SESSION 7

MONOPOLISTIC COMPETITION
AND OLIGOPOLY
MONOPOLISTIC COMPETITION
•Three key characteristics:
◦ Firms compete by selling differentiated products that are highly substitutable for one another but not perfect
substitutes.
◦ There is free entry and exit: it is relatively easy for new firms to enter the market with their own brands and for
existing firms to leave if their products become unprofitable.
◦ Some degree of market power and some control over price

•Because the firm is the only producer of its brand, it faces a downward-sloping demand curve.
•Firms enter the market in response to profit opportunities. Example: Soaps, shampoos
•Several factors affect the number of firms that enter:
◦ Fixed cost associated with becoming active in the market
◦ As the fixed cost shrinks and the number of firms grows, the possible profits of an active firm approach zero
◦ Size of the market
◦ Intensity of competition
◦ Because profits are lower in a market with more intense competition, fewer firms will enter
SHORT RUN EQUILIBRIUM
•Because the firm is the only producer of its brand, it
faces a downward-sloping demand curve.

•Price exceeds marginal cost and the firm has

monopoly power.

•In the short run, described in part (a), price also

exceeds average cost, and the firm earns profits
shown by the yellow- shaded rectangle.
LONG RUN EQUILIBRIUM
•In the long run, these profits attract new firms with
competing brands. The firm’s market share falls, and its
demand curve shifts downward.

•In long-run equilibrium, described in part (b), price equals

average cost, so the firm earns zero profit even though it
has monopoly power.
 EXAMPLE
ELASTICITIES OF DEMAND FOR COLAS AND COFFEE
BRAND ELASTICITY OF DEMAND
Colas RC Cola –2.4
Coke –5.2 to –5.7
Ground coffee Folgers –6.4
Maxwell House –8.2
Chock Full o’ Nuts –3.6

With the exception of RC Cola and Chock Full o’ Nuts, all the colas and The markets for soft drinks and coffee
coffees are quite price elastic. With elasticities on the order of −4 to −8, each illustrate the characteristics of
monopolistic competition.
brand has only limited monopoly power. This is typical of monopolistic
competition. Each market has a variety of brands that
differ slightly but are close substitutes for
one another.
RELEVANCE OF MONPOLISTIC COMPETITION
•Monopolistic competition → price-setting; Allows monetary transmission & sticky prices
•Innovation produces differentiated products
•Monopolistic competition explains:
• why markets produce many varieties
• why firms invest in branding & quality
• welfare gains from product diversity

•Traditional trade theories assume: identical products, constant returns to scale, perfect competition
→ Cannot explain why similar countries trade similar goods (e.g., India and Japan exchanging cars).
•In new trade theories, Countries import and export similar but differentiated products.
•India exports textiles and imports textiles; India exports Maruti cars and imports Hyundai cars; Trade increases the
number of product varieties available.
•Under monopolistic competition, firms adjust markups in foreign markets: When exchange rate changes → prices do
not fully adjust → incomplete pass-through
OLIGOPOLY MARKET
•Oligopoly refers to a market situation or a type of market organisational in which a few firms control
the supply of a commodity.
•The competing firms are few in number but each one is large enough so as to be able to control the
total industry output and a moderate.
•However, increase of its output or sales will reduce the sales of rival firms by a noticeable amount.
•The chief characteristic of oligopoly is the interdependence among the rival sellers.
•In oligopoly situation, each firm has to stick to its price. If any firm tries to reduce its price, the rival
firms will retaliate by a higher reduction in their prices
•The interdependence of the oligopolists, however, makes it impossible to draw a demand curve for
such sellers except for the situations where the form of interdependence is well defined.
 OLIGOPOLY MARKET-OTHER FEATURES
•Oligopolistic demand curve – Kinked demand curve

•Why kink – Relatively inelastic demand during price

reductions and relatively elastic demand for price
increase

•Firm’s price reduction will generate a very small

increase in sales as rival firms start responding

•Price rise will lead them to lose the market share even
marginally and hence demand is elastic for price rise

•Price behaviour dependent on rival’s price reactions

 OLIGOPOLY MARKET-OTHER FEATURES
•Rivals match price reductions MC1
D2
•Rivals ignore price increases
MR2 e
MC2
•It is a tool which explains the stickiness of prices in P0 f
oligopolistic markets, but not as a tool for
determination of prices itself.

•Profit maximizing price and quantity are Po and Qo g

•MR drops discontinuously if price goes below Po D1

Q0
MR1
EQUILIBRIUM IN OLIGOPOLY MARKET
•In an oligopolistic market, however, a firm sets price or output based partly on strategic
considerations regarding the behavior of its competitors.
•With some modification, the underlying principle to describe an equilibrium when firms make
decisions that explicitly take each other’s behavior into account is the same as the equilibrium in
competitive and monopolistic markets:
•When a market is in equilibrium, firms are doing the best they can and have no reason to
change their price or output.
•Nash equilibrium: Set of strategies or actions in which each firm does the best it can given its
competitors’ actions.
Nash Equilibrium: Each firm is doing the best it can given what its competitors are doing.
COURNOT MODEL
•Oligopoly model in which firms produce a homogeneous good,
each firm treats the output of its competitors as fixed, and all firms
decide simultaneously how much to produce.
•Firm 1’s profit-maximizing output depends on how much it thinks
that Firm 2 will produce.
•If it thinks Firm 2 will produce nothing, its demand curve, labeled
D1(0), is the market demand curve. The corresponding marginal
revenue curve, labeled MR1(0), intersects Firm 1’s marginal cost
curve MC1 at an output of 50 units.
•If Firm 1 thinks that Firm 2 will produce 50 units, its demand
curve, D1(50), is shifted to the left by this amount. Profit
maximization now implies an output of 25 units.
•Finally, if Firm 1 thinks that Firm 2 will produce 75 units, Firm 1
will produce only 12.5 units.
FEATURES OF COURNOT EQUILIBRIUM
• Equilibrium in the Cournot model in which each firm correctly assumes how much its
competitor will produce and sets its own production level accordingly.
• Cournot equilibrium is an example of a Nash equilibrium (and thus it is sometimes
called a Cournot-Nash equilibrium).
• In a Nash equilibrium, each firm is doing the best it can given what its competitors are doing.
• As a result, no firm would individually want to change its behavior.
• In the Cournot equilibrium, each firm is producing an amount that maximizes its profit given
what its competitor is producing, so neither would want to change its output.
REACTION CURVES
• Firm 1’s reaction curve shows how much it will produce as a
function of how much it thinks Firm 2 will produce.

• Firm 2’s reaction curve shows its output as a function of how

much it thinks Firm 1 will produce.

• In Cournot equilibrium, each firm correctly assumes the

amount that its competitor will produce and thereby
maximizes its own profits. Therefore, neither firm will move
from this equilibrium.
 NUMERICAL-I
Two identical firms face the following market demand curve 𝑃 = 30 − 𝑄
Also, The firms face constant costs

1. Find Cournot Nash equilibrium

2. If the two firms collude, then find the total profit-maximizing quantity

Cournot equilibrium: Q1=Q2=10; Total quantity = 20; P=10

DUOPOLY EXAMPLE
• The demand curve is P = 30 − Q, and both firms have zero
marginal cost. In Cournot equilibrium, each firm produces
10.
• The collusion curve shows combinations of Q1 and Q2 that
maximize total profits.
• If the firms collude and share profits equally, each will
produce 7.5.
• Also shown is the competitive equilibrium, in which price
equals marginal cost and profit is zero.
STACKELBERG MODEL
•Stackelberg competition describes an oligopoly market model based on a non-cooperative strategic game where one
firm (the “leader”) moves first and decides how much to produce, while all other firms (the “followers”) decide how
much to produce afterwards.
•The leader might emerge in a market because of its size, reputation, innovative capacity, or because it simply started
operating first.
•The leader will generally be better known and more recognized by customers, and is therefore better placed to decide
first which quantity to sell.
•All firms produce a homogenous good, and are subject to the same demand and cost functions. In other words, there is
no product differentiation.
•Firms decide sequentially on the output they produce, which means we have a model consisting of two distinct periods.
In the first period, the leader chooses its production quantity. This decision cannot be changed after.
•In the second period, the follower firm(s) choose(s) their output after observing the quantity chosen by the leader. This
is the key difference when compared to Cournot competition, in which the production decisions by all firms are taken
simultaneously.
NUMERICAL-2
Stackelberg model: Oligopoly model in which one firm sets its output before other firms do.
Suppose Firm 1 sets its output first and then Firm 2, after observing Firm 1’s output, makes its
output decision. In setting output, Firm 1 must therefore consider how Firm 2 will react.
P = 30 – Q

(Hint: Use firm 2’s reaction function and incorporate it in firm 1’s profit function)
BERTRAND MODEL
• Each firm independently sets its price in order to maximize profits (price is each firms’ control variable).

• Firms set P1 = P2 = MC! Why?

• Suppose MC < P1 < P2.

• Firm 1 earns (P1 - MC) on each unit sold, while firm 2 earns nothing.

• Firm 2 has an incentive to slightly undercut firm 1’s price to capture the entire market.

• Firm 1 then has an incentive to undercut firm 2’s price. This undercutting continues...

• Equilibrium: Each firm charges P1 = P2 = MC.

BERTRAND MODEL
• Let’s return to the duopoly example of the last section.
• P = 30 – Q
• MC1 = MC2 = $3
• Q1 = Q2 = 9, and in Cournot equilibrium, the market price is $12, so that each firm makes a profit of $81.
• Now suppose that these two duopolists compete by simultaneously choosing a price instead of a quantity.
• Nash equilibrium in the Bertrand model results in both firms setting price equal to marginal cost: P1 = P2
= $3. Then industry output is 27 units, of which each firm produces 13.5 units, and both firms earn zero
profit.
• In the Cournot model, because each firm produces only 9 units, the market price is $12. Now the market
price is $3. In the Cournot model, each firm made a profit; in the Bertrand model, the firms price at
marginal cost and make no profit.
BERTRAND MODEL-NUMERICAL 3
•Oligopoly model in which firms produce a homogeneous good, each firm treats the price of its
competitors as fixed, and all firms decide simultaneously what price to charge.
Suppose each of two duopolists has fixed costs of $20 but zero variable costs, and that they face the
same demand curves:

Firm 1’s demand: Q1 =12− 2P1 + P2

Firm 2’s demand: Q2 =12− 2P2 + P1

NASH EQUILIBRIUM IN PRICES
• Here two firms sell a differentiated product, and each
firm’s demand depends both on its own price and on its
competitor’s price. The two firms choose their prices at the
same time, each taking its competitor’s price as given.
• Firm 1’s reaction curve gives its profit- maximizing price as
a function of the price that Firm 2 sets, and similarly for
Firm 2.
• The Nash equilibrium is at the intersection of the two
reaction curves: When each firm charges a price of $4, it is
doing the best it can given its competitor’s price and has no
incentive to change price.
• Also shown is the collusive equilibrium: If the firms
cooperatively set price, they will choose $6.