0.5(80)
= 100 – 80 – 15 = 100 – 30 – 40
=5 = 30
MR1 < MR2 because MC1 < MC2 and q1 >q2
G. The long run equilibrium output and price are calculated from the MR functions using
simultaneous equation method. That is
q1 + 0.5q2 = 100
(0.5q1 + q2 = 100) (-2)
q1 + 0.5q2 = 100
-q1 – 2q2 = -200
-1.5q2 = -100
q2 = 100/1.5 = 66.7, substituting this in any of the above MR will give us q1 in the
long run. That is
q1 + 0.5q2 = 100
q1 = 100 –0.5 (66.7)

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q1 = 100 – 33.3 = 66.7

=> P = 100 – 0.5Q
P = 100 – 0.5 (66.7 +66.7)
P = 100 – 66.7 = 33.3
=> Π1 = Pq1 – TC1 Π2 = Pq2 – TC2
= 33.3 (66.7) – 5(66.7) = 33.3 (66.7) – 0.5 (66.7) 2
= 2221.11 – 333.5 = 2221.11 – 2224.45
= 1887.61 = -3.34
Π = Π1 + Π2 = 1887.61 + (-3.34) = 1884.27 is total industry profit in the
long run. Note that, each firm’s and industry profits are higher in the short
run than in the long run.

 Exercise: Given, (1) P = 140 – 0.6Q, TC1 = 7q1, TC2 = 0.6q22 and
(2) P = 150 – 8Q, TC1 = 10q1, TC2 = 4q22 answer the questions A to G as
done in the example. Note that Q = q1 + q2
 Answer: For the first
(A) q2 = 35 and q1 = 93.333
(B) P = 63
(C) q1 = 110.8 – 0.5q2. Then if q2 = 0, q1 =110.8, if q1 = 0, q2 = 221.6 and
q2 = 58.333 – 0.25q1. Then, if q1 = 0, q2 = 58.33, if q2 = 0, q1 =233.33. Draw the
graph plotting the values of q1 and q2 for the above DD functions.
(D) Π1= 5224.8, Π2 = 1470, and Π = 6694.8
(E) From the graphs you will get Π1 = q1 (P – ATC1) = 93.33 (63 – 7) = 5224.8 and
Π2 = q2 (P – ATC2) = 35 (63 – 21) = 1470
(F) MR1 = 140 - 1.2q1 – 0.6q2 = 140 – 1.2 (93.33) – 0.6 (35) = 7
MR2 = 140 – 0.6q1 – 1.2q2 = 140 – 0.6 (93.33) – 1.2 (35) = 42
Since MC1 (7) < MC2 (42) and MR1 (7) < MR2 (42), then q1 (93.33) > q2 (35)
(G) MR1 = 1.2q1 + 0.6q2 = 140
(MR2 = 0.6q1 + 1.2q2 = 140) (-2)
1.2q1 + 0.6q2 =140
-1.2q1 – 2.4q2 = -280
q2 = -140/ -1.8 = 77.77 and q1 = 77.77, P = 46.76
Π1= 3092.5, Π2= 5.3, and Π= 3097.8
 For the second
(A) q2 = 4 and q1 = 6.75
(B) P = 64
(C) q1 = 8.75 – 0.5q2 .Then, if q2 = 0, q1 = 8.75, if q1 = 0, q2 = 17.5 and
q2 = 6.25 – 0.33q1. Then, if q1 = 0, q2 = 6.25, if q2 =0, q1 = 18.75. Draw the
graph plotting the values of q1 and q2 for the above DD functions.
(D) Π1 =364.5, Π2 = 192, and Π =556.5
(E) From the graphs we will get Π1= q1 (P – ATC1) = 6.75 (64 – 10) = 364.5 and
Π2= q2 (P – ATC2) = 4 (64 – 16) = 192
(F) MR1 = 150 – 16q1 –8q2 = 150 – 16 (6.75) – 8 (4) = 10
MR2 = 150 –8q1 –16q2 = 150 – 8(6.75) – 16(4) = 32
Since MC1 < MC2 and MR1 < MR2, then q1 > q2
(G) 16q1 + 8q2 = 150
(8q1 + 16q2 = 150) (-2)
16q1 + 8q2 = 150
–16q1 – 16q2 = -300
q2 and q1 are = -150/-8 = 6.25, Q = 12.5, P = 50

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Π1= 250, Π2= 156.25, and Π= 406.25

8.1.2. THE STACKELBERG MODEL (Quantity leadership)

 This model often used to describe industries in which there is a dominant firm or a natural
leader. For example, IBM is often considered to be a dominant firm in the computer industry.
A commonly observed pattern of behaviour is for the smaller firms in the computer industry to
wait for IBM’s announcements of new products and then adjust their own product decisions
accordingly. In this case we might want to model the computer industry with IBM playing the
role of a Stackelberg leader and the other firms in the industry being Stackelberg follower.
 Suppose that firm 1 is the leader and that it chooses to produce q1. Firm 2 responds by
choosing a quantity q2. Each firm knows that the equilibrium price in the market depends on
the total output produced. That is by substituting Q (q1 +q2) in the inverse demand function
(curve).
 What output should the leader choose to produce to maximize profits? The answer depends on
how the leader thinks the followers will react to its choice. Presumably, the leader should
expect that the follower will also attempt to maximize profits as well, given the choice made by
the leader. In order for the leader to make a sensible decision about its own product, it has to
consider the follower’s profit maximization problem as its own.

Numerical example: Consider the example we have used to describe Cournot’s model. That is,
P = 100 – 0.5Q, where Q=q1 + q2, TC1 = 5q1, and TC2 = 0.5q22. Given this,
(A) Find the equilibrium q1, q2, market price, Π1, and Π2
- Firm 1 being Stackelbrg’s sophisticated leader and firm 2 the follower
- Firm 2 being Stacklberg’s sophisticated leader and 1 the follower
(B) From the view point of profit obtained is it better for the firms to be a leader or
a follower?
 Solution:
A. The reaction (DD) functions or curves are found by taking the partial derivatives w.r.t.
q1 and q2 and equating to zero.
Π1= Pq1 – TC1= (100 –0.5 (q1+q2)) q1 –5q1
= 100q1 – 0.5q12 – 0.5q1q2 – 5q1
= 95q1 – 0.5q12 - 0.5q1q2
Π2 = Pq2 – TC2 = (100 – 0.5 (q1+q2) q2 –0.5q22
= 100q2 – 0.5q1q2 – 0.5q22 – 0.5q22
= 100q2 – 0.5q1q2 – q22
 The partial derivatives w.r.t. q1 and q2
 ∂ Π1= 95 – 0.5q2 – q1
 ∂q1
 ∂ Π1= 100 – 0.5q1 – 2q2
 ∂q1
 The reaction (DD) function are
 q1= 95 – 0.5q2 --- firm 1 reaction (DD) function
 q2= 50 – 0.25q1 --- firm 2 reaction (DD) function
 Stakelberg’s solution with firm 1 being the sophisticated leader. Firm 1 will
substitute firm 2’s reaction (DD) function in its own profit equation to produce an
output that will maximize profit as if it were a monopoly. That is
Π1= Pq1 – TC1
= 95q1 – 0.5q12 – 0.5q1q2, substituting firm 2’s DD function
= 95q1 – 0.5q12 – 0.5q1 (50 – 0.25q1)
= 95q1 – 0.5q12 – 25q1 + 0.125q12

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= 70q1 – 0.375q12
 The first order condition of the profit function w.r.t. q1
 ∂Π1= 70 – 0.75q1
∂q1
= 70= 0.75q1
= q1 = 70/0.75 = 93.333
Π1= 70q1 – 0.375q12
= 70 (93.333) – 0.375 (93.333) 2
= 6533.333 – 3266.666 = 3266.66
 Firm 2 will substitute firm 1’s output in its own DD as a follower. That is
 q2 = 50 – 0.25q1
= 50 – 0.25 (93.333)
= 50 – 23.333 = 26.666
Π2 = 100q2 – q22 – 0.5q1q2
= 100 (26.666) – 26.6662 – 0.5 (93.333) (26.666)
= 2666.66 – 711.1 – 0.5 (2488.8)
= 2666.7 – 711.1 – 1244.4 = 711.1
 P = 100 – 0.5 Q
= 100 – 0.5 (93.33 + 26.666)
= 100 – 0.5 (120)
= 100 – 60 = 40
 Stakelberg’s solution with firm 2 being the sophisticated leader. It will substitute
firm 1’s DD function in its own profit function to produce an output that will
maximize its profit as it were a monopoly. That is
 Π2 =Pq2 – TC2
 Π2 = 100q2 – q22 – 0.5q1q2, substituting firm 1’s DD function
= 100q2 – q22 – 0.5q2 (95 – 0.5q2)
= 100q2 – q22 – 47.5q2 + 0.25 q22
= 52.5q2 – 0.75q22
 The first order condition of Π2 w.r.t.q2 gives
 ∂ Π2 = 52.5 – 1.5q2
∂q2
= 52.5 = 1.5q2
= q2 = 52.5/1.5 = 35
Π2 = 52.2q2 – 0.75q22
= 52.2 (35) – 0.75 (35) 2
= 1837.5 – 0.75 (1225)
= 1837.5 – 918.75 = 918.75
 As a follower firm 1 will substitute the output produced by firm 2 on its DD
function. That is
 q1 = 95 – 0.5 q2
= 95 – 0.5 (35)
= 95 – 17.5 = 77.5
 Π1 = 95q1 – 0.5q12 – 0.5q1q2
= 95 (77.5) – 0.5 (77.5) 2 – 0.5 (35) (77.5)
= 7362.5 – 3003.125 –1356.25
= 3003.125
 P = 100 – 0.5 (35 + 77.5)
= 100 – 0.5 (112.5)
= 100 – 56.25 = 43.75

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B. As can be seen from the profits as a leader and follower, both are better off as a leader.

8.1.3. THE “KINKED DEMAND” MODEL: SWEEZY’S NON-COLLUSIVE STABLE

EQUILIBRIUM
 Consider a firm in an oligopolistic market structure which behaves that
1. If it raises price above the on going market price, none of its rivals will follow suit. But, the
firm will loose a considerable part of its consumers. Hence, the demand curve confronting
the firm is very elastic above the ongoing price. The relevant curve for decision-making is
the perceived demand curve (d). It is assumed that the other firms will not change their
price when one firm changes (increases) its price.
2. If it reduces its price, its competitors will follow suit, matching the price cut. That is to say
all rivals will reduce their prices. So the share of the competitors in the market demand
remains unchanged. Therefore, for price reduction below the on going market price, the
relevant curve for decision marking is the proportional demand curve (D).
 In short, oligopolies rivals will ignore a price rise and follow a price cut. This in turn cause
1. The oligopoly’s DD curve to be kinked. That is CED.
2. His/her MR curve to have a vertical break or gap. That is due to the kink in the DD curve
the MR curve becomes discontinuous at the level of output corresponding to the kink. The
discontinuous segment AB in the graph below shows this. Thus, the MR curve will be
CABF. Where, CA corresponds to the upper part of the perceived DD curve (i.e. CA) and
BF corresponds to the lower part of the proportional curve (i.e. ED).
3. Further more, since any shift in MC between MC1 and MC2 will cut the vertical segment
(dashes) of the MR curve, no change in either Pk or Qk will occur.

P
MC1
E MC2
Pk

A d

B D
MRd

Q
Qk

 The equilibrium of the firm is defined by theMRkink

D because at any point to the left of the
kink MC lies below MR implying output must increase while to the right of the kink MC
lies above MR implying output must decrease. Thus, total profit is maximised at the point
of the kink by the intersection of d and D curves at point E.
 The discontinuous segment AB on the MR curve implies that there is a range within
which cost may change without affecting the equilibrium price (Pk) and output (Qk) of
the firm. So long as the MC passes through the segment AB the firm maximizes profits by
producing Qk and selling at Pk. Hence, oligopoly price is said to be very sticky, changing
only infrequently (rarely). This is because the equilibrium price and output change only
as a result of significant change in costs of production. Example, a rise in costs due to the
imposition of substantial sales tax and affects all firms equally.

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 The kinked demand model has two limitations. These are

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

8.1.4. THE BERTRAND’S MODEL (simultaneous price setting): This model assumed a model of
competitive bidding and hence is the opposite of the Cournot’ model.
 The Cournot’s model described that firms were choosing their quantities and letting the
market determines the price. Another approach is to think of firms as setting their prices and
letting the market determines the quantity sold. This model is known as the Bertrand model.
 What does the Bertrand model looks like? The answer is that when firms are selling identical
(homogenous) products and have significant effect on the price, the Bertrand equilibrium is a
competitive equilibrium for they engaged in strategic interaction. That is the Bertrand
equilibrium is where price equals MC. How?
 First, we note that price can never be less than MC. As a result, either firm would increase
its profits by producing less output. So let us consider the case where P >MC. Suppose that
both firms are selling at some P >MC. Consider the position of firm 1. If it lowers its price
by any small amount ε and if the other firm keeps it price at P , all the consumers will prefer
to purchase from firm 1. By cutting its price by an arbitrary small amount, form 1 can steel
all the consumers from firm 2.
 If firm 1 really believes that firm 2 will charge a price P that is greater than MC, it will
always pay firm 1 to cut its price to P - ε. But firm 2 can reason the same way. Thus, any
price higher than MC cannot be equilibrium. The only equilibrium is then the competitive
equilibrium.
 This result seems paradoxical when you first encounter it. You may wonder how we can get a
competitive price if there are only two firms that produce identical products in the market. If
we think of the Bertrand model as a model of competitive bidding it makes more sense.
Suppose that one firm “bids” for the consumers’ business by quoting a price above MC.
Then the other firm can always make a profit by undercutting this price with a lower price. It
follows that the only price that each firm can not rationally expects to be undercut is a price
equal to MC. Thus, it is often observed that competitive bidding among firms that are unable
to collude can result in prices that are much lower than it can be achieved by other means.
This phenomenon is simply an example of Bertrand competition.

Numerical Example: Given P = 100 – 0.5Q, where Q = q1+q2, TC1= 5q1, TC2 = 0.5q22 find the
Bertrand’s equilibrium.
 Solution:
Firm 1 Firm 2
P = MC1 P = MC2
P=5 P = q2
5 = 100 – 0.5Q
-95 = -0.5Q
Q = 95/0.5 = 190

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 Check that P = MC1 = MC2

100 – 0.5 (q1 + q2) = 5 100 – 0.5 (q1 + q2) = q2
95 – 0.5q1 – 0.5q2 100 – 0.5q1 –1.5q2
95 = 0.5q1 + 0.5q2 100 = 0.5q1 + 1.5q2
 Solving the two equations simultaneously
 95 = 0.5q1 + 0.5q2
(100 = 0.5q1 +1.5q2) –1
95 = 0.5q1 + 0.5q2
-100 = -0.5q1 – 1.5q2
-5 = -q2, q2 = 5
95 = 0.5q1 + 0.5 (5)
95 = 0.5q1 + 2.5
0.5q1 = 95 – 2.5
0.5q1 = 92.5, q1 = 92.5/0.5 = 185 and Q = 5+185 = 190
 P = 100 – 0.5Q
= 100 – 0.5 (5 + 185)
= 100 – 0.5 (190)
= 100 – 95 = 5, is the price which cannot be undercut because it is equal to MC1
and MC2.
8.2. COLLUSIVE OLIGOPOLY: One way of avoiding the uncertainty that may arise from
interdependence of firms in oligopoly market is to enter in to collusive agreement (that is to
adopt more strategic cooperation). There are two main types of collusive oligopoly. These
are
1. Cartels
2. Price leadership. They have been exclusively analysed by W. Fellner.

8.2.1.CARTELS: A cartel is a cooperation of firms whose objective is to limit (reduce) the scope
of competitive environment that arises due to mutual interdependence of firms within the
market and act as a monopoly. There are two forms of cartel. These are
a) Cartel aiming at joint profit maximization
b) Cartel aiming at sharing the market

A. CARTEL AIMING AT JOINT PROFIT MAXIMIZATION: As the name of the cartel

entails, the aim of this particular form of cartel is to set prices and outputs together so as to
maximize total industry (joint) profit not profit of individual firms. In this cartel solution the
firms act together to restrict output so as no to “spoil” the market. They recognize the effect
on joint profits from producing more output in either firm. This situation is similar to the
multi plant monopoly case that seeks (wants) the maximization of his profit.

 For simplicity we will consider two oligopoly firms (firm A and B) producing identical
(homogenous) products. The firms appoint a central agency (cartel) to which they delegate
the authority to decide
1) The total quantity and the price level at which each quantity should be sold so as to
attain maximum group (joint) profit
2) The allocation of production among the members of the cartel and
3) The distribution of the maximized joint profits among the participating members.
 The authority of the central cartel agency is complete. The central agency has access to the
cost figures of individual members (firms). Besides, it calculates the market demand and the
corresponding MR. Given the market demand, the cartel (monopoly) solution-output and
price levels- that maximizes joint industry profit is determined by equating MR = MC.

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 Next the central agency allocates the production among firm A and B by equating the MR to
individual firm’s MC. That is MR = MCA and MR = MCB. In short, the optimality condition
implies that the MR of the extra unit of output must be the same no matter where it is
produced. It follows that MCA = MCB. So the two MCs will be equal in equilibrium. Thus,
firm A will produce qA and firm B, qB,. Note that if one firm has lower cost (cost advantage)
its MC curve always lies below that of the other firm, and then it will necessarily produce
more output in equilibrium in the cartel solution. However, this does not mean that the firm
with lower cost will take the larger share of the attained joint profit. This is because the total
industry (joint) profit is distributed by the central agency of the cartel according to some
agreed upon criteria.

MCA MC
MCB
ATC
P P

D
C MR

q1 q2 Q = q1 + q2
Firm A Firm B Central Cartel

 Theoretically it is easy to derive the monopoly solution of the cartel aiming at joint profit
maximization. However, maximum joint profit is rarely achieved due to the following
reasons.
1. Mistake in the estimation of the market demand which leads to mistake in the
derivation of MR and hence to a price that is higher or lower than monopoly
price
2. Mistake in the estimation of MC, may be due to reporting low cost figures by a
firm/s, leading to an equilibrium Q which differs from the monopoly solution.
3. The temptation to cheat when there is no effective way (means) to detect and
punish cheating. This arise because at the output levels that maximize joint
profits, it will always be profitable for each firm to unilaterally increase its output
if each firm expects the other firm will keep its output fixed.
 Numerical example: Given P = 100 – 0.5Q, where Q = q1 +q2, TC1 = 5q1, and TC2 =
0.5q22 determine Q, q1, q2, P, and joint profit.
 Solution: First the central agency of the cartel compute the joint profit function as
П = П1 + П2
= TR1 – TC1 + TR2 – TC2
= (Pq1+Pq2) – (TC1 + TC2)
= P (q1+q2) – (TC1+TC2)
= 100 – 0.5 (q1+q2) (q1+q2) – (5q1+0.5q22)
= 100q1+100q2 – 0.5q12 – 0.5q1q2 – 0.5q1q2 – 0.5q22 – 5q1 – 0.5q22
= 95q1+100q2 – 0.5q12 – q1q2 – q22
 Find the partial derivative of the profit function w.r.t q1 and q2 and equate them to zero.
∂ П = 0 = 95 – q1 – q2 = 0 ∂ П = 100 – q1 – 2q2 = 0
∂ q1 ∂ q2
= q1+q2 = 95 -------- (1) = q1+2q2 = 100 --------- (2)

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 To obtain the level of output and price that maximizes joint profit, the central agency of
the cartel solves q1 and q2 using the above two equations simultaneously as follows
q1+q2 = 95
(q1+2q2 = 100) –1
q1+q2 = 95
-q1 – 2q2 = -100
-q2 = -5, q2 = 5. Substituting this in one of the two equations above will give us
q1+q2 = 95
q1+ 5 = 95
q1 = 95 – 5
q1 = 90. Thus Q = q1+q2 = 90+5 = 95. Then joint profit maximizing price is
P = 100 – 0.5Q
= 100 – 0.5 (95)
= 100 – 47.5 = 52.5. Finally, the joint profit will be obtained by substituting the
values of q1 and q2 in the above П function or alternatively as follows

П = TR1+TR2 – TC1 – TC2

= Pq1+Pq2 – TC1 – TC2
= 52.5 (90) + 52.5 (5) – 5 (90) – 0.5 (5) 2
= 4725 + 262.5 – 450 – 12.5
= 4525. Check that at the output level (Q = 95) that maximizes joint profit, MR =
MC1 = MC2.
TR = PQ
= (100 –0.5Q) Q
= 100Q – 0.5Q2
∂ TR = 100 – Q = 100 – 95 = 5, ∂ TC1 = 5, ∂ TC2 = q2 = 5.
∂Q ∂ q1 ∂q2
 Thus, Q = 95 and P = 52.5 are the output and price levels that maximizes joint profit.

B. CARTEL AIMING AT SHARING THE MARKET: This is the most common type of cartel.
The two methods of sharing the market are through
I. Non price competition
II. The determination of quotas

I. NON-PRICE COMPETITION (Price matching and competition): Under this cartel

members agree on a common price informally not by bargaining. This implies that firms
agree not to sell below the cartel price; but they can vary the style of their products and their
selling activities. For example
- Doctors charge the same price
- Barbers charge the same price
- Gasoline stations charge the same price
- Cinema halls charge the same price etc. These prices are not the result
of perfect competition in the market. Rather, they result from tacit agreement upon price.
Hence, sellers compete one another through advertising but not by price changes.
 Due to cost difference among manufacturing firms, this type of cartel is loose or unstable
than the complete cartel aiming at joint profit maximization. In other words, the cartel is
inherently unstable for there is a temptation to cheat by low cost firm. Hence, there is a
strong incentive to break away from the cartel and charge lower price (give price concession
to buyers). However, other members from the cartel will soon discover such a cheating when
they loose consumers.

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 Another method (way) to acquire information as to whether other firms keep track of the
price is to use your customers to spy on the other firms. When firms are not sure that the
other firm is not cheating on their agreement and selling at the implicitly agreed price, price
war (instability) may develop and the cartel splits.

II. SHARING THE MARKET BY AGREEMENT ON QUOTAS: Here, cartel members agree
explicitly on the common price and quantity each member may sell in the market (national or
international). The best example of this cartel is OPEC and ICO.
 If all firms have identical cost, a monopoly solution will emerge with the market being
shared equally. That is equal quotas will be allocated. This will happen if and only if firms
have identical costs. However, if costs are different, the quotas (shares) of the market will
differ. Again, allocation of quotas on the basis of cost is unstable. Therefore, the quotas will
be decided by bargaining. During the bargaining process to decide the quotas of members of
the cartel, two main criterions are often considered. These are
a) Past level (historical) sells
b) The production capacity of the firm. Both criterions, however, are influenced by the
bargaining power and skills of cartel members.
 Though it is not main criterion, defining the region in which each cartel member is allowed
to sell (spheres of influence) is another criterion of sharing the market. The best example of
this kind of agreement is what the Japanese, Malaysian, and Chinese companies producing
Sony products have agreed.
 Note that cartel models of collusive oligopoly are closed models. That is they assume no
entry. However, if entry is free, the inherent instability of cartel will be intensified. This is
because new entrant firms may charge lower prices in order to secure a considerable share
of the market. Besides, if either firm are not sure the other firm keeps track on prices and
production levels, price war and eventually the dissolution of the cartel is inevitable. A
successful cartel will only be maintained if they found a means to police members’ and new
entrants’ behaviour.

8.2.2. PRICE LEADERSHIP: The collusion among the oligopolies also entails that one firm will
set the market price and others followed (adopt) it. Followers usually prefer to avoid the
uncertainty that might occur because of their competitor’s reaction for their action even if this
implies departure from profit maximizing point.
 Price leadership is more widespread than cartel. The two most common types of price
leadership are
 Price leadership by low cost firm
 Price leadership by the dominant (large) firm
1. Low Cost Price Leadership:- Consider a situation where there are only two firms (duopoly)
that produce identical (homogenous) products at different costs but sell their products at the
same market price. However, firms may have equal (the high cost firm also to produce the
same level of output to that of the low cost firm and sell at the same price) or unequal share.
 Assuming firm 2 is the low cost firm and firm 1 is the high cost firm, the graphic solution is
given as follows.

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P
MC1

P1 MC2
P2

D
E

q1 q2 MR Q = q2+q2 Q = 2(q2)

 Firm 2 has lower cost and hence it charges lower price, p2, and produce q2 to maximize
profits. Firm 1, with the highest cost, on the other hand would like to charge p1 and
produce q1. However, firm 1 prefers to follow the leader because if it charges p1 its sells
will be zero implying no one will pay a higher price for identical products. Therefore, the
high cost firm 1 must be willing (satisfied) to accept the price decision of the low cost firm.
Thus, it changes P2 and produces the same quantity as firm 2, q2.
 The two together then produce output level, which is equal to q2 + q2 = 2Q2. It is only in
this case the anti trust monopoly legislation, which forbid monopoly production will work.
In short the high cost firm must tolerate to the price and output level equal to the low cost
firm to avoid the uncertainty that may arise when firm 2, reduces price lower than p2.
 Numerical example: Given P = 24 – 0.1Q, where Q = q1+q2 and q1 = q2, TC1 = 0.1q12,
TC2 = 0.05q22,
a) Determine the output and price of low cost firm
b) Calculate the profit of the low cost firm
c) What is the profit maximizing price level the high firm would like to charge but that
doesn’t realise in the market
d) Compare the profits of the price taker at its own profit maximizing output and low
cost firm’s output
e) Show the results a to d graphically
 Solution
a) Since q1 = q2, 0.075q12 > 0.05q22. This implies that firm 2 is a low cost price leader.
Hence,
П2 = Pq2 – TC2 P = 24 – 0.1Q, where q1 = q2
2
= (24 – 0.1(q1+q2)) q2 – 0.05q2 P = 24 – 0.1 (2q2)
= (24 – 0.1 (q2+q2)) q2 – 0.05q22 = 24 – 0.2q2
2
= (24 – 0.1 (2q2)) q2 – 0.05q2 = 24 – 0.2 (48)
= (24 – 0.2q2) q2 – 0.05q22 = 24 – 9.6 = 14.4
2 2
= 24q2 – 0.2q2 – 0.05q2 b) П2 = Pq2 –TC2
= 24q2 – 0.25q22
dП2 = 0 = 24 – 0.5q2 = 0 = 14.4 (48) – 0.05 (48) 2
dq2
= q2 = 24/0.5 = 48 = 691.2 –115.2 = 576
c) П1 = Pq1 – TC1 d) П1= Pq1 – TC1

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= (24 – 0.1(q1+q2)) q1 – 0.075q12 = 14.4 (43.63) – 0.075 (43.63) 2

= (24 – 0.1 (q1+q1)) q1 – 0.075q12 = 628.36 –142.77= 485.59 and

= (24 – 0.1 (2q1) q1 – 0.075q12 П1= Pq1 – TC1

= (24 – 0.2q1) q1 – 0.075q12 = 14.4 (48) – 0.1 (48) 2
= 24q1 –0.2q12 – 0.075q12 = 691.2 – 230.4 = 460.8
= 24q1 – 0.275q12 though, 485.59>460.8 firm 1 will
produce 48 than 43.63
dП1 = 0 = 24 –0.55q1 = 0
dq1
q1= 24/0.55 = 43.63

 Exercise: Given P = 300 – 5X, where X = x1+x2, TC1= 0.5x12, TC2 = 3x22 answer the
questions above.
 Answer: x1 = 14.29, P1 = 157.96, x2 =11.54, and P2 = 184.62

2) The Dominant – Firm Price Leadership (Partial Monopoly)

 This type of duopoly assumes that there is a dominant firm, which has considerable share
of the market and smaller firms, each of them having a smaller market share.
 The dominant firm is assumed
 To know the market demand curve
 The MC of smaller firms. Hence, firm the horizontal summation of the MCs of
smaller firms the dominant firms found the total SS by the smaller firms at each
price.
 Knowing the market DD and the SS of the smaller firms the dominant firm calculates its
DD curve as follows. At each price the dominant firm will be able to SS that section of the
total market DD not supplied by the smaller forms. That is, the DD for the product of the
firm will be the difference between the total dd (D) and the total SS of the smaller firms.

P S small
MCL

PS D1
SSsm
B C
PL1
SSsm SSL1
P2 A D2
SSsm SSL2
D3
P3 dL
SSL3 DD MRL

Q qL q2 q3
Smaller firms Dominant firm

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 At ps, market DD is equal to the market SS of smaller firms. This is equal to PSD1 amount.
The dd for the product of the leader will be zero.
 As price falls below PS, the dd for the leader increases, for instance, at P2, total market dd is
P2D2 amount of which P2A is supplied by the smaller firms. The share of the dominant is
AD2.
 At P3, total market dd is P3D3 of which the share of smaller firms is zero, while P3D3 (all) is
the share of the dominant firm. Below Ps the market dd coincides with the leader dd curve.
 Having derived the dd curve of the leader (dL) and given its MC, the dominant firm will set
the price p at which MRL = MCL and out put is qL. At price PL1 the total market dd is PL1C of
which PLA is the share of smaller firms while AC is the share of the dominant firm. The
dominant firm maximizes its profit be equating its MR to MC, but the smaller firms or price
taker may or may not attain the point where MRS = MCS.
 Numerical example: Given Q = 120 – 0.2P, SSsm = 4.8P, and TCL = 4qL determine the
supply, price, and profit of the dominant (large) firm. Finally, the supply of smaller
(followers) firms.
 Solution:
qL (dL ) = Q – SSsm)
qL= 120 – 0.2P – 4.8P
qL = 120 – 5P
qL – 120 = -5P
 P = 24 - 0.2qL
 TRL = (24 – 0.2 q2) q2
 ПL = TRL – TCL
= (24 – 0.2qL) qL – 4qL
= 24qL – 0.2qL2 – 4qL
= 20qL - 0.2qL2
d ПL= 20 – 0.4qL = 0
dqL
= 20 = 0.4qL
qL = 20/0.4 = 50
 P = 24 – 0.2 qL
 P = 24 – 0.2 (50)
= 24 – 10 = 14, this is the equilibrium price both the dominant and smaller firms
will adopt.
ПL = PqL – TCL
= 14 (50) – 4 (50)
= 700 – 200 = 500
 The supply of smaller firms will then be Q – dL. That is
SSsm = (120 – 0.2P) – 50 or SSsm = 4.8P
= (120 – 0.2 (14)) – 50 = 4.8(14)
= (120 – 2.8) – 50 = 67.2
= 117.82– 50 = 67.2

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CHAPTER NINE
GAME THEORY
INTRODUCTION
 The oligopoly theories we discussed so far are the classical theory of strategic interaction
among firms. Oligopoly economic agents can have been studied by using the apparatus of
game theory.
 Game theory is concerned with the general analysis of strategic interaction. It can be used to
study:
- Parlor games
- Political negotiation and
- Economic behaviour
 Thus, in this chapter we will briefly explore this fascinating subject to give you a flavour
or how it works and how it can be used to study economic behaviour in oligopolistic
markets.

9.1. THE PAYOFF MATRIX OF A GAME

 Strategic interaction can involve many players and many strategies, but we will limit
ourselves to two-person game with a finite number of strategies. This will allow us to depict
the game easily in a payoff (outcome) matrix.
 Suppose that -two people (A and B) are playing a simple game and
- Each has two strategies to play
 Let the two strategies of A are top and bottom and that of B left and right. There strategies
could represent economic choices like “raise price” as “lower price” and “don‟t advertise” or
“advertise” or they could represent political choices like “declare war” or “ don‟t declare
war”.
 The payoff matrix of a game simply depicts the payoffs to each player for each combination
of strategies that are chosen. What will be the outcome of this sort of game?
 Consider the following example 1. In this matrix the payoffs to A are in the first entry and
the payoff to B are in the second entry in the cells of the box.

A pay off matrix of a game

Player B
Left (don‟t adv) Right (advertise)
Top (↑ P)
Player A 1,2 0,1
Bottom (P) 2,1 1,0

 From the viewpoint of person A, it is always better for him to play bottom. Since his/her
payoff from this choice (2 or 1) are always greater than their corresponding entries in top (1
or 0). Similarly, it is always better for B to play left. Since 2 and 1 dominate 1 and 0. Thus,
we would expect that the equilibrium strategy for A is to play bottom and B to play left
 A dominant strategy is the optimal (best) choice of strategy for each player no matter what
the other player does. Whatever choice B makes, player A will get a higher payoff if he/she
plays bottom, so it make sense for A to play bottom. And whatever choice A makes, B will
get a higher payoff if he plays left. Hence, bottom and left dominates the alternatives and
we have equilibrium in dominant strategy.

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 If there is a dominant strategy for each player, in some game, then we would predict that it
would be the equilibrium outcome of the game. In this example, we would expect an
equilibrium outcome in which A plays bottom, receiving an equilibrium pay off of 2, and B
plays left, receiving an equilibrium pay off of 1.

9.2 Nash Equilibrium

 Dominant strategy equilibria are nice when they happen, but they don‟t happen all that often.
This is because we may not have dominant strategy equilibrium when the optional (best)
choice of one depends on what he/she thinks the other will do. If this is the case, we call the
equilibrium Nash equilibrium.
 Consider the following example 2.
A Nash Equilibrium
Player B
Left Right
Top 1,2 0,0
Player A
Bottom 0,0 1,2

 Here when B chooses right, the payoffs to A are 0 or 1. This means that when B choose left,
A would want to choose top, and when B choose right, A would want to choose bottom.
Thus, A‟s optional choice depends on what he thinks B will do and vice versa.
 Thus, we will say that a pair of strategies is a Nash equilibrium If A‟s choice is optional
given B‟s choice, and B‟s choice is optional given A‟s choice. Remember that neither
person knows what the other player will do when he has to make his own choice of strategy.
But each person may have some expectation about what the other person‟s choice will be.
 Nash equilibrium can be interpreted as a pair of expectations about each person‟s choice such
that, when the other person‟s choice is revealed neither individual wants to change his
behaviour.
 Therefore,
- If A choose top, then the best thing for B is to choose left, since the payoffs to B from
choosing left is 2 and from choosing right is 0.
- And if B chooses left, then A will be better off by choosing top than bottom because
(1>0). Thus (Top, left) is a Nash equilibrium. Similarly.
- If A choose bottom, B will choose right and
- If B chooses right, A will choose bottom. Thus (bottom, right) is also another Nash
equilibrium.
 From the above we can conclude that the Nash equilibrium is a generalisation of the Cournot
equilibrium for each firm chooses its output level taking the other firm‟s choice as being
fixed.
 Though Nash equilibrium has certain logic, it has the following problems.
1. The game may have more than one Nash equilibriums. From example 2, bottom
and right can also be another equilibrium.
2. There are games that have no Nash equilibrium of the sort we have been describing at
all. Example 3.
Player B
Left Right
0,0 0, -1
Top
Player A 1,0 -1,3
Bottom

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 The above payoff matrix doesn‟t have unique or some Nash equilibrium. And, all of them
cannot be equilibrium outcomes. From the above payoff matrix for example, if A chooses
top, B will choose left- (top, left)
- If B chooses left, A will choose bottom- (left, bottom)
- If A chooses bottom, B will choose right- (bottom, right)
- If B chooses right, A will choose top- (right, top)
- If A chooses top, B will choose left- (top, left)

9.3 MIXED STRATEGY

 So far we have been thinking that each agent as choosing a strategy once and for all (a one
shot game) and sticking to it. This called a pure strategy.
 A Nash equilibrium in mixed strategies refers to an equilibrium situation in which each agent
chooses the optional frequency with which to play his strategies given the frequency choice
of the other agent. Thus, a Nash equilibrium in mixed strategy always exists.
 From the payoff matrix in Example 3
- If A and B follow the mixed strategy, then they will have a probability of ¼ ending up in
each of the four cells in the pay off matrix. Thus, the average payoff to A will be 0/4 +
0/4 + ¼ + (-1/4) = 0/4 = 0, and the average payoff to B will be 0/4 + (-1/4) + 0/4 + ¾ =
2/4 = ½

9.4 THE PRISONER’S DILEMMA (The zero sum game)

 Another problem of Nash equilibrium is that it doesn’t necessarily lead to Pareto efficient
outcome. Consider for example, the game depicted in the table 4. It refers to a situation
where two prisoners who were partners in a crime were being questioned in separate rooms.
Each prisoner has a choice of confessing (guilty) in the crime and there by implicating the
other or denying (not guilty) that he/she had participated in the crime.
- If only one prisoner confessed, then he would go free and the authority (judges)
will throw the book (sentenced) at the other prisoner, requiring him to spend 6
months in prison.
- If both prisoner denied being involved, then both would be held for 1 month on a
technicality (labour work) and
- If both prisoners confessed they would be both held for 3 months. The payoff
matrix for this game is given as

The prisoner, s dilemma

Player B
Confess Deny
-3, -3 0, -6
Confess
Player A -6, 0 -1, -1
Deny

 Put yourself in the position of player A.

- If B decides to deny committing the crime, then you are certainly better off confessing,
since you will get off free.
- Similarly, if B confesses, then you will better off confessing since you will get a sentence
of 3 months rather than a sentence of 6 months. Thus, whatever player B does, player A

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is better off confessing. The same is true for plays B–he/she is better off confessing.
Thus, the unique Nash equilibrium for this game is for both to confess.
 In fact, both players‟ confessing is not only a Nash equilibrium; it is a dominant strategy
equilibrium since each player has the same optimal (best) choice independent of the other.
 However, if they could both just hang tight, they would each be better off. In other words, if
they both could be sure that the other would hold out and both could agree to hold out
themselves, they would get a payoff of -1, which would make each of them better off.
 The strategy (deny, deny) is not only Pareto efficient but also Pareto Optimal because there is
no other strategy choice that makes both players better off or either of them with out
making the other worse off. Thus, the strategy (confess, confess) is Pareto inefficient for
both.
 The problem is that there is no way for the two prisoners to coordinate their action. If each
could trust the other, they could both be made better off. This applies to a wide range of
economic and political phenomena. Consider, for example, the problem of arms control.
Interpret “confess” as “ deploy a new missiles” and the strategy of “deny” as “don‟t deploy”.
Note that the payoffs are reasonable. If my opponent deploys his missile, I certainly want to
deploy. But if there is no way to make a binding agreement not to deploy a missile, we each
end up deploying the missile and are both made worse off, which is Pareto inefficient for
both of us. However, if there had been a strong binding agreement that forces us not to
deploy a missile or absolute trust among us, both would have been better off by reducing
the likely hood of human and physical capital loss and using the money in activities that will
enhance economic growth and is not only Pareto efficient but also Pareto optimal for both of
us.
 Another good example is the problem of cheating in a cartel. Now interpret confess a
“produce more than your quota” and interpret deny as “stick to the original quota”. If one
firm (A) thinks the other firm (B) is going to stick to its quota, it will pay to it to produce
more than its quota. And if A thinks that B will overproduce, then A might as well, too.

 The prisoner‟s dilemma provoked controversy as to what is a reasonable way to play the
game. The answer seems to depend on whether you are playing a one-shot game or the game
is to be repeated an indefinite number of time.

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CHAPTER TEN
PRICING OF FACTORS OF PRODUCTION AND INCOME DISTRIBUTION

INTRODUCTION

 The mechanism of determination of factor price does not differ very much from that of
commodities. That is, factor prices are determined through the interaction of supply and
demand in the factor market. The difference lays that government policies, intervention,
trade union, and business firms play an important role in the determination of the demand
and supply of factor of production (inputs).
 Factor inputs are generally divided into four. These are Land, Labour, Capital, and
Entrepreneurship. The prices of these factors are called rent, wage, interest, and profit
respectively.

10.1.FACTOR PRICING IN A PERFECTLY COMPETITIVE MARKET

10.1.1THE DD FOR FACTORS OF PRODUCTION: Consider two cases
I) When labour is the only factor of production
II) When there are several variable factors

I. Demand for a single variable factor by a firm: Assumptions

a) A single commodity Q is produced in a perfectly competitive market, which implies P
is given for all firms in the market (individual firms are price takers)
b) The goal of the firm is profit maximization
c) There is a single variable factor labour, whose market is perfectly competitive. The
price of labour to the individual firm is perfectly elastic. At the going market wage rate
(W) the firm can employ or hire any amount of labour it wants. Hence, W = MC L
W

W SL = MCL

L
b) Technology is given and it is represented by the production function Q = ƒ (L, K ). The
slope of the production function is the marginal physical of labour (MPPL).
dQ
 MPPL
dL

TP
TP

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 The MPPL declines at higher levels of employment because of the law of diminishing
marginal physical product (the law of variable proportion).
 P Q.MPPL = VMPL (value of marginal product of labour) = (MRPL). In other words, the
equilibrium condition for a profit maximizing firm in labour market is
MCL = VMPL
W = VMPL

VMPL
MPPL

VMPL = P Q. MPPL
MPPPL

 The DD for labour that maximizes profit can be determined by two ways. That is
A. TR-TC approach
B. W = VMPL approach

A. TR-TC Approach: Maximum profit is obtained when the difference between TR and
TC is the greatest.

B
TR
A TR
Π
TC
TC

L* L
B. The MRPL or VMPL Approach: At L* level of employment, the slope of TR and TC
curves are equal. This is because the tangent line AB is parallel to TC curves. The slope
of TR is MRPL and the slope of TC is MCL= W . Therefore, we say at the equilibrium
when VMPL (MRPL) = MCL (W)

 Relationship between MRPL and VMPL

 
TR  ( P .Q) P Q 
MRPL     P .MPPL  VMPL
L  ( L) L

 
TC  W L W L 
MCL    W
L L L

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 Alternatively the profit function can be used to find equilibrium point i.e.
∏ = TR – TC, where

TR = P Q.Q
Q = ƒ (L)

TC = W . L. Thus, the condition for II maximization is


   P Q
∏ = P Q. Q - W . L = L  0  L  W  0

= P Q. MPPL – W = 0
= VMPL = W

 Being a profit maximizer, a firm will hire a factor as long as it adds more total revenue
than total cost (MR > MC). So the equilibrium condition in labour market is given as
MCL = VMPL. We also know that MCL = W. Therefore, VMPL = W at the equilibrium.
Graphically

W1 SL1 = MCL 1
W* e SL = MCL
W2 SL2 = MCL2

VMPL = MRPL

L1 L* L2 L

 Therefore, we say a firm is at equilibrium at e where VMP L (MRPL) intersects to SL

(MCL = W ). A change in the market wage rate leads to a change in the profit maximizing
level of labour input. When the wage rate increases to W1, the firm will reduce its
demand for labour to L1.If wage rate decreases to W2, the firm will maximize its profit by
increasing its demand for labour to L2. Thus, from the above analysis the demand curve
of a firm for a single variable factor, labour, is its VMPL (MRPL).
 Consider the following example

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1.Unit of 2. Total 3. dQ 4. 5. MRPL 6. 7. 8. 9.TR-TC

labour product dL PQ or VMPL TP. P Q TC=VC II
W
(L) TP =Q MPPL = TR 1x6
0 0 - 5 - 20 - 0 0
1 10 10 5 50 20 50 20 30
2 19 9 5 45 20 95 40 55
3 27 8 5 40 20 135 60 75
4 34 7 5 35 20 170 80 90
5 40 6 5 30 20 200 100 100
6 45 5 5 25 20 225 120 105
7 49 4 5 20 20 245 140 105
8 52 3 5 15 20 260 160 100
9 54 2 5 10 20 270 180 90
10 55 1 5 5 20 275 200 75

 From the table we can understand that the profit maximizing level of labour input is 7. At 7 level
of employment, not only the different between TR and TC is the highest but also the
slope of TR and TC curves are equal because the tangent line AB is parallel to TC curves.
 The SS of labour for a firm is a straight line with a given wage rate of 20. The VMP L and
SS labour curve intersect at a point equal to 7 units of labour. Hence, the equilibrium of
the firm is obtained by equating the VMPL to market wage rate.

W = 20 SL = MCL = W

VMPL

7
II. DD of a firm for several variable inputs. When there are more than one variable factors of
production the VMPL is not its demand curve. The reason is that the various resources (inputs)
are used simultaneously in the production of goods. In this case a change in the P of one factor
leads changes in employment of the others. A change in the employment of other factors
intern shifts the MPP curve of the input whose P initially changed.
 Consider for instance a case where a firm uses two inputs (k & L). Further assume that
the wage rate falls. Now such changes have three effects.
a. A substitution effect
b. An output effect
c. A profit maximizing effect

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E
The expansion path

K3 D
Q4
D
C
K2
K1 A Q3
1
K11 B Q2
Q1

L1 L11 L2 F L3 G F1 J

 Suppose that the firm initially produced the II maximizing level of output, Q, using the
combination with K1 and L1 whose price is I1 and W1. This is given by point A on
isoquant Q1. The ratio W1/I1 defines the slope of the isocost line EF.
 Let us assume that the wage rate falls to W2, the new isocost line becomes EF1. The firm
using the same expenditure can now produce a higher level of output given by Q3 using
K2 and L2. The new equilibrium is then given by point C.
 The movement from A to C can be broken in to two. That is the substitution effect and
output effect. The movement from A to B along the original isoquant represents the
substitution effect. To understand this movement we construct an isocost line DG known
as the compensated isocost line. It has the following two characteristics
(1) It is parallel to the new isocost and thus represents the new input price ratio.
(2) It is tangent to the old isoquant Q1 and thus makes the original inputs affordable.
 The movement from A to B is therefore a pure substitution of labour for capital as a result
of a decrease in the relative price of labour. This implies that the firm substitutes the
cheaper labour for the relative expensive capital. Therefore, the employment of labour
increases from L1 to L11 while that of capital decreases from K1 to K11. This movement
would occur if the entrepreneur were restricted to the original level of output at the new
input price ratio.
 The movement from B to C on the other hand represents the output effect. After the fall
in the price of labour the firm doesn‟t stay at B for the firm can buy more of labour and
more of capital. Hence the firm can produce the higher output Q3 using both labour and
capital, L2 and K2. The increase of employment of labour from L11 to L2 and capital from
K1‟to K2 (corresponding the movement from B to C) is the output effect.
 However, the movement from C to D is the profit maximization effect. Point C indicates
the optimal input ratio for a given expenditure on resources. But it doesn‟t show the
profit maximization amount of inputs.
 When wage rate falls, the MC of production is reduced for every level of output.
Therefore, the firm will increase its expenditure in order to maximize its profit in a
perfectly competitive market. Due to the increase in expenditure, the isocost line EF1

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must shift outwards parallel at a distance corresponding to the increase in the firm‟s total
expenditure to JJ. The final equilibrium of the firm will then be denoted by the point of
tangency of the new isocost line JJ, with the new isoquant Q4 at point D. Thus, the
increase in employment firm L2 to L3 and capital from K2 to K3 (corresponding to the
movement from C to D) is the profit maximizing effect.
 Given the substitution out put and profit maximizing effect how should a decrease in the
price of one factor affect the MPPL or VMPL?

1) The substitution effect of a decrease in the wage rate tends to increase the
employment of labour but reduces that of capital. Therefore, there is small
amount of capital with which labour is combined. Hence, there will be a
decrease in MPPL. That is, the substitution effect tends to shift the MPPL and
VMPL curves inwards or to the left.
2) The output effect and the profit maximizing effect on the other hand
result in an increase employment of both inputs. This causes the MPPL
and VMPL to shift to the right. The net effect is that the output and is
maximizing effect more than offset the substitution effect. Therefore, a
fall in the wage rate shifts the MPPL as well as VMPL to the right when
several variable factors are used in the production process. The shift in
the VMPL can be shown as follows.

 Let P1 and P2 be the original and the

new commodities price, respectively.
Thus, VMPL1 = P1 MP1 and VMP2 =
P2MP2. Since P1 < P2, VMP1 < VMP2 (for
W1 A the decrease in the price of an input)

W* B

W2 C dL
VMPL1
VMPL2 VMPL3

L1 L* L2

 For different wage rates one can generate a series of points such as A, B, and C. The
locus of these points defines the demand for labour by the firm when several factors are
variable. This is some time referred as the long run (LR) demand for labour by a firm.
Therefore, the long run DD curve for labour when several factors are variable is a
derived DD not VMPL.
 The long run demand for a factor is negatively sloped. The balance of the three effects of
an input price change must cause quantity demanded to vary inversely with price. Thus,
the long run demand curve is more elastic than the demand curve for a single variable
input-short run demand curve–VMPL.

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DETERMINANTS OF DD FOR PRODUCTIVE RESOURCES

1) The price of the inputs - Negatively related

2) The price of out put - Positively related
3) The MPP of the factor –Positively related
4) The amount of the other factors combined with labour. Eg. Fertilizer- positively
related
5) Technological progress (this first increases the MPPL of an input and thus
increases the demand for labour)

THE MARKET DD FOR A FACTOR

 The market demand for a variable input like the market demand for a commodity. It is the
sum total of the individual firms demand. However, in the case of productive inputs the
process of addition is not a simple horizontal summation of the demand curve of the
individual firms. This is because when all firms expand or contract simultaneously, the
market price of the commodity changes (decrease and increases, respectively). For
instance, when wage rate falls, all firms tend to demand more labour. The increase in
employment in turn leads to an increase in total output (SS). Therefore, the market supply
for the commodity produced shifts to the right.
 Assume given fixed market demand, wage rate declines. This in tern will reduce the price
of a commodity. The decline in the price of the commodity further reduces the VMPL at
all levels of employment. As a result, the VMP L curve (the individual demand curve for
labour) shifts to the left.

W1 a W1 A

W2 b b1 W2 B B1
dL1
dL2 DL

L1 L2 L21 L1 L2 L21
Individual Firm Market DD

 In other words, at W1, L1 amount of labour is demanded. But at W2, L21 units of labour
would have been demanded had there been no change in the price of the commodity due
to the fall in the wage rate. But when wage rate falls to W 2, the VMPL (dL) shifts to the
left and the new demand curve becomes dL2. Now the firm is in equilibrium at point b
on dL2 not at b1 on dL1. Hence, the demand for labour is L2 not L21, implying the demand
for labour increases by smaller margin from L1 to L2 not from L1 to L21. Summing
horizontally for all firms we get the market demand curve (DL). Hence, at W1 the market
demand for labour is given by point A, this corresponds to L1 unit of labour. At W2 the
market demand for labour is given by point B, this corresponds to L2 units of labour.
 If the fall of the commodity price was not taken in to account we will be led to an over
estimation of the demand for labour following the decline in the wage rate. Therefore, B1
represents the demand for labour assuming no change in commodity price as a result of
fall in wage rate.

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10.1.2. THE SUPPLY OF LABOUR IN A PERFECTLY COMPETITITVE MARKET

 The most important variable factors are raw materials, intermediate good, and labour.
Raw materials and intermediate goods are commodities and hence their market SS is
derived in the same principle as the SS of any commodity. The SS of labour, however,
requires a different approach. To begin with, assume that labour is a homogenous factor
(all labour units are identical).
 The main determinants of market SS of labour are
i. The price of labour (wage rate)
ii. The tastes of consumers which defines their trade off between leisure and
work
iii. The size of the population
iv. The labour force participation rate (at what age people start working?)
v. The occupational, educational and geographical distribution of labour
force. The relationship between the SS of labour and wage rate defines
the labour SS curve. The other determinants are considered (assumed) as
fixed or given. The market SS is the summation of the SS of labour by
individuals.

I. THE SS OF LABOUR BY AN INDIVIDUAL WORKER

 This can be derived using indifference curve analysis. On the horizontal axis we measure
hours available for leisure and work over a given period of time. On the vertical axis we
measure money income.

Y5
Y4

Labour SS curve
Y3 E1 W5
D11 D1 IC5 W4
IC
Y2 C1 4 W3
C11 IC3
B11 B1
Y1 IC2 W2

A1 A1 W1
IC
1
0
Z E DA B C work
hrs (L)
Leisure work individual SS of labour

 The maximum hours in a day, which an individual can use for leisure or for work is given
by 0Z. If the individual were to work are 0Z hours he/she would earn a total income of
0Y1. The wage rate is given by

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W1 = 0Y1 , The slope of Y1Z line

0Z
 What happens to the income line when wage rate increases to W2? The income line
becomes steeper.
 The indifference curves represent the preferences of an individual between leisure/work
and income. When the wage rate is W1 an individual will earn 0A11 (AA1) level of
income by working ZA hours and have 0A hours of leisure time.
 If the wage rate increases to W2, the individual is in equilibrium at point B1 by working
ZB and earning is 0B11 (BB1) income and devote 0B unit of time for leisure.
 If the wage rate increases to W3, the individual is in equilibrium at point C1 by working
ZC hrs and earning 0C11 (CC1) income and spent 0C amount of hrs for leisure.
 As the wage rate increases, the amount of labour supplied increases. However, the
hours devoted for work may decline beyond some higher wage rate. At wage rate W4,
the individual will work ZB hrs and this is less than the amount worked when the wage
rate was W3, W2, and W1. When wage rate increase further to W5, the hrs devoted for
work decline even more. Therefore, up to W 3, an increase in wage rate creates an
incentive for increased supply of labour. Above W3 labour SS declines. This implies that
higher wage rates create a disincentive for longer hrs of work. Thus, as wage rate
increases, the individual‟s income increases and this enables the workers to demand more
leisure than work. Hence, beyond a certain level of wage rate the SS of labour will
decrease.

II. THE MARKET SS OF LABOUR

 Although there is general an agreement that the SS curve for labour by a single
individuals exhibits the back-ward bending pattern, economists disagree as to the shape
of the aggregate (market) SS of labour.
 Consider the case of skilled (specialised) labour
1) Several economists argue that in the short run the market SS of labour may have
segments of positive and negative slope. However, in the long run the SS must have a
positive slope because
a) Young people may plan their education in line with the expected wages are high
b) Older worker may undertake retraining and change job if the wage incentive is
strong enough.
2) Other economists maintain that the backward bending supply curve of labour. As the
standard of living increases, people find that unless they have the time to enjoy leisure
activities it is not worthwhile to work harder in order to obtain the higher income
required for more leisure. Thus, as income reaches the level required for a comfortable
standard of living workers put forward greater demands for more holidays longer
vacations, shorter work weeks, and few hours per working day rather than demanding
higher wage rates associated with longer working hours.
 For the case of non-specialized type of labour, however, the labour SS curve is
always positively sloped both in the short run and long run. Therefore, the market SS
of labour (skilled or unskilled) in the short run can be approximated by a curve with
positive slope

III. The Supply of Other Factors

 The supply of other factors of production (like raw materials, intermediate goods, capital,
Land etc) in the market is the same as the SS of a commodity determined by
a) Their own price- positively related

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b) Production cost of a good (i.e. technology and their price). When production cost
of a particular good is low relative to the market price, then it will be profitable
for producers to produce a great deal, thus this increase the SS for other inputs
and vice verse-negatively related
c) Prices of substitute factors. If the price of Dap falls, the SS of urea falls-positively
related
d) Market organization. For example, the removals of quota, tariffs, custom duties
etc increase the SS of other factors-positively related
e) Particular factors. If government lower (reduces) restrictions, standards etc the SS
of other factor increase-negatively related.

10.1.3. THE DETERMINATION OF FACTOR PRICES

(A) IN A PERFECTLY COMPETITIVE MARKET

 Given the market demand and market SS of an input, the equilibrium price is determined
by the intersection of there two curves.

SL

B
We

Derived mkt DD
DL

Le
 The determination of equilibrium price of a commodity and a productive resource is the
same. The difference lies in the determination of the DD for variable factors and the
method used to derive the SS of labour. This means that the DD for a factor is a derived
DD (that is the DD for the service of a factor is based on the DD (P) of the commodities).
The SS of labour is not cost determined like the SS of commodities, but involves the
attitudes of individuals towards work and leisure.

(B) IN IMPERFECTLY COMPETITIVE MARKET

 The same as perfect competitive market, the intersection of DD and SS determine the
price of the factor and the level of its employment when there are imperfections in the
market. However, the determination of the DD and SS are different in the case of market
imperfection. We will consider three models with various kinds of imperfections. These
are
(1) MODEL A: When the firm has monopoly power in the product market and while
the factor market is perfect.
(2) MODEL B: When a firm has monopoly power in the product market and
monopsony power (the only buyer) in the factor (input) market.
(3) Bilateral Monopoly: When a firm has monopoly power in the product market and
the SS of labour is controlled (monopolized) by labour union.

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MODEL A: MNOPOLY POWER IN THE PRODUCT MARKET AND

PERFECT COMPETITIVE FACTOR (LABOUR) MAKET

I. DD of a monopolistic firm for a single variable factor

 In this model we assume that the firm uses a single variable factor-labour whose market
is perfectly competitive. This means that the wage rate is given and the SS of labour to
the individual firm is perfectly elastic.

W SL = MCL

Labour

 For the product of a monopoly firm is down ward sloping, MR is smaller than P at all
level of out put.
P

P1

P2 Ed=1

DD

MR= P(1-1/ed)

 Note that, under perfect competitive market VMPL=MRPL because P=MR

 On the basis of the above graph, the demand for labour by a monopolist firm is not the
VMPL curve but the MRPL, which is defined by multiplying the MPPL by MR of the
commodity produced.
MRPL = MPPL. MRX

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Consider the following table

1.Unit 2.Unit 3.TP 5.PQ 6.TR 7.MR 8.VMPL 9.MRPL 10.Wage 11. 12.LxW 13. 14.∏
of of =Q 4.MPPL PQ.Q ∆TR MPPL. MPPL.MRQ rate W TFC TVC TC = R-C
Fixed (L) ∆Q PQ
Capital
(K)
10 0 0 - - - - - - - $ 50 - $ -50
50
10 1 20 $ 20 $ 10 $ 200 $ 10 $ 200 $ 200 $ 40 50 40 90 110
10 2 38 18 9.05 344 8 163 144 40 50 80 130 214
10 3 54 16 8.44 456 7 135 112 40 50 120 170 286
10 4 68 14 7.94 540 6 111 84 40 50 160 210 330
10 5 80 12 7.5 600 5 90 60 40 50 200 250 350
10 6 90 10 7.11 640 4 71 40 40 50 240 290 350
10 7 98 8 6.78 670 3 54 24 40 50 280 330 334
10 8 104 6 6.66 696.8 1 40 6 40 50 320 370 326.8
10 9 108 4 6.20 670 0 25 0 40 50 360 410 260
10 10 110 2 6.05 660 -2 12 -4 40 50 400 450 216

 Observe that VMPL > MRPL because PQ > MRQ at all level of employment. To get the
equilibrium level of labour employed, we equate MRPL to MCL (W). We call the SS of
labour is perfectly elastic. Being a profit maximizer, the monopolist will be in
equilibrium at 6 units of labour employment where MRPL = W = 40 = 40

W1
e MCL = W
W
W2
MRPL = dL

L1 6 L2

 Since labour is the only variable input used in the production process while K is constant,
the MRPL curve is the monopolist‟s demand curve for labour.

 Mathematical derivation of the MRPL curve

1) Let the demand function for the product be
Px = ƒ (Qx)
- The TR of the firm is Px.Qx

TR Q P
- The MR =  Px x  Qx x
Qx Qx Qx

Px
- MR x = Px  Qx
Qx
2) The production function with labour the only variable factor is =
Qx = ƒ (L)

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Qx
The MPPL =
L
3) By definition the MRPL is the change in TR attributable to as unit change in labour.

 (TR )
MRPL =
L
PxQx
=
L
Qx Px
= Px  Qx
L L
Qx  Px Qx 
= Px  Qx  . 
L  Qx L 
Qx  Px 
=  Px  Qx. 
L  Qx 
Qx
From (2)  MPPL
L
Px
From (1) Px  Qx.  MRx
Qx

Therefore = MRPL = (MPPL). (MRX)

II. Demand for a variable labour (factor) by a monopolistic firm when several
factors are used.
 When more than one variable factor are used in the production process, the demand curve
is derived from points on shifting MRPL curves. A change in the price of labour (W)
results in substitution, output, and profit maximization effects as in the care of perfectly
competitive firm. The net result of these effects is a shift of the MRPL to the right (in
general) that leads to the equilibrium point B. Joining points such as A, B, and C at
various levels of wage rates (W) we obtain the demand curve for labour (dL)

W1 A
W B

W2 MRPL1 C
MRPL dL

MRPL2

L1 L* L2

III. The Market DD and SS of Labour

 The Market DD. The market demand for labour (a factor) is the summation of the
demand curves of the individual monopolistic firms. In aggregating the curves, however,
we must take into account the shift in the demand curve due to a change in the price of
the factor. As all monopolistic firms expand their output, the market price of products

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falls. Hence, the individual demand curve and MR curves for commodity produced shift
to the left. This in turn shifts the demand curve for labour to the left.

W1 a A
1 1
W b b B B

dL1 (MRPL1)
dL2(MRPL2)

L1 L* L1
L1 L* L1

 The Market SS. The market SS for labour is not affected by the fact that firms have
monopolistic power. This the market SS of labour is then the horizontal summation of
the SS curves of the individuals as derived earlier.

 The Market Price. The equilibrium market price for a factor (labour) is determined by
the intersection of the market demand and market SS of that factor (labour). For a
monopoly firm the market DD is based on the MRPL not on the VMPL. This means that
when firms have monopolistic power, the factor is paid its MRP, which is smaller than
the VMP. Joan Robinson calls this effect monopolistic exploitation. According to
Robinson a productive factor is exploited if it is paid a price less than its VMP.

 In both perfect competition and monopoly market condition a firm employs a factor when
MCL = W = MRPL. But MRP equals VMP under perfect computation. Because VMP =
MPP.P and MRP = MPP.MR and P = MR hence, MC L = W = MRPL (VMPL). Under
monopoly market, however, MRPL< VMPL because P>MR.Therefore, MCL = W =
MRPL < VMPL.
SL

W1 b1 monopolistic WL
exploitation
W b a WM
VMPL
∑VMPL
MRP L ∑MRPL
Lm LC Lm LC
Individual firm Market

MODEL B: MONOPOLY POWER IN THE PRODUCT MARKET AND

MONOPSONY POWER IN THE FACTOR MARKET

I. Equilibrium of a monopolistic firm who use a single variable factor

 In the case of a monopolistic firm the demand for labour is the as in model A. That is the
demand for labour is MRPL curve. The SS of labour to the individual firm, however, is
not perfectly elastic because the firm is large (monopsonist or the only buyer) in the
labour market. In this case the SS of labour to the firm has a positive slope.

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 As the monopsonist expands the use of labour, he must pay a higher wage. The SS of
labour shows the average expenditure or price that the monopsonist pays at different level
of employment.
 Multiplying the price of the input (w) by the level of employment gives the total
expenditure (TE) of the monopsonist for the input. That is TEL = WL
 The equilibrium of a monopsonist firm is given by equating the marginal expenditure
(MEL) of purchasing an additional labour and the MRPL. That is MEL = MRPL.
MEL (MCL)

MEL E
SL=AEL=W

WS

MRPL

LS

TE L
 The marginal expenditure (MEL) =
L
 Hiring an additional unit of labour input increases the total expenditure on the factor by
more than the price of this unit because all the previous units employed are paid the new
higher price (W). The ME of the factor is greater than its price (W) at all level of
employment. Thus, the ME curve lies above and to the left of the SS curve (average
expense curve). This implies that the slope of the ME curve is greater than the slope of
the supply of labour (SL or AEL) curve.

 The wage rate that the monopsonist will pay for LE units of labour is WF, which is
defined by the point of the supply of labour (SL) corresponding to the intersection of
MEL and MRPL.
 When the firm has a monopsony power in the input market it pays the factor a price that
is less than not only VMPL but also its MRPL. This gives rise to monopolistic
exploitation, which is something in addition to monopolistic exploitation.
 Formal derivation of ME curve
1.The input SS function is W= ƒ (L)
Slope = dW > 0
dL
TE = WL
2. By definition, marginal expense (ME) is the change in TE to a change in L. That is
MEL = d (TE) =d (WL) =WdL + LdW = W+LdW,
dL dL dL dL dL
Since dW >0, L>0, and W>0 it shows that MEL>W for any level of L.
dL

3.The slope of the SS function is dW

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dL
- The slope of MEL curve is
- d(MEL)= d (W + LdW)
dL dL
dL

= dW + dW.dL +Ld2 W = 2dW + Ld2W .

dL dL dL dL2 dL dL
- Thus, MEL has a steeper slope than the SL (W).
 Summery of comparison of market equilibrium of a firm in perfectly competitive, model
A, and model B when labour is the only variable factor (in the short run).
1. In a perfectly competitive market labour is paid its VMPL. That is W =VMPL.

Wpc E SL=MCL

VMPL

Lpc
2. In model A where a firm has monopoly power in the product market but does not
have power in the factor market, labour is paid it MRPL which is less than VMPL.
This give monopolistic exploitation.

SL

Monopolistic Wpc
Exploitation Wm E

VMPL
MRPL

Lm
3. In model B where a firm has monopolistic power in the product market and
monopsony power in the factor market, labour is paid wage rate, which is even
lower than its MRPL. That is MEL = MRPL.

MEL

SL=AEL
Ws

MRPL

Ls

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4. Bringing the above three curves together, we can show how monoposonistic
exploitation is something in addition to monopolistic exploitation.

MEL

SL

Wpc C
Wm M
Ws S
VMPL
MRPL

Ls Lm Lc

MODEL C: BILATERAL MONOPOLY

 In this model we assume that all firms are organized as a single body, which acts like a
monopsonist, while the labour is organized in labour union, which acts like a monopolist.
Thus we have a model in which the participants are two monopolists, one on the SS side
and one on the DD side. In general, bilateral monopoly arises when a single seller
(monopolist) faces a single buyer (monopsonist).
 It can be shown that the solution to a bilateral monopoly solution is „indeterminate‟. The
model gives only the upper and lower limits with in which the wage rate will be
determined by bargaining. The outcome of the bargaining cannot be known with
certainty. It depends on bargaining skills, political, and economic power of the labour
union and the firm and on many other factors.
 The monopsonists (single buyer‟s) demand curve is Db. It is the MRP L of the input being
demanded. From the point of view of the monopolist (labour union) this curve (Db)
represents his overage revenue curve (ARs). Thus, we denote this curve as Db=ARs
(Average revenue curve of seller). The seller‟s (union‟s) MRs curve can be derived by
the usual graphic technique; the MRs will be below the ARs, and will cut the horizontal
line at its mid point.

MEb

WU
F SL=AEL=MCS

WF U
Db=MRPL=ARs

MRS

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LU LF
 The SS of labour facing the monopsonist is upward sloping curve, S L. This shows the
average expense (average cost) of labour to the monopsonist. Corresponding to this
average cost (expenditure) curve is the ME curve which we derived in model B.
 From the point of view of the monopolist (labour union) the curve S L is its marginal cost.
Given the above cost and revenue curves we can find the equilibrium position of each
participant in the labour market. The monopsonist (Federation of manufactures or firms)
maximizes his profit at point F, where his marginal expense of labour (MEb) is equal to
the marginal revenue product of labour (MRPL). Thus, the monopsonist will desire to
hire LF units of labour and pay a wage rate equal to WF.
 The monopolist (labour union) on the other hand, maximizes his profit (gains) at point U,
where his marginal cost is equal to his marginal revenue. Thus, the monopolist will want
to supply LU units of labour and receive a wage equal to WU.
 The price desired by the monopsonist WF is the lower limit of price, which can be
realized only if he could force the monopolist to act as perfect competitor. The price
desired by the monopolist, WU is the upper price limit, which could be realized if he
could force the monopsonist to act as perfect competitor.

 Since, the price goal of the two parties cannot be realized the price and quantity in the
bilateral monopoly market are indeterminate. That is economic analysis cannot provide a
determinate solution to a bilateral monopoly market. The only result is the determination
of upper and lower limits to the price of labour (W). The level of which the price will be
settled depends on the bargaining skills and power of the two parties.

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