Chapter II Oligopoly

Chapter Two
Oligopoly
Introduction
• Oligopoly is a market structure in which a few large firms produce
homogeneous or differentiated products.
• The firms in such market are highly interdependent. i.e., the decision of
any one firm will have considerable impact on others leading to strategic
behavior.
• When a small number of firms compete in a market they are

interdependent in the sense that the profit earned by each firm depends
on the firm’s own actions and on the actions of the other firm.
• Before making a decision, each firm must consider how the other firms
will react to its decision and influence its profit.
• Oligopoly model focuses on the examination of strategic interaction in an

industry with a few numbers of firms.
2
Assumptions
• Small number of firms where two or more large firms dominate the
market.
• The firms produce either differentiated or homogeneous products.
• Each firm has a large market share.
• Firms make price and output decisions strategically taking into

account the possible actions of the other firms in the market i.e.
firms are interdependent.
• The firms have an incentive to collude.
• There are natural or legal barriers to entry.
3
Entry Barriers
• Legal barriers like patents.
• Control over technology or raw materials.
• Strategic actions by the existing firms to deter the entry of new

firms. For example, by keeping excess capacity and they can threat
to flood the market and reduce the price if entry occurs.
• The capital investment requirement may be large.
• Scale economies may make it unprofitable for more than a few

firms to coexist in the markets (the market is too small to many
firms).
4
Oligopoly Models
• There are different types of oligopoly models, and thus there is no single
general model.
• We try to capture the most important features of strategic behaviors.
• To study these behaviors we will concentrate on the simple case of

duopoly models.
• Duopoly is as market structure comprises of only two firms.
• If there are two firms in the market, there are four variables: P1, P2, Q1
and Q2.
• And there are different scenarios under which a firm makes decisions
regarding these four variables depending on the type of oligopoly.
5
Oligopoly Models
• There are two types of oligopoly: (1) Non - collusive
oligopoly, and (2) Collusive oligopoly
• If the oligopoly is non-collusive type,
o The firm might be price leader (set price before the other firm).
o The firm might be price follower
o The firm might be quantity leader (choose quantity level first
than the other firm)
o The firms might be quantity followers
• If the oligopoly is of collusive type, firms jointly agree to

determine price and/or quantity so as to maximize sum of
their profit.
6
Non-collusive Oligopoly
• We examine four types of non-collusive oligopoly:
o Kinked demand model
o Cournot’s duopoly model
o Bertrand’s duopoly model
o Stackelberg’s duopoly model
7
Kinked Demand Model
• Kinked demand model is emerged as a tool of analysis from the
intersection of Chamberlin market share curve (D) and expected
sales curve (d) where now the model is applied to small number of
firms.
• The kinked demand curve model, developed by Paul Sweezy in

1939, explains why prices are rigid in some oligopoly market.
• The model assume that oligopolist often have strong desire to keep
stable price.
• Even under the condition when cost and demand changes, firms are
reluctant to change their prices.
8
Kinked Demand Model
• If costs fall or market demand declines, they fear that the lower
prices send the wrong message to their competitors and initiate
price war among them.
• If costs and demand rises, they do not increase price because they
are afraid that their competitors may not raise their price.
• According to this model therefore, demand curve facing each firm

in oligopoly market is kinked at prevailing market price reflecting
the following behavioral pattern of oligopolists.
• The kinked demand curve is the result of the expectation that the
competing firms will follow price cuts by an individual firm but not
price increase.
9
Kinked Demand Model
• For price reduction
below P (which
correspond to point of
kink), the share of the
market demand curve is
the relevant demand
curve.
• But above price level P,

if the firm increases
price, the other firms
will not follow suit so
that the firm lose some
of its customers.
• Ed is flatter than ED
which shows that Ed is
more elastic than ED.
10
Kinked Demand Model
• The discontinuity (between A and B) is a range within which costs
may very without affecting price and quantity of the firm.
• The kink explains why firms keep their price and output constant
while their cost structure is changing.
• In such market structure, firms focus more on non-price

competition like innovation, quality of services, branding, sales
promotion etc.
• In general, the kinked demand curve model does not explain how
equilibrium price and output is determined like other models,
rather, it explain why price once set remain rigid in oligopoly
market.
11
Kinked Demand Model
• But if the rise in cost
affects all firms equally
and the firm is aware of
this, then it can certainly
expect that the other
firms will follow to
simultaneously raise
price and equilibrium
will shift up.
• The equilibrium will be

at a higher price and
lower output level.
• The kink shifts up to the

left.
12
Kinked Demand Model
• Furthermore, there is a
range through which
demand may shift
without change in price
though quantity will
change.
• If there is increase in
market demand, the
demand curve shifts
upward and will change
the equilibrium level of
output but not the
price level as long as
the cost passes through
the discontinuity of the
new MR.
13
Cournot’s Duopoly Model
• In this model a firm is consider as trying to forecast its rival’s output
before it makes decisions about its optimal output.
• Given this forecast it chooses the profit maximizing output for itself.
• Suppose two firms produce identical products (there is no products

differentiation).
• If firm 1 expects firm 2 to produce 𝑄2𝑒 then it expects the total

market supply to be 𝑄 = 𝑄1 + 𝑄2𝑒 .
• And price will be a function of the total quantity available for sale,
𝑃 = 𝑓(𝑄) = (𝑄1 + 𝑄2𝑒 ).
14
• The profit maximization problem of firms 1 is maximization
of π1 = 𝑃𝑄1 − 𝑇𝐶1 given expected output of firms 2, 𝑄2𝑒 .
• Given any belief about firm 2’s output 𝑄2𝑒 , there will be
specific optimal output for firm 1 (i.e., 𝑄1 ).
• The Functional relationship between 𝑄2𝑒 and optimal

output choice of firm one is called reaction function of firm
1 which is given as 𝑄1 = f(𝑄2𝑒 ).
• The reaction function presents firm’s optimal choice as a

function of its beliefs/expectation about firm 2’s output.
15
• Similarly firm 2 solve its profit maximization problem given
expected output of firm 1, (𝑄1𝑒 ).
• The functional relationship between 𝑄1𝑒 and the optimal quantity of

firm 2 is called reaction function of firm 2 given as 𝑄2 = f(𝑄1𝑒 ).
• The reaction function for the firms will be derived from the
isoprofit functions and the reaction curves are derived from the
isoprofit curves.
• Consider a simple linear inverse market demand;
𝑃 = 𝑎 − 𝑏𝑄 𝑤ℎ𝑒𝑟𝑒 𝑄 = 𝑄1 + 𝑄2
𝑃 = 𝑎 − 𝑏 𝑄1 + 𝑄2 = 𝑎 − 𝑏𝑄1 − 𝑏𝑄2
16
• For simplicity assume that cost of production equals zero.
• Profit for firm 1 is, π1 = 𝑇𝑅1 − 𝑇𝐶1
π1 = 𝑇𝑅1 = 𝑃𝑄1 = (𝑎 − 𝑏𝑄1 − b𝑄2 )𝑄1

π1 = 𝑎𝑄1 − 𝑏𝑄12 − b𝑄2 𝑄1
• The isoprofit curves can be constructed by taking different value for

π1 .
• The isoprofit curve for firm 1 is the locus of different combinations

of 𝑄1 and 𝑄2 which yield the same level of profit to firm 1.
17
• Profit for firm 2 is, π2 = 𝑇𝑅2 − 𝑇𝐶2
π2 = 𝑇𝑅2 = 𝑃𝑄2 = (𝑎 − 𝑏𝑄1 − b𝑄2 )𝑄2

π2 = 𝑎𝑄2 − 𝑏𝑄22 − b𝑄2 𝑄1
• The isoprofit curve for firm 2 can be drawn by taking different

combinations of 𝑄1 and 𝑄2 which give the same level of profit.
• π1 is a deceasing function of 𝑄2 and π2 is a decreasing function of

𝑄1 .
• Solve the reaction functions for the two firms ….
18
19
• The further the isoprofit curves (for substitute
commodities) lie from the axes, the lower is the profit.
• And the closer to the quantity axis an isoprofit curve lies,

the higher the profitability of the firm is.
• Reaction curves are derived from the isoprofit maps of

each firm.
• The isoprofit map for firm 2 can be constructed by taking

different values for π2 .
• π2 increases as one gets closer to 𝑄2 axis.

20
• Given any expectation about output of firm 1, firm 2 tries to set its
output such that its profit is the maximum possible.
• This is attained when a vertical line through the expected output of

firm 1 is tangent to the left most isoprofit curve of firm 2.
• The locus of such tangency points defines the reaction curve of firm
2, given output choice of firm 1.
• The locus of maximum profits of firm 2, given output choice by

firm1.
• The reaction curve is negatively sloped because π2 is a negative

function of 𝑄2 .
21
• Similarly, for any given output that firm 2 may produce, there will
be unique level of output for firm 1 which maximizes the latter’s
profit.
• This unique profit-maximizing level of output will be determined by

the point of tangency of the line through the given output of firm 2
and the lowest attainable isoprofit curve of firm 1.
• The locus of such points defines the reaction curve of firm 1, given
output choice of firm 2.
• The locus of maximum profits of firm 1, given output choice by firm

2.
• The reaction curve is downward sloping because π1 is a decreasing

function of 𝑄2 .
22
Cournot’s Equilibrium
• Cournot’s model, it is assumed that a firm expects the other firm to
keep its output constant while making its optimization decisions.
• Each firm acts independently under the assumption that the other
firms will not react under similar behavioral pattern.
• Under these assumption a stable equilibrium is established when

the reaction curves of the two firms intersect each other.
• The intersection point of the reaction curve is the only point at

which each firm will find its expectation about the other firm’s
output confirmed.
23
• Cournot’s
equilibrium is
determined by the
intersection of the
two reaction
curves.
• It is a stable
equilibrium.
24
• To see that, let us examine the situation arising from firm 1’s
decision to produce quantity A1, lower than the equilibrium
quantity Q1*.
• Firm B will react by producing B1 given the Cournot assumption

that firm 1 will keep its quantity fixed at A1.
• However, firm 1 reacts by producing a higher quantity, of A2, on the

assumption that firm 2 will stay at the level B1.
• Now firm 2 reacts by reducing its quantity to B2.
• This adjustment will continue until point e is reached.
25
• What will be the values of Q1* and Q2*? To get the equilibrium
quantities, solve the reaction functions of the two firms
simultaneously.
• …… follow class lecture
• Note that when firms act independently the industry’s profit is not
maximized.
• Industry profit could be made higher if the two firms were to act
jointly (i.e., through collusion).
• …… follow class lecture
• Different combination of Q1 and Q2 which maximize industry profit

constitute what is called a contract curve for the industry.
26
• Point E is Cournot’s
equilibrium.
• At point A, firm one

will continue to
earn the same level
of profit but firm 2
will get a higher
profit.
• At point B, firm 2
will earn the same
profit but firm 1
will have a higher
profit level.
27
• So if the firms move from point ‘e’ to a point between
‘A’ and ‘B’ the firms will get higher profit levels.
• But the firms will be at the suboptimal equilibrium

point ‘e’ due to the behavior of the firms.
• Each firm expecting that the other firm to remain at a

given level output, it adjusts its optimal output level.
• But each firm act with the same behavioral pattern

which leads to point ‘e’.
28
Bertrand’s Duopoly Model
• In cournot model, we have seen that firms are choosing quantities
of output produced and letting the market to determine price.
• However, in case of Bertrand model, firms set their price and letting
the market to determine the amount of output sold.
• This implies the strategic variable up on which firms are competing

to maximize their profit is price rather than output for Bertrand
duopolist.
• Similar to cournot model however, each firm makes decision about

the level of price that maximizes their profit simultaneously by
assuming their competitor’s price fixed at existing level.
29
• The model also assumes that firms operating in the
industry produce homogenous product with identical cost.
• This implies that each firm faces the same demand curve
and consumer will prefer to purchase from lower price
seller or firm.
• Thus if the two firm charge different price, lower price firm
will supply the entire market while the firm which charges
higher price sell nothing.
• If both firms charge the same price, the consumers are

indifferent between the two firms’ product.
30
• This leads to a return to firm-1 of the form:
[ 𝑝1 − 𝑐 𝑦 𝑝1 ] … … … 1
1
• 𝜋 1 𝑝1 , 𝑝2 = [ 𝑝1 − 𝑐 𝑦 𝑝1 ] … … (2)
2
0 … … … … … … … … … (3)
• Equation (1) to (3) represent the profit earned by firm-1,

when it set price less than, equal to and greater than firm-2
respectively.
31
• The equilibrium price level of Bertrand model can be determined
through reaction curve approach.
• As we have seen under cournot model, reaction curves are derived

from Isoprofit maps.
• However, Bertrand Isoprofit curve represent different thing from

cournot’s isoprofit curve.
• Bertrand model isoprofit curves contain locus of point that

represents a combination of prices of a firm and its competitor
that yields the same level of profit to the firm.
• Unlike cournot isoprofit curve, the shape of Bertrand duopolist

isoprofit curve is convex to the price axis of the firms.
32
𝑃1 = 𝑓(𝑃2 )
P1 P2 P3
Reaction curve of firm 1 Reaction curve of firm 2

33
• The shape of Isoprofit of Bertrand duopolist show how a firm reacts
to price cut by its competitor.
• For example if the competitor of a firm cut price, the firm also
adjust its price to maintain its profit at the same level.
• Such process continues up to the minimum point of the isoprofit

curve, which represents lower level of profit.
• If the competitor cut price beyond the minimum point, the firm
cannot adjust its price to keep the same level of profit.
• The profit of the firm decreases due to fall in price and increase in
output level which is indicated by moving to the lower level of
Isoprofit curve.
34
• The Isoprofit curve found nearer to the price axis of the duopolist
represent lower level of profit.
• If we join the minimum point of successive isoprofit curves of firm

1, it result in reaction curve of the firm.
• They are locus of point firm 1 can attain by charging a certain price,
given the price of its rival.
• The reaction curve for firm 2 also derived in the similar way by
joining the lowest point of isoprofit curves given the price level of
firm 1.
• Given the two reaction curves, Bertrand equilibrium defined by the

intersection of the reaction curves of the firms.
35
• Any point other than
‘e’ is not stable.
• If firm 1 charges a1,

firm 2 will charge b1
amount.
• And to this, firm 1

reacts by charging a2
amount.
• This process continues

until equilibrium at
point ‘e’ is maintained.
36
• When firms operate under Bertrand’s assumption selling
homogeneous product, equilibrium will turn out to be
competitive market equilibrium (P = MC).
• This is so because when a firm expects its rival to keep its

price constant, it will have an incentive to undercut the
price of its rival and attract all customers.
• Both firms are likely to try to undercut each other’s price.
• The price competition is likely to continue until P = MC.
37
• Although the Bertrand model used to understand the
strategic interaction of oligopolist on price setting, it
has plenty of shortcomings for various reasons.
• For one thing, firms, which produce exactly the same

product, seem to compete more by focusing on non-
price competition than on price competition.
• Also like cournot model, Bertrand model is criticized

for its naïve assumption of firms (i.e., firms never learn
from past experience).
38
Stackelberg’s Duopoly Model
• This applies to a situation where there exists one dominant firm
that makes output choice before other firm (quantity leadership
which is an extension of Cournot’s model) who recognized that his
competitor acts on the Cournot assumption.
• This recognition allows the sophisticated duopolistic (stackelberg

leader) to determine the reaction curve of his rival (the follower)
and incorporate it in his own profit function, which he then
proceeds to maximize like monopolist.
• The follower firm, after identifying the level of output produced by

the leader firm, responds by producing certain amount of output to
maximize its profit.
• Numerical Example: … follow class lecture
44
• This recognition will permit firm 1 to choose to set its own output
at the level which maximizes its own profit.
• This is point ‘a’ which lies on the lowest possible isoprofit curve of
firm 1, denoting the maximum profit firm 1 can achieve given firm
2’s reaction curve.
• Firm 1, acting as a monopolist (by incorporating firm 2’s reaction

curve in his profit maximizing computations), will produce Q1A and
firm 2 will react by producing Q2A according to its reaction curve.
• The sophisticated oligopolist becomes in effect the leader, while the

naive rival who acts on the Cournots assumption becomes the
follower.
45
• Given the reaction function of the follower firm, firm 1
maximizes its profit by operating on the isoprofit curve that
represents the highest possible profit for itself.
• This is attained when the reaction function of firm 2 is

tangent to the isoprofit curve of firm 1.
• This is called Stackelberg’s equilibrium when firm 1 is a

dominant leader and firm 2 is a Cournot’s follower.
• If firm 2 is dominant leader and firm 1 is Cournot’s follower,

Stackelberg’s equilibrium will be at the point of tangency of
the reaction curve of firm 1 and the profit curve of firm 2.
46
47
• In summary, if only one firm is sophisticated, it will emerge as the
leader and a stable equilibrium will emerge, since the naive firm will
act as a follower.
• The leader takes a larger share of the market and profit (given
identical cost structure).
• In such a situation the Stackelberg’s equilibrium will be stable if and

only if there is one dominant firm.
• However, if both firms think that they are dominant, instability will
occur because both firms will look for the larger share of the
market.
• In the instability, there may be price war until one surrenders and
agrees to be follower; or the firms may create collusion.
48
• If the rivals recognize
their interdependence,
each firm can be at
higher profit level by
operating on the
contract curve.
• If each ignores the

other, a price war will
be inevitable.
• This is destructive for

both firms as a result
of which both will be
worse off.
49
Collusive Oligopoly
• One way of avoiding the uncertainty arising from oligopolistic
interdependence is to enter into collusive agreements.
• There are two main types of collusion:
o Cartels
o Price leadership
• Both forms generally imply tacit (secret) agreements, since open

collusive action is commonly illegal in most countries at present.
50
Cartels
• Cartel is an association of producers who agree to fix common
price and outputs quotas in an oligopolistic market.
• A cartel is simply a group of firms that jointly collude to behave like

a single monopolist and maximize the sum of their profits.
• As the aim of a carter is to prevent competition, there is a tendency

for the producers to strive to maintain existing market shares, with
the consequence that a firm can only increase its output if total
market demand rises.
• The two typical forms of cartel are;
– Joint – profit maximization cartel

– Market sharing cartel
51
Joint – Profit Maximizing Cartel
• Firms agree to maximize group (industry) profits by jointly
determining the industry output and the price at which it is
sold and the share of each member on the industry output.
• This maximization procedure is identical to multi-plant

monopolist.
• For simplicity we assume that there are only two firms in

the cartel.
• The profit maximizing output is determined by the

intersection of MR and aggregate MC curve.
52
• The aggregate MC is obtained by the horizontal summation of

individual firm’s MC curves.
• The total output will be shared by the member firms by equating the
individual firms MCs to the MR at the industry equilibrium, i.e., MC1 =
MC2 = MR
53
• Note that the firm with lower costs produces a larger amount of
output.
• However, this does not mean that the firm will also take the larger
share of the attained join profit.
• The total profit is the sum of profits from output of the two firms.
• The distribution of profits will be determined by agreement

between the two firms.
• Numerical Example: … follow lecture note
54
Mergers
• An amalgamation of two or more firms into a new firm.
• A vertical merger occurs when firms in industries at different

stages of bringing a good to the final consumer, i.e., extractive,
manufacturing or distribution, join together.
• If the firms are in the same industry there is a horizontal merger.
• A conglomerate merger is an amalgamation of firms with

dissimilar activities.
• A merger involves the decision of number independent firms to

form a single corporation. The new firm may act as cartel.
• The decision of a merger is the same as joint profit maximizing

cartel.
55
• We found from
Cournot’s model
that industry’s
profit is maximized
along the contract
curve.
• Contract curve
equation gives us
different
combination of Q1
and Q2 that
maximize cartel
profit.
56
Market Sharing Cartels
• This form of collusion is more common in practice because
it is more popular.
• Here the firms agree to share the market but keeps

considerable degree of freedom regarding product style,
selling strategies and other decisions.
• There are two ways of sharing the market:
• (i) Non- price competition
• (ii) Determination of quotas
57
Non-price competition
• It is not a strong cartel as compared to a joint profit
maximizing cartel.
• In the non-price competition, firms agree on a common

price level but firms can sell any quantity demanded.
• Firms do not have any limitation on the quality, style or

selling strategies of their products.
• So firms will be competition in other characteristics (i.e.

they compete in non- price basis).
58
• There price level is determined by bargaining (negotiation).
• The high cost firm negotiates for high price level and the low cost
firm negotiates for low price level.
• Agreement will be reached on price level which gives some amount

of profit for each firm.
• But this is unstable because the firm with low cost will have an
incentive to cheat and lower price level.
• Soon it will be known by the other firm because the firm will lose
his customers.
59
• Then, the firm will react on one of the following two alternatives:
• 1. There may be price war until only the stronger firm with low cost
stay in market.
• 2. The other firms altogether may engage in price war with the one
who has cheated until the cheated is driven out of business.
• The successfulness of the second strategy depends on:

– The cost differential of the cheater and the other cartel members.
– The capacity of the members to finance possible losses during the
price war.
• If all firms agree to charge a common price the price will be

monopoly price i.e. Pm.
60
• At price level Pm, both firms get positive profit level. But firm B has
incentive of lowering price to PB and driving out the high cost firm i.e.
firm A.
• This is because at PB, for firm A, the AC is greater than the price level.
61
• Not only when firms have different costs but also when
firms have the same cost the cartel is unstable.
• Those firms with the same cost will have an incentive to

lower their price level than the monopoly price because if
one firm splits away and charges a slightly lower price than
the monopoly price Pm while the others remain in the
cartel, the splitting firm will attract a considerable number
of consumer from the others: its demand curve will be
much more elastic and its profit will be increased making
the the cartel unstable.
• However, it can be made stable with legislation.
62
Sharing of the market by agreement on Quotas
• Here the firms will agree on the quantity that each member may
sell at the agreed price.
• If the two firms have identical costs, the market will be shared
equally at the monopoly price.
• The monopoly price is Pm and the quotas which will be agreed are
QA = QB = ½ (Q).
• But if the costs are different, the quotas and shares of the market
will differ.
• Similar to the above case the cartel is unstable under different costs
of production.
63
• Quota shares will be determined by bargaining.
• During the bargaining process two main statistical criteria are most
often adopted: quotas are decided on the basis of past level sales
and on the basis of ‘productive capacity’.
• The past- period sales and/or the definition of ‘capacity’ of the firm
depend largely on their bargaining power and skill.
• Another way of sharing the market is by defining the region that

each firm is allowed to sell.
• Generally, factors that affect the share of a firm in the total market
output include : cost differences, productive capacity, past level of
sales and geographic proximity.
64
• This form of market sharing is also unstable because low cost firms will
always have incentive the violate the deal.
• If entry is allowed, the instability will increase as the behavior of the new
entrant is not known.
65
Price Leadership
• Firms follow the price leader to avoid the uncertainty about the
firms reactions even if this implies departure of the followers from
their profit maximizing position.
• It is advantageous to them for they cannot compete with the

leader.
• Formally or informally (usually informally) price leadership exists.
• There are various forms of price leadership. The most common

types are:
– price leadership by a low cost firm and

– price leadership by a large or dominant firm.
66
Price leadership by low-cost firm
• There are two firms that produce homogeneous product at
different costs, which clearly must be sold at the same price.
• They may share the market equally or unequally.
• In the cases of cost differences, the high cost firm may agree to
adopt whatever price the lowest cost firm sets in the market
because it is impossible to compete with this kind of firm.
• The low cost firm sets price at MR=MC level for itself.
• The high cost firm adopts this price level even if it does not
maximize its profit.
67
Firms sharing the market equally
• When the firms have identical
demand curve the market will
be shared equally. The low
cost firm (firm 1) set the price
level P1 by the equalization of
MR1 =MC1. The high cost firm
(firm2) will adopt this price
even though it will not
maximize profit of the firm.
• For the high-cost firm profit is

maximum when the firm
charges P2 (higher Price) and
reduce quantity to Q’2. But
the high-cost firm prefers to
follow the low cost firm in
order to avoid price war.
68
Firms sharing the market unequally
• When the firms have
different demand curves,
the market will be shared
unequally. The low cost firm
(firm 1) determines the
price level, P1, by equating
MR1 to MC1.
• The high-cost firm follows

this price level and supply
Q2 amount but this is not a
profit maximizing level.
Profit for the high cost firm
will be maximum at price
level of P2 i.e. price level
determined by MR2=MC2.
69
Dominant Firm Price Leadership
• This is a model when there exists one large and dominant firm with
a considerable market share and some other smaller firms with
small market share.
• The market demand is assumed known to the dominant firm.
• The smaller firms may think that it is difficult to compete with the
dominant firm and may simply adopt whatever price it sets in the
market.
• The smaller firms take the price determined by the dominant firm
as given and maximize profit by equating it (the price) to their MC.
• The small firms are price takers.
70
The dominant leader is assumed to know the supply of each firm at each
price level. And the dominant firm can determine total output supplied by all
small firms by adding horizontally each firm supply.
Therefore, at each price level the dominant firm can sell the part of the
market demand that could not be satisfied by the smaller firms.
71
• At price PL, the total market demand is ‘ac’ and part of it i.e. ‘ab’
amount is supplied by small firms and the remaining by the
dominant firm i.e. bc = 0Q - QL.
• Once the dominant firm determine its residual demand (dL) and
given his MC curve the leader sets price using its MC=MR condition
to maximize profit. Accordingly, the leader sets rice at PL and sells
QL.
• The smaller firms adopt the same price (PL) and sells Qf. The
smaller firms are price takers who may or may not maximize their
profits depending on their costs structure.
• If the small firms got maximum profit, it is not due to the actions of
these firms. It is only by accident. Market output (Q) = QL + Qf
72

Chapter II Oligopoly

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

Chapter II Oligopoly

Uploaded by

Copyright:

Available Formats

Chapter Two

• When a small number of firms compete in a market they are

• Oligopoly model focuses on the examination of strategic interaction in an

• The firms produce either differentiated or homogeneous products.

• Each firm has a large market share.

• Firms make price and output decisions strategically taking into

• The firms have an incentive to collude.

• There are natural or legal barriers to entry.

• Control over technology or raw materials.

• Strategic actions by the existing firms to deter the entry of new

• The capital investment requirement may be large.

• Scale economies may make it unprofitable for more than a few

• We try to capture the most important features of strategic behaviors.

• To study these behaviors we will concentrate on the simple case of

• Duopoly is as market structure comprises of only two firms.

• If the oligopoly is non-collusive type,

• If the oligopoly is of collusive type, firms jointly agree to

o Kinked demand model

o Cournot’s duopoly model

o Bertrand’s duopoly model

o Stackelberg’s duopoly model

• The kinked demand curve model, developed by Paul Sweezy in

• According to this model therefore, demand curve facing each firm

• But above price level P,

• In such market structure, firms focus more on non-price

• The equilibrium will be

• The kink shifts up to the

• Suppose two firms produce identical products (there is no products

• If firm 1 expects firm 2 to produce 𝑄2𝑒 then it expects the total

• The Functional relationship between 𝑄2𝑒 and optimal

• The reaction function presents firm’s optimal choice as a

• The functional relationship between 𝑄1𝑒 and the optimal quantity of

• Consider a simple linear inverse market demand;

• Profit for firm 1 is, π1 = 𝑇𝑅1 − 𝑇𝐶1

π1 = 𝑇𝑅1 = 𝑃𝑄1 = (𝑎 − 𝑏𝑄1 − b𝑄2 )𝑄1

• The isoprofit curves can be constructed by taking different value for

• The isoprofit curve for firm 1 is the locus of different combinations

π2 = 𝑇𝑅2 = 𝑃𝑄2 = (𝑎 − 𝑏𝑄1 − b𝑄2 )𝑄2

• The isoprofit curve for firm 2 can be drawn by taking different

• π1 is a deceasing function of 𝑄2 and π2 is a decreasing function of

• Solve the reaction functions for the two firms ….

• And the closer to the quantity axis an isoprofit curve lies,

• Reaction curves are derived from the isoprofit maps of

• The isoprofit map for firm 2 can be constructed by taking

• π2 increases as one gets closer to 𝑄2 axis.

• This is attained when a vertical line through the expected output of

• The locus of maximum profits of firm 2, given output choice by

• The reaction curve is negatively sloped because π2 is a negative

• This unique profit-maximizing level of output will be determined by

• The locus of maximum profits of firm 1, given output choice by firm

• The reaction curve is downward sloping because π1 is a decreasing

• Under these assumption a stable equilibrium is established when

• The intersection point of the reaction curve is the only point at

• Firm B will react by producing B1 given the Cournot assumption

• However, firm 1 reacts by producing a higher quantity, of A2, on the

• Now firm 2 reacts by reducing its quantity to B2.

• This adjustment will continue until point e is reached.

• Different combination of Q1 and Q2 which maximize industry profit

• At point A, firm one

• But the firms will be at the suboptimal equilibrium

• Each firm expecting that the other firm to remain at a

• But each firm act with the same behavioral pattern

• This implies the strategic variable up on which firms are competing