Principle of Microeconomics: Recitation Week 14

Oligopoly and Monopolistic Competition

連振安
December 4, 2024
NTU Economics
Contents

1 Oligopoly

2 Monopolistic Competition

3 Summary

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Preface - Marketing Power

Perfect Competition Oligopoly

Monopolistic Competition Monopoly

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Last Two Market Structures

• So far, we’ve learned two kinds of market structures: perfect competition and
monopoly.
• The last two market structures we will learn are monopolistic competition and
oligopoly.

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Oligopoly
Oligopoly

Basic Concepts
Definition - Oligopoly

Definition
Oligopoly is a market structure in which a small number of firms compete.

Example
• The automobile industry is an example of an oligopoly. There are only three
firms (e.g., CHT, Taiwan Mobile, Far EasTone) that dominate the market.

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Oligopoly and Game Theory

• Game theory is a tool used to analyze strategic interactions among firms.

• In oligopolies, firms must consider the actions of their competitors when
making decisions.
• Due to the limited number of sellers, oligopoly is characterized by a constant
conflict between collaboration and individual self-interest.

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Definition - Collusion

Definition
Collusion is an agreement among firms to increase economic profits by fixing
prices or quantities.

Example
• Two construction companies tacitly take turns submitting lower bids to
secure contracts.

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Definition - Cartel

Definition
Cartel is a group of firms that collude to restrict output and increase prices.

Example
• OPEC is a cartel that controls the production and price of oil.

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Water Market

Table 1: Price, Quantity, and Total Revenue in Water Market

Quantity (in gallons) Price Total Revenue (and total profit)

0 $120 $0
10 $110 $1,100
20 $100 $2,000
30 $90 $2,700
40 $80 $3,200
50 $70 $3,500
60 $60 $3,600
70 $50 $3,500
80 $40 $3,200
90 $30 $2,700
100 $20 $2,000
110 $10 $1,100
120 $0 $0

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Ways of competition

• Suppose there are two firms, A and B, in the water market.

• How can they compete with each other?
1. Cournot competition: Firms simultaneously choose quantities.
2. Bertrand competition: Firms simultaneously choose prices.

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Bertrand competition

• In Bertrand competition, firms simultaneously choose prices.

• If both firms set the same price, they will split the market equally.
• If one firm sets a lower price, it will capture the entire market.
• In equilibrium, firms will set prices equal to marginal cost.

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Oligopoly

Cournot Competition
Cartel - Happy Ever After?

• Suppose Jack and Jill are the only two sellers in the market and they agree on
forming a cartel. That is, each of them produce 30 gallons (half of the
monopoly quantity), and each earns profit = 30 × 60 = 1800.
• But then Jill would reason:
⇝ If I produce 40, and Jack still produces 30, then 𝑃 = 120 − (40 + 30) = 50, I earn
40 × 50 = 2000 > 1800 !
• However, Jack is no fool; he thought the same thing! He would also produce
40, resulting in a total quantity of 80. The price would drop to 40, and each
would earn a revenue of 1600.

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Cartel - Can things get worse?

• However, will Jill or Jack produce 50 even 60 gallons?

• No! If Jill produces 50, and Jack still produces 40, then total 𝑄 = 90, 𝑃 = 30,
profit = 1500 < 1600 !

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Cartel - Lesson

• This example demonstrates that in an oligopoly market, forming a cartel can

lead to higher profits for all members through cooperation.
• However, individual self-interest may result in the breakdown of cooperation
and reduced overall profits.
• When both parties aim to maximize their own profits, the outcome is a Nash
equilibrium (both producing 40), which is suboptimal for both but stable
because neither has an incentive to unilaterally change their strategy.

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Oligopoly

Numerical Illustration for Cournot

Competition
Duopoly: Setup

• Suppose there are two firms, A and B, in the market.

• The demand curve is 𝑄 = 339 − 𝑃, where 𝑄 = 𝑞𝐴 + 𝑞𝐵 .
• They have the same constant marginal cost, 𝑀𝐶 = 147.
• Can you express the best response function for each firm?
• What is the Cournot equilibrium?

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Duopoly: Best Response Function for Firm A

• For firm A, the revenue function is:

𝑇𝑅𝐴 = (339 − 𝑞𝐴 − 𝑞𝐵̂ )𝑞𝑎 (1)

= 339𝑞𝐴 − 𝑞𝐴2 − 𝑞𝐴 𝑞𝐵̂ (2)

• We know that if firm A wants to maximize its profit, it should make 𝑀𝑅 = 𝑀𝐶.
• So, 𝑀𝑅𝐴 = 339 − 2𝑞𝐴 − 𝑞𝐵̂ = 𝑀𝐶 = 147.
• That is, given 𝑞𝐵̂ , firm A’s best response function is 𝑞𝐴∗ = 96 − 1 𝑞𝐵̂ .
2
• By symmetry, firm B’s best response function is 𝑞𝐵∗ = 96 − 1 𝑞𝐴̂ .
2

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Best Response Functions

𝑞𝐵

Firm A’s Best Response

Firm B’s Best Response

𝑞𝐴

Figure 1: Firm A and Firm B’s Best Response Functions

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Cournot Equilibrium

• The Cournot equilibrium is the intersection of the best response functions.

• In this case, the Cournot equilibrium quantity is 𝑞𝐴∗ = 𝑞𝐵∗ = 64.
• How can we see this?

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Monopolistic Competition
Monopolistic Competition

Basic Concepts
Definition
Monopolistic competition is a market structure in which many firms sell
products that are similar but not identical.

Example
• The market for food stands is an example of monopolistic competition.

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Decision Steps of Monopolistic Competition in Short Run

• Short-run:
1. Expand 𝑄 until 𝑀𝐶 = 𝑀𝑅
2. Produce 𝑄∗ at that point
3. Trace up to the demand curve
4. Find 𝑃 ∗ associated with 𝑄∗

Figure 2: Optimal Pricing Strategy for a

Monopolistic Competitor 19/22
Monopolistic Competition in Long Run

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Figure 3: Monopolistic Competition in the Long Run
Herfindahl-Hirschman Index

• The Herfindahl-Hirschman Index (HHI) is a measure of market concentration.

• It is calculated by summing the squares of the market shares of all firms in the
market.
• With higher HHI values indicate greater market concentration.

Example
• If there are 3 firms in the market, with market shares of 50%, 30% and 20%,
the HHI is calculated as 0.52 + 0.32 + 0.22 = 0.25 + 0.09 + 0.04 = 0.38.

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Summary
Two Market Structures

Two Market Structures Oligopoly

• Oligopoly • Strategic interactions
• Duopoly • Cournot competition
• Monopolistic competition • Bertrand competition
• Collusion & Cartel
• Best response function
Monopolistic Competition
• HHI index
• Short-run profit is non-zero
• Long-run profit is zero

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Questions? Ask on NTU COOL or Email TA!

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