Econ-A311 U05 241

ECON A311
Intermediate Microeconomics
Unit 5
Imperfect competition
241
HKMU Course Team
Course Development Coordinator
W H Cheuk, HKMU
Developer
Lo Wai Chung, HKMU
Instructional Designer
Ross Vermeer, HKMU
Member
C L Kwong, HKMU
External Course Reviewer

Dr Li Kui Wai, City University of Hong Kong
Production
Office for Advancement of Learning and Teaching (ALTO)
Copyright © Hong Kong Metropolitan University 2011, 2012, 2020,

2021
Reprinted 2024
All rights reserved.
No part of this material may be reproduced in any form by any means
without permission in writing from the President, Hong Kong
Metropolitan University. Sale of this material is prohibited.
Hong Kong Metropolitan University

Ho Man Tin, Kowloon
Hong Kong
This course material is printed on environmentally friendly paper.

Contents
Introduction 1
Pure monopoly 2
The condition for profit maximization 2
Pricing policy 4
There is no supply curve 5
Taxing monopolists 7
Inefficiency created by monopoly 7
Price discrimination 9
Optimal pricing policy 9
Bundling and two-part tariffs 11
An overview of oligopoly 13
Cooperative strategy 13
Non-cooperative strategy 13
Some basic concepts in game theory 14
Dominant strategy 15
Nash equilibrium 16
The prisoners’ dilemma 18
Explaining non-cooperative behaviour 19
The Cournot model 19
The Bertrand model 21
Repeated games 22
Sequential games 23
Summary 27
Answers to self-test questions 28

Unit 5 1
Introduction
In Unit 4 we discussed perfect competition. However, perfect
competition assumes that all firms produce homogeneous products, each
firm accounts for a negligible market share and that firms have absolutely
no market power because of competition. This is not really what we have
in the real world. For example, until the late 1980s, there was only one
long-distance telecommunications carrier in Hong Kong, and this long-
distance carrier charged a very high price compared to regions where the
markets were open to competition. Thanks to new developments in
telecommunications technology, starting in the late 80s small firms began
to break through this monopoly barrier and the price of long-distance
calling has since dropped significantly. This is clear evidence that a
monopolist gains economic profit by charging higher prices. In this unit,
we shall discuss the theory of the monopoly, as well as the pricing
practices of firms under imperfect competition.
Many industries in the modern economy, however, do not fit into the
categories of perfect competition or monopoly. For example, the
automobile industry in the United States is dominated by three firms i.e.
General Motors, Ford and Chrysler. In Hong Kong, the property
development business is concentrated in a small number of real estate
developers. The behaviour of producers under oligopoly, i.e. an industry
structure with just a few producers, has drawn the attention of
economists for a long time. Classic models, such as Cournot model, have
been developed to explain the behaviour of firms under oligopoly. One of
the recent advances in economic analysis is to apply game theory — a
theory used to study strategy — to analyse the behaviour of oligopolies.
This unit will therefore include a brief introduction to the application of
game theory in imperfect competition.
To summarize, this unit:
• analyses the characteristics and the pricing behaviour of monopolists;
• evaluates the policies regulating monopolies;
• analyses the behaviour of oligopolists under cartels;
• uses the Cournot model and the Bertrand model to analyse the non-
cooperative behaviour of oligopolists;
• explains the concept of the Nash equilibrium and the key elements of
a game; and
• uses the game theoretical approach to analyse strategic moves.

2 ECON A311 Intermediate Microeconomics
Pure monopoly
This first topic is quite straightforward. The only point I want to
emphasize is that a monopolist is also a profit maximizer. You should be
familiar with the following definition of a pure monopoly: there is only
one producer in the industry because of the barriers to entry and the
absence of close substitutes.
There is obviously no competition if there is only one producer in an

industry. Thus the industry demand curve is in fact the firm’s demand
curve. The following figure compares the demand curve of a
representative firm in a competitive industry to that of the monopolist’s.
Figure 5.1 Price-taker and price-maker
A representative firm under perfect competition faces a horizontal

demand curve, depicting the firm’s complete lack of influence on market
prices. The pure monopolist has a downward-sloping demand curve. The
slope of the demand curve reflects the firm’s ability to influence the
market price by changing output. You should recall that the slope of a
demand curve is related to the price elasticity of demand.
The condition for profit maximization

A pure monopolist is also a profit-maximizer. We can apply the rule:
marginal cost = marginal revenue,
to analyse the behaviour of a monopolist. Recall that total revenue (R) is

the product of price (P) and quantity (Q):
R = P × Q,
and the marginal revenue (MR) is the change of revenue (∆R) for a small
change in quantity output (∆Q):
MR = ∆R/∆Q.
Unit 5 3
However, since the monopolist is also the price-maker, P is no longer a

constant but is a function of Q instead. (A demand function is in general
written as Q = f(P). When we express P as a function of Q, it is referred
to as an inverse demand function). Thus, the marginal revenue is:
MR = ∆R/∆Q = P + Q(∆P/∆Q).
The second term on the right-hand side of the above expression is a

consequence of the fact that the market price is affected by the firm’s
output, Q. You can see that for a horizontal demand curve, ∆P/∆Q = 0,
and MR = P, so we go back to the condition of profit maximization under
perfect competition.
Since the monopolist’s demand curve is downward-sloping, i.e. ∆P/∆Q is

negative, P is therefore larger than MR. The marginal revenue curve must
therefore lie below the demand curve, as shown in the following figure.
Figure 5.2 The marginal revenue curve of a price-maker
A monopolist generally enjoys positive economic profits. The firm can

charge a price higher than the average cost of production due to lack of
competition. This is demonstrated in the following figure. The shaded
area represents the economic profit which is equal to (P – AC) × Q.
Figure 5.3 A price-maker can enjoy positive economic profit
It is also useful to relate the price elasticity of demand, EP, to the

marginal revenue:
MR = P(1 + 1/EP).
The marginal revenue (MR) is, of course, equal to the marginal cost (MC)
if the monopolist is to maximize profit. Since EP is negative, it is clear
that MR is zero when EP equals -1.
Pricing policy
You should remember from your introductory course in economics that a
monopolist does not have absolute market power. It is always useful to
refer to the case of perfect competition where producers in fact have no
market power. The extent to which a monopolist can manipulate the
market price relates to the price elasticity of the output. To illustrate this
point, we rearrange the expression MC = P(1 + 1/EP) as
P 1 .
=
MC 1 + (1 EP )
From this expression, it is clear that a monopolist can have a higher mark
up (higher P/MC ratio) if the price elasticity is lower. However, you must
not draw the conclusion that a monopolist prefers price inelastic demand.
Since marginal revenue is negative when the demand is inelastic i.e. the
absolute value of the price elasticity of demand is less than one (EP < |1|),
no producer will produce when marginal revenue is negative.
Reading
PR (2018) 10.1 ‘Monopoly’, pp. 369–70; ‘Average revenue and
marginal revenue’, pp. 370–71; ‘The monopolist’s output
decision’, pp. 371–74; ‘A rule of thumb for pricing’, pp. 375–77.
Self-test 5.1
1 The demand function of a firm is given by Q = 10 – 5P. The firm is a

price-maker. Do you agree?
2 A firm under a monopoly has absolute freedom in pricing the product

because it is the only producer of a good which has no close
substitute. Do you agree?
3 Both a monopolist and firms in a competitive market are profit-

maximizers. To maximize profit, they produce at the levels where
marginal cost equals marginal revenue. Thus, they have the same
pricing rule. Do you agree?
4 Explain in your own words why monopolists can enjoy positive

economic profits in the long-run.
5 Suppose the monopolist’s demand curve is given by Q = 5 – 3P.

What is the marginal revenue if the price increases from five to six?
6 Since monopolists are price-makers, they never experience loss. Do

you agree?
Unit 5 5
7 What is the marginal revenue if the price is $10 and the price
elasticity is -1.2?
There is no supply curve

In a perfect competitive market, the marginal cost of production is the
supply curve, which shows a clear relationship between price and the
quantity supplied. However in monopolistic market, there is no supply
curve. It implies that no single curve can clearly show the relationship
between price and output produced; instead these are co-determined by
both the demand curve and the marginal cost curve.
In the following figure (5.4a), to begin with the monopolist faces the
demand curve D1 and marginal revenue curve MR1. With the marginal
cost curve and marginal revenue curve, the profit maximizing output is
Q1 and the price is P1. When the demand changes from D1 to D2, the
marginal revenue also changes to MR2. The marginal cost now intersects
with the marginal revenue curve at a different point. The price is still P1
according to D2 but the profit maximizing output has increased to Q2.
Figure 5.4a A single price corresponding to different outputs
Figure 5.4b shows another scenario. The demand curve again shifts from
D1 to D2 (and thus MR1 to MR2). The profit maximizing output remains
the same but the price falls.
Figure 5.4b A single output corresponding to different prices
We can observe that unlike in a perfect competitive market, there is not a

one-to-one relationship between output and price. You may refer to the
following reading for a detailed description.
Reading
PR (2018) ‘Shift in demand’, pp. 377–78.
Self-test 5.2
1 What is the mark up ratio P/MC when EP = -0.5? How do you explain
the result?
2 ‘The company responsible for the management of a new railway

grants the construction project to the developer who offers the lowest
bid. Thus the users of the railway will pay less because the price
mark up is based on the cost.’ Evaluate this statement.
3 The Post Office is going to issue 30,000 stamps to pay respect to a

famous opera singer. To give people more chance to buy the stamps,
the Post Office decides to offer the stamps on Mondays for three
consecutive weeks so that 10,000 stamps go on sale each Monday.
From past experience, the inverse demand function is estimated as P
= 50 – 0.001Q. The financial manager reckons that the numbers of
stamps available in the market are 10,000, 20,000 and 30,000 by the
end of the first, second, and the third Mondays, respectively. Hence
the price of the stamps should be, according to the inverse demand
curve, $40, $30 and $20, respectively. This will generate a total
revenue of $900,000. Thus the financial manager decides to set the
price at $30 for all three days, expecting to generate the total revenue
of $900,000. Evaluate this pricing strategy.
Unit 5 7
Taxing monopolists
You can now go directly to the next textbook reading for an analysis of
the impact on a monopolist when government imposes a per unit tax on
that monopolist. The crucial point is that a producer views the per unit
tax as a variable cost, and hence the marginal cost curve will be shifted
up when government imposes the tax. The tax will lower the
monopolist’s profit, and the monopolist will respond by producing less.
Reading
PR (2018) ‘The effect of a tax’, pp. 378–79.
Inefficiency created by monopoly

Under a monopoly, goods are not produced at the minimum of the long-
run average cost curve, which clearly signifies production inefficiency.
This inefficiency is also reflected by the size of the dead weight loss. We
know that consumer surplus is reduced under a monopoly, and the
monopolist gains positive economic profits. However, only part of the
consumer surplus is transferred to the monopolist. The remaining part,
known as the ‘dead weight loss’, is gone. How does this happen? This
loss is due to the fact that output is not produced in the most efficient
way because the monopolist restricts the output from the optimal level.
For this reason, mainstream economists are generally hostile towards
monopolies.
The following reading gives a more detailed, graphical analysis of

welfare loss under monopolies.
Reading
PR (2018) 10.4 ‘The social costs of monopoly power’,
pp. 389–93.
The inefficiencies due to the condition of monopoly can also be

discussed in the context of general equilibrium. In a market economy,
resources are allocated to different sectors according to price signals.
Remember from the previous unit that if an economy is perfectly
competitive, price signals serve the function of allocating resources to the
various sectors efficiently (in a Pareto sense). If some sectors of the
economy are monopolized, price signals are distorted, resulting in the
inefficient allocation of resources.
Let’s say a two-goods economy consists of good X and good Y. The

market of good X is monopolized while the market of good Y is perfectly
competitive. The monopolist in industry X enjoys a positive profit
because she can produce at a price which is higher than the marginal cost.
Since the price of X is higher than the marginal cost of X, the price ratio
of X and Y is greater than the ratio of the marginal cost of X and Y. This
is a deviation from the condition of Pareto-efficiency in product mix. If
market X is monopolized, the price signal (the price ratio) no longer
serves the function of directing resources for efficient production and
consumption. In this example, good X is underproduced, indicating that
more resources (capital and goods) should have been channelled to
produce X.
Please go through the detailed explanation of this phenomenon in the

following reading.
Reading
PR (2018) 16.7 ‘Why markets fail — market power’, pp. 638–39.
In the previous section, you learned that a monopolist sets the output
where marginal revenue equals marginal cost. Or, equivalently, a firm
sets the price under which marginal revenue equals marginal cost. Since
the firm is a price-maker, it can set different prices in markets of
different price elasticities, provided that the markets are effectively
separated. This is the concept of price discrimination.
It’s time for another self-test. It’s quite brief, but it should help you
consolidate your understanding of monopolies.
Self-test 5.3
1 A monopolist faces the demand curve P = 54 – 2Q, and the

associated marginal revenue curve is MR = 54 – 4Q. The fixed cost is
150 and the marginal cost curve is constant at 10.
a What is the firm’s output and profit?
b How does a lump sum tax of $99 affect the output decision of the
firm? What should the firm do in the short-run and in the long-
run?
c How does a per unit tax of $9 affect the firm’s output decision?
What should the firm do in the short-run and in the long-run?
Unit 5 9
Price discrimination
So far, we’ve assumed that a firm under the conditions of a monopoly
charges all consumers the same price. In fact, however, you may already
have realized that such a firm could capture all or part of the consumer
surplus if it were able to charge different prices to different consumers.
Doing so is called ‘price discrimination’.
There are in fact three types of price discrimination. Under first-degree

price discrimination, a firm is able to capture all the consumer surplus.
The price that consumers are willing to pay is the same as the price that
consumers actually do pay. Recall that market demand is composed of
the demand from individual consumers. If a firm has full knowledge of
the demand curve of each consumer, it can charge each consumer the
price which the consumer is willing to pay. Clearly, price discrimination
of the first-degree is unlikely because it is not possible for a firm to have
full information on each consumer’s demand curve.
Price discrimination of the second degree is easier to implement. Under

this pricing practice, a firm offers different prices to consumers
according to the quantity purchased, with block purchasers offered lower
prices. You can see that under second-degree price discrimination, firms
cannot capture all the consumer surplus. In the next reading you’ll see
some examples of second-degree price discrimination.
Firms practising third-degree price discrimination try to charge different

prices to consumers from different categories. To practise this kind of
price discrimination, firms must be able to group and separate their
consumers effectively, which may not always be possible.
Optimal pricing policy

Suppose a monopolist knows the demand curves of his purchasers. What
pricing policy would maximize profit? For simplicity, assume that the
firm faces two markets only, and the demand curve for each market is
known. You should also assume that output — and hence the cost of
production — is fixed. Thus, the firm simply has to maximize its total
revenue in order to maximize profit.
Suppose a firm’s total output is Q. The inverse demand functions and

marginal revenue curves for the two markets are:
Market 1: P1 = 72 – 2.5Q1, MR1(Q1) = 72 – 5Q1.
Market 2: P2 = 110 – 1.5Q2, MR2(Q2) = 110 – 3Q2.
The firm’s profit is maximized when MR1 = MR2 :
72 – 5Q1 = 110 – 3Q2 .

If total output is 30, the profit maximization sales in each market can be
obtained by solving the equations:
72 – 5Q1 = 110 – 3Q2,
Q1 + Q2 = 30.
This yields Q1 = 6.5, Q2 = 23.5. From the demand function, the prices in
the two markets are P1 = 55.75, and P2 = 74.75.
In the previous example, you could see that the firm could charge
different prices to the two markets. The next question is: to what extent
can the firm impose price differences in the two markets?
The answer depends on the price elasticity of demand. To be specific, the

price ratio of the two markets is related to the price elasticities, E1, E2, of
the two markets:
P 1 .
=
MC 1 + (1 EP )
The firm should set the price higher in the market where the demand is
less elastic.
In our continuing discussion of how a monopoly’s outputs to two markets

are distributed, we assume that the total outputs are given. In general, the
total output and the distribution to the markets are determined
simultaneously. In order to maximize profit, the marginal cost of
producing the total output, Q1 + Q2, must be equal to the marginal
revenues, MR1(Q1) and MR2(Q2):
MC(Q1 + Q2) = MR1(Q1) = MR2(Q2).
In PR Figure 11.5 (p. 421), you will learn how to use a graphical
approach to solve this problem. The basic idea is to develop the
combined marginal revenue curve, which is the horizontal sum of the
marginal revenues of the separated markets. The monopolist’s optimal
output is then obtained from the intersection of the monopolist’s
marginal cost curve and combined marginal revenue curve. Example 11.2
on page 423 illustrates how airline companies practise price
discrimination in reality.
Reading
PR (2018) 11.1 ‘Capturing consumer surplus’, pp. 413–15;
11.2 ‘Price discrimination’, pp. 415–24.
Unit 5 11
Bundling and two-part tariffs

The next reading describes two common pricing practices used to exploit
consumer surplus: bundling and two-part tariffs.
When different goods, say good A and good B, are bundled together,
consumers who are willing to pay a higher price for good A are forced to
pay the same price for good B, which they would only be willing to buy
at a lower price. Clearly, this bundling practice lowers the consumer
surplus in good B. The concept of bundling is easy to comprehend. But
you should note the condition for this pricing practice to be effective
when you go through the reading.
Sometimes consumers are required to pay a one-time fee for the access to
buy a good, and then are levied with additional charges for each unit
consumed. This is referred to as a ‘two-part tariff’. The purpose of a two-
part tariff is again to exploit the consumer surplus. You will see from the
next reading that the one-time fee is in fact the consumer surplus. You
should also note how the optimal quantity is determined.
After this reading, there’s another self-test for you to complete.
Reading
PR (2018) 11.4 ‘The two-part tariff’, pp. 428–32; 11.5 ‘Bundling’,
pp. 433–36.
Self-test 5.4
1 Why is first-degree price discrimination difficult to implement? Try

to name an example of first-degree price discrimination.
2 A monopolist faces a demand curve given by
Q = 20 – 3P.
a What is the monopolist’s total revenue if sales are equal to five

units?
b What is the total revenue if the monopolist successfully practises

first-degree price discrimination? What is the consumer surplus
exploited?
3 In the previous question, let’s say the producer sells the first two
units at $6 and the next three units at $5. What is the consumer
surplus exploited? What do you call this kind of price discrimination?
4 What are the two conditions required for effective third-degree price
discrimination?
Unit 5 13
An overview of oligopoly
As you‘ve learned, under conditions of perfect competition producers are
price-takers. Individually the firms are so small that the market simply
does not respond to the firms’ actions; there is therefore no need for a
firm to consider the reaction of its rivals. Under a monopoly, by
definition, there is no rival to the monopolist. When there are only a few
producers, however, the situation is more complicated. For example,
each firm knows that decisions in, say, the quantity of its output, will
affect not only the market price but also the production of other firms,
which in turn will also affect the market price.
Cooperative strategy
Of course, for producers as a group to gain the most benefit, they are
better-off if they collude. That is, they could collude in order to increase
their market power. A cartel is an arrangement under which firms agree
to refrain from increasing output in order to raise the market price. The
most prominent cartel today is the Organization of Petroleum Exporting
Countries (OPEC). The members of OPEC agree not to expand output in
order to keep oil prices high.
Behaving cooperatively in this way is not always possible because

collusion is illegal in many countries. But even the OPEC members find
it difficult to collude effectively. For collusion to be effective, each
member of the organization must be honest regarding the execution of its
agreements. For example, the members of OPEC must not produce more
petroleum than they have promised.
You will see from the subsequent sections how firms can increase their
profits if they cooperate, i.e. if they do produce according to an
agreement. You will also learn that a cartel is generally an unstable
organization by its very nature. The members of a cartel have very strong
incentives to cheat to deviate from agreements with the other colluding
parties.
Self- test 5.5
1 Why are cartels generally unstable?
Non-cooperative strategy
Since collusion generally is illegal, firms tend to behave non-
cooperatively. A typical firm under such a market structure must
calculate how other firms are likely to respond to its actions. Analysing
such non-cooperative behaviour is quite demanding. In this unit, we’ll
use the game theory as a useful tool for analysing non-cooperative

behaviour. The following section is a brief introduction to game theory.
You will see that game theory is not really about games — the name
‘game’ is, in fact, somewhat misplaced. Instead, it is a tool to study the
strategic moves of related parties.
Reading
PR (2018) ‘Noncooperative versus cooperative games’, pp. 502–4.
Some basic concepts in game theory

Start by imagining a very simple game: tic-tac-toe. There are two players
in the game. Suppose you are one of the players. You may be the first
mover or second mover. The three possible outcomes of the game are:
you win, you lose, or you draw. As an experienced player, you have a set
of rules in mind. Your every move, contingent upon your opponent’s
moves, should have been thoroughly considered and well planned. Your
objective is, of course, to maximize your utility (your ego?), i.e. to win.
Of course, tic-tac-toe is really a very simple (and boring) game. You
know that if both you and your opponent are rational, the only
equilibrium outcome is a tie.
Most games are much more complex than the two-person tic-tac-toe,
however. There can be more than two players in many games, and the
moves in these games may not be sequential, i.e. the players move
simultaneously without observing the moves of others. Nevertheless, a
two-person tic-tac-toe game does include the key elements of all games:
players, strategies for making moves, and a pay-off at the outcome.
Summing up, a game is a setting composed of:
1 a group of players;
2 a set of strategies for each player, given that the players are free to
choose a specific strategy from their set of strategies; and
3 a pay-off for the players, which depends on the strategy chosen by

each of them.
Given the setting of a game, the job of a game analyst is to find a

solution — the strategic moves of all players in the game. It is worth
noting that a player’s ‘strategic move’ does not really mean a single
move; it refers to a series of moves. In other words, a strategic move (or,
simply, a strategy) is a set of rules, including responses to every possible
contingency, from the beginning to the end of the game.
The solution to a game is composed of the chosen strategies of all players.

It must be a scenario in which the players do not deviate from their
chosen strategies, or it will be impossible to tell the outcome of the game.
Unit 5 15
In other words, the solution must be an equilibrium in the sense that the
players of a game have no incentive to switch to alternative strategies.
You will see later, however, that not all games have equilibria. Now let’s
go into some more important concepts in game theory.
Dominant strategy
The strategy that a rational player chooses is related to the strategy that
other players, presumably also rational, adopt. The players formulate
their strategies based on their expectations of their opponents’ strategies.
However, there are cases in which a player’s best strategy is independent
of her opponent’s choice. A dominant strategy can therefore be defined
as the player’s best strategy no matter what strategy a rival adopts.
Reading
PR (2018) 13.2 ‘Dominant strategies’, pp. 504–5.
Table 13.1 on page 505 of the above reading displays the game in a
normal form. The normal form of a game shows the pay-offs of the
various combinations of strategies among the players in a matrix form.
Alternatively, a game can be presented in an extensive form, showing
each of the players’ moves. For example, the game on page 399 can be
presented as in Figure 5.5.
Figure 5.5 A game in extensive form
We can read the moves and the pay-offs of the players in the game tree
shown in the figure. When both firm one and firm two cheat, the profits
are 36 for each firm. When the firms share the market, the profit for each
firm is 42. When firm one adopts the strategy of market sharing and firm
two cheats, the profits are 35 for firm one and 45 for firm two. Finally,
when firm one cheats and firm two adopts the strategy of sharing the
market, the profits are 45 and 35 respectively. Notice that the moves of
the firms are not sequential, i.e., the firms decide whether to cheat or to
share the market simultaneously without knowing which strategy their
rival adopts, although the game tree apparently shows that firm one
moves before firm two.
You should note that many games do not have solutions composed of
dominant strategies. ‘Dominance’ is too strong a condition to be satisfied
in practice. The example on page 507 of the next reading (Table 13.3) is
a game in which not all players have a dominant strategy. This motivates
the next important concept in game theory — the Nash equilibrium.
Nash equilibrium
The Nash equilibrium is one of the most important concepts in modern
economics. Simply put, the Nash equilibrium describes a scenario in
which each competitor (i.e. player) does not deviate from her strategy,
given that other competitors do not deviate from their strategies. The
following reading gives you a demonstration of Nash equilibrium.
Reading
PR (2018) 13.3 ‘The Nash equilibrium revisited’, pp. 506–8.
There are two points you should note. First, a solution composed of
dominant strategies is a Nash equilibrium, but the vice versa is not
necessarily true. Second, there can be more than one Nash equilibrium in
a game. For example, there are two Nash equilibria in the game
(Table 13.3). In recent years, game theorists have developed additional
rules, referred to as refinement, to pinpoint the solution. This, however,
is outside the scope of this course. But you should bear in mind that the
Nash equilibrium, by itself, may not be a sufficient condition for solving
a game problem.
Self-test 5.6
1 Explain why a solution composed of dominant strategies is consistent

with the Nash equilibrium, but the vice versa is not necessarily true
i.e. a Nash equilibrium is not necessarily composed of dominant
strategies.
2 What are the dominant strategies of A and B in the following setup?

The numbers at the lower corners and upper corners in each cell are
the pay-offs of A and B respectively.
Unit 5 17
a
B’s action
strategy b1 strategy b2
20 25
strategy a1
20 12
A’s action
12 15
strategy a2
25 15
b
B’s action
15 25
strategy a1
20 12
A’s action
22 28
strategy a2
25 10
c
B’s action
18 20
strategy a1
10 6
A’s action
15 14
strategy a2
12 5
3 The numbers at the lower corner and upper corner in each cell in the
following matrix are the pay-offs of A and B respectively. Identify the
Nash equilibrium.
B’s action
20 25
strategy a1
20 12
A’s action
12 15
strategy a2
25 15
The prisoners’ dilemma

Let’s go back to the game in Figure 5.5. As explained in the previous
reading, the dominant strategy of firm one is to cheat. Regardless of
which strategy is adopted by firm two, firm one achieves a higher profit
if it cheats. The same is true for firm two; its dominant strategy also is ‘to
cheat’.
You can see that players do not have an incentive to deviate from their
dominant strategies. In our previous example, firm one will not switch its
strategy to ‘sharing the market’ because by doing so, its pay-off will be
less, regardless of whether firm two adopts the strategy of ‘cheating’ or
‘sharing’. The same is true for firm two. Hence the solution of the game
is composed of the dominant strategies of firm one and firm two. Can
you see that this is an equilibrium outcome?
The remarkable feature of this outcome is that both players adopt their
dominant strategies to maximize their pay-offs, but their outcomes are
jointly worse than if they adopt the strategies of minimizing their pay-offs!
You should be able to see why this is so. Even if firm one wanted to
follow the strategy to share the market, firm two still has an incentive to
cheat. Then firm two will gain at the expense of firm one. Clearly, firm
one is foolish if it sticks to the strategy of sharing the market.
What we have just discussed is sometimes referred to as ‘the prisoners

dilemma’. The story goes like this. A and B commit a crime together and
they are both caught. If they both confess, the sentence is five years for
both. If they both refuse to confess, both will be sentenced to three years.
If one confesses and the other does not confess, the one who confessed
will be sentenced to two years, and the one who does not will be
sentenced to eight years. If you were one of the prisoners, what would
you do? Would you confess or not confess? This is the problem.
We can treat this setting as a game. The game can be represented as a

normal form, as follows. The numbers at the lower corner and the upper
corner in each cell are the pay-offs (i.e. sentences) of A and B respectively.
B’s action
Confess Not confess
5 8
Confess
5 2
A’s action
Not 2 3
confess 8 3
Figure 5.6 The prisoners’ dilemma

Unit 5 19
You can see that the dominant strategy of A is to confess: it maximizes

the pay-off (i.e. minimizes the sentence) no matter whether B confesses
or not. Similarly, B’s dominant strategy is also to confess. Again, you can
see that they could be better-off if they both adopted the strategy of not
confessing.
The following reading shows you how the concept of the prisoner
dilemma helps explain why collusion is difficult.
Reading
PR (2018) 12.4 ‘Competition versus collusion: The prisoners’
dilemma’, pp. 483–85.
Self-test 5.7
1 The prisoner’s dilemma indicates that collusion is difficult to

maintain. Explain.
So far, we have gone through some important concepts in game theory.

We are now ready to apply these concepts to discuss the non-cooperative
behaviour of firms under oligopoly.
Explaining non-cooperative behaviour

The two commonly used models to explain non-cooperative behaviour
are the Cournot (pronounced as koon-no) model and the Bertrand model.
The following outline will help you to appreciate how the models work.
Both the Cournot model and the Bertrand model can be considered as a
two-person game, i.e. there are two firms competing in the market. What
differentiates the two models are the conjectures that the firms make in
considering the action and reaction of their competitors. In the Cournot
model, the decision variable is quantity, i.e. the firms’ strategy is to
determine the quantity of output in order to maximize profit. In contrast,
firms under the Bertrand model set the prices to maximize profit.
The Cournot model

The crucial point of the model is the Cournot conjecture:
Each Cournot competitor expects that she can change her output without
causing her competitor to change her output.
For a two producer industry, the total industry output is the sum of the
individual output q1 and q2, or
Q = q1 + q2.
Thus the price, and hence the profits, of the individual firms depends on
the output decision of each firm. From the Cournot conjecture, each firm
calculates the quantity of output that maximizes profit, assuming that the
output of its rival is given. In other words, the profit-maximizing output
is a function of the quantity of output of the other firm. This is known as
the reaction function. The reaction function of both firms can be
computed, given that the demand function is known.
For simplicity, assume a linear inverse demand function
P = a – bQ = a – b(q1 + q2).
and constant marginal cost
mc = c
The profit function of firm one is
Pq1 = [a – b(q1+ q2)]q1 – cq1
It can be shown (using calculus) that the reaction function for firm one is
a − c − bq2
q1 = .
2b
Similarly, the reaction function for firm two is given as
a − c − bq1
q2 = .
2b
The equilibrium output of the two firms is obtained by solving the two
reaction functions.
The following reading addresses this topic in more detail.
Reading
PR (2018) ‘The Cournot model’, pp. 472–77.
The procedure used to obtain the solution of the Cournot model is rather
straightforward. But make sure you understand the concept of reaction
function! Also, make sure that you apply the concept of the Nash
equilibrium.
In our Cournot model, there are two firms. Each firm computes its profit-
maximizing output based on the output decision of the other firm. Since
the Cournot solution describes the situation in which the profit of each
Unit 5 21
firm is maximized, there is no reason for either firm to deviate from its
production strategy if its competitor does not deviate from its production
strategy. This, of course, fits within the definition of the Nash equilibrium.
The Bertrand model

The Bertrand Model differs from the Cournot model in its conjecture of
how the competitor behaves. If firm one makes a Bertrand conjecture, it
expects that firm two (its competitor) will not change its quoted price
when it changes its own price. There are three possible outcomes in
setting prices. Firm one sets a higher price than firm two, firm two sets a
higher price than firm one, or the prices are set equally. Since each firm
knows that buyers have no loyalty to any firm, the firm with the higher
price will lose all of its market share. Assuming that both firms are
rational (and smart), they would set the same price to share the market
equally. Or, in the jargon of game theory, the Nash equilibrium is only
achieved when firm one and firm two ask for the same price.
Reading
PR (2018) ‘Price competition with homogeneous products — the
Bertrand model’, pp. 478–79.
Self-test 5.8
1 What is the difference in the assumptions between the Cournot model

and the Bertrand model?
2 Suppose the industry demand function and marginal revenue function

are:
P = 60 – Q
MR = 60 – 2Q.
The firms in the industry are identical, with constant marginal cost
equal to 8.
a What is the industry output and price if there is only one firm?
b What is the industry output and price of each firm if there are
thousands of firms?
c What is the industry output and price of each firm if there are two
Cournot-like firms?
3 In the previous question, what would be the industry output and price
if the number of firms increases to, say, 10? Or 100? What can you
conclude from this result?
Repeated games
In the discussion on the prisoner dilemma, we can see that by choosing
dominant strategy, each player ends up in a position which is not of her
best interest. The crucial point of the setting is that the prisoners do not
know the decision of their opponents. It is clear that if the prisoners have
the opportunity to communicate, they will cooperate, that is, choose not
to confess, to minimize the sentence. You should also notice that our
setting in the prisoner dilemma is a ‘one-shot’ game. Imagine that our
prisoners are discharged after serving their sentences, and somehow they
commit the same crime and are tried again. Do you think they will
confess (behave non-cooperatively) or not confess (behave
cooperatively)? In other words, would the behaviour of the players
change in the setting of repeated game?
In the following reading, you are shown that in repeated game,

cooperation can emerge as equilibrium.
Reading
PR (2018) 13.4 ‘Repeated games’, pp. 512–16.
Self-test 5.9
1 It is 3 am on the morning of a Chinese New Year’s Day. The florists

at the fair in Victoria Park, after several days of exhausting effort to
sell their flowers to people coming to the fair, are smashing the
unsold flowers. You wonder why the florists do not sell the
remaining flowers at a lower price. Since their fixed costs are sunk
and there is no variable cost, the marginal revenue from whatever
low price they charge will still raise their total profits. It seems
irrational that the florists are destroying all their remaining flowers
instead of selling them a reduced price. How might you comment on
what you see happening?
Unit 5 23
Sequential games
This section discusses an example of sequential games in which
decisions are made in sequence. So far, we assume that all firms have
equal muscle to compete in the oligopoly setting. However, it is not
uncommon for an industry to be dominated by a single firm. To protect
its turf, the incumbent will adopt a strategy to keep away competitors.
The following paragraphs depict the ‘entry deterrence’ game, a predatory
pricing strategy to keep away competitors.
Consider the following scenario. There is initially only one firm in an

industry. A new firm is considering challenging the incumbent. The new
firm may enter the industry or stay out, depending on whether the
incumbent expands or remains at the current scale of production.
Similarly, the incumbent is considering whether to expand or remain at
the current scale of production, depending on whether the potential
entrant will enter or stay out. Suppose the pay-offs of the two firms under
the different strategies are shown in the following normal form of the
game.
Incumbent
Maintain output Expand output
Enter (18, 12) (-10, 5)
Entrant
Stay out (0, 20) (0, 25)
Figure 5.7a The pay-off matrix of incumbent and potential entrant
In the matrix, the first number in the parenthesis is the pay-off of the
entrant and the second number is that of the incumbent. The incumbent,
to keep the new firm from entering the industry, can choose to compete
fiercely by expanding its production capacity. Hopefully, the entrant
would be scared and decide not to enter, and the incumbent can have a
profit of $25 by expanding its production capacity. However, this
strategy will hurt both the entrant and the incumbent if the new firm
insists on entering. Thus, the incumbent has to consider the entrant’s
strategy when it chooses its own strategy. Similarly, the entrant can
choose to enter or to stay out — it has to consider the incumbent’s
strategy when making its own plan. We assume that both the incumbent
and the entrant are rational; otherwise there is no way to explain and
predict their behaviour. Firms are rational in the sense that they are
profit-maximizers, and they also assume their rivals are profit-
maximizers. They develop their strategies based on this assumption.
What is the solution to this game? Or, equivalently, which strategies will
the incumbent and the entrant adopt?
We know that the solution of the game must be a Nash equilibrium. But
note that both the strategies (stay out, expand) and (enter, maintain)
satisfy the requirements of a Nash equilibrium. Clearly, reaching a Nash
equilibrium is not the end of the story because there may be several Nash
equilibria for a game.
Consider the Nash equilibrium (stay out, expand). The potential entrant
knows that if it really enters, the incumbent will not expand its
production capacity. This is because the incumbent has a higher profit
($12) if it maintains the production capacity, but the profit is $5 if it
expands the production capacity. Thus, the declaration that the
incumbent will expand capacity if the potential entrant enters is an empty
threat.
Thus, one of the Nash equilibria, (stay out, expand), is ruled out because
the entrant’s strategy to expand when the rival enters is an empty threat.
The solution of the game is (enter, maintain).
Of course, this is not desirable from the standpoint of the incumbent.

What should it do to keep the potential entrant from really entering?
The crucial point is credible commitment. To discourage the potential

entrant from really entering, the incumbent has to credibly convince the
rival that it will expand capacity if entry occurs. The commitment —
such as paying up-front for the cost of expansion — changes the pay-offs
of the incumbent. Suppose the incumbent has committed to expand its
production line and spent $8, as a result the pay-offs for ‘maintaining
output’ are reduced by $8 (as the incumbent has already spent the
investment cost). The new pay-offs are shown in the following table.
Incumbent
Maintain output Expand output
Enter (18, 4) (-10, 5)
Entrant
Stay out (0, 12) (0, 25)
Figure 5.7b The pay-off matrix of incumbent and potential entrant after credible
commitment
For the sake of comparison, the pay-offs with and without credible
commitment are shown in the following figure.
Unit 5 25
Figure 5.8 Credible commitment changes the outcome of a game
You can see that, with credible commitment, the declaration that the
incumbent will expand capacity when the entrant enters is not an empty
threat. The strategy (enter, maintain) is no longer a Nash equilibrium.
The only Nash equilibrium is (stay out, expand), which is the solution of
the game.
The discussion in this section is by no means an in-depth discussion of

game theory. Nor is it a complete introduction to the application of game
theory for analysing oligopoly. Nevertheless, it illustrates the basic
concepts of game theory for you. If you’re really interested in this topic,
you could refer to the article by Vickers, J (1985) ‘Strategic competition
among the few — some recent developments in the economics of
industry’, Oxford Review of Economic Policy, 1(3) for a good summary
of recent developments in applying game theory to economic problems.
The following reading gives another example to illustrate the idea of
threats and commitments in game theory.
Reading
PR (2018) 13.6 ‘Threats, commitments, and credibility’,
pp. 519–22.
In any case, be sure you understand the basics, which is what this next
self-test will help you do.
Self-test 5.10
1 What is an ‘empty threat’?
2 What is a ‘credible commitment’?
3 In the following game tree, the first number in the parenthesis is the
pay-off of X and the second number is the pay-off of Y. Suppose Y
makes the threat that if X chooses the strategy u, Y will choose the
strategy n. Is this a Nash equilibrium? Is this an empty threat? What
can be done so that this strategy is not an empty threat?
4 Suggest a pay-off pattern due to a credible commitment in the

previous question so that the threat — if X plays u then Y will play
n — is not empty.
Unit 5 27
Summary
This unit has covered the major issues in imperfect competition. We
discussed the theory of monopoly, and asserted that monopolists are
price-makers. By limiting output and hence raising prices consistent with
the market demand curve, a monopolist generally enjoys positive
economic profit. A monopolist can charge a price higher than the long-
run average cost, and this is an indication of inefficiency. You also
learned about inefficiency from both the partial equilibrium and general
equilibrium perspectives.
Pricing practices under monopolies were then discussed. You found out
that price discrimination is a common practice when competition is
imperfect, and we discussed the three types of price discrimination. I also
explained practices such as bundling and two part tariffs to illustrate the
implementation of price discrimination.
The second part of this unit is a discussion on oligopoly. We adopt a

game theory approach in our discussion. We first introduce the basic
concepts in the game theory, in which the most important is Nash
equilibrium. We then apply the concepts to discuss the Cournot model
and Bertrand model to analyse the non-cooperative behaviour. We also
go through the concept of prisoner dilemma to explain why players do
not behave cooperatively. We go further to explain that players would
behave cooperatively under the setting of repeated game. Finally, we
demonstrate that there exists the possibility of the abuse of dominant
position.
Answers to self-test questions

Self-test 5.1
1 Yes. The inverse demand function is P = 2 – Q/2. The firm can affect
the market price by changing the quantity supplied.
2 No. Some consumers can always stop buying if the price is too high.
As a result, the profit of the firm falls.
3 No. Although the profit maximization principle, MR = MC, is

applicable to all firms — competitive firms and monopolists alike —
the firms in a competitive industry are price-takers. The marginal
revenue is equal to market price; the profit maximization condition is
reduced to P = MC. Since the monopolist is a price-maker, the
pricing rule P = MC is not applicable.
4 The positive profit is due to the lack of competition. Since the

monopolist is the only supplier of this good, the firm can limit the
quantity supplied and charge a price above the average cost of
production. Due to the barrier to entry, other firms cannot enter the
industry. The monopolist can keep the higher price to maintain the
positive economic profit.
5 When P = 5, Q = 20 – 3P = 5, R = P × Q = 25.
When P = 6, Q = 20 – 3P = 3, R = P × Q = 18.
The revenue decreases by 25 – 18 = 7.
6 No. In the short-run, a monopolist may operate at a loss, as

demonstrated in the following figure.
It is possible that the average cost of production is higher than the

market price when MR = MC, yielding a loss equals (AC – P) × Q,
represented by the shaded area.
7 Using the formula on page 5 of the study unit,

MR = 101 − 1  = 1.67.
 1.2 
Unit 5 29
Self-test 5.2
P 1
1 From the formula = ,
MC 1 + 1
Ep
P 1
= = -1.
MC 1 + 1
− 0.5
Since neither price nor marginal cost can be negative, a negative

P/MC indicates the breakdown of the profit maximization condition.
As mentioned in the unit, marginal revenue is negative when EP > -1.
2 It is not true. The scenario in the question is similar to proposal one

in Application 9-4 in Reading 5.5. The low bid lowers the average
cost, but the marginal cost remains the same. The company, being a
monopolist, will charge the users according to the MC = MR rule.
Thus, unless the company is regulated by government, the
construction cost is irrelevant.
3 This is a durability problem. The buyers will take the total quantity
supplied as 30,000, expecting the fair price to be $20. If the price is
set at $30, the total quantity demanded will be 20,000, hence the total
revenue will be $30 × 20,000 = $600,000 which is $300,000 less than
the expectation.
Self-test 5.3
1 a Set the marginal cost equal to the marginal revenue:
10 = 54 – 4Q.
Solving, Q = 11. From the demand curve, at Q = 11,
P = 54 – 2 × 11 = 32.
Profit = 32 × 11 – (150 + 10 × 11) = 92.
b The firm sets its output level at MR = MC. Since from the firm’s
perspective, the lump sum tax is a fixed cost, it will not affect the
firm’s output decision. Thus, the firm remains to produce at
Q = 11.
Since the price P = 32, higher than the average variable cost
(= 10), the firm should produce at Q = 11 in the short-run.
However, the lump sum tax affects the firm’s profit. With the
lump sum tax of $100, the profit is:
Profit = 92 – 100 = -8.
In the long-run, the firm has to shut down.

c With the per unit tax, the firm’s marginal cost is 10 + 9 = 19.
MR = MC ⇒ 54 – 4Q = 19, Q = 8.75.
From the demand curve, P = 54 – 2 × 8.75 = 36.5.
Since the price is higher then the average variable cost, the firm
should produce at Q = 8.75 in the short-run.
Moreover, profit = 36.5 × 8.75 – (150 + 19 × 8.75) = 3.13
Thus, unlike the case of a lump sum tax, the firm will not have to
shut down in the long-run.
Note that in this example, the lump sum tax is $99. With the per
unit tax, the tax burden would be $9 × 11 = $99 if the firm
remains to produce 11 units. The firm responds by producing less
(8.75 units), increasing the price to $36.5 and lowering the tax
burden to $9 × 8.75 = $78.78.
Self test 5.4

1 The first-degree price discrimination takes away all the consumer
surplus. To implement the first-degree price discrimination, the
producer has to have information about the consumer’s demand curve,
which is not always possible, or the cost for gathering this
information is too high. Assuming consumers have identical demand
curves, a producer can adopt the practice of two-part tariffs to exploit
all the consumer surplus.
2 a From the demand curve, Q = 5 ⇒ P = 5.
The total revenue is 5 × 5 = 25.
b The total revenue is represented by the area under the demand

curve from Q = 0 to Q = 5, as shown in the following diagram.
The total revenue is (20 + 5)/2 × 5 = 62.5.
The consumer surplus exploited is 62.5 – 25 = 37.5.
3 This is second-degree price discrimination. The total revenue is

$6 × 2 + $5 × 3 = $27. The consumer surplus exploited is 62.5 – 27 =
35.5, which is less than that of the first-degree price discrimination in
the previous question.
Unit 5 31
4 First, there must be consumers in different markets which are

effectively separated, or there will be arbitrage opportunities for the
consumers. Second, the price elasticity of demand must be different
across the markets.
Self-test 5.5
1 The purpose of collusion is to limit output to raise prices so that total
revenue can be increased. A member of a cartel can increase the
revenue by expanding the output, but at the same time selling the
product at a higher price. Unless there is an effective way to monitor
the behaviour of the members, cartels are generally unstable.
Self-test 5.6
1 A dominant strategy is defined as the best strategy no matter what
strategy rivals adopt. Thus, a player has no incentive to deviate from
this strategy. If all players have chosen dominant strategies, then they
must have no incentive to deviate from these chosen strategies no
matter whether their rivals deviate from their strategies or not. In
particular, if their rivals do not deviate from their chosen strategies,
they have no incentive to deviate from their chosen strategy.
However, under a Nash equilibrium, a player would generally adopt a
different strategy if the rivals deviate from their initial strategies.
These strategies clearly are not dominant.
2 a The dominant strategy of A is a2. The dominant strategy of B is

b2. From A’s perspective, if B adopts b1, A maximizes the pay-off
by adopting a2 (25 from 20, 25). If B adopts b2, A also
maximizes its pay-off by adopting a2 (15 from 12, 15). From B’s
perspective, if A adopts a1, B maximizes its pay-off by adopting
b2 (25 from 20, 25); if A adopts a2, B also maximizes its pay-off
by adopting b2 (15 from 12, 15).
b From A’s perspective, if B adopts b1, A maximizes its pay-off by

adopting a2 (25 from 20,25); if B adopts b2, A maximizes its pay-
off by adopting a1 (20 from 20, 12). Thus there is no dominating
strategy for A. From B’s perspective, if A adopts a1, B maximizes
its pay-off by adopting b2 (25 from 15,25); if A adopts a2, B also
maximizes its pay-off by adopting b2 (28 from 22, 28). The
dominating strategy for B is b2.
c From A’s perspective, if B adopts b1, A maximizes its pay-off by

adopting a2 (12 from 10,12); if B adopts b2, A maximizes its pay-
off by adopting a1 (6 from 6,5). There is no dominating strategy
for A. From B’s perspective, if A adopts a1, B maximizes its pay-
off by adopting b2 (20 from 18,20); if A adopts a2, B maximizes
its pay-off by adopting b1 (15 from 15,14). There is also no
dominating strategy for B.
3 Consider (a1, b1). If B sticks to b1, A has an incentive to switch to a2,

thus (a1, b1) is not a Nash equilibrium. Similarly, (a1, b2) is not a
Nash equilibrium because if B sticks with b2, A has an incentive to
switch to a2. Also, (a2, b1) is not a Nash equilibrium because when
A sticks to a2, B has an incentive to switch to b2. The only Nash
equilibrium is (a2, b2). When A sticks to a2, B has no incentive to
deviate from b2, and when B sticks to b2, A has no incentive to
deviate from a2.
Self-test 5.7
Under the setting of the prisoner’s dilemma, there are four possible
outcomes:
a The players collude.

b Both players cheat.
c Player A wants to collude but player B cheats.
d Player B wants to collude but player A cheats.
Outcome one is better than the outcome two. However, if one firm cheats
while the other firm wants to collude, the cheating firm will be better-off
while the honest firm will be worse-off. As a result, both firms will cheat
although both firms will have higher pay offs if they collude.
Self-test 5.8
1 The nature of the assumptions in the Cournot model and Bertrand
model are very similar. Each firm will expect its rivals not to change
their set targets even if it changes its target. In the Cournot model,
each firm expects that it can change its output without causing its
competitors to change their outputs. In the Bertrand model, each firm
expects that the other firms will not change their quoted prices when
it changes its own price.
2 a Set MC = MR: 8 = 60 - 2Q; Q = 26, P = 34.
b This is the case of perfect competition. Price = MC = 8, Q = 52.
c The Cournot output and price are given by Q = 4  a − c  ,

3  2b 
P = 4  a − c  (page 386, BPP).
3  2b 
With a = 60, b = 1, c = 8, The output and price are: Q = 34.67;

P = 25.33.
Unit 5 33
3 Applying formula 10-7 on page 383 of BPP, the industry output is:
n a−c a nc
Q= × and P = × .
n +1 b n +1 n +1
Thus, if n = 10, then Q = 47.27, and P = 12.73.
If n = 100, then Q = 51.49, and P = 8.51.
Clearly, when the number of firms is large, the Cournot result

approaches that of perfect competition.
Self-test 5.9
You must keep in mind the fact that most of the florists selling flowers at
the New Year’s Eve flower fair will return next year.
This year, they could lower their prices to sell their remaining inventory
in order to increase their revenues and hence the profits. However, if the
customers know that the florists will cut their prices when the fair is over,
they will not hurry to buy.
Clearly, none of this is a problem if the flower fair is once and for all.
But since the fair is a annual event, and most of the florists will return
next year, it is in their best interest to avoid cutting their prices so that
customers will not wait until the last minute to buy. The florists smash
their flowers instead of selling them at reduced prices because of the
repeated-game nature of the setting.
Self-test 5.10
1 A ‘threat’ typically takes this form: if you (X) do this, I (Y) will do
that. A threat is empty when X commits to do this, Y will not do that
because doing that will hurt Y if X really committed this. In other
words, the threat is empty because it is not credible.
2 The concept of credible commitment is related to that of an empty

threat. A threat is empty because it is not credible. To make a threat
credible, a player has to commit herself to change the pay-off of the
outcomes of the game. In other words, without a credible
commitment, the Nash equilibrium of the game is not consistent with
the desired outcome. By placing a credible commitment, the player
changes the pay offs of the game so that the Nash equilibrium is
consistent with her desired outcome.
3 Y claims that if X plays u, she will play n so that X will be hurt deeply
(X receives a pay-off of -10 and Y receives a pay-off of +10).
However, this outcome is not a Nash equilibrium because when X
plays u, Y will be better-off by playing m (she receives a pay-off of
30). In fact, when X plays d and Y plays n, both players have no
incentive to deviate. This is the Nash equilibrium. Also, when X
plays u and Y plays m, both players again have no incentive to
deviate. This is another Nash equilibrium.
4 A credible commitment will change the pay-off of the game so that

when X plays u, Y is better off by playing n i.e. (u, m) must not be a
Nash equilibrium. One possible pay-off pattern is suggested in the
following figure.
The outcome (u, m) is no longer a Nash equilibrium and hence —

when X plays u, Y will play n — is not an empty threat. (d, n) is the
unique Nash equilibrium and hence the solution of the game.

Econ-A311 U05 241

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Econ-A311 U05 241

Uploaded by

Copyright:

Available Formats

ECON A311

External Course Reviewer

Copyright © Hong Kong Metropolitan University 2011, 2012, 2020,

Hong Kong Metropolitan University

This course material is printed on environmentally friendly paper.

Answers to self-test questions 28

To summarize, this unit:

• analyses the characteristics and the pricing behaviour of monopolists;

• evaluates the policies regulating monopolies;

• analyses the behaviour of oligopolists under cartels;

• uses the game theoretical approach to analyse strategic moves.

There is obviously no competition if there is only one producer in an

Figure 5.1 Price-taker and price-maker

A representative firm under perfect competition faces a horizontal

The condition for profit maximization

marginal cost = marginal revenue,

to analyse the behaviour of a monopolist. Recall that total revenue (R) is

However, since the monopolist is also the price-maker, P is no longer a

The second term on the right-hand side of the above expression is a

Since the monopolist’s demand curve is downward-sloping, i.e. ∆P/∆Q is

Figure 5.2 The marginal revenue curve of a price-maker

A monopolist generally enjoys positive economic profits. The firm can

Figure 5.3 A price-maker can enjoy positive economic profit

It is also useful to relate the price elasticity of demand, EP, to the

1 The demand function of a firm is given by Q = 10 – 5P. The firm is a

2 A firm under a monopoly has absolute freedom in pricing the product

3 Both a monopolist and firms in a competitive market are profit-

4 Explain in your own words why monopolists can enjoy positive

5 Suppose the monopolist’s demand curve is given by Q = 5 – 3P.

6 Since monopolists are price-makers, they never experience loss. Do

There is no supply curve

Figure 5.4a A single price corresponding to different outputs

Figure 5.4b A single output corresponding to different prices

We can observe that unlike in a perfect competitive market, there is not a

2 ‘The company responsible for the management of a new railway

3 The Post Office is going to issue 30,000 stamps to pay respect to a

Inefficiency created by monopoly

The following reading gives a more detailed, graphical analysis of

The inefficiencies due to the condition of monopoly can also be

Let’s say a two-goods economy consists of good X and good Y. The

Please go through the detailed explanation of this phenomenon in the

1 A monopolist faces the demand curve P = 54 – 2Q, and the

a What is the firm’s output and profit?

There are in fact three types of price discrimination. Under first-degree

Price discrimination of the second degree is easier to implement. Under

Firms practising third-degree price discrimination try to charge different

Optimal pricing policy

Suppose a firm’s total output is Q. The inverse demand functions and

Market 1: P1 = 72 – 2.5Q1, MR1(Q1) = 72 – 5Q1.

Market 2: P2 = 110 – 1.5Q2, MR2(Q2) = 110 – 3Q2.

The firm’s profit is maximized when MR1 = MR2 :

72 – 5Q1 = 110 – 3Q2 .

72 – 5Q1 = 110 – 3Q2,

The answer depends on the price elasticity of demand. To be specific, the

In our continuing discussion of how a monopoly’s outputs to two markets

MC(Q1 + Q2) = MR1(Q1) = MR2(Q2).

Bundling and two-part tariffs

After this reading, there’s another self-test for you to complete.

1 Why is first-degree price discrimination difficult to implement? Try

2 A monopolist faces a demand curve given by

a What is the monopolist’s total revenue if sales are equal to five

b What is the total revenue if the monopolist successfully practises

Behaving cooperatively in this way is not always possible because