Chapter 13

Market Structure and

Competition
Chapter Thirteen Overview
• Describing and Measuring Market Structure
• Oligopoly with Homogeneous Products
• Dominant Firm Markets
• Oligopoly with Horizontally Differentiated Products
• Monopolistic Competition

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• The Cournot Equilibrium and the Inverse Elasticity Pricing
Rule

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Market Structures: Four Key Dimensions

1. The number of sellers

2. The number of buyers

3. Entry conditions

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4. The degree of product differentiation

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Product Differentiation
• Product differentiation between
two or more products exists
when the products possess
attributes that, in the minds of
consumers, set the products
apart from one another and
make them less than perfect
substitutes
• Examples: Pepsi is sweeter than
Coke, brand name batteries last
longer than "generic" batteries
• "Superiority" is when one product is
viewed as unambiguously better
than another so that, at the same
price, all consumers would buy the
better product
– Vertical product differentiation
• "Substitutability" is when, at the
same price, some consumers would
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prefer the characteristics of product
A while other consumers would
prefer the characteristics of B
– Horizontal product differentiation
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 Types of Market Structures

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Oligopoly Assumptions
• Many buyers and few sellers
• Each firm faces downward-sloping demand because each
is a large producer compared to the total market size
• There is no one dominant model of oligopoly

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Cournot Oligopoly
• Augustin Cournot developed
the first theory of oligopoly
• Assumptions
– Firms set outputs (quantities)
– Homogeneous products
– Simultaneous
– Non-cooperative
• In a Cournot game, each firm
sets its output (quantity) taking
as given the output level of its
competitor(s), to maximize
profits
• Price adjusts according to
demand
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• Firm's guess about its rival's
output determines its residual
demand
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Simultaneously vs. Non-cooperatively
• Firms act simultaneously if each firm makes its strategic
decision at the same time, without prior observation of the
other firm's decision
• Firms act non-cooperatively if they set strategy
independently, without colluding with the other firm in any
way

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Residual Demand
• The relationship between the
price charged by firm I and the
demand firm I faces is firm is
residual demand
• In other words, the residual
demand of firm I is the market
demand minus the amount of

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demand fulfilled by other firms
in the market: Q1 = Q - Q2

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Profit Maximization
• Each firm acts as a monopolist on its
residual demand curve, equating MR r
to MC
• MRr = p + q1(p/q) = MC
• Best response function:
– The point where (residual) marginal
revenue equals marginal cost gives the
best response of firm I to its rival's actions

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– For every possible output of the rival(s),
we can determine firm i's best response
– The sum of all these points makes up the
best response (reaction) function of firm I

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Equilibrium
• Equilibrium: No firm has an incentive to • What is the equation of firm 1's
deviate in equilibrium reaction function?
– Each firm is maximizing profits given its
• Firm 1's residual demand:
rival's output
• P = 100 - Q1 - Q2 • P = (100 - Q2) - Q1
• MC = AC = 10 • MRr = 100 - Q2 - 2Q1
• What is firm 1's profit-maximizing output • MRr = MC  100 - Q2 - 2Q1 = 10
when firm 2 produces 50?

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• Firm 1's residual demand: • Q1r = 45 - Q2/2 firm 1's reaction
– P = (100 - 50) - Q1 function
– MR50 = 50 - 2Q1 • Similarly, one can compute that
– MR50 = MC  50 - 2Q1 = 10 • Q2r = 45 - Q1/2
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Calculate the Cournot Equilibrium
• Q1 = 45 - (45 - Q1/2)/2
• Q1* = 30
• Q2* = 30
• P* = 40
• 1* = 2* = 30(30) = 900

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The Bertrand Model of Oligopoly
• In a Bertrand oligopoly, each • Firms set price
firm sets its price, taking as • Homogeneous product
given the price(s) set by other • Simultaneous
firm(s), so as to maximize
profits • Non-cooperative
• The resulting total output
determines the market price

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Setting Price
• Homogeneity implies that consumers will buy from the low-
price seller
• Further, each firm realizes that the demand that it faces
depends both on its own price and on the price set by other
firms
• Specifically, any firm charging a higher price than its rivals

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will sell no output
• Any firm charging a lower price than its rivals will obtain the
entire market demand
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Residual Demand Curve – Price Setting
• Assume firm always meets its
residual demand
– No capacity constraints
• Assume that marginal cost is
constant at c per unit
• Hence, any price at least equal

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to c ensures non-negative
profits

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Best Response Function
• Each firm's profit maximizing • Two firms
response to the other firm's • Bertrand competitors
price is to undercut
• Firm 1's best response function
– As long as P > MC
is P1 = P2 - e
• Definition: the firm's profit
• Firm 2's best response function
maximizing action as a
is P2 = P1 - e
function of the action by the

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rival firm is the firm's best
response (or reaction) function

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Equilibrium
• If we assume no capacity
constraints and that all firms
have the same constant average
and marginal cost of c then:
• For each firm's response to be a
best response to the other's each
firm must undercut the other
– As long as P> MC
• Where does this stop?
– P = MC (!)
• Firms price at marginal cost
• Firms make zero profits
• The number of firms is irrelevant to
the price level when more than one
firm is present
– Two firms is enough to replicate the
perfectly competitive outcome
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• Essentially, the assumption of no
capacity constraints combined with
a constant average and marginal
cost takes the place of free entry
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Stackelberg Oligopoly
• Stackelberg model of oligopoly is a
situation in which one firm acts as a
quantity leader, choosing its quantity first,
with all other firms acting as followers
– Call the first mover the “leader” and the
second mover the “follower”
• The second firm is in the same situation
as a Cournot firm
– It takes the leader’s output as given and

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maximizes profits accordingly, using its
residual demand
• The second firm’s behavior can, then, be
summarized by a Cournot reaction
function
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Dominant Firm Markets
• A single company with an
overwhelming market share (a
dominant firm) competes against
many small producers
(competitive fringe), each of
whom has a small market share
• Limit pricing – a strategy whereby

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the dominant firm keeps its price
below the level that maximizes its
current profit in order to reduce
the rate of expansion by the fringe
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Bertrand Competition – Assumptions
• Firms set price*
• Differentiated product
• Simultaneous
• Non-cooperative

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• *Differentiation means that lowering price below your rivals' will
not result in capturing the entire market, nor will raising price
mean losing the entire market so that residual demand
decreases smoothly
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Bertrand Competition – Example
• Q1 = 100 - 2P1 + P2 "Coke's demand"
• Q2 = 100 - 2P2 + P1 "Pepsi's demand"
• MC1 = MC2 = 5
• What is firm 1's residual demand when
• Firm 2's price is $10? $0?

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• Q1(10) = 100 - 2P1 + 10 = 110 - 2P1
• Q1(0) = 100 - 2P1 + 0 = 100 - 2P1
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Bertrand Competition – Example Continued

• Each firm maximizes profits

based on its residual demand
by setting MR (based on
residual demand) = MC
• Pepsi’s price = $0 for D0 and
$10 for D10

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 Bertrand Competition – Example
Continued

23

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 Bertrand Competition – Example
Continued

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Bertrand Competition – Key Concepts
• MR1(10) = 55 - Q1(10) = 5 • Solving for firm 1's reaction
function for any arbitrary price by
• Q1(10) = 50 firm 2
• P1(10) = 30 – P1 = 50 - Q1/2 + P2/2
• Therefore, firm 1's best – MR = 50 - Q1 + P2/2
response to a price of $10 by – MR = MC => Q1 = 45 + P2/2
firm 2 is a price of $30 • And, using the demand curve, we

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have:
– P1 = 50 + P2/2 - 45/2 - P2/4 or
– P1 = 27.5 + P2/4 the reaction function

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 Equilibrium and Reaction Functions

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Equilibrium and Reaction Functions
Continued

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Equilibrium
• Equilibrium occurs when all
firms simultaneously choose
their best response to each
others' actions
• Graphically, this amounts to
the point where the best
response functions cross
• Example: Firm 1 and Firm 2, continued
• P1 = 27.5 + P2/4
• P2 = 27.5 + P1/4
• Solving these two equations in two
unknowns.
– P1* = P2* = 110/3
• Plugging these prices into demand, we
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have:
• Q1* = Q2* = 190/3
• 1* = 2* = 2005.55
•  = 4011.10
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Equilibrium Continued
• Profits are positive in equilibrium
since both prices are above
marginal cost!
• Even if we have no capacity
constraints, and constant marginal
cost, a firm cannot capture all
demand by cutting price
• This blunts price-cutting incentives
and means that the firms' own
behavior does not mimic free
entry
• Only if the number of firms
approaches infinity would price
approach marginal cost
• Prices need not be equal in
equilibrium if firms not identical
– Marginal costs differ implies that
prices differ
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• The reaction functions slope
upward: "aggression =>
aggression"
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Cournot, Bertrand, and Monopoly Equilibriums

• P > MC for Cournot competitors, but P < PM

• If the firms were to act as a monopolist (perfectly collude), they
would set market MR equal to MC:
– P = 100 - Q
– MC = AC = 10
• MR = MC => 100 - 2Q = 10 => QM = 45

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– PM = 55
– M= 45(45) = 2025
– c = 1800
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Cournot, Bertrand, and Monopoly Equilibriums
Continued

• A perfectly collusive industry considers that an increase in output by one firm

depresses the profits of the other firm(s) in the industry
• A Cournot competitor considers the effect of the increase in output on its own
profits only
• Therefore, Cournot competitors "overproduce" relative to the collusive
(monopoly) point
• Further, this problem gets "worse" as the number of competitors grows because
the market share of each individual firm falls, increasing the difference between

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the private gain from increasing production and the profit destruction effect on
rivals
• Therefore, the more concentrated the industry in the Cournot case, the higher
the price-cost margin
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Cournot, Bertrand, and Monopoly Equilibriums
Continued

• Homogeneous product Bertrand resulted in zero profits, whereas

the Cournot case resulted in positive profits
• The best response functions in the Cournot model slope
downward
– In other words, the more aggressive a rival (in terms of output), the
more passive the Cournot firm's response

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• The best response functions in the Bertrand model slope upward
– In other words, the more aggressive a rival (in terms of price) the more
aggressive the Bertrand firm's response

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Cournot, Bertrand, and Monopoly Equilibriums
Continued

• Cournot
– Suppose firm j raises its output…the price at which firm i can sell
output falls
– This means that the incentive to increase output falls as the output of
the competitor rises
• Bertrand

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– Suppose firm j raises price the price at which firm i can sell output
rises
– So long as firm's price is less than firm's, the incentive to increase
price will depend on the (market) marginal revenue
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Monopolistic Competition
• Market structure
– Many buyers
– Many sellers
– Free entry and exit
– (Horizontal) product differentiation
• When firms have horizontally differentiated products, they each face

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downward-sloping demand for their product because a small
change in price will not cause all buyers to switch to another firm's
product
• Example: restaurants, local markets for doctors
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Monopolistic Competition – Short Run
1. Each firm is small each takes the observed "market price"
as given in its production decisions
2. Since market price may not stay given, the firm's perceived
demand may differ from its actual demand
3. if all firms' prices fall the same amount, no customers
switch supplier, but the total market consumption grows

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4. If only one firm's price falls, it steals customers from other
firms as well as increases total market consumption

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 Perceived vs. Actual Demand

36

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 Perceived vs. Actual Demand Continued

37

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Market Equilibrium
• Each firm maximizes profit taking the average market
price as given

• Each firm can sell the quantity it desires at the actual

average market price that prevails

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 Short Run Equilibrium

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 Short Run Equilibrium Continued

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Short Run Monopolistically Competitive
Equilibrium
• MC = $15 A. What is the equation of d40? What is
the equation of D?
• N = 100 – d40: Qd = 100 - 2P + 40 = 140 - 2P
• Q = 100 - 2P + PA – D: Note that P = PA so that
– QD = 100 - P
• Where: PA is the average
B. Show that d40 and D intersect at P =
market price N is the number
40
of firms
– P = 40 => Qd = 140 - 80 = 60

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– QD = 100 - 40 = 60
C. For any given average price, PA,
find a typical firm's profit maximizing
quantity
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Inverse Perceived Demand
• P = 50 - (1/2)Q + (1/2)PA
• MR = 50 - Q + (1/2)PA
• MR = MC => 50 - Q + (1/2)PA = 15
• Qe = 35 + (1/2)PA
• Pe = 50 - (1/2)Qe + (1/2)PA

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• Pe = 32.5 + (1/4)PA

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Short Run Monopolistically Competitive
Equilibrium
• What is the short run equilibrium price in this industry?
• In equilibrium, Qe = QD at PA so that
– 100 - PA = 35 + (1/2)PA
– PA = 43.33
– Qe = 56.66

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– QD = 56.66

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Monopolistic Competition in the Long Run
• At the short run equilibrium
P > AC so that each firm may make
positive profit
• Entry shifts d and D left until average
industry price equals average cost
• This is long run equilibrium is
represented graphically by:
– MR = MC for each firm

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– D = d at the average market price
– d and AC are tangent at average market
price

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Summary
1. Market structures are characterized by the number of
buyers, the number of sellers, the degree of product
differentiation and the entry conditions
2. Product differentiation alone or a small number of
competitors alone is not enough to destroy the long run
zero profit result of perfect competition

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3. Monopolistic competition assumes that there are many
buyers, many sellers, differentiated products and free
entry in the long run
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Summary Continued
4. Sellers face downward-sloping demand but are price takers (i.e. they do
not perceive that their change in price will affect the average price level)
– Profits may be positive in the short run but free entry drives profits to zero in the
long run
5. Bertrand and Cournot competition assume that there are many buyers,
few sellers, and homogeneous or differentiated products
– Firms compete in price in Bertrand oligopoly and in quantity in Cournot oligopoly

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6. Bertrand and Cournot competitors take into account their strategic
interdependence by means of constructing a best response schedule:
each firm maximizes profits given the rival's strategy

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Summary Continued
7. Equilibrium in such a setting requires that all firms be on their best
response functions
8. If the products are homogeneous, the Bertrand equilibrium results in
zero profits
– By changing the strategic variable from price to quantity, we obtain much higher
prices (and profits)
– Further, the results are sensitive to the assumption of simultaneous moves

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9. This result can be traced to the slope of the reaction functions: upwards
in the case of Bertrand and downwards in the case of Cournot
– These slopes imply that "aggressivity" results in a "passive" response in the
Cournot case and an "aggressive" response in the Bertrand case
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