Monopolistic Competition and Oligopoly: Managerial Economics, 2e

Chapter 10
Monopolistic Competition and

Oligopoly
Managerial Economics, 2e All rights reserved

©Oxford University Press, 2010
Features of monopolistic
Competition
• Large number of sellers but each seller is a
Price Maker
• Large number of imperfect substitutes due to
product differentiation
• Large number of uninfluencing buyers – both
informed and uninformed
• Free entry

DETERTMINATION OF SHORT TERM
AND LONG RUN EQUILIBRIUM
MC
AVC
D
MR
DETERTMINATION OF SHORT TERM
AND LONG RUN EQUILIBRIUM
MC
AVC
MRL DL D
MR
PROFIT IN LONG RUN
PROFIT
NUMBER OF FIRMS
Equilibrium- Short run and Long
run
• In the Short run at MR =MC , the seller
makes Super normal Profits
• In the Long run, ‘ Free entry’ squeezes
out the Profit
• So at the Long run equilibrium, MR =
MC= AC

Normative analysis of Monopolistic
Competition
• Long run equilibrium at Price=AC=MC
BUT
With demand curve being downward sloping, AC
is not at its minimum.
Therefore inefficiency and excess capacity.
* With free entry and product differentiation,
variety is available.

Features of Oligopoly
• Few sellers
• Interdependence
• Intense rivalry
• ‘Strategy’ plays a dominant role.
• Barriers to entry; Natural and Strategic

Equilibrium in Oligopoly
• Cournot Equilibrium
• Bertrand Equilibrium
• Stackelberg Equilibrium
• The kinked demand model
• Cartel
• Collusion
• Price Leadership

Equilibrium in Oligopoly
MARKET DEMAND FACED BY HERO AND ATLAS
PRICE
500
400
300
200
100
0 100 200 300 400 500 600 700 800 900

Managerial Economics, 2e
©Oxford University Press, 2010 No of cycles All rights reserved
Cournot equilibrium
• Special case of Duopoly
• Passive players
• Identical firms
• MC is identical, constant and assumed to
be equal to zero.

Cournot equilibrium
• Demand Equation for the product Q
P = 12-Q
where Q = q1 + q2
So P =12-q1- q2
TR 1 = q1((12 –q2) – q1)
MR 1 = 12- q2 – 2q1
Equating to MC = 0, we get
q1 = (12-q2) / 2---Reaction curve

Cournot equilibrium
• Similarly Reaction function of firm 2:
q2 = (12-q1) /2
Solving these two simultaneously, gives:
q1 = 4 and q2 = 4
Graphically this is the point of intersection
of the Reaction curves.
This is the Cournot equilibrium

Case 1
• a) The roll preparation involves two variable cost
components: (i) the center filling
• (ii) Ten minutes of labour
• So, we have 4Q + 1Q = 5Q.
• c) Cournot players:
• TC = 5Q
• MC = 5
• Q = 100 – P or P = 100-Q
• P = 100-(q1+q2) = 100-q1-q2
• TR1=PXq1=(100-q1-q2)q1 = 100q1-(q1)2 –q1xq2
• MR1 = TR1/ q1=100-2q1-q2
• MC = 5

Case 1
• MR1 = TR1/ q1=100-2q1-q2
• MC = 5
• MR1=MC1 = 100-2q1-q2 = 5
• q1=100-5-q2 = 0=(95-q2-2q2)… Equilibrium for firm 1
• FOR FIRM 2
• TR2=PXq2=(100-q1-q2)q2 =100q2-(q2)2 –q1xq2
• MR2 = TR2/ q2=100-2q2-q1
• MC = 5
• MR2=MC2= 100-2q2-q1=5 =95-2q2-q1
• Solve 95-2q1-q2=0 ……1
• 95-q1-2q2=0…….2 (x2) and subtract
• 190-2q1-4q2 =0....2
• 95-0-3q2=0, q2=95/3=32, smiliarly 32 for other also.(rounded)

Case 1
• Deriving the reaction curves and solving for q1 and q2,

we get q1 = 32, q2 = 32.
• The total Q = 64, and P = 36.

BERTRAND EQUILIBRIUM
• b) Bertrand players will keep cutting prices
till price equals cost. So they will be
• selling at the price of Rs.5.
• Q = 100 – 5 = 95 units in all.

Bertrand Equilibrium
• Two identical firms
• Sequential reaction.
• First, firm 1 cuts price below the going
price to grab the entire market share
• Second firm retaliates
…….This goes on till
P = MC …… Bertrand Equilibrium

Stackelberg Equilibrium
• Leader – follower
• Leader-Firm1- expresses demand equation
in terms of q1.
How?
Incorporates firm 2’s reaction equation for
q2 in the demand equation:
P = 12 – q1 – ((12-q1)/2)
Stackelberg Equilibrium
• Derive TR1, MR1.
• Equate to MC and solve for q1.

• Solve for q2 = (12-q1) / 2
• q1 = 6 ; q2 = 3

Kinked demand hypothesis
• Paul Sweezy:
P The stretch PE is elastic – no incentive to raise prices
The stretch EQ is inelastic-no incentive to cut prices

E

Cartels
• Objective: to raise the price to an artificial
high.
• Agree on a high price by restricting supply
• Inherently fragile because of the incentive
to ‘chisel’.
• So cartels break down.

Collusion
• Conditions that favour collusion:
- fewer rather than larger number of firms
- Lesser differences in costs rather than greater
- steady demand rather than variations in demand
- easier to detect cheating rather than …..
- More homogeneity in product rather than
heterogeneity

Price leadership
• Dominant price leadership
• Barometric price leadership

Dominant price leadership
MC
D
MR

Barriers to entry
• Structural entry Barriers and strategic entry
barriers
• Sources:
Control over critical inputs
Absolute cost advantage
Economies of scale
Product differentiation
Preemption of Product and geographic space

Game Theory and Oligopoly
• A Pay off Matrix: WIPRO
without remote with remote
without areas areas
H remote areas 40,70 35,55
C
L With remote
areas 30,60 45,45

A Game Tree
Rs 4000,4000
high
Atlas
Rs 6000,1000
high low
Hero low high
Rs 1000,6000
Atlas
low
Rs 3000,3000

Strategies
• Maximin Strategy
• Dominant Strategy
• Dominated Strategy
• Pure and mixed Strategy

Dominant Strategies
• Dominant Strategy:
Firm 2
no Price change Price change
no price change 10,10 140,30
Firm1
Price change -20,20 100,25

The dominant strategy for firm 1 is no price change.
The dominant strategy for firm 2 is price change

Dominated strategies
• incumbent firm
block cut price increase
entry capacity
Entrant enter 2 6 14
single
enter jointly 8 7 10
This is the payoff of the entrant-increase in market share,
where, total market size is constant .
Increase capacity is dominated strategy for incumbent.

Maximin strategies
• Firm 2
introduce donot introduce
new product new product
Firm1 introduce 2, 2 6,3
do not introduce 3,6 4,4

Maximin strategy for firm1 is donot introduce.
Maximin for firm 2 is do not introduce.

Different Games
• Entry Game
• Games of imperfect and incomplete
information – Prisoners’ Dilemma
Games
• Sequential Games
• Repeated Games
• Finitely repeated Games

Entry Game
-2lakhs, +5lakhs
High output
Indian
Low output
+6 lakhs, +6lakhs
enter
Jet 0 lakhs, +12 lakhs
Stay out high
Indian
low
0 lakhs, +8 lakhs

Prisoners’ Dilemma
• Prisoner 2
confess don’t confess
confess -20,-20 -5,-25
Prisoner1
don’t confess -25,-5 -10,-10

Sequential games
• Games of first mover advantage:
firm 1
chocolate natural
chocolate -10,-10 20,15
Firm2
natural 15,20 -10,-10

Sequential games
• First mover advantage: New Product Introduction
firm 1
Introduce Do not introduce
Introduce -5, -5 10, 3
Firm2
Do not introduce -3 ,10 3, 3


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Chapter 10

Monopolistic Competition and

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

0 100 200 300 400 500 600 700 800 900

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

• Deriving the reaction curves and solving for q1 and q2,

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

• Equate to MC and solve for q1.

Managerial Economics, 2e All rights reserved

P The stretch PE is elastic – no incentive to raise prices

The stretch EQ is inelastic-no incentive to cut prices

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

• Barometric price leadership

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Price change -20,20 100,25

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

do not introduce 3,6 4,4

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

Managerial Economics, 2e All rights reserved

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