Chapter 13
Oligopoly and
Monopolistic
Competition
Topics
•
•
•
•
•
•
Market Structures.
Cartels.
Noncooperative Oligopoly.
Cournot Model.
Stackelberg Model.
Comparison of Collusive, Cournot,
Stackelberg, and Competitive Equilibria.
• Bertrand Model.
• Monopolistic Competition.
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Oligopoly
• Oligopoly - a small group of firms in a
market with substantial barriers to entry.
• Cartel - a group of firms that explicitly
agree to coordinate their activities.
• Monopolistic competition - a market
structure in which firms have market
power but no additional firm can enter and
earn positive profits
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Market Structures
• Markets differ according to:
 the number of firms in the market,
 the ease with which firms may enter and
leave the market, and
 the ability of firms in a market to differentiate
their products from those of their rivals.
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Table 13.1 Properties of Monopoly, Oligopoly,
Monopolistic Competition, and Competition
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Why Cartels Form
• A cartel forms if members of the cartel
believe that they can raise their profits by
coordinating their actions.
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Figure 13.1 Competition Versus Cartel
(b) Market
MC
pm
AC
pc
Price, p, $ per unit
Price, p, $ per unit
(a) Firm
S
pm
em
ec
pc
MCm
MCm
Market demand
MR
qm qc q*
Quantity, q, Units
per year
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Qm
Qc
Quantity, Q, Units
per year
Laws Against Cartels
• Cartels persist despite these laws for
three reasons:
 international cartels and cartels within certain
countries operate legally.
 some illegal cartels operate believing that
they can avoid detection or that the
punishment will be insignificant.
 some firms are able to coordinate their
activity without explicitly colluding and
thereby running afoul of competition laws.
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Laws Against Cartels (cont.)
• In the late nineteenth century, cartels
were legal and common in the United
States.
 Examples: oil, railroad, sugar, and tobacco.
• Sherman Antitrust Act in 1890 and the
Federal Trade Commission Act of 1914,
 Prohibit firms from explicitly agreeing to take
actions that reduce competition.
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Laws Against Cartels (cont.)
• The Organization of Petroleum Exporting
Countries (OPEC) - an international cartel
that was formed in 1960 by five major oilexporting countries:
 Iran, Iraq, Kuwait, Saudi Arabia, and
Venezuela.
 In 1971, OPEC members agreed to take an
active role in setting oil prices.
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Why Cartels Fail
• Cartels fail if noncartel members can
supply consumers with large quantities of
goods.
• Each member of a cartel has an incentive
to cheat on the cartel agreement.
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Maintaining Cartels
• To keep firms from violating the cartel
agreement, the cartel must be able to
 detect cheating and punish violators.
 keep their illegal behavior hidden from
customers and government agencies.
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Mergers
• U.S. laws restrict the ability of firms to
merge if the effect would be
anticompetitive.
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Noncooperative Oligopoly
• Duopoly - an oligopoly with two firms.
• Three models:
 Cournot model
 Stackelberg model
 Bertrand model
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Noncooperative Oligopoly (cont.)
• Three restrictive assumptions:
 All firms are identical in the sense that they
have the same cost functions and produce
identical, undifferentiated products.
 We initially illustrate each of these oligopoly
models for a duopoly
 The market lasts for only one period.
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Noncooperative Oligopoly (cont.)
• Duopoly equilibrium:
A set of actions taken by the firms is a Nash
equilibrium if, holding the actions of all
other firms constant, no firm can obtain a
higher profit by choosing a different
action.
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Cournot Model
• Four assumptions:
(1) there are two firms and no other firms can
enter the market,
(2) the firms have identical costs,
(3) they sell identical products, and
(4) the firms set their quantities simultaneously.
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Cournot Model of an Airlines Market
• Example: American Airlines and United
Airlines compete for customers on flights
between Chicago and Los Angeles.
• Cournot equilibrium (Nash-Cournot
equilibrium) - a set of quantities sold by
firms such that, holding the quantities of
all other firms constant, no firm can obtain
a higher profit by choosing a different
quantity
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Cournot Model of an Airlines Market
(cont.)
• Residual demand curve - the market
demand that is not met by other sellers at
any given price
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(a) Monopoly
(b) Duopoly
p, $ per passenger
p, $ per passenger
Figure 13.2 American Airlines’ ProfitMaximizing Output
339
243
147
MC
339
275
211
147
MC
qU = 64
MR
0
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MRr
D
96
169.5
339
qA, Thousand American Airlines
passengers per quarter
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0
64
Dr
D
128 137.5
275 339
qA, Thousand American Airlines
passengers per quarter
Figure 13.3 American and United’s
Best-Response Curves
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Cournot Model of an Airlines Market
(cont.)
• Market demand function is
Q = 339 − p
 p - dollar cost of a one-way flight
 Q total quantity of the two airlines (thousands of
passengers flying one way per quarter).
• Each airline has a constant marginal cost, MC,
and average cost, AC, of $147 per passenger
per flight.
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Cournot Model of an Airlines Market
(cont.)
•
Residual demand American faces is:
qA = Q(p) − qU = (339 − p) − qU.

rewriting
p = 339 − qA − qU
•
The marginal revenue function is:
MRr = 339 − 2qA − qU
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Cournot Model of an Airlines Market
(cont.)
•
American Airlines’ best response is the
output that equates its marginal
revenue, and its marginal cost:
MRr = 339 − 2qA − qU = 147 = MC
 and rearranging
qA = 96−1/2 qU
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Cournot Model of an Airlines Market
(cont.)
•
United’s best-response function is
qU = 96−1/2 qA
 This statement is equivalent to saying that
the Cournot equilibrium is a point at which
the bestresponse curves cross.
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Cournot Model of an Airlines Market
(cont.)
•
To solve the model:
qA = 96−1/2 (96−1/2 qA)
 and solve for qA.
•
Doing so, we find that
 qA = 64; qU = 64
 Q = qA + qU = 128.
 Cournot equilibrium price is $211.
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The Cournot Equilibrium and the Number
of Firms
• We can write a typical Cournot firm’s profit-maximizing
condition as:
1 

MR  p1 
  MC
 n 
 If n = 1, the Cournot firm is a monopoly,
• The more firms there are, the larger the residual demand elasticity,
nε, a single firm faces.
 As n grows very large, the residual demand elasticity approaches
negative infinity , and the equation above becomes
p = MC,
• which is the profit-maximizing condition of a price-taking competitive
firm.
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Table 13.2 Cournot Equilibrium
Varies with the Number of Firms
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The Cournot Equilibrium and the Number
of Firms
• Cournot firm’s Lerner Index depends on the
elasticity the firm faces
p  MC
1

p
n
 Thus, a Cournot firm’s Lerner Index equals the
monopoly level, −1/ε, if there is only one firm
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Application: Air Ticket Prices and
Rivalry
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Figure 13.4(a) Effect of a Drop in One Firm’s
Marginal Cost on a Duopoly Cournot
Equilibrium
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Figure 13.4(b) Effect of a Drop in One Firm’s
Marginal Cost on a Duopoly Cournot
Equilibrium
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Solved Problem 13.1
• Derive United Airlines’ best-response
function if its marginal cost falls to $99 per
unit.
• Answer
 Determine United’s marginal revenue
function corresponding to its residual demand
curve.
 Equate United’s marginal revenue function
and its marginal cost to determine its bestresponse function.
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Solved Problem 13.2
• Intel and Advanced Micro Devices (AMD) are the only two firms
that produce central processing units (CPUs), which are the brains
of personal computers. Both because the products differ physically
and because Intel’s advertising “Intel Inside” campaign has
convinced some consumers’ of its superiority, consumers view the
CPUs as imperfect substitutes. Consequently, the two firms’
inverse demand functions differ:
pA = 197 − 15.1qA − 0.3qI,
pI = 490 − 10qI − 6qA,
• where price is dollars per CPU, quantity is in millions of CPUs, the
subscript I indicates Intel, and the subscript A represents AMD.
Each firm faces a constant marginal cost of m = $40 per unit. (For
simplicity, we will assume there are no fixed costs.) Solve for the
Cournot equilibrium quantities and prices.
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Stackelberg Model
• In the Cournot model, both firms make
their output decisions at the same time.
 Suppose, however, that one of the firms,
called the leader, can set its output before its
rival, the follower, sets its output.
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Figure 13.5
Stackelberg
Equilibrium
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Solved Problem 13.3
• Use algebra to solve for the Stackelberg
equilibrium quantities and market price if
American Airlines were a Stackelberg
leader and United Airlines were a follower.
(Hint: As the graphical analysis shows,
American Airlines, the Stackelberg leader,
maximizes its profit as though it were a
monopoly facing a residual demand
function.)
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Why Moving Sequentially Is Essential
• When the firms move simultaneously,
United doesn’t view American’s warning
that it will produce a large quantity as a
credible threat.
 If United believed that threat, it would indeed
produce the Stackelberg follower output level.
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Strategic Trade Policy
• Suppose that two identical firms in two
different countries compete in a world
market.
 Both firms act simultaneously, so neither firm
can make itself the Stackelberg leader.
 A government may be tempted to intervene
to make its firm a Stackelberg leader.
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Problems with Intervention
• For government subsidies to work five
conditions must hold:
 government must be able to set its subsidy
before the firms choose their output levels.
 other government must not retaliate.
 government’s actions must be credible.
 government must know enough about how
firms behave to intervene appropriately.
 government must know which game the firms
are playing.
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Table 13.3 Effects of a Subsidy
Given to United Airlines
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Solved Problem 13.4
• If governments subsidize identical
Cournot duopolies with a specific subsidy
of s per unit of output, what is the
qualitative effect (direction of change) on
the equilibrium quantities and price?
Assume that the before-subsidy bestresponse functions are linear.
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Solved Problem 13.4
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Comparison of Collusive, Cournot,
Stackelberg, and Competitive Equilibria
• How would American and United behave
if they colluded?
 They would maximize joint profits by
producing the monopoly output, 96 units, at
the monopoly price, $243 per passenger.
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Figure 13.6(a) Duopoly Equilibria
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Figure 13.6(b) Duopoly Equilibria
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Application: Deadweight Losses in the
Food and Tobacco Industries
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Bertrand Model
• Bertrand equilibrium (Nash-Bertrand
equilibrium) - a Nash equilibrium in
prices; a set of prices such that no firm
can obtain a higher profit by choosing a
different price if the other firms continue to
charge these prices.
 Bertrand equilibrium depends on whether
firms are producing identical or differentiated
products.
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Best-Response Curves
• Suppose that each of the two price-setting
oligopoly firms in a market produces an
identical product and faces a constant
marginal and average cost of $5 per unit.
 What is Firm 1’s best response if Firm 2 sets
a price of p2 = $10?
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Figure 13.7 Bertrand Equilibrium
with Identical Products
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Bertrand Versus Cournot
• Cournot equilibrium price for firms with
constant marginal costs of $5 per unit by:
MC
$5
p

1  1 /( n ) 1  1 /( n )
 where n is the number of firms and ε is the market
demand elasticity.
 If the market demand elasticity is ε = −1 and n = 2,
the Cournot equilibrium price is $5/(1− 1 2) = $10
which is double the Bertrand equilibrium price.
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Bertrand Equilibrium with Differentiated
Products
• In markets with differentiated products
such markets, the Bertrand equilibrium is
plausible, and the two “problems” of the
homogeneous-goods model disappear:
 Firms set prices above marginal cost, and
 prices are sensitive to demand conditions.
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Figure 13.8 Bertrand Equilibrium
with Differentiated Products
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Monopolistic Competition
• Monopolistically competitive markets do
not have barriers to entry,
 so firms enter the market until no new firm
can enter profitably.
 monopolistically competitive firms face
downward-sloping residual demand curves,
so they charge prices above marginal cost.
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Monopolistically Competitive Equilibrium
• Two conditions hold in a monopolistically
competitive equilibrium:
 Marginal revenue equals marginal cost
• because firms set output to maximize profit, and
 Price equals average cost
• because firms enter until no further profitable
entry is possible.
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Figure 13.9 Monopolistically
Competitive Equilibrium
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Minimum Efficient Scale
• Minimum Efficient Scale - (full capacity)
the smallest quantity at which the average
cost curve reaches its minimum
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Fixed Costs and the Number of Firms
• The number of firms in a monopolistically
competitive equilibrium depends on firms’
costs.
 The larger each firm’s fixed cost, the smaller
the number of monopolistically competitive
firms in the market equilibrium.
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Figure 13.10 Monopolistic
Competition Among Airlines
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