Imperfectly Competitive Markets:

Improving managerial decision making by using

economic insights
Course coordinator: prof. dr. Marijn Verschelde∗

2022-2023

1 Market forms and market power

Producers and consumers come together in various market forms. We will discuss that the
price elasticity of demand, boundaries for entry/exit, and strategic interaction are at the
basis of the differences between market forms. While the course Imperfectly Competitive
Markets focuses on producers and market forms, we start from consumers. This is because
the field of economics is built upon the assumption that consumers act as rational economic
agents. You could consider them as cold-hearted robots that pursue their self-interest, but
face constraints. In reality, humans and families show altruism and deviations from rational
robot-like behavior. The assumption of rational behavior is just a starting point, from which
we can gain many structural insights. In intermediate and advanced master classes, you will
learn that altruism, deviations from rationality, etc. can naturally be included in economic
∗
Email: m.verschelde@ieseg.fr. This text should not be considered as an exhaustive textbook, but as
an introductory document, intended to help business school students to get familiar with basic concepts of
microeconomics. As such, they can improve their (future) managerial decision-making. I am grateful for the
comments that I received from colleagues and in particular acknowledge the support of prof. Cherchye, as this
document is highly inspired by and contains direct translations from the KU Leuven course documentation
of Markets and Prices (Cherchye, 2017). In turn, Markets and Prices is based on the textbook of Decoster
(2017). For a comprehensive introductory economics textbook, we refer to e.g. Mankiw (2014). For a
complete intermediate economics textbook, we refer the reader to e.g. Varian (2014).

1
science. But first things first, throughout Imperfectly Competitive Markets, we thus presume
consumers to behave rationally and you will notice that we can gain many structural insights
on product differentiation, marketing, and managerial decision-making with the help of this
assumption.

• What does it mean that consumers strive for their self-interest? It means that they
want to buy products/services that are best in terms of pleasure, well-being, comfort,
etc. Stated differently, they maximize their utility.

• Which constraints are consumers facing? The main constraint of consumers is their
budget. Their consumption of different products/services should be affordable.

• Which product/service bundle will they buy? The bundle which is best in terms
of utility, but still is affordable. Technically speaking, this bundle is optimal as it
maximizes utility, under the budget constraint.

• What happens if the price of a salad increases? Price changes influence the budget
constraint of consumers. Like robots, consumers will re-optimize their product bundle
to maximize utility under the new budget constraint. Usually, a price increase for a
product goes together with lower consumption of the respective product. To gain more
detailed insights, we will introduce the concept of price elasticity.

• How many consumers are there in a market? Consumer theory starts from one con-
sumer that maximizes utility. As each consumer has different preferences (e.g. Kilian
prefers football over music while Angèle prefers music over football), the demand for a
product can be described in terms of (i) a representative consumer that faces a utility
optimization problem, (ii) aggregation of the utility-maximizing behavior of various
consumers. In the following, we will consider the demand function as the relation
between price p and demand q, covering various consumers with heterogeneity in pref-
erences.

1.1 Price elasticity

As we will see below, in markets wherein consumers are price insensitive, firms more often
have the potential to make profits (at least in the short run). For (future) managers and

2
entrepreneurs, one successful strategy is to select and/or create a market with so-called price
inelastic demand. Question: are consumers more sensitive to price increases of iPhones or
pizzas?

To understand price sensitivity and its relation to market forms and market power, we
introduce the concept of price elasticity. Price elasticity pi measures the relative change in
demand for a good i, ∆qi /qi , after a relative change in the price of that good. Usually, price
elasticity is negative (i.e., p < 0), meaning that a relative price increase of a good implies a
relative demand decrease for the good. As percentage changes are a very good approximation
of relative changes, we can easily interpret price elasticity as the percentage change in
demand after a percentage change in price. Formally, price elasticity is given by:
∆qi
qi %∆qi
pi = ∆pi
≈ . (1)
pi
%∆pi

When price elasticity is in absolute value lower (higher) than one, we note the price elasticity
for the good as inelastic (elastic). Perfect price elasticity occurs when |p | = ∞. Perfectly
price-inelastic demand occurs when |p | = 0. Unitary price elastic demand occurs when
|p | = 1.

About price sensitivity of demand Example 1: Indila, a professional artist, wanted to

turn to an empty place after her last dance of the year. She decided to go on a voyage to the
desert of Australia. She had the bad luck of having leakage in her water bottle in the middle
of her 10-day desert hike. Her numerous S.O.S. signaling attempts remained unanswered
and she noticed on day eight that if she would not be able to obtain drinking water that
day, she would die that evening. Luckily, in the middle of the desert, she found a shop: The
desert water shop, a new start-up, with a labeled price of 1 euro for a bottle of water. Of
course, she is willing to pay this amount for a bottle of water, but when arriving at the shop,
the owner (who had read a microeconomics textbook) was just increasing the price to 1000
euro. Questions: Do you expect that she will still buy the bottle of water? Would you say
her demand is (close to) perfectly inelastic or perfectly elastic?
Example 2: Stromae wants to exchange euros for dollars for a trip to the US. For simplicity,
presume that the world market exchange rate is 1 dollar for 1 euro. In one of the many

3
currency exchange platforms, named All The Same, you can obtain 2 dollars for 1 euro.
How many euros would Stromae exchange on this specific platform? What if on All The
Same, you could only obtain 0.5 dollars for 1 euro? Question: In this kind of market, would
you say price elasticity is (close to) perfectly inelastic or perfectly elastic?

Real-world examples Table 1 shows examples of price elasticity. For example, a price
increase of apples of 1 percent goes together with a demand decrease of 1.159 percent. As
the price elasticity of apples is larger than one, we can conclude demand is elastic for apples.
Questions: if the government wants to reduce smoking behavior by increasing the price of
cigarettes, based on the numbers in Table 1, would you expect this strategy to be effective?
Can you relate the price elasticity estimates for health care to the societal benefits of public
health care?

Table 1: Price elasticity of demand. Source: Allen et al. (2013), Roquebert and Tenand
(2017), Auray et al. (2019)
Good/service Price elasticity
Apples (U.S.) -1.159
Lettuce (U.S.) -2.58
Beer and malt beverages (U.S.) -2.83
Cigarettes (U.S.) -1.107
Gasoline - short run (Canada) -0.01 to -0.2
Gasoline - long run (Canada) -0.4 to -0.8
Child care (North America) -0.570
Government health care (Kenya) -0.100
First-class US-Europe airline travel -0.45
Regular economy US-Europe airline travel -1.30
Home care for the disabled elderly (France) -0.4
Electricity (private households, France) -0.8

Price elasticity relates to the slope of the inverse demand function (i.e., the function that
stipulates how p depends on q).1 In Figure 1, demand which is perfectly elastic (|p | = ∞),
1
To estimate price elasticity, researchers often rely on an iso-elastic demand function, meaning that the
price elasticity does not vary with q. An iso-elastic demand function has a linear relationship between the
log of p and the log of q, as percentage changes of p and q are very similar to unit changes of the logs of p
and q.

4
perfectly inelastic (|p | = 0), elastic (|p | > 1) and inelastic (|p | < 1) is shown.

Figure 1: Price elasticity: graphical representation

1.2 Market forms

In this section, we describe the main characteristics of the four most important market
forms: monopoly, oligopoly, monopolistic competition, and perfect competition. All of these
market forms have in common that there are many buyers.2 We will start with a discussion
of the pure market forms of perfect competition and monopoly, whereafter we will discuss
the realistic market forms of oligopoly and monopolistic competition.

Pure market forms In the case of perfect competition, there are many suppliers and
buyers. In the case of monopoly, there is only one supplier (and many buyers). In short, if
the final product market is characterized by perfect competition, the firm is a price taker :
the market price is unaffected by the individual firm’s production decisions. Differently put,
the firm is confronted with perfectly elastic demand at the prevailing market price.
2
Discussion of market forms with only a few or one buyer (e.g., monopsony, bilateral monopoly) go beyond
the scope of this course.

5
Conversely, if the firm is a monopolist (serving the entire market), the relevant demand curve
for the firm will be the declining market demand curve. In this case, the market price is
influenced by the production decisions of the individual firm, which is the price setter.

In both market forms, we presume that the traded good is homogeneous and both market
parties have complete information (regarding both the price of the good and the quality).
These pure market forms are rare in practice but are very relevant as their study already
makes it possible to gain insight into the effects of certain market conditions (such as market
power ; see below). Moreover, the perfect competition outcome can under certain conditions
be considered as the best possible from a societal welfare-maximizing viewpoint; therefore
perfect competition is by policy makers often regarded as a reference point against which we
compare other market structures.

The main characteristic of a perfect competition situation is that buying and selling
decisions by individual buyers and sellers have no effect whatsoever on the price realized in
the market. We can therefore best imagine this market form as a collection of very many
small companies that are responsible for the supply (of a homogeneous product) while there
are many individual consumers on the demand side. Suppliers (as well as the consumers)
are price takers: each company only accounts for a fraction of the total supply, so offering
less or more does not influence the price. The price for the individual firm is thus given
exogenously by the intersection of the market demand curve and market supply curve; this
price remains the same regardless of the quantity offered by the individual firm. Demand
for the goods of the firm is perfectly elastic.
At the market price (e.g., 15 euros) the demand is infinitely large. The firm can sell as many
quantities as wanted, but will usually not sell extremely high quantities as production scale
increases usually correspond with increases in marginal and average costs.3
If the company charges more than the market price, then no consumer will buy from this firm.
The consumers, presumed to have no transportation costs and to have perfect information,
know that there are plenty of other firms that sell the same good at the market price. It is
thus not optimal for consumers (in terms of utility maximization under a budget constraint)
to spend more than needed. The option to charge less than the market price is also not
3
Marginal cost is the additional cost of increasing production with a very small unit. The average cost is
the total cost divided by the number of quantities produced.

6
interesting since the individual company can still sell everything at the market price.
In a perfectly competitive market, it is optimal for a profit-maximizing firm to
produce and sell exactly the number of units whereby selling price p equals the
additional costs of creating an additional unit MC (p = M C; in this case equalling
the additional revenue of selling one additional item). This is intuitive, as:

• surpassing this point would imply lower profits as additional costs would exceed addi-
tional revenues,

• producing less than this point is also not optimal from a profit maximization viewpoint,
as additional revenues corresponding with a production increase would in that case be
higher than the corresponding additional costs.

From the above, it is clear that perfect competition only occurs when very specific conditions
are met simultaneously. These conditions are:

• Market atomism: individual actions (i.e. increasing or decreasing the price by an

individual firm) do not affect the market price.

• Perfect information: consumers know the quality of the product and the prices of all
suppliers, and the producers know the buyers’ willingness to pay.

• Homogeneity: all companies sell a product that consumers consider identical; the goods
are therefore perfect substitutes for the consumers.

• Free entry and exit: any outsider can start production in the relevant sector whenever
he/she wishes, and any company can stop production and leave the industry whenever
it wishes.

Monopoly as a market form is characterized by one supplier who supplies the entire mar-
ket with a product for which there are no good substitutes. The monopolist, therefore, has an
economic dominant position, because there are no replacement options for buyers/consumers.
We say that the monopolist has market power ; see further. This is an important difference
from the perfect competition market form, where firms have no market power. The mo-
nopolist has market power in the sense that he is a price setter: the firm determines the
final market price via the quantity produced. This market power is, however, limited by the

7
market demand curve: when it is declining (as usual), a smaller quantity can be sold at a
higher price. Thus, the firm’s revenues for different production quantities will depend on the
market demand curve. In addition, the profit-maximizing company must of course also take
into account the cost-side of profit maximization (i.e. the relationship between costs and the
quantity produced).

When a monopolist makes a profit, other companies will want to join. This entry would
lead to an erosion of profits. For a monopolist’s profits to last in the long run, barriers to
entry must exist that prevent other firms from being able or willing to enter the monopolist’s
market. The question of the causes of monopolies is thus reduced to a question of the causes
of these barriers to entry. We distinguish 4 types of entry barriers:

1. Technological Barriers: economies of scale leading to a natural monopoly. Usually, low

production quantity goes together with increasing returns to scale (implying lower-
ing average costs with q) while high production quantity corresponds with increasing
returns to scale (implying increasing average costs with q). If there are increasing
returns to scale for a wide range of production levels, it is possible that the demand
can be (almost) completely fulfilled by only one company at the perfect competition
equilibrium price (equalling the minimum of average costs). As only a small fraction
of demand can be fulfilled by a competitor, it will not be profitable to supply this
remaining demand. Moreover, the incumbent usually has a first mover advantage over
potential competitors (e.g. due to learning effects concerning technology, production,
etc.), hindering other firms to be profitable in the same sector. As there is only one
firm (that can be) active in the sector, the firm will behave as a monopolist and will
thus set the price.

2. Exclusive usage rights of production factors and legal barriers, e.g. as the exclusive
owner of a scarce resource (e.g. bauxite), or via the possession of technical know-how
(e.g. the secret recipe of Coca-Cola). Other companies can (partly) break through such
exclusivity by recycling used raw materials or designing counterfeit products. Imitation
is usually possible but is often prohibited by law (e.g. as the know-how is protected
by patents).

3. Strategic behavior of the monopolist: in addition to external (technological or legal)

8
 barriers, the monopolist can also create barriers itself. An example is a monopolist
that makes entry expensive by manipulating patents and technological knowledge; the
monopolist can fight patent disputes by potential rivals through expensive lawsuits.
Further, the monopolist can build a reputation of high quality through expensive mar-
keting campaigns, making new products appear unreliable. This means that newcomers
also have to carry out major advertising campaigns to convince the market of their
product; these additional costs can make entry not worth the effort. Important for the
effectiveness of internal barriers to preserve monopoly power is the credibility of the
threats made by the monopolist.

4. Network externalities: in many digital platforms, the value of a platform is dependent

on the number of people using it. This frequently leads to a winner takes all market,
as will be discussed in the master level course Managerial Economics.

Realistic market forms More realistic market structures, which are discussed further
below in detail, are oligopolistic (with a limited number of larger companies) and/or are
characterized by product variety (or heterogeneity) or incomplete information.4 In practice,
firms usually operate in a market in-between perfect competition and monopoly. In many
markets, at least one of the properties of perfect competition is not satisfied, without ending
up in a situation of monopoly. Some examples:
• Washing powder: the traded products are not homogeneous, both subjectively due to
differences in marketing and objectively due to differences in composition. In this case,
the market form is characterized by product differentiation.

• Smartphones: there are only a few firms that are competing in the market, implying
that the firm’s pricing and quantity decisions do affect the market conditions. Stated
differently, the condition of market atomism is not met and there is strategic interaction.
The market form for smartphones consists of a small number of suppliers and a large
number of buyers; we refer to this market form as oligopoly.
In oligopoly, firms have market power (i.e. they are not price takers), and can therefore
sell more by lowering the price. As there are only a few suppliers in the market, the
4
A discussion of the important concept of incomplete information goes beyond the scope of this intro-
ductory course.

9
oligopolist has to take into account the behavior of its rivals (i.e. the other suppliers
on the market), and the impact of its behavior on this rival behavior: the quantity that the
oligopolist can sell at a given price depends on the quantities of the other suppliers in the
market. In turn, the quantity supplied by the oligopolist determines the price the other
oligopolists can get for their products. A fundamental difference between the market form
oligopoly on the one hand and the market forms perfect competition and monopoly on the
other hand is the following: in monopoly and perfect competition, it is sufficient for firms to
consider only their individual cost structure and demand curve to determine their optimal
level of production (or: their supply). In an oligopoly, the firm must take into account the
behavior of the rival firms. Depending on the homogeneity of the traded product, one speaks
of a homogeneous or a heterogeneous oligopoly. A duopoly refers to a situation where there
are only 2 providers. Due to (legal, technological, etc.) barriers to entry, both in the short
and long run, only a few firms are supplying the market.

In monopolistic competition5 , there are many firms (and consumers) such that there
is no strategic interaction, there is perfect information and there is free entry/exit. As
such, many conditions of perfect competition are satisfied. The assumption of homogeneity
of products is however not met. Product differentiation is central to monopolistic
competition. To be specific, product differentiation occurs when different products meet
the same needs (and are therefore essentially comparable) but are nevertheless perceived
differently by the customers/consumers. Some examples of product differentiation are dif-
ferences between soft drinks, pizzerias versus burger joints, restaurants with Michelin stars,
different types of cars, fashionable clothes and items, etc. Each time, the different products
meet the same need, yet they are not perceived as identical by the consumer. It does not
matter whether those differences only exist in the eyes of the customer or whether there are
real differences. The fact that a particular product is perceived as unique to some extent
means that the demand curve for the product is no longer horizontal (or: perfectly elastic)
as it is under perfect competition. In other words, because of product differentiation,
each company has its own (downward-sloping) demand curve (with a finite price
elasticity). Thus, the firm is no longer a price taker in the market, but holds to a certain
5
This market form was introduced independently by the American economist E. Chamberlin (1899-1967)
and the British economist J. Robinson (1903-1983).

10
extent monopoly power (and is thus a price setter). Thus, under product differentiation, the
firm has greater market power. Because product differentiation implies market power, firms
will facilitate such product differentiation. This is exactly what advertising does: creating
a brand name and advertising campaigns serve to convince consumers of the uniqueness of
a brand (and associated product). By differentiating their goods in this way according to
quality, companies try to develop their own market to escape the price-taking straitjacket.

As stated before, it does not matter whether the perceived differences only exist in the
eyes of the customer or whether there are real differences. One of the most discussed effects
of advertising then concerns precisely its possible contribution to the creation of a certain
image. An image then means that a certain brand, in the eyes of the consumer, would
have a superior quality, a quality that is objectively not present. Such an image creates
an artificial differentiation; this decreases the price elasticity of demand, thus enabling the
brand concerned to have more market power. Some examples of strong image building:
beer brands (for some beers, in blind testing, most consumers cannot detect a difference),
some pharmaceuticals, the country-linked image of some products (such as shoes or pasta
for Italy), etc.
Other sources of product differentiation include geographic location and after-sales service.
For example, even though banks A and B may at first sight offer very homogeneous services
(e.g. the current account offered is essentially the same), bank A can still seem much more
attractive because this bank, for example, has a branch nearby. We then speak of geographical
product differentiation. In such a case, bank A can in principle charge a higher price than
bank B for the same service; the consumer will then weigh this price disadvantage for bank
A against the advantage of the proximity of a bank branch. An additional example of
geographical product differentiation relates to convenience stores: some consumers prefer to
pay a little more for a liter of milk in the convenience store than in the chain store outside the
city. Usually, product differentiation is multi-dimensional, making the empirical detection
of particular niches less straightforward. For example, hotel X has no swimming pool, but
does have a tennis court and is located close to the airport, while hotel Y has a swimming
pool and is located in the tourist center, but has no tennis infrastructure. Some consumers
will be willing to pay more for hotel X while others will prefer hotel Y.

Monopolistic competition thus contains elements of perfect competition as well as a

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monopoly.

• On the one hand, this market form exhibits monopoly characteristics. The supplier, like
any monopolist, has its own sub-market for the sale of its product because of product
differentiation. Stated differently, because of product differentiation, each supplier has
an (albeit limited) influence on the price (or: each supplier has a certain market power).
Thus, just as in the monopoly situation, the demand of the individual producer is not
perfectly elastic (as it is in perfect competition).

• On the other hand, this market form also exhibits perfect competition characteristics:
because there are many suppliers of a similar product, each supplier is relatively small
in relation to the total market. Consequently, there is no strategic interaction: because
there are so many producers, a price reduction by one producer has only a minimal
impact on demand for other producers, who will therefore not find it worthwhile to
react. This means that each firm will take into account only the demand for its own
product and its own cost development in making its output decision, as in perfect
competition. Moreover, as in perfect competition, there is free entry and exit: profit
attracts new companies and loss causes existing companies to leave the sector.

Free entry and exit mean that the short-term equilibrium is different from the long-term
equilibrium. In the long run, all production inputs are freely chosen by the firm, and firms
can enter or leave markets, while in the short run, the market and some production inputs
(e.g. capital, buildings) are fixed. In the short run, the equilibrium is determined for a given
number of producers, while the long-term equilibrium takes into account the consequences
of free entry (i.e., in the long run, the number of producers is variable). The difference
between monopoly and monopolistic competition is in the long run: more specifically, the
profits provoke the entry of new firms. This entry means there will be additional providers
of similar products. For example, if the ‘niche’ of an Irish pub is proven to be profitable in a
city, multiple similar pubs will be started. This additional supply of similar products affects
the demand curve of the product already present:

• demand for the product of the existing producer will decrease (i.e., an inward shift of
the demand function),

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 • demand will become more price elastic because more and more producers offer the
same product (i.e., the demand function becomes flatter).
This process continues as long as positive profit is made by the existing company. The
market only comes to rest when no more profit is made by the producers present (and there
is therefore no more incentive to enter). Contrary to monopolists and oligopolists, in
the long run, firms under monopolistic competition have no potential to make
a profit. From a managerial viewpoint, it is thus important to constantly innovate, apply
marketing, and thus pursue product differentiation under monopolistic competition, to avoid
the long-run solution of no profits. To summarize, in Table 2, the main differences between
market forms are characterized:

Table 2: Characteristics of the four main market forms, based on Allen et al. (2013)
Market Examples Producers Product Market Barriers
form power to entry
Perfect Some agricultural Many Homogeneous No No
competition sectors

Monopolistic Retail Many Differentiated Yes No

competition trade

Oligopoly Oil, steel, Some Homogeneous or Yes Yes

tech. differentiated

Monopoly Public utilities One Unique product Yes Yes

1.3 Market power

Market power is the ability of a firm to have a substantial influence on market prices. It thus
relates to price-setting behavior. Market power exists when the firm’s profit-maximizing price
p∗ (q ∗ ), corresponding to a profit-maximizing production quantity q ∗ , exceeds the marginal
cost M C(q ∗ ); when markups µ exceed one:

p∗ (q ∗ )
µ= (2)
M C(q ∗ )

The extent of market power indicates the potential that firms have to make a profit.
It follows from the foregoing that a situation characterized by market power, results from

13
a departure from the conditions of perfect competition. Price elasticity and market
power are inversely related. |p | = ∞ corresponds with no market power (µ=1), while
|p | = 0 corresponds with extreme market power (µ = ∞).6 In real-world examples of a
monopoly, oligopoly, and monopolistic competition, there is at least some degree of market
power: 0 < |p | < ∞. All together, we can conclude that the slope of the inverse demand
function (i.e., how p depends on q) determines market power and thus the potential of firms
to make profits.
The degree of market power can within each of the imperfect market forms vary across
settings, countries, and over time. While there is no consensus on the optimal strategy to
measure markups, empirical research shows vast evidence of rising global market power in
more recent years. As illustrated in Figure 2, from De Loecker et al. (2020), market power
is sharply rising in recent years. Further, the authors note that also the distribution of
markups is changing. The increase in markups comes from a small minority of firms that
are increasingly setting very high markups, rather than from an increase in markups by all
firms. Last, the figure shows that the rise of market power is not only due to U.S.-based
firms. Also in Europe and Asia, we find rising markups in recent years.
6
When using the Lerner index of market power, we can algebraically show this inverse relation. It can
be proven that (p∗ − M C(q ∗ ))/(p∗ ) = |(p )−1 |.

14
 Figure 2: The rise of market power in different continents, De Loecker et al. (2020)

Is market power bad? While market power leads to Pareto inefficiency7 , the answer to
the question of whether any deviation from perfect competition only leads to welfare losses
is nuanced. It is particularly excessive market power which is shown to be welfare destroying
and which is shown to be the basis of the lowering revenue share of labor (implying lower wage
and/or lower employment levels). Some market power is warranted. Product differentiation
(under monopolistic competition or oligopoly) is valued by consumers. In addition, it should
also be noted that the possibility of monopoly power and product differentiation under
oligopoly can stimulate innovation.
7
Pareto-efficiency is the situation whereby allocation of resources is fully efficient and whereby you can
not improve one agent her state without lowering the state of another agent. Strictly defined static societal
welfare is the sum of consumer and producer surplus. This total surplus is maximal under perfect competition
and is measured as the area between the inverse demand curve and the marginal cost curve to the left of
their intersection. Perfect competition is Pareto-efficient and optimal in terms of static societal welfare as
total surplus is maximal. Caution is however needed, as distributional concerns, the utility of variation, and
technology accumulation are not taken into account in this definition of static societal welfare maximization.

15
One common cause of a monopoly is that the monopolist has patents. The rationale for
patents is that they provide incentives for investment in research and development (R&D),
thereby stimulating innovation activities: after all, for every innovative company, there is a
danger that other companies will imitate the (costly) innovation (for free) so that there are
too few innovations if they are left to the free market. In a sense, innovations can therefore
be regarded as a public good. Patent legislation provides a temporary monopoly to innovative
companies: this temporary monopoly makes it possible to recover the research costs incurred
and to compensate for the risk incurred. Such rewards for innovative activities thus stimulate
investment in R&D.
The importance of innovation fits in a dynamic perspective on the efficiency of an economy.
The static analysis does not address innovation: the result that perfect competition leads
to a Pareto-efficient result presupposes a given, constant technology. Such static analysis,
in a sense, implies a short-term perspective on the efficiency of an economy. Innovation
activities have to do with the dynamic efficiency of an economy: innovations imply a new,
better technology, and thus an expansion of the possibilities of an economy. Market power
can thus lead to better or cheaper products being offered in the longer term. In practice,
therefore, the economy must find a good trade-off between static and dynamic efficiency.
These innovation-based arguments hold especially when the threat of entry is real: when the
monopolist has to fear accession, it has every interest in not resting on its monopoly laurels
but effectively trying to maintain its monopoly position through all kinds of innovations.
Conversely, when entry is impossible, the monopolist has much less to gain from innovation,
and there is a risk that protected firms will simply eat up their monopoly profits.

1.4 Societal discussion: Market power and big-tech companies

Nowadays, more than ever, with the rise of big-tech firms and their anti-competitive at-
tempts, policy action that goes against anti-competitive conduct is warranted. For readings
on this topic, see www.ieseg-online.com.

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1.5 Exercises on 1. Market forms and market power
These applications are intended to help students develop their economic skills concerning
imperfectly competitive markets. The student is advised to exercise his/her economic skills
by solving these questions at home. Some of these questions will be discussed in class. The
labeling BASIC/INTERMEDIATE can help you decide whether to go for the BASIC MCQ
or INTERMEDIATE MCQ during the continuous evaluation assessments.

Question 1.1 (BASIC): True or False: In a monopoly and under perfect competition,
it is sufficient for a company to consider only its individual cost structure and the demand
curve when determining the optimal production level. This is not the case when firms are
competing under oligopoly.

Question 1.2: Describe the attributes of monopolistic competition. How is monopolistic

competition like monopoly? How is it like perfect competition?

Question 1.3 (BASIC): True or False: Because of product differentiation in a setting

with many firms, each company has its own demand curve.

Question 1.4 (BASIC): True or False: In a setting with many firms, product differen-
tiation is a promising strategy to ensure at least some market power.

Question 1.5 (BASIC): True or False: A strong image will imply that the price elas-
ticity will increase in absolute terms, thus making it possible that the brand concerned can
receive a premium over the normal price.

Question 1.6 (INTERMEDIATE): Which of these statements is TRUE?

1. Because of product differentiation in a setting with many firms, each company has its
own demand curve.

2. The lipstick market can usually be considered as a market with monopolistic compe-
tition.

3. Legal constraints are an example of a barrier to entry in a monopolistically competitive

market.

17
 (a) 1, 2 are TRUE.

(b) 1, 3 are TRUE.

(c) 2, 3 are TRUE.

(d) All are TRUE.

(e) None are TRUE.

Question 1.7: Classify the following markets as (close-to) perfectly competitive, mo-
nopolistic, oligopolistic, or monopolistically competitive, and explain your answers. Note
that for some markets, the classification to a market form is open for discussion.

(a) Wooden HB pencils.

(b) Bottled water.

(c) Copper.

(d) Strawberry jam.

(e) Lipstick.

(f) Retail market for water and sewerage services.

(g) Economics textbooks.

(h) Mobile phone producers.

(i) Mobile phone operators.

(j) Restaurants in a large city.

(k) Breakfast cereal.

18
2 Strategic interaction under oligopoly
We start this section with some observations: the oligopolist has market power (i.e., is not
a price taker), and can therefore increase the price without losing all customers. Further,
the oligopolist takes into account the behavior of its rivals (i.e., the other providers on the
market), and the impact of its own behavior on these rivals.

• The quantity that the oligopolist can sell at a given price depends on the quantities of
the other suppliers in the market.

• The oligopolist’s offered quantity influences the price that the other oligopolists can
get for their products.

A fundamental difference between the market form of oligopoly on the one hand and the
market forms of perfect competition, monopoly, and monopolistic competition, on the other
hand, is the following: in the other market forms, it is sufficient for firms to consider only
their individual cost structure and the demand curve to determine their optimal level of
production (or: their supply). In an oligopoly, the firm must take into account the behavior
of the rival firms.

To study the decision problem of a firm in an oligopolistic market, for the sake of simplic-
ity, we consider in subsection 2.1 oligopolistic markets with only 2 suppliers: a duopoly. In
reality (see, for example, the banking or smartphone market), there are usually more than
two companies active in the market. Understanding the duopoly situation is a first step
towards understanding these more realistic (and more complicated) situations.
To start, we limit ourselves to a market in which the traded products are considered by
customers as fully interchangeable (e.g., the market for oil and the market for detergents).
In such cases, we speak of a homogeneous oligopoly (and in the case of 2 providers of a
homogeneous duopoly). In reality, we often have to deal with a heterogeneous oligopoly: in
such a case the suppliers try to differentiate themselves somewhat from their rivals through
product differentiation, and the traded products are not perfect substitutes. In the case of
product differentiation, each product has its own demand curve and price (see subsection
2.3).

19
2.1 Strategic interaction: Game theory
To find the optimal profit-maximizing strategy of a firm in a duopoly, we need to take into
account the interdependence between the two firms: what is optimal for the 1st duopolist
depends on what the 2nd does; but the behavior of the 2nd duopolist also depends on what
the 1st does, etc.
Such mutual influence is a typical element that is dealt with in game theory. As we will see,
in game theory one speaks of an equilibrium situation when each player chooses the best
possible strategy given the chosen strategy of the other players.

Game theory refers to the everyday meaning of a game (such as a game of chess) in which
the players take certain actions, taking into account the reactions of the other players. Some
examples of game-theoretical situations in an economic context include pricing of companies
in an oligopoly situation, wage negotiations between employers and employees, negotiations
between countries regarding internationally set standards (such as the Maastricht standards,
the Kyoto standards, the Paris agreement standards, etc.). Game theory provides a coher-
ent framework for mapping the interactions between the various rational individuals (the
players). In what follows, we introduce some basic elements of game theory. Some concepts:

• A game: a situation where the decision-makers take into account interdependence

• The players: the decision-makers

• Pure strategies: the possible actions of the players. In principle, the player can in a
continuous fashion choose e.g. the output level. But throughout this course, we make
the simplifying assumption that choices are discrete: only a limited number of e.g.
output levels can be chosen.8

• A payoff matrix : this gives the outcomes for each player and each possible combination
of strategies for the different players.

In the analysis of a game, we make the following assumptions about the behavior of the
players/decision-makers:
8
For a detailed overview of quantitative (pure and mixed) strategies in simultaneous and sequential games,
and the respective implied Cournot-Nash and Stackelberg-Nash equilibria, we refer to Varian (2014).

20
 • The players are supposed to be individualistic: each player is driven by self-interest and
strives for the best possible outcome for herself (where that outcome can be expressed
in e.g. profit levels or sales).

• The players are supposed to be rational and every player is supposed to understand
the rules of the game.

• The players are presumed to play a one-shot simultaneous game: they will only play
the game once and make decisions at the same moment.9

The homogeneous duopoly with output competition fits perfectly into a game-theoretic
framework. In this setting, there are two players, which are the two duopolists, and two
possible strategies: (1) maintain the cartel agreement and (2) break the cartel agreement.
In the following, we narrow the definition of a cartel agreement to: multiple firms agree to
cooperate and coordinate on quantity and/or price decisions, to maximize the sum of the
profits of the two firms. As such, they will make production and price-setting decisions as if
they were one merged company with a monopoly. The duopolists thus play a game:

• The players are the two duopolists

• A strategy of each player consists in choosing a certain output level. Maintaining the
cartel output level implies a choice for a low output level (because if both players choose
to limit production, the market price will be higher). Breaking the cartel agreement
implies a choice for a high output level.

• The outcome for each player is a certain level of profit; this profit level for each player
depends not only on their own strategy, but also on the strategy of the other player. For
example, the market price (and thus the profit) is partly determined by the strategy
(i.e. the output level) of the other player/duopolist.

The essential question in any game situation is whether we can give any indication of the
most likely outcome of the game. As a starting point to understand the strategic interaction
between oligopolists, we will move away from firms for a moment and answer the question
of the most likely outcome based on a classic example: the so-called prisoner’s dilemma.
9
In master-level courses such as Managerial Economics, sequential and repeated games will be discussed.

21
2.1.1 The prisoner’s dilemma

In the prisoner’s dilemma, we study the behavior of criminals under interrogation by the
police. 2 individuals committed a robbery, in which people were injured. Both individuals
were arrested but the police have no evidence; the police can only prove that the used
weapons belonged to the 2 arrested individuals. The two individuals are kept separate and
are interrogated (so they have no opportunity to confer). The two individuals (the players)
now have two choices (two possible pure strategies):

• Confess (indicated by s1 for individual 1 and by t1 for individual 2)

• Deny (indicated by s2 for individual 1 and by t2 for individual 2)

The outcomes are as follows:

• If both continue to deny, they will be sentenced to illegal possession of weapons; this
implies a prison sentence of 2 years for both.

• If they both confess, they will be convicted for armed robbery with wounded civil-
ians. This implies a 10-year prison sentence, but the prosecutor will plead extenuating
circumstances that will get them both off with 8 years in prison.

• If only 1 of the 2 confesses, the other is sentenced to 10 years, while the ‘snitch’ gets
only 1 year because of his cooperation.

The different outcomes are represented in the following payoff matrix:

Table 3: Prisoner’s dilemma

Prisoner 2
Confess (t1 ) Deny (t2 )
Prisoner 1

Confess (s1 ) (8 years; 8 years) (1 year; 10 years)

Deny (s2 ) (10 years; 1 year) (2 years; 2 years)

It is not clear at first sight which strategy is the best for each prisoner. If the prisoners
agree to deny just before the arrest, then each prisoner will benefit from breaking this
agreement (and thus making confessions) while the other sticks to the agreement. However,

22
this is a bold strategy: if the other also confesses in the meantime, the prison sentence will
be increased to 8 years. On the other hand, continuing to deny is also not without risk,
because if the other confesses in the meantime, the denier will be sentenced to ten-year
imprisonment.
However, when considering the payoff matrix of the prisoner’s dilemma in more detail, it is
relatively easy to predict the outcome: there are so-called dominant strategies. A dominant
strategy for a player is a strategy that always produces the best result for that player,
regardless of what the other player does. If there is a dominant strategy, then all other
strategies are dominated strategies.
In the previous prisoner’s dilemma, the dominant strategy for both players is to confess. We
show this for prisoner 1:

• If prisoner 2 confesses, it is better for prisoner 1 to confess: this will get him a prison
sentence of 8 years, compared to 10 years if he denies.

• If prisoner 2 denies, it is better for prisoner 1 to confess: this gets him a prison sentence
of 1 year, compared to 2 years if he denies.

In the same way, we can deduce that confession is also a dominant strategy for the second
prisoner. So, in the end, both prisoners will confess.

The conclusion that both prisoners will eventually confess can also be reached by explicitly
referring to their rational behavior : the rational second prisoner will (based on an analysis
similar to the one we performed above) come to the conclusion that the first prisoner will
confess. Consequently, the second prisoner can neglect or ‘delete’ the second row of the
payoff matrix (with the dominated strategy deny) (i.e., he only considers the outcomes of
his possible strategies for the scenario where the first prisoner confesses). His best possible
strategy is to confess himself. Note that this result is independent of the order in which we
go through the dominated strategies: we get the same result if we let the first player delete
the second column, which corresponds to the dominated strategy t2 for the second player.

The existence of dominant strategies leads to the expected solution of the game. In the
prisoner’s dilemma, the expected solution is (s1 , t1 ). Importantly, this expected solution
does not have to be ideal. In the prisoner’s dilemma, the expected solution is a sentence of

23
8 years for both prisoners; while this sentence is only 2 years if both keep to the agreement
to deny. This is a central insight of game theory: the context in which economic agents (or
the players) act contains so many feedback effects that the blind pursuit of self-interest
does not necessarily lead to the best outcome for the individual himself ! In the
prisoner’s dilemma, the pursuit of self-interest leads to an individual player’s sentence of
8 years, which is higher than the 2-year sentence associated with the cooperative solution
where the previous agreement is kept.

2.1.2 Homogeneous duopoly: Equilibrium in dominant strategies

In this subsection, we return to the economic discussion of a homogeneous duopoly. In some

cases, we can also find an equilibrium in dominant strategies for the dilemma of duopolists
whether to break or maintain the installed cartel agreement. In Table 4, we illustrate a
one-shot simultaneous game between duopolists, whereby each duopolist has two pure and
discrete strategies :

• maintaining the cartel agreement, corresponding to a production quantity of 400,

• breaking the cartel agreement, corresponding to a higher production quantity of 600.

The sum of profits is highest when both maintain the cartel agreement. Under the cartel,
they maximize the sum of profits as if they were merged into a firm with monopoly power.
When both break the cartel agreement, this not only lowers the sum of profits but as well the
individual profits of each duopolist. Despite cell (break, break) being a suboptimal outcome
for both duopolists, both duopolists are expected to choose break as it is the best strategy,
irrespective of the chosen strategy of the other duopolist. For example for the first duopolist,
breaking the cartel agreement is optimal both when the second duopolist maintains or breaks
the cartel agreement. Cell (break, break) is thus an equilibrium in dominant strategies.

Table 4: A homogeneous duopoly with an equilibrium in dominant strategies

Duopolist 2
Maintain Break
Maintain (4000; 4000) (2900; 4500)
Duop. 1

Break (4500; 2900) (3000; 3000)

24
2.1.3 Homogeneous duopoly: Nash-equilibria

Often, there is no dominant strategy for the players: the optimal strategy of a player often
depends on the chosen strategy of the other player. In general, the best choice for each
duopolist will depend on what the other is doing. For example, in the game-theoretical
setting, as shown in Table 5, there is no equilibrium in dominant strategies. For the first
duopolist, it is optimal to choose to maintain when the second duopolist chooses to maintain.
If the second duopolist chooses to break, it is optimal for the first duopolist to choose break.

In the absence of a dominant strategy, one expected solution or multiple possible solu-
tions can often be characterized in terms of the concept of Nash equilibrium. In our examples
concerning the prisoner’s dilemma and homogeneous duopoly, both players always have an
incentive not to keep to the agreement. This means that the agreed-upon state does not
meet the essence of what we call an equilibrium, i.e. a state in which there is no longer
any tendency to deviate from it. The Nash equilibrium is an expression of that equilibrium
character in game-theoretical situations: it concerns a combination of strategies where no
player wishes to change his strategy given the expected strategy of the other players. After all,
the player will change strategy as long as he has an interest in doing so, given the strategy
of the other players; and a balance means a player doesn’t want to change his strategy.
The Nash equilibrium is a more general concept than the equilibrium in dominant strategies:
an expected solution consisting of dominant strategies is always a Nash equilibrium. How-
ever, the converse is not necessarily true: a Nash equilibrium is not necessarily an expected
solution consisting of dominant strategies. For example, in Table 4, cell (break, break) is an
equilibrium in dominant strategies and thus also a unique Nash equilibrium.

Nash equilibria do not need to be unique. The payoff matrix in Table 5 gives rise to two
Nash equilibria: cells (maintain, maintain) and (break, break). In both cells, no player has an
incentive to change his strategy, given the strategy of the other player. Importantly, if there
is no unique Nash equilibrium, there is no expected solution in the absence of coordination.

25
 Table 5: Homogeneous duopoly with Nash equilibria
Duopolist 2
Maintain Break
Maintain (4000; 4000) (2900; 3900)

Duop. 1
Break (3900; 2900) (3000; 3000)

With the concept of Nash equilibrium, we can find equilibria for more complex payoff
matrices, e.g. with a discrete choice between 4 output levels. In the following Table 6, the
rows indicate the strategies that the first duopolist can choose; we denote them as s1 to s4 .
The columns then indicate the strategies that the second duopolist can choose; we denote
them as t1 to t4 .
By applying the concept of Nash equilibrium to this 4-by-4 payoff matrix, we can find all
the possible solutions. Most of the combinations of strategies are not Nash equilibria. For
instance, the combination (s1 , t1 ) is not a Nash equilibrium: given the choice of duopolist 2
(i.e. t1 ), duopolist 1 has every interest in changing his strategy to s3 or s4 . However, the same
reasoning applies for the combination (s3 , t1 ), which is therefore not a Nash equilibrium, and
for other combinations. In the payoff matrix, there are ultimately only 3 Nash equilibria,
namely (s3 , t2 ), (s2 , t3 ) and (s3 , t3 ): in none of these cases, the player has an interest in
changing strategy given the other player’s strategy; the players are therefore in an equilibrium
situation.

Table 6: game-theoretical setting with 4 strategies per player

Strategies for duopolist 2
t1 t2 t3 t4
Strategies for duopolist 1

q2 = 200 q2 = 400 q2 = 600 q2 = 800

s1 q1 = 200 (3000;3000) (2500;5000) (2000;6000) (1500;6000)
s2 q1 = 400 (5000;2500) (4000;4000) (3000;4500) (2000;4000)
s3 q1 = 600 (6000;2000) (4500;3000) (3000;3000) (1500;2000)
s4 q1 = 800 (6000;1500) (4000;2000) (2000;1500) (0;0)

26
2.2 Societal discussion: The benefits of cooperation, social norms,
and contracts in the pursuit of climate change reduction and
societal well-being
The main insight from the prisoner’s dilemma is that blind pursuit of self-interest does not
necessarily lead to the best outcome for the respective player. This insight is general as it
applies to many game-theoretical settings related to e.g. (illegal or legal) cartel agreements
between duopolistic firms, restrictions in oil production by Opec countries, free-riding in
group projects, but also to agreements to reduce CO2 emissions (e.g. the Kyoto and Paris
agreement).

To better understand the societal implications of game theory, let us return to a classical
example of a game-theoretical setting with 2 Nash equilibria (of which the duopoly game
as shown in Table 5 is an example): the battle of the sexes. In the battle of the sexes, a
stereotypical heterosexual couple has to decide on a night out: the man prefers to go to
football while the woman prefers the cinema. Both would rather be in each other’s company
than go to their preferred activity alone.

Table 7: Battle of the sexes

Mrs.
Football (t1 ) Cinema (t2 )
Mr.

Football (s1 ) (3; 1) (0; 0)

Cinema (s2 ) (0; 0) (1; 3)

There are no dominant strategies. There is no dominant strategy for Mrs.: if Mr. chooses
football (s1 ), then Mrs. chooses football (t1 ); however, if Mr. chooses the cinema (s2 ), then
the optimal strategy for Mrs. is to also choose to go to the cinema (t2 ). In the same way, we
can show that there is no dominant strategy for Mr. However, there are two Nash equilibria:
namely (s1 , t1 ) and (s2 , t2 ): each time neither player can improve by choosing a different
strategy for the given strategy of the other player. This example further illustrates 3 things:

• The importance of coordinated strategies,

• The importance of simultaneous choice vs. sequential choices,

27
 • The fact that a Nash equilibrium doesn’t have to be unique.

In the battle of the sexes, the payoffs are positive for both parties and a Nash equilibrium
is only reached if both parties make the same choice (namely, both Mr. and Mrs. both
choose football or the cinema together). Whether they will end up in one of the two Nash
equilibria is uncertain. An important and relevant application of this is the choice between
different ecological standards: a Nash equilibrium is only achieved if different players choose
the same standards. In Table 8, we apply the battle of the sexes idea to the case of CO2
emission standards. Each country has the choice to reduce or not reduce CO2 emissions.
The choice to reduce CO2 emissions impacts both the economy (negatively in the short run)
and the ecology (positively, especially if both pursue this strategy). Without cross-country
cooperation, there are two possible solutions: (reduce, reduce) or (not reduce, not reduce).
None of these two possible solutions is the expected solution.

Thus how can we ensure that the countries will reach the superior Nash equilibrium
corresponding with CO2 emission reduction, even if we cannot enforce agreements compul-
sively?10

• A promising first avenue is to change the game into a sequential game: sequential
choices make it easier to arrive at a Nash equilibrium (i.e., a coordinated solution).
For example: if the gentleman first chooses football, then it is in the best interests of
the lady to subsequently adapt to that choice; and analogously, the man will choose
the cinema if the woman can choose it first. This also illustrates the importance of
being the first to choose (i.e., the first mover advantage): who can choose first can
sometimes influence the opponent’s choice. If e.g. the European Union moves first to
an ecological production model in line with the European green deal, it can influence
e.g. US-based and Asia-based countries and firms to follow a similar path.

• A second avenue is the introduction of cooperation, e.g. in the form of e.g. a bi-
lateral agreement. Even when the agreements are not enforceable, in this specific case,
10
We discuss the branch of game theory that is referred to as non-cooperative game theory: it is assumed
that binding agreements are not possible. Another branch of game theory, which assumes that the partici-
pating parties will implement the collective agreements, is then referred to as ‘cooperative’ game theory. To
motivate the binding nature of the agreements, one refers, for example, to the power of habits, legislation,
or all kinds of punishments.

28
 cooperation would lead the two countries to the desirable Nash equilibrium implying
climate change reduction.

• Another path to prevent that the suboptimal equilibrium of high pollution comes reality
is the introduction of social norms (e.g. the conviction that one should never break an
agreement). In this way, like an enforceable and binding agreement, the (cooperative)
outcome can be imposed from the outside by social norms, to lead to a better outcome
for the players.

Table 8: Reduction of CO2 emissions: a game-theoretical example (scenario 1)

Country 2
Reduce Not reduce
Country 1

Reduce (8; 8) (1; 3)

Not reduce (3; 1) (2; 2)

Above, we represented the strategies to reduce or not CO2 emissions in the form of a
battle of the sexes example with two Nash equilibria. For many multi-lateral agreements such
as the Paris agreement, we can presume that the sociably desired outcome (reduce, reduce)
is not an equilibrium. Table 9 represents the dilemma to reduce or not CO2 emissions in
the form of the prisoner’s dilemma, with the unique Nash equilibrium being the suboptimal
combination of strategies (not reduce, not reduce). In such cases, non-binding agreements
often do not result in actual and considerable CO2 emission reductions, but end up in false
promises and disillusionment. As many multilateral agreements between countries serve
society, an important question is therefore how can it be ensured that the various members
adhere to the negotiated agreement? In short, if you can’t win the game, change the
rules. Stated differently, if the desired solution is not an equilibrium, the best way out is to
change the structure and pay-offs of the game: the mechanism design. For example, it is not
by coincidence that the police interrogate separately and simultaneously alleged criminals,
it is because this design of interrogation makes (confess, confess) the expected solution. In
the same spirit, climate change agreements between countries are best designed in such a
way that defection becomes very costly (e.g. by CO2 taxes, consumer action, raising social
awareness, etc.); thus by changing the pay-offs. Making defection costly implies lowering the

29
pay-offs for unilateral defection, for our example from 10 to e.g. 3. As such, we return to
the setting as given in Table 8, making (reduce, reduce) a possible Nash equilibrium that
can be reached by non-enforceable cooperative agreements or sequential choice.

Table 9: Reduction of CO2 emissions: a game-theoretical example (scenario 2)

Country 2
Reduce Not reduce
Country 1
Reduce (8; 8) (1;10)
Not reduce (10; 1) (2; 2)

2.3 Product differentiation and price competition

Product differentiation often occurs in an oligopolistic market form. Examples include the
smartphone market, the market for personal computers, the car market, etc. In such a
case, the various providers will behave strategically; the different providers will take the
behavior of the other providers into account when determining their own behavior. More
specifically, the different providers will take each other into account in determining the output
level, but also the price and the positioning of the product (i.e., the product differentiation
itself). Product differentiation in combination with oligopoly is one of the most realistic
market forms. Earlier we discussed game theory concerning discrete quantity decisions for the
analysis of an oligopolistic situation with a homogeneous product. In the discussed model,
the different suppliers compete with each other via the quantity produced as a strategic
variable. In this subsection, we will discuss the relationship between product differentiation
and price competition via the paradox of Bertrand and Hotelling’s model.

2.3.1 The paradox of Bertrand.

This paradox implies that a homogeneous duopoly with price as a strategic variable (price
competition), leads to the same equilibrium price and quantity as we would obtain under
perfect competition (even though there are only two providers!). The reasoning is as follows:
since the product offered by both companies is identical, only the price counts for the buyer;
all consumers will therefore buy from the supplier that charges the lowest price. Conse-
quently, one provider can capture the entire market by setting the price slightly lower than

30
the competitor; but then the competitor will of course react by lowering the price itself; etc.
Ultimately, this price war leads to a price that exactly covers the costs: the price is, there-
fore, equal to the minimum of the average costs (and therefore also equal to the marginal
costs)11 ; profit is zero for any company. So we get the same equilibrium situation as under
perfect competition; the duopolists have no market power.

2.3.2 Hotelling’s model.

If we take into account the possibility of product differentiation (and thus no longer have a
homogeneous oligopoly), we can escape the paradox that price competition in an oligopoly
leads to the same equilibrium as under perfect competition. Hotelling’s model shows that
firms can escape the paradox of Bertrand by offering a differentiated product: this differen-
tiation implies that price competition can generate a positive profit, i.e. it allows the price
to rise above marginal costs in such a case. It is essential that the product variation in
question corresponds to a variation in consumer preferences. This becomes clear based on
the following illustration of the metaphor of Hotelling.
The starting situation is as follows, as illustrated in Figure 3: on a two-kilometer beach,
there are 2 vendors with their ice cream carts. The first seller is 500 meters from the left
end of the beach, the second seller is 500 meters from the right end. The potential buyers
are sunbathing, evenly spread over the beach.
Presume there are travel costs: a sunbather who wishes an ice cream takes into account the
time lost while walking to the ice cream cart. In this scenario, there is a natural form of
product differentiation. For a consumer who is at the left end of the beach, ice cream from
seller 1 is a different product than ice cream from seller 2, because she does not have to walk
as far for it as for a comparable product from ice cream cart 2. Analogous reasoning applies
to consumers on the right side of the beach. This is therefore a case of ‘geographical’ product
differentiation: even if the price and quality of the ice creams are the same, the difference in
the distance leads to a natural form of product differentiation. This geographical product
differentiation (because of travel costs) makes ice creams from ice cream cart 1 (respectively
2) more attractive to a sunbather on the left (respectively right side) than ice creams from
11
Throughout this course, we maintain the assumption of constant returns to scale, with average costs
equalling marginal costs. Under variable returns to scale, the firm will produce in this case at the minimum
of its average cost function, which corresponds to its marginal cost.

31
ice cream cart 2 (respectively 1): if price and quality are the same, it seems inconceivable
that the consumer would walk half a kilometer, then pass ice cream cart 1 (respectively 2),
and walk another kilometer to buy ice cream at ice cream truck 2 (respectively 1), to finally
walk a mile back to her lounger. Product differentiation thus provides each ice cream vendor
with its own clientele (a so-called ‘niche’), which gives it a certain market power. Because
of this market power, he can set the price higher than the marginal cost, and thus realize a
positive profit. In conclusion, profit is therefore no longer equal to zero (as with price com-
petition in a homogeneous duopoly), because product differentiation counterbalances price
competition.

This metaphor of Hotelling can easily be translated into many real-life situations. Namely,
replace the position of sunbathers along the beach with differences in consumer preferences
and replace the location of the ice cream carts with product differentiation, which caters
to these different preferences. For example, various car brands respond to consumers with
their profile; thus creating their niche, they gain market power and can push the price above
cost. Through product differentiation, the suppliers thus acquire market power, and can
thus charge a higher price than the cost price. However, they should not exaggerate this:
product differentiation inhibits price competition but does not eliminate it.

The m

Figure 3: Metaphor of Hotelling: socially optimal solution

To study Hotelling’s model in detail, presume firstly that the ice cream vendors sell at a
fixed price and let us start from an initial situation as shown in Figure 3. This is an optimal

32
location pattern from a welfare point of view because the average walking distance is as
small as possible: it can be shown that with this placement the average walking distance of
the sunbathers is 250 meters; and that every other location increases the average walking
distance. In this case, as discussed, we have product differentiation and we can thus denote
the market form as a heterogeneous duopoly. However, under fixed prices, the socially
optimal solution will not be the expected solution.

Figure 4: Metaphor of Hotelling: changing location to gain market share under fixed prices

As illustrated in Figure 4, each ice cream vendor has an incentive to move to the center.
For example, suppose that ice cream cart 1 moves to the right. Then this vendor doesn’t lose
customers to his left because he is still the closest ice cream seller to these consumers. He
does steal customers from ice cream vendor 2 because he has now become the closest seller
to those customers. So, ice cream vendor 1 is increasing its market share (represented by
the green area of the beach) at the expense of ice cream vendor 2 (represented by the purple
area of the beach). Analogous reasoning applies to ice cream vendor 2, which can increase
its market share through the symmetrical strategy of moving left. In the equilibrium, both
ice cream vendors are placed in the middle, right next to each other: we obtain a situation
of ‘minimal product differentiation’ as illustrated in Figure 5. Note that this equilibrium
is a Nash equilibrium as neither player has an incentive to change its strategy, given the
expected strategy of the other player.
In general, in the absence of price competition, there is a tendency towards minimal to
no product differentiation, which means that the delivered product becomes homogeneous
again. In sum, under fixed prices, we expect the duopoly to be homogeneous.

33
 The m

Figure 5: Metaphor of Hotelling: homogeneous duopoly

Working further on the result under fixed prices (a homogeneous duopoly with ice cream
carts right next to each other, at the center of the beach), presume now that prices are no
longer fixed (e.g. due to price liberalization in the respective market). We now obtain the
situation of a homogeneous duopoly with price competition. The duopolists, as shown in the
paradox of Bertrand, are expected to start a price war. This implies that firms will no longer
have market power as the optimal price will no longer exceed its marginal costs. Even though
there are only two ice cream vendors, we obtain the equilibrium under perfect competition.
Under liberalized prices, the situation that both ice cream carts position themselves at the
center is no longer a Nash equilibrium. By moving away from the center, given the expected
strategy of the other player, each ice cream cart can increase its profits. Stated differently,
to escape the paradox of Bertrand, corresponding to no market power and zero profits, firms
will pursue product differentiation by moving away from the center of the beach as illustrated
in Figure 6. As such, the ice cream carts can ask for a higher price than the marginal costs
to a certain ‘niche’ of customers who are positioned close to the ice cream cart.
Price competition and product differentiation are thus interrelated; the effect of a change
in the price of ice cream will depend, among other things, on the location of the ice cream
vendor along the beach line. Overall, more (less) severe price competition implies
more (less) product differentiation.12
12
While an exact calculation of the degree of optimal product differentiation for particular situations goes
beyond the scope of this course, we can note that firms will usually not apply maximal product differentiation,
represented by a location at the left and right endpoint of the beach. Some, rather than extreme, product
differentiation often suffices to counterbalance the influences from price competition on market power.

34
 The m

Figure 6: Metaphor of Hotelling: escaping the paradox of Bertrand by product differentiation

35
 2.4 Exercises on 2. Strategic interaction under oligopoly
These exercises are intended to help students develop their economic skills concerning im-
perfectly competitive markets. The student is advised to exercise his/her economic skills by
solving these questions at home. Some of these questions will be discussed in class. The
labeling BASIC/INTERMEDIATE can help you decide whether to go for the BASIC MCQ
or INTERMEDIATE MCQ during the continuous evaluation assessments.

Question 2.1 (BASIC): True or False: Hotelling’s metaphor teaches us, among other
things, that in a duopolistic setting, with the absence of the possibility of price competition,
there will be minimal product differentiation. TRUE

Question 2.2 (BASIC): True or False: The cartel solution or the cooperative solution
guarantees maximum profit for at least one of the two duopolists. true

Question 2.3 (BASIC): True or False: The profit of each duopolist is higher when
fulfilling the agreement than when both duopolists break the agreement because the profit
depends only on their own production. false

Question 2.4 (BASIC): In a game with a unique Nash equilibrium, there is always an
expected outcome: namely this Nash equilibrium. TRUE

Question 2.5: (BASIC) Consider two students, Aimée (A) and Étienne (E), accused
C . D
of copying during an exam. They are questioned separately. Possible actions for each of them
C
5;5 6;1
are confess (C) or deny (D). A and B have no way of talking and do not know the decision of
1;6 2;2
D
the other. The disciplinary committee proposes to each, separately: “If you confess and the
THUS =
Confess and other denies, you are suspended for 1 quarter, the other is suspended for 6 quarters; if you
confess deny and he confesses, you are suspended for 6 quarters, the other for 1 quarter; if you both
confess, you are both suspended for 5 quarters; if you both deny, you are both suspended
for 2 quarters.” What is the expected solution for this game when A and E play rationally?

Question 2.6: (BASIC) Antoine (A) and Bernard (B) are the only two ice cream
vendors on the Côte d’Azur. They have to decide whether to cooperate (C), setting a
monopoly price for their ice cream, or to not cooperate (NC), setting a price as in perfect Texte
competition. This choice is made simultaneously by the two vendors. If they cooperate, A

36
and B make a profit equal to 150. However, if they do not cooperate, A and B obtain a
profit equal to 100. In the case they take different decisions, the one who decided NC and
sets a monopoly price, gets a profit equal to 300, while the one choosing C will earn zero
profits.

(a) Write down the payoff matrix of the game. Do A and B have dominant strategies?

(b) Are there Nash equilibria?

Question 2.7: (INTERMEDIATE) Suppose that you and a fellow student are as-
signed a project on which you will receive one combined grade. You each want to receive
a good grade (which means you have to work), but you also want to do as little work as
possible (which means you shirk). In particular, here is the situation:

• If both of you work hard, you both get an A, which gives each of you 40 units of
happiness.

• If only one of you works hard, you both get a B, which gives each of you 30 units of
happiness.

• If neither of you works hard, you both get a D, which gives each of you 10 units of
happiness.

On the other hand, working hard costs 25 units of happiness while shirking costs 0 units of
happiness.

(a) Complete the payoff matrix:

You
Work (t1 ) Shirk (t2 )
Classmate

Work (s1 ) (... ; ...) (... ; ...)

Shirk (s2 ) (... ; ...) (... ; ...)

(b) What is the likely outcome?

(b.1) (s1 ; t1 )

37
 (b.2) (s1 ; t2 )
(b.3) (s2 ; t1 )
(b.4) (s2 ; t2 )

(c) Another person on your course cares more about good grades. He gets 50 units of
happiness for a B and 80 units of happiness for an A. If this person was your partner
(but your preferences were unchanged), how would your answers to parts (a) and (b)
change?

(c.1) (s1 ; t1 )
(c.2) (s1 ; t2 )
(c.3) (s2 ; t1 )
(c.4) (s2 ; t2 )
(c.5) There are multiple Nash equilibria.

Question 2.8: (INTERMEDIATE) Assume that two airline companies decide to

engage in collusive behavior. Suppose that each company can charge either a high price for
tickets (p = 200) or a low price (p= 100). If one company charges 100, it earns low profits if
the other company also charges 100, and high profits if the other company charges 200. On
the other hand, if the company charges 200, it earns very low profits if the other company
charges 100, and medium profits if the other company also charges 200.

(a) Complete the payoff matrix:

Airline B
p=100 (t1 ) p=200 (t2 )
Airline A p=100 (s1 ) (... ; ...) (... ; ...)
p=200 (s2 ) (... ; ...) (... ; ...)

(b) What is the Nash equilibrium in this game? Explain.

38
 (c) Is there an outcome that would be better than the Nash equilibrium for both airlines?
How could it be achieved? Who would lose if it were achieved?

Question 2.9: (INTERMEDIATE) Two firms compete with each other for profits
in a market. The two firms have decisions to make about their pricing strategies. They can
choose to set their prices at 10, 20, or 30. The matrix showing the profits made at these
different prices is shown in the table below:

Firm B
t1 t2 t3
p=10 p=20 p=30
Firm A s1 p=10 (0 ; 0) (-20 ; 60) (-30 ; 50)
s2 p=20 (60 ; -20) (30 ; 30) (20 ; 100)
s3 p=30 (50 ; -30) (100 ; 20) (60 ; 60)

(a) Does any of the two firms have a dominant strategy?

(b) What is the best strategy for each firm in this situation?

39
3 Profit maximization under monopoly power
If the output market is characterized by perfect competition, the firm is a ‘price taker’: the
market price is unaffected by the individual firm’s production decisions, so it is confronted
with perfectly elastic demand at the prevailing market price. Conversely, if the firm has
monopoly power in the form of monopolistic competition in the short run (serving an entire
niche, till the entry of copy-cats) or in the form of a monopoly (serving the entire market),
the relevant demand curve for the firm will be the declining (niche) market demand curve;
in this case, the market price is influenced by the production decisions of the individual firm,
which is the ‘price setter’.

3.1 Profit maximization: Graphical and algebraic representation

We focus on profit-maximizing firms with monopoly power, having a downward sloping
inverse demand function for their product; a negative relation between p and q. For these
firms, both revenues and costs, and thus profits, will depend on the produced (and sold)
output q. We note: P (q) = T R(q)–T C(q), where P (q), T R(q) and T C(q) are respectively
the profit, revenue and costs associated with the output level q. Profit maximization thus
comes down to choosing the profit-maximizing quantity q ∗ , as it indirectly implies optimal
price p∗ (q ∗ ), optimal revenues T R(q ∗ ) = p∗ (q ∗ )q ∗ , optimal total costs T C(q ∗ ) and maximal
profit P (q ∗ ) = T R(q ∗ ) − T C(q ∗ ). The optimal output quantity q ∗ will be chosen such that
P (q ∗ ) is equal to the maximum achievable profit, under the given technological limitations
(i.e. production capabilities) and market constraints (the demand for the products being
produced, the supply of the factors of production required, and the specific market form in
which the firm operates).13

3.1.1 The cost-side of profit maximization

In the following, we assume that every producer is on the production function. This means
that every output is produced via an efficient allocation of the inputs.14 The cost function
13
Economic profit usually differs from accounting profit. The economic concept of profit includes both
explicit and implicit costs (while the accounting concept only includes explicit costs).
14
A production function f stipulates how production inputs can efficiently be transformed into output.
For example, with as production factors x = [labor, intermediate inputs, capital, energy], the production

40
then returns, for each quantity of output produced, the minimum cost level associated with
that quantity of output. The cost function therefore always gives the minimum cost level
(which corresponds to the optimal input bundle) as a function of the output level. We
distinguish between the short and the long term:

• The short term is the period in which one or more factors have a fixed character. In the
short term, the quantity of certain production factors is therefore fixed (e.g., capital
stock; machines, and buildings), while other production factors are variable (e.g., labor
and materials and services usages); their quantity can be adjusted (approximately) free
of charge.

• In the long run, all factors of production are variable.

However, which are the ‘fixed’ and the ‘variable’ production factors depends on the specific
production setting being analyzed. For example, specialized workers can have a ‘permanent’
character in the short term (after all: their recruitment usually takes a lot of time). The
‘short term’ does not correspond to a specific time interval: the ‘short’ or ‘long’ character
depends on the nature of the production process and the magnitude of the adjustment costs
resulting from the change in input quantities. For example, the short term in the retail and
services sector is much ‘shorter’ than in the heavy industry and energy sector. After all,
buying a PC goes faster than, for example, building a power plant.

In the short run, the cost function gives the minimum (total) costs associated with a
certain level of production, whereby certain production factors are fixed. Focusing on a
2-input production function with labor qL and capital q̄K as respective variable and fixed
input (i.e., q = f (qL , q̄K )), we obtain the following total cost function:

T C(q) = pL qL (q) + pK q̄K , (3)

where pL and pK denote the price of respectively labor and capital. The variable costs
(represented as V C(q)) are pL qL (q), with qL (q) the (efficient) amount of labor required to
function is q = f (x). Under constant returns to scale, a proportional increase in x implies a proportional
increase of q. Under increasing (decreasing) returns to scale, a proportional increase in x implies a more
than (less than) proportional increase of q.

41
produce the output level q. The fixed costs (represented as F C) are pK q̄K ; they are formed
by the product of the capital quantity q̄K and the price per unit of capital pK . In the
following we write T C(q) = V C(q) + F C.

Example: Set the following cost function: TC(q) = 63 + 20q.

• The fixed costs F C = 63. These fixed costs must always be paid, even if there is no
production. In a graphical representation with q on the horizontal axis, fixed costs
correspond to a horizontal line: regardless of the level of production, the fixed costs
always remain the same.

• The variable costs V C(q) = 20q. These costs arise from variable factors of production:
raw material costs, energy costs, wages, and salaries of ordinary workers (i.e. non-
specialized workers who are easily recruited). Higher production typically leads to
higher variable costs.

• Average costs AC(q) = 63/q + 20 and AV C(q) = 20 are defined as respectively T C(q)
and T V C(q), divided by q.

• Marginal costs are defined as the additional costs arising from the production of an
additional (small) unit. The marginal cost of the qth unit produced is, therefore:

∂T C(q)
M C(q) = . (4)
∂q

We can graphically derive marginal cost as the slope of the tangent to the total cost
function at the point considered. In this example, M C = 20.

• Throughout the course, for simplicity, we will presume that the average variable costs
AV C = (V C(q)/q) do not vary with q. This in turn implies that the average vari-
able costs are equal to the marginal costs (i.e., AV C = M C). See Figure 7 for an
illustration.

42
 Figure 7: The cost function under constant returns to scale

3.1.2 The revenue-side of profit maximization

Until now, we have not yet taken into account the sales aspects of the firm. However, a
firm can only make a profit (and production only makes sense) if there is sufficient demand
for the product. In general, we define the firm’s total revenues (TR(q)) as the value of the
quantity q produced, which is evaluated at the market price p(q) at which the production
can be sold:
T R(q) = p(q)q. (5)

Note that the price of the product p(q) is expressed as a function of the quantity q sold.
p(q) is the demand function of the product, expressed in the inverse form: this indicates the
price at which each quantity q produced can be sold on the market; generally this means the
price has to go down to sell more. Total revenues, therefore, depend on the quantity sold in
two ways:

43
 • directly through the quantity sold,

• indirectly through the price that can be asked for a given quantity.

Example as illustrated in Figure 8: Set the (linear) demand function for books:

q = 2400–80p.

As result, the inverse demand function is:

p(q) = 30–0.0125q.

Thus, the total revenues are:

T R(q) = p(q)q = 30q–0.0125q 2

Starting from a linear demand function, the revenue function is always a quadratic function.
Starting from total revenues, we can define the average revenues as the total revenues per
unit produced:
AR(q) = T R(q)/q = (p(q)q)/q = p(q). (6)

The average revenues are therefore equal to the selling price of the quantity q. In general, this
function coincides with the previously defined inverse demand function. In our numerical
example, we have
AR(q) = p(q) = 30–0.0125q. (7)

Average revenues are generally decreasing with q: a decreasing demand curve implies that
the price (= the revenues per unit) must decrease to sell more.

Starting from total revenues, we define marginal revenues as the additional revenues
resulting from the sale of an additional (very small) unit. The marginal revenue is determined
as the derivative of the total revenue:
∂T R(q)
M R(q) = . (8)
∂q

44
So in our numerical example, we have:

M R(q) = 30–0.025q.

Marginal revenues are also declining with q. Moreover, they are everywhere below average
revenues (otherwise the latter would not fall) and are declining faster than average revenues.
For linear demand curves (as in our example), the slope of the MR line is always twice as
large in absolute values as the slope of the AR line.

Figure 8: Total, average and marginal revenues for the demand function: q = 2400–80p.

The total revenue curve (with T R(q) = 30q–0.0125q 2 ) satisfies the following: the function
is parabolic, which is typical for a linear demand function. The intuition is as follows: At
point A, the price is so high that nothing is sold, so the revenues are 0. In point B, books are
sold, but the price is now 0 such that the revenues are also 0. Since the MR is determined
as the first derivative of the TR, the TR will rise (and fall) if the MR is greater (less) than
0; and the TR reaches a maximum when the MR is equal to 0.

We previously stated that marginal revenues are declining faster than average revenues.
The intuition is that the drop in price required for the sale of an additional unit does not refer
only to the last unit sold, but to all units sold. In AR, therefore, the fall in price is distributed

45
over all units sold, which is not the case for the MR (where the fall is only attributed to the
last unit sold). See Table 10; suppose the price falls from 17.5 to 16.25 euros. The result is
that 1100 instead of 1000 books (∆q = 100) are sold; and the TR increase with 375 euros
(∆T R = 17875 euro – 17500 euro). So the MR are 3.75 ((∆T R/∆q) = 375/100), which
means a decrease of 2.50 (compared to the MR of 6.25 for q = 1000). The AR is equal to
the price of 16.25 euros, which represents a decrease of 1.25 euros (compared to the AR of
17.5 for q = 1000). We conclude that the marginal revenues are below the average revenues
and have fallen faster (i.e. twice as fast).

Table 10: Example of the relation between (total, average and marginal) revenues, price,
and demand, based on the demand function q = 2400–80p.
price (euro) q TR AR ∆T R MR( ∆T ∆q
R
)
20 800 16000 20 – –
18.75 900 16875 18.75 875 8.75
17.5 1000 17500 17.5 625 6.25
16.25 1100 17875 16.25 375 3.75
15 1200 18000 15 125 1.25
13.75 1300 17875 13.75 -125 -1.25
12.5 1400 17500 12.5 -375 -3.75

3.1.3 Profit maximization

As discussed, the firm will choose its production volume q such that its profit P (q) =
T R(q)–T C(q) is maximal. We distinguish 2 steps in the production decision:

1. The identification of the positive production volume q ∗ (> 0) where the profit is maxi-
mal.

2. The decision whether to produce the profit-maximizing production (q∗ > 0)) or not to
produce at all (i.e. to choose no production (q = 0).

We first determine the positive production level q ∗ at which the profit is maximal. Suppose
that current production is q units, and that firm considers whether it is worthwhile to
produce one unit more or less. The company will then look at the marginal profit (M P (q) =
∂P (q)/∂q), i.e. the change in profit for a marginal change in production. As we will see,

46
it is the value of MP that determines whether or not the profit is maximal. The marginal
profit MP for a produced quantity q is given by:

∂P (q) ∂T R(q) ∂T C(q)

M P (q) = = − = M R(q)–M C(q). (9)
∂q ∂q ∂q

Intuitively, as illustrated in Figure 9, when additional production corresponds to additional

profit (i.e., M P (q) > 0), the profit-maximizing firm will increase production. When extra
production corresponds to profit losses (i.e., M P (q) < 0), the profit-maximizing firm will
decrease production:

• If M P (q) > 0, the firm will decide to produce one unit more. M P (q) > 0 means
M R(q) > M C(q). Thus: extra production implies more additional revenues than ad-
ditional costs and thus leads to a higher profit.

• Conversely, if M P (q) < 0, the firm will decide to produce one unit less. M P (q) < 0
means M R(q) < M C(q). Thus: less production implies more decrease in costs than
loss in revenues and thus leads to a higher profit.

This brings us to the profit maximization rule: production can only be optimal
if the marginal profit is equal to 0:

M P (q ∗ ) = M R(q ∗ ) − M C(q ∗ ) = 0 (10)

The intuition is that in that situation the company has no incentive to increase or decrease
production. Left (right) of q ∗ , the firm has an incentive to increase (decrease) its production,
as illustrated in Figure 9.15
15
A profit-maximizing production volume q ∗ must also satisfy the following conditions in addition to the
profit maximization rule: M R(q) > M C(q) for q < q ∗ and M R(q) < M C(q) for q > q ∗ . Only if these
conditions are met, the firm has an incentive to expand production if q < q ∗ and to contract if q > q ∗ .
As we presume constant returns to scale throughout this course, together with a linear demand curve, this
condition is always satisfied. These additional conditions are especially important when considering a firm
with marginal costs that go from decreasing to increasing; a firm that operates under variable returns to
scale. For these firms, usually, two optima can be found, corresponding to the respective profit minimum
(when not satisfied) and maximum (when satisfied).

47
 Figure 9: Profit maximization rule

The second step concerns the decision whether or not to produce (i.e., to choose no
production (q = 0) or the profit-maximizing production q ∗ > 0). After all, the previously
derived optimality conditions (for q ∗ ) guarantee a maximum but not necessarily a positive
profit; q ∗ may be associated with a loss. The question then is whether the firm will prefer
producing at a loss or not producing at all. For this question, we make a distinction between
the short term and the long term:

• In the long run, a profit-maximizing firm will certainly not choose to produce the
positive profit maximizing q ∗ that leads to a loss (i.e., P (q ∗ ) < 0). Indeed, a company
that can exhaust all possibilities (i.e. in the long run all production factors can be
adapted), and that even then still makes a loss, can better withdraw from the market.

• In the short term, the production decision is more complicated. In principle, it can
make sense for the company to produce at a loss. The reason is that in the short term
one has to bear the fixed costs (already incurred anyway). By definition, these fixed
costs do not depend on the chosen output level q. Thus, if the company decides not to
produce, the company still needs to bear the fixed costs, and only the variable costs
are set to zero (i.e., V C(0) = 0). The following table presents the choice between
producing and non-producing, assuming that a loss is made (i.e., TC > TR with a
positive production):

48
 Table 11: Choice between producing and non-producing, assuming that a loss is made
Produce (q > 0) Don’t produce (q=0)
Revenues TR(q) 0
Costs TC(q)=FC+VC(q) TC=FC
Loss (TC - TR) FC + VC - TR FC

So, starting from the previous table, the firm will produce if the loss for q > 0 is less
than the loss for q = 0; when F C + V C–T R < F C. In other words, a firm will produce
if V C < T R. That is, producing at a loss is beneficial as long as the total revenues
are greater than the variable costs. As a final remark, we highlight that the size of
the fixed costs does not play any role in the production decision of profit-maximizing
firms.

The decision to produce can also be expressed in mean values, dividing VC and TR
by the quantity produced. Then the company will produce as long as p = AR >
AV C. That is, the firm will produce as long as the price (and thus the average
revenues) is higher than the average variable costs. In summary, the firm’s short-term
output decision is as follows: one calculates the profit-maximizing production q ∗ (which
satisfies the profit maximization rule). Then one compares AV C(q ∗ ) with p(q ∗ ):

– if AV C(q ∗ ) > p(q ∗ ) one chooses not to produce,

– if AV C(q ∗ ) < p(q ∗ ) one chooses the production q*,

– if AV C(q ∗ ) = p(q ∗ ) one is indifferent between production q* and no production.

Example, as illustrated in Figure 10: For our example with p(q) = 30 − 0.0125q and
T C(q) = 63 + 20q, applying the profit maximization rule gives us q ∗ :

M R(q ∗ ) = M C(q ∗ ) → 30–0.025q ∗ = 20 → q ∗ = 400.

49
As p(q ∗ ) = 25 > AV C(q ∗ ) = 20, production of q ∗ = 400 will be chosen above no production
in the short run. Short-run profits can be calculated by:

P (q ∗ ) = T R(q ∗ ) − T C(q ∗ ) = 30(q ∗ ) − 0.0125(q ∗ )2 − [63 + 20(q ∗ )]

 
= 1937
∗ ∗ ∗
= q (p − AV C(q )) − F C = 400(25 − 20) − 63 = 1937

Graphically, Figure 10 illustrates the downward-sloping (inverse) demand curve, the

marginal revenue curve, which has a slope that is in absolute terms double of the slope
of the demand curve. Marginal costs and average variable costs are equal and do not vary
with q. The firm thinks at the margin and selects the output quantity q ∗ using the profit
maximization rule (i.e., q ∗ where M R(q ∗ ) = M R(q ∗ )). In point E, corresponding to q = 400,
this is the case as both MR(400) and MC(400) equal 20. q ∗ thus equals 400. We obtain
the profit-maximizing price p∗ graphically by finding point F, where we plug q ∗ = 400 into
the p(q) function. p∗ = 30 − 0.0125q ∗ = 25. Profits P (q ∗ ) = 1937 can be obtained as
q ∗ (p∗ − AV C(q ∗ )) − F C, equalling to the pink area minus F C = 63. In this example, the
profit is positive at the optimal production quantity q ∗ . As discussed earlier, in this case,
the monopolist will effectively choose to produce (and thus offer the amount of q ∗ = 400).
However, it is important to recognize that this need not always be the case: if p∗ is lower
than the average (variable) cost, the firm will choose not to offer anything. Contrary to
popular belief, monopoly power is no guarantee of profit.

50
Figure 10: Graphical representation of the profit maximization rule, for the example with
p(q) = 30 − 0.0125q and T C(q) = 63 + 20q.

3.2 Profit maximization with price discrimination.

In determining profit-maximizing output, we assumed that the monopolist charges the same,
uniform price for all units of the good sold. Under uniform prices, all the consumers pay the
same price, independent of their characteristics. This implies that consumers earn a positive
consumer surplus – their willingness to pay for each unit they buy is higher than the price
they effectively pay. Only for the last unit sold, the willingness to pay equals the price.
Price discrimination is the practice of setting different prices for the same product. As such,
producers can skim (part of ) the consumer surplus. In general, the monopolist will be able
to realize an even higher profit by charging different prices to different buyers.

3.2.1 First-degree price discrimination

Price discrimination of the first degree, as illustrated in Figure 11 refers to the extreme case
where the monopolist charges an individualized price to each each buyer equal to the buyer’s
(maximal) willingness to pay (WTP). To understand first-degree price discrimination, let
us presume that each consumer can only buy one item and that all potential customers
have different willingness to pay for one additional item (i.e., their marginal WTP differs).
The buyers’ WTP for one additional quantity consumed is in this case given by the inverse

51
demand function. By charging each buyer his/her willingness to pay, the monopolist can in-
dividualize the charged price. As prices no longer are uniform but sale-specific, the marginal
revenue of a sale equals the price. In line with the profit maximization rule, the monopolist
will sell to all individuals who have a WTP higher than or equal to the marginal cost. By
first-degree price discrimination, the monopolist exploits additional profit opportunities that
are not exploited with uniform pricing and the monopolist reaches maximal profit, given the
demand curve and cost function.
This is because the monopolist can skim the consumer surplus. Stated differently, as the
(marginal) WTP equals the price for each sale, the consumer surplus is zero and has been con-
verted into producer surplus (i.e., the sum of the difference between the price and marginal
cost for each sale). Figure 11 illustrates for four (out of the many) customers that the mo-
nopolist charges their willingness to pay. The monopolist will not sell to potential customers
with a lower reservation price than Elon, as selling to such a customer with a willingness to
pay lower than the marginal cost, would imply that the marginal revenues (here equalling
the willingness to pay) of that sale would be lower than its implied marginal costs. The
profit of the monopolist is represented by the blue area (minus the fixed costs in the short
run). From a static (naive) societal welfare point of view, first-degree price discrimination
is optimal as the production quantity equals the one that would be reached under perfect
competition. This implies Pareto-efficiency and maximal societal welfare. However, when we
also include distributional (and ethical) considerations, it is highly doubtful that first-degree
price discrimination is good from a societal well-being point of view.

52
Figure 11: First-degree price discrimination, with the individualized prices shown for four
customers

3.2.2 Market segmentation

In practice, the suppliers usually do not know (perfectly) the WTP of the buyers, and perfect
(first-degree) price discrimination is therefore rare. The unknown WTP is often estimated
through the observation of the buyer’s characteristics. A frequently used discriminatory
characteristic is the age of the buyer: adults are often less price sensitive (and often want to
pay more) compared to younger potential customers. In such a case, the seller tries to divide
the market into different customer groups, to charge each group a different price. We call
this process market segmentation, which indicates that the market is divided into segments.

An example of market segmentation with 2 market segments is the situation where adults
have to pay a different (higher) price for a cinema ticket than young people, as illustrated in
Figure 12. The reason is that cinema operators believe that the demand of students and/or
young people is more elastic than that of adults. We represent this in the following figure,
assuming a constant marginal cost for the cinema operator.
With a uniform price for the two segments, the different demand curves imply a different
marginal revenue for the two segments. With a constant marginal cost, the monopolist can
increase its profit (relative to the situation with a uniform price) by redistributing the existing
output. In particular, if the marginal revenues are in the youngster market higher than in
the adult market, the monopolist has an interest in selling more in the youngster market and
less in the adult market segment. He will do this through price differentiation: the price is

53
reduced in the youngster market segment and increased in the adult market segment. This
price differentiation continues until the marginal revenues of the last quantity sold are in
each segment equal to the (constant) marginal cost. This situation is presented in Figure
12: the profit-maximizing price in the adult market with inelastic demand is higher than in
the youngster market with elastic demand. An essential condition for market segmentation
is that it is very difficult to impossible for different customer groups to resell to each other.
Examples where this condition is met, include medical procedures (which of course cannot
be resold) and segmentation by country of sale when transport costs and/or import duties
are high.

Figure 12: Market segmentation, with adults and youngsters as segments

Example: Presume that for segments 1 (e.g., youngsters) and 2 (e.g., adults), the marginal
cost is the same and that market 1 groups consumers that are more price elastic in comparison
to market 2:

T C(q) = 6q → M C(q) = 6
q1 (p1 ) = 20–2p1 → p1 (q1 ) = 10–0.5q1
q2 (p2) = 16–p2 → p2 (q2 ) = 16–q2

Profit maximization under uniform pricing (i.e., p1 = p2 = p) then implies the application of
the profit maximization rule to obtain the optimal output quantity q ∗ , with corresponding
uniform price p(q ∗ ). As shown below, for the example, q ∗ equals 9, p∗ equals 9, and profit

54
under uniform pricing equals 27:

q(p) = q1 (p) + q2 (p) = 36–3p → p(q) = 12–q/3

T R(q) = p(q)q = 12q–q 2 /3
∂T R(q)
M R(q) = = 12–(2/3)q
∂q
M C = M R(q ∗ ) → 6 = 12–(2/3)q ∗ → q ∗ = 9
p(q ∗ ) = 12–q ∗ /3 = 9
P (q) = T R(q ∗ )–T C(q ∗ ) = 81–54 = 27

Under market segmentation, we apply the profit maximization rule separately for segment 1
and segment 2, to obtain respectively q1∗ and q2∗ , with corresponding segment-specific prices
p1 (q ∗ ) and p2 (q ∗ ). For segment 1, q1∗ equals 4, p1 (q1∗ ) equals 8 (i.e., lower than the uniform
price!) and the optimal profit is 8:

T R1 (q1 ) = 10q1 –(q1 )2 /2

M R1 (q1 ) = 10 − q1
(M C =)6 = 10 − q1 → q1∗ = 4
p1 (q1∗ ) = 10–q1∗ /2 = 8
P1 (q1∗ ) = T R1 (q1∗ )–T C(q1∗ ) = 32–24 = 8

For segment 2, q2∗ equals 5, p2 (q2∗ ) equals 11 (i.e., higher than the uniform price!) and the
optimal profit is 25:

T R2 (q2 ) = 16q2 –(q2 )2

M R2 (q2 ) = 16 − 2q2
(M C =)6 = 16 − 2q2 → q2∗ = 5
p2 (q2∗ ) = 16–q2∗ = 11
P2 (q2∗ ) = T R2 (q2∗ )–T C(q2∗ ) = 55–30 = 25

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Market segmentation implies thus a lower price (and more sales) for the relatively more price
elastic segment and a higher price for the relatively less price elastic segment. This higher
freedom in price setting, allows the firm to make more profit. Maximal profit with price
segmentation is the sum of the segment-specific profits and equals 33, which is higher than
the maximal profit under uniform pricing (i.e., 27):

P1 (q1∗ ) + P2 (q2∗ ) = 8 + 25 = 33 > P (q ∗ ) = 27

3.3 Societal discussion: The societal impact of personalized and

dynamic pricing
For readings on this topic, see www.ieseg-online.com.

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3.4 Exercises on 3. Profit maximization under monopoly power
These exercises are intended to help students develop their economic skills concerning im-
perfectly competitive markets. The student is advised to exercise his/her economic skills by
solving these questions at home. Some of these questions will be discussed in class. The
labeling BASIC/INTERMEDIATE can help you decide whether to go for the BASIC MCQ
or INTERMEDIATE MCQ during the continuous evaluation assessments.

Question 3.1: (BASIC) The following table provides information about the demand
for a product by a monopolist.

Quantity Price T R(q) M R(q)

0 20
1 18
2 16
3 14
4 12
5 10
6 8
7 6

(a) Complete the above table.

(b) Suppose there are no fixed costs and the marginal cost is 6. What are the quantity
and price chosen by the monopolist?

Question 3.2: (BASIC) Consider a company that sells e-books over the internet or
makes money from streaming music (Spotify, etc.). How large do you think the marginal
costs are for such a company? Are they larger or smaller in comparison to companies that
produce traditional, tangible products? Explain.

Question 3.3: (BASIC) True of false: Under constant returns to scale, the long-term
average costs are constant and everywhere equal to the long-term marginal costs.

Question 3.4: (BASIC) True or false: In the short run, a profit-maximizing firm

57
will continue to produce if its average revenues are lower than the average costs and total
revenues are greater than variable costs.

Question 3.5: (INTERMEDIATE) A tour operator is a monopolist for the organiza-

tion of weekend packages in Paris. The total cost function of the tour operator is T C = 100q.
The inverse demand function for week-end packages is p = 500 − q, where p is the price of
the package.

(a) Derive the marginal cost of the tour package.

(b) Derive the marginal revenue of the tour package.

(c) What is the total output (no. of tours) chosen by the tour operator to maximize their
own profits?

(d) What is the profit-maximizing price?

(e) What are the tour operator’s profits?

Question 3.6: (INTERMEDIATE) A monopolist faces a demand curve q = 100 − p

where q is the quantity and p is the price. Suppose the monopolist has a marginal cost of
10 and there is no fixed cost.

(a) Calculate the profit-maximizing quantity and price.

(b) Will the monopolist produce or not?

(c) Draw a clearly-labeled figure to illustrate your answers in (a) and (b).

Question 3.7: (INTERMEDIATE) The demand function for membership to the

economic website ‘The True Economist’ differs between non-students (N) and students (S).
The inverse demand functions are respectively pN = 12 − q N and pS = 6 − q S . Assume that
the The True Economist’s total cost function is T C(q) = 10 + 2q.

(a) Calculate the maximal profit under a uniform price setting.

58
(b) Suppose ‘The True Economist’ can apply price discrimination between the two con-
sumer groups by asking students for a copy of their student ID card. Compute the
profit-maximizing prices pN and pS , the number of tickets sold to each group of con-
sumers, and total monopoly profit.

(c) If the news website would obtain information on the inverse demand function per year
of birth and would be allowed to ask for the ID of each customer, could it further raise
its profits via market segmentation according to year of birth?

(d) If the news website would obtain information on the maximal willingness to pay of each
individual and would be allowed to ask for the ID of each customer, could it further
raise its profits by personalized price setting?

59
References
Allen, W.B., Doherty, N.A., Weigelt, K., Mansfield, E., 2013. Managerial economics: Theory,
applications, and cases. WW Norton New York.

Auray, S., Caponi, V., Ravel, B., 2019. Price elasticity of electricity demand in France.
Economie et Statistique 513, 91–103.

Cherchye, L., 2017. Markten en Prijzen. KULAK.

De Loecker, J., Eeckhout, J., Unger, G., 2020. The rise of market power and the macroeco-
nomic implications. The Quarterly Journal of Economics 135, 561–644.

Decoster, A. (Ed.), 2017. Economie, een inleiding. Universitaire Pers Leuven.

Mankiw, N.G. (Ed.), 2014. Principles of economics. Cengage Learning.

Roquebert, Q., Tenand, M., 2017. Pay less, consume more? The price elasticity of home
care for the disabled elderly in France. Health economics 26, 1162–1174.

Varian, H.R., 2014. Intermediate microeconomics with calculus: a modern approach. WW

Norton & Company.

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Imperfectly Competitive Markets: Mock Exam
Question 1 (4 points): Read the attached Economist article “Bursting the bubble: how
gum lost its cool. Gen Z doesn’t see the appeal of chewing plastic”

(a) Under which market form do you consider chewing gum firms to be active? Argument
in detail your choice of market form.

(b) Can chewing gum suppliers make a profit in the long run? Explain why (not).

Question 2 (4 points): Consider two firms (say A and B) simultaneously deciding

whether to build a new plant. Each player can choose L (building a large plant), S (building
a small plant), or N (not building any new plant). The payoff matrix is shown below.

Firm B
t1 t2 t3
L S N
Firm A s1 L (0 ; 0) (12 ; 8) (18 ; 9)
s2 S (8 ; 12) (16 ; 16) (20 ; 15)
s3 N (9 ; 18) (15 ; 20) (18 ; 18)

(a) Give the definition of a Nash equilibrium.

(a) Find the Nash equilibrium(s) of this game.

(b) Do the players have dominant strategies?

Question 3 (4 points): During a newly introduced festival for IESEG students Arise-
Land, only two vendors of beverages are allowed to position themselves in the festival area.
Consider the statement: ‘Escaping fierce price wars is impossible for these two beverage
vendors.’. Do you agree or not? Explain in detail why (not).

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 Question 4 (8 points): The SNCF operates in France as a monopolist in the market
for passenger railway transport. Young people under 28 pay less for a single journey between
two French cities than people older than 28 years.

(a) Is this a case of perfect (first-degree) price discrimination? Why / why not?

Suppose that the demand function for train tickets for young people (younger than 28 years)
is equal to q1 = −3p1 + 150 and the demand function for train tickets for people older than
28 years q2 = −p2 + 100. The average cost function of SNCF is AC = 2 + 40/q.

(b) How many train tickets will SNCF offer in each market in the event of profit maxi-
mization and at what price?

(c) Calculate the total profit achieved by SNCF with the profit-maximizing output from
question (b).

(d) If the SNCF charges the same price in both markets, will the maximum profit increase
or decrease? Further, calculate the optimal output level and maximal profit under a
uniform price setting. Explain the change in profit level compared to the situation
where a different price is charged in the submarkets. Illustrate this graphically.

(e) Give yourself an example of market segmentation in practice and check whether the
conditions for it to be successful have been met.

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