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Chapter 12
Monopolistic Competition
and Oligopoly
Topics to be Discussed
 Monopolistic Competition
 Oligopoly
 Price Competition
©2005 Pearson Education, Inc.
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Monopolistic Competition
 Characteristics
1. Many firms
2. Free entry and exit
3. Differentiated product
©2005 Pearson Education, Inc.
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Monopolistic Competition
 The amount of monopoly power depends
on the degree of differentiation
 Examples of this very common market
structure include:
Toothpaste
Soap
Cold remedies
©2005 Pearson Education, Inc.
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Monopolistic Competition
 Toothpaste
 Crest and monopoly power
 Procter
& Gamble is the sole producer of Crest
 Consumers can have a preference for Crest –
taste, reputation, decay-preventing efficacy
 The greater the preference (differentiation) the
higher the price
©2005 Pearson Education, Inc.
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Monopolistic Competition
 Two important characteristics
Differentiated but highly substitutable
products
Free entry and exit
©2005 Pearson Education, Inc.
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A Monopolistically Competitive
Firm in the Short and Long Run
$/Q
Short Run
$/Q
MC
Long Run
MC
AC
AC
PSR
PLR
DSR
DLR
MRSR
QSR
Quantity
MRLR
QLR
Quantity
A Monopolistically Competitive
Firm in the Short and Long Run
 Short run
Downward sloping demand – differentiated
product
Demand is relatively elastic – good
substitutes
MR < P
Profits are maximized when MR = MC
This firm is making economic profits
©2005 Pearson Education, Inc.
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A Monopolistically Competitive
Firm in the Short and Long Run
 Long run
Profits will attract new firms to the industry
(no barriers to entry)
The old firm’s demand will decrease to DLR
Firm’s output and price will fall
Industry output will rise
No economic profit (P = AC)
P > MC  some monopoly power
©2005 Pearson Education, Inc.
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Monopolistically and Perfectly
Competitive Equilibrium (LR)
$/Q
Monopolistic Competition
Perfect Competition
$/Q
MC
Deadweight
loss
AC
MC
AC
P
PC
D = MR
DLR
MRLR
QC
Quantity
QMC
Quantity
Monopolistic Competition and
Economic Efficiency
 The monopoly power yields a higher
price than perfect competition. If price
was lowered to the point where MC = D,
consumer surplus would increase by the
yellow triangle – deadweight loss.
 With no economic profits in the long run,
the firm is still not producing at minimum
AC and excess capacity exists.
©2005 Pearson Education, Inc.
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Monopolistic Competition and
Economic Efficiency
 Firm faces downward sloping demand so
zero profit point is to the left of minimum
average cost
 Excess capacity is inefficient because
average cost would be lower with fewer
firms
©2005 Pearson Education, Inc.
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Monopolistic Competition
 If inefficiency is bad for consumers,
should monopolistic competition be
regulated?
 Market power is relatively small. Usually
there are enough firms to compete with
enough substitutability between firms –
deadweight loss small.
 Inefficiency is balanced by benefit of
increased product diversity – may easily
outweigh deadweight loss.
©2005 Pearson Education, Inc.
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The Market for Colas and Coffee
 Each market has much differentiation in
products and tries to gain consumers
through that differentiation
Coke vs. Pepsi
Maxwell House vs. Folgers
 How much monopoly power do each of
these producers have?
How elastic is demand for each brand?
©2005 Pearson Education, Inc.
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Elasticities of Demand for
Brands of Colas and Coffee
©2005 Pearson Education, Inc.
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The Market for Colas and Coffee
 The demand for Royal Crown is more
price inelastic than for Coke
 There is significant monopoly power in
these two markets
 The greater the elasticity, the less
monopoly power and vice versa
©2005 Pearson Education, Inc.
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Oligopoly – Characteristics
 Small number of firms
 Product differentiation may or may not
exist
 Barriers to entry
Scale economies
Patents
Technology
Name recognition
Strategic action
©2005 Pearson Education, Inc.
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Oligopoly
 Examples
Automobiles
Steel
Aluminum
Petrochemicals
Electrical equipment
©2005 Pearson Education, Inc.
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Oligopoly
 Management Challenges
Strategic actions to deter entry
 Threaten
to decrease price against new
competitors by keeping excess capacity
Rival behavior
 Because
only a few firms, each must consider
how its actions will affect its rivals and in turn
how their rivals will react
©2005 Pearson Education, Inc.
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Oligopoly – Equilibrium
 If one firm decides to cut their price, they
must consider what the other firms in the
industry will do
Could cut price some, the same amount, or
more than firm
Could lead to price war and drastic fall in
profits for all
 Actions and reactions are dynamic,
evolving over time
©2005 Pearson Education, Inc.
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Oligopoly – Equilibrium
 Defining Equilibrium
 Firms are doing the best they can and have no
incentive to change their output or price
 All firms assume competitors are taking rival
decisions into account
 Nash Equilibrium
 Each firm is doing the best it can given what its
competitors are doing
 We will focus on duopoly
 Markets in which two firms compete
©2005 Pearson Education, Inc.
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Oligopoly
 The Cournot Model
Oligopoly model in which firms produce a
homogeneous good, each firm treats the
output of its competitors as fixed, and all
firms decide simultaneously how much to
produce
Firm will adjust its output based on what it
thinks the other firm will produce
©2005 Pearson Education, Inc.
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Firm 1’s Output Decision
P1
Firm 1 and market demand curve,
D1(0), if Firm 2 produces nothing.
D1(0)
If Firm 1 thinks Firm 2 will produce
50 units, its demand curve is
shifted to the left by this amount.
MR1(0)
D1(75)
If Firm 1 thinks Firm 2 will produce
75 units, its demand curve is
shifted to the left by this amount.
MR1(75)
MC1
MR1(50)
12.5 25
©2005 Pearson Education, Inc.
D1(50)
50
Chapter 12
Q1
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Oligopoly
 The Reaction Curve
The relationship between a firm’s profitmaximizing output and the amount it thinks
its competitor will produce
A firm’s profit-maximizing output is a
decreasing schedule of the expected output
of Firm 2
©2005 Pearson Education, Inc.
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Reaction Curves and Cournot
Equilibrium
Q1
Firm 1’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 2 will produce. The x’s
correspond to the previous model.
100
75
Firm 2’s Reaction
Curve Q*2(Q1)
Firm 2’s reaction curve shows how much it
will produce as a function of how much
it thinks Firm 1 will produce.
50 x
25
x
Firm 1’s Reaction
Curve Q*1(Q2)
25
©2005 Pearson Education, Inc.
50
x
75
Chapter 12
x
100
Q2
25
Reaction Curves and Cournot
Equilibrium
Q1
In Cournot equilibrium, each
firm correctly assumes how
much its competitors will
produce and thereby
maximizes its own profits.
100
75
Firm 2’s Reaction
Curve Q*2(Q1)
50 x
25
Cournot
Equilibrium
x
Firm 1’s Reaction
Curve Q*1(Q2)
25
©2005 Pearson Education, Inc.
50
x
75
Chapter 12
x
100
Q2
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Cournot Equilibrium
 Each firm’s reaction curve tells it how
much to produce given the output of its
competitor
 Equilibrium in the Cournot model, in
which each firm correctly assumes how
much its competitor will produce and sets
its own production level accordingly
©2005 Pearson Education, Inc.
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Oligopoly
 Cournot equilibrium is an example of a
Nash equilibrium (Cournot-Nash
Equilibrium)
 The Cournot equilibrium says nothing
about the dynamics of the adjustment
process
 Since both firms adjust their output, neither
output would be fixed
©2005 Pearson Education, Inc.
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The Linear Demand Curve
 An Example of the Cournot Equilibrium
Two firms face linear market demand curve
We can compare competitive equilibrium and
the equilibrium resulting from collusion
Market demand is P = 30 - Q
Q is total production of both firms:
Q = Q1 + Q2
Both firms have MC1 = MC2 = 0
©2005 Pearson Education, Inc.
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Oligopoly Example
 Firm 1’s Reaction Curve  MR = MC
Total Revenue : R1  PQ1  (30  Q)Q1
 30Q1  (Q1  Q2 )Q1
 30Q1  Q12  Q2Q1
©2005 Pearson Education, Inc.
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Oligopoly Example
 An Example of the Cournot Equilibrium
MR1  R1 Q1  30  2Q1  Q2
MR1  0  MC 1
Firm 1' s Reaction Curve
Q1  15  1 2 Q2
Firm 2' s Reaction Curve
Q2  15  1 2 Q1
©2005 Pearson Education, Inc.
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Oligopoly Example
 An Example of the Cournot Equilibrium
Cournot Equilibrium : Q1  Q2
15  1 2(15  1 2Q1 )  10
Q  Q1  Q2  20
P  30  Q  10
©2005 Pearson Education, Inc.
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Duopoly Example
Q1
30
Firm 2’s
Reaction Curve
The demand curve is P = 30 - Q and
both firms have 0 marginal cost.
Cournot Equilibrium
15
10
Firm 1’s
Reaction Curve
10
©2005 Pearson Education, Inc.
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Q2
33
Oligopoly Example
 Profit Maximization with Collusion
R  PQ  (30  Q)Q  30Q  Q
MR  R Q  30  2Q
MR  0 when Q  15 and MR  MC
2
©2005 Pearson Education, Inc.
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Profit Maximization w/ Collusion
 Collusion Curve
Q1 + Q2 = 15
 Shows
all pairs of output Q1 and Q2 that
maximize total profits
Q1 = Q2 = 7.5
 Less
output and higher profits than the Cournot
equilibrium
©2005 Pearson Education, Inc.
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Duopoly Example
Q1
30
Firm 2’s
Reaction Curve
For the firm, collusion is the best
outcome followed by the Cournot
Equilibrium and then the
competitive equilibrium
Competitive Equilibrium (P = MC; Profit = 0)
15
Cournot Equilibrium
Collusive Equilibrium
10
7.5
Firm 1’s
Reaction Curve
Collusion
Curve
7.5 10
©2005 Pearson Education, Inc.
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Q2
36
First Mover Advantage – The
Stackelberg Model
 Oligopoly model in which one firm sets its
output before other firms do
 Assumptions
One firm can set output first
MC = 0
Market demand is P = 30 - Q where Q is total
output
Firm 1 sets output first and Firm 2 then
makes an output decision seeing Firm 1’s
output
©2005 Pearson Education, Inc.
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First Mover Advantage – The
Stackelberg Model
 Firm 1
Must consider the reaction of Firm 2
 Firm 2
Takes Firm 1’s output as fixed and therefore
determines output with the Cournot reaction
curve: Q2 = 15 - ½(Q1)
©2005 Pearson Education, Inc.
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First Mover Advantage – The
Stackelberg Model
 Firm 1
Choose Q1 so that:
MR  MC  0
R1  PQ1  30Q1 - Q - Q2Q1
2
1
Firm 1 knows Firm 2 will choose output
based on its reaction curve. We can use Firm
2’s reaction curve as Q2 .
©2005 Pearson Education, Inc.
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First Mover Advantage – The
Stackelberg Model
 Using Firm 2’s Reaction Curve for Q2:
R1  30Q1  Q12  Q1 (15  1 2Q1 )
 15Q1  1 2 Q
2
1
MR1  R1 Q1  15  Q1
MR  0 : Q1  15 and Q2  7.5
©2005 Pearson Education, Inc.
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First Mover Advantage – The
Stackelberg Model
 Conclusion
Going first gives Firm 1 the advantage
Firm 1’s output is twice as large as Firm 2’s
Firm 1’s profit is twice as large as Firm 2’s
 Going first allows Firm 1 to produce a
large quantity. Firm 2 must take that into
account and produce less unless it wants
to reduce profits for everyone.
©2005 Pearson Education, Inc.
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Price Competition
 Competition in an oligopolistic industry
may occur with price instead of output
 The Bertrand Model is used
Oligopoly model in which firms produce a
homogeneous good, each firm treats the
price of its competitors as fixed, and all firms
decide simultaneously what price to charge
©2005 Pearson Education, Inc.
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Price Competition – Bertrand
Model
 Assumptions
Homogenous good
Market demand is P = 30 - Q where
Q = Q1 + Q2
MC1 = MC2 = $3
 Can show the Cournot equilibrium if Q1 =
Q2 = 9 and market price is $12, giving
each firm a profit of $81.
©2005 Pearson Education, Inc.
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Price Competition – Bertrand
Model
 Assume here that the firms compete with
price, not quantity
 Since good is homogeneous, consumers
will buy from lowest price seller
If firms charge different prices, consumers
buy from lowest priced firm only
If firms charge same price, consumers are
indifferent who they buy from
©2005 Pearson Education, Inc.
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Price Competition – Bertrand
Model
 Nash equilibrium is competitive output
since have incentive to cut prices
 Both firms set price equal to MC
P = MC; P1 = P2 = $3
Q = 27; Q1 & Q2 = 13.5
 Both firms earn zero profit
©2005 Pearson Education, Inc.
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Price Competition – Bertrand
Model
 Why not charge a different price?
If charge more, sell nothing
If charge less, lose money on each unit sold
 The Bertrand model demonstrates the
importance of the strategic variable
Price versus output
©2005 Pearson Education, Inc.
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Bertrand Model – Criticisms
 When firms produce a homogenous
good, it is more natural to compete by
setting quantities rather than prices
 Even if the firms do set prices and
choose the same price, what share of
total sales will go to each one?
It may not be equally divided
 Kreps and Scheinkman
©2005 Pearson Education, Inc.
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Price Competition –
Differentiated Products
 Market shares are now determined not
just by prices, but by differences in the
design, performance, and durability of
each firm’s product
 In these markets, more likely to compete
using price instead of quantity
©2005 Pearson Education, Inc.
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Price Competition –
Differentiated Products
 Example
Duopoly with fixed costs of $20 but zero
variable costs
Firms face the same demand curves
 Firm
1’s demand: Q1 = 12 - 2P1 + P2
 Firm 2’s demand: Q2 = 12 - 2P1 + P2
Quantity that each firm can sell decreases
when it raises its own price but increases
when its competitor charges a higher price
©2005 Pearson Education, Inc.
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Price Competition –
Differentiated Products
 Firms set prices at the same time
Firm 1 :  1  P1Q1  $20
 P1 (12  2 P1  P2 )  20
 12 P1 - 2 P  P1 P2  20
2
1
©2005 Pearson Education, Inc.
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Price Competition –
Differentiated Products
 If P2 is fixed:
Firm 1' s profit maximizing price 
 1 P1  12  4 P1  P2  0
Firm 1' s reaction curve 
P1  3  1 4 P2
Firm 2' s reaction curve 
P2  3  1 4 P1
©2005 Pearson Education, Inc.
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