Chapter 12

Monopolistic Competition and

Oligopoly

Monopolistic Competition and

Oligopoly

Chapter 12 Slide 2

Monopolistic Competition

Characteristics

1) Many firms

2) Free entry and exit

3) Differentiated product

Chapter 12 Slide 3

Monopolistic Competition

The amount of monopoly power depends on the degree of differentiation.

Examples of this very common market structure include:ToothpasteSoapCold remedies

A Monopolistically CompetitiveFirm in the Short and Long Run

Quantity

$/Q

Quantity

$/QMC

AC

MC

AC

DSR

MRSR

DLR

MRLR

QSR

PSR

QLR

PLR

Short Run Long Run

Deadweight lossMC AC

Comparison of Monopolistically CompetitiveEquilibrium and Perfectly Competitive Equilibrium

$/Q

Quantity

$/Q

D = MR

QC

PC

MC AC

DLR

MRLR

QMC

P

Quantity

Perfect Competition Monopolistic Competition

Chapter 12 Slide 6

Oligopoly

CharacteristicsSmall number of firms

Product differentiation may or may not exist

Barriers to entry

Chapter 12 Slide 7

Oligopoly

The barriers to entry are:Natural

Scale economiesPatentsTechnologyName recognition

Chapter 12 Slide 8

Oligopoly

The barriers to entry are:Strategic action

Flooding the marketControlling an essential input

Chapter 12 Slide 9

Oligopoly

Management ChallengesStrategic actions

Rival behavior

QuestionWhat are the possible rival responses to a

10% price cut by Ford?

Chapter 12 Slide 10

Oligopoly

Equilibrium in an Oligopolistic MarketIn perfect competition, monopoly, and

monopolistic competition the producers did not have to consider a rival’s response when choosing output and price.

In oligopoly the producers must consider the response of competitors when choosing output and price.

Chapter 12 Slide 11

Oligopoly

Equilibrium in an Oligopolistic MarketDefining Equilibrium

Firms do the best they can and have no incentive to change their output or price

All firms assume competitors are taking rival decisions into account.

Chapter 12 Slide 12

Oligopoly

Nash EquilibriumEach firm is doing the best it can given

what its competitors are doing.

Chapter 12 Slide 13

Oligopoly

The Cournot ModelDuopoly

Two firms competing with each otherHomogenous goodThe output of the other firm is assumed

to be fixedFirms decide simultaneously how much

to produce

Chapter 12 Slide 14

MC1

50

MR1(75)

D1(75)

12.5

If Firm 1 thinks Firm 2 will produce 75 units, its demand curve is

shifted to the left by this amount.

Firm 1’s Output Decision

Q1

P1

D1(0)

MR1(0)

If Firm 1 thinks Firm 2 will produce nothing, its demand

curve, D1(0), is the market demand curve.

D1(50)MR1(50)

25

If Firm 1 thinks Firm 2 will produce 50 units, its demand curve is

shifted to the left by this amount.

Chapter 12 Slide 15

Firm 2’s ReactionCurve Q2*(Q1)

Firm 2’s reaction curve shows how much itwill produce as a function of how much

it thinks Firm 1 will produce.

Reaction Curves and Cournot Equilibrium

Q2

Q1

25 50 75 100

25

50

75

100

Firm 1’s ReactionCurve Q*1(Q2)

x

x

x

x

Firm 1’s reaction curve shows how much itwill produce as a function of how much it thinks Firm 2 will produce. The x’s correspond to the previous example.

In Cournot equilibrium, eachfirm correctly assumes how

much its competitors willproduce and thereby

maximizes its own profits.

CournotEquilibrium

Chapter 12 Slide 16

Oligopoly

Questions

1) If the firms are not producing at the Cournot equilibrium, will they

adjust until the Cournot equilibrium is reached?

2) When is it rational to assume that a competitor’s output is fixed?

Chapter 12 Slide 17

Oligopoly

An Example of the Cournot EquilibriumDuopoly

Market demand is P = 30 - Q where Q = Q1 + Q2

MC1 = MC2 = 0

The Linear Demand CurveThe Linear Demand Curve

Chapter 12 Slide 18

Oligopoly

An Example of the Cournot EquilibriumFirm 1’s Reaction Curve

111 )30( Revenue, Total QQPQR

122

11

1211

30

)(30

QQQQ

QQQQ

The Linear Demand CurveThe Linear Demand Curve

Chapter 12 Slide 19

Oligopoly

An Example of the Cournot Equilibrium

12

21

11

21111

2115

2115

0

230

QQ

QQ

MCMR

QQQRMR

Curve Reaction s2' Firm

Curve Reaction s1' Firm

The Linear Demand CurveThe Linear Demand Curve

Chapter 12 Slide 20

Oligopoly

An Example of the Cournot Equilibrium

1030

20

10)2115(2115

21

2111

1

QP

QQQ

QQQQ

QQ 2:mEquilibriu Cournot

The Linear Demand CurveThe Linear Demand Curve

Chapter 12 Slide 21

Duopoly Example

Q1

Q2

Firm 2’sReaction Curve

30

15

Firm 1’sReaction Curve

15

30

10

10

Cournot Equilibrium

The demand curve is P = 30 - Q andboth firms have 0 marginal cost.

Chapter 12 Slide 22

Oligopoly

MCMRMR

QQRMR

QQQQPQR

and 15 Q when 0

230

30)30( 2

Profit Maximization with CollusionProfit Maximization with Collusion

Chapter 12 Slide 23

Oligopoly

Contract Curve

Q1 + Q2 = 15

Shows all pairs of output Q1 and Q2 that maximizes total profits

Q1 = Q2 = 7.5

Less output and higher profits than the Cournot equilibrium

Profit Maximization with CollusionProfit Maximization with Collusion

Chapter 12 Slide 24

Firm 1’sReaction Curve

Firm 2’sReaction Curve

Duopoly Example

Q1

Q2

30

30

10

10

Cournot Equilibrium15

15

Competitive Equilibrium (P = MC; Profit = 0)

CollusionCurve

7.5

7.5

Collusive Equilibrium

For the firm, collusion is the bestoutcome followed by the Cournot

Equilibrium and then the competitive equilibrium

Chapter 12 Slide 25

First Mover Advantage--The Stackelberg Model

AssumptionsOne firm can set output first

MC = 0

Market demand is P = 30 - Q where Q = total output

Firm 1 sets output first and Firm 2 then makes an output decision

Chapter 12 Slide 26

Firm 1Must consider the reaction of Firm 2

Firm 2Takes Firm 1’s output as fixed and

therefore determines output with the Cournot reaction curve: Q2 = 15 - 1/2Q1

First Mover Advantage--The Stackelberg Model

Chapter 12 Slide 27

Firm 1

Choose Q1 so that:

122

1111 30

0

Q - Q - QQ PQ R

MC, MC MR

0 MR therefore

First Mover Advantage--The Stackelberg Model

Chapter 12 Slide 28

Substituting Firm 2’s Reaction Curve for Q2:

5.7 and 15:0

15

21

1111

QQMR

QQRMR

211

112

111

2115

)2115(30

QQ

QQQQR

First Mover Advantage--The Stackelberg Model

Chapter 12 Slide 29

ConclusionFirm 1’s output is twice as large as firm 2’s

Firm 1’s profit is twice as large as firm 2’s

QuestionsWhy is it more profitable to be the first mover?

Which model (Cournot or Stackelberg) is more appropriate?

First Mover Advantage--The Stackelberg Model