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 Learning objectives:
◦ To understand the meaning of market structure

◦ To briefly discuss the effect of competition on business
decisions in different market structures
◦ To understand various measures available for measuring
market structures
Introduction
 Market structure refers to the competitive environment
within which buyers and sellers interact (or firms operate).
 There are as many ways to classify a market structure.
 Market structure can be categorized in terms of certain basic
characteristics, for example. These include:
1) Number and size distribution of sellers
2) Number and size distribution of buyers
3) Product differentiation
4) Conditions of entry into and exit from the industry.
 Based on these characteristics, we often divide markets into
four main types: a) perfect competition, b) monopolistic
competition, c) oligopoly, and d) pure monopoly.
4.1. Perfect Competition
 Characteristics of a Competitive Market Structure
1) A large number of firms supply a good or service for a
market consisting of a large number of consumers.
2) There are no barriers with respect to new firms entering
the market. As a result, the typical competitive firm will
earn a zero economic profit.
3) All firms produce and sell identical standardized
products: firms compete only with respect to price. All
consumers have perfect information about competing
prices. Thus, all goods must sell at a single market price.
4) Firms and consumers are price takers. Therefore, their
actions have no impact on market price.
4.1. Perfect Competition … continued
 Two key conditions are necessary for price taking.
1) The market is composed of a large number of sellers
and buyers, each of which is small relative to the total
market.
2) The firms’ outputs are perfect substitutes for one
another; that is, each firm’s output is perceived to be
indistinguishable from any other’s output. Perfect
substitutability usually requires that all firms produce a
standard, homogeneous, undifferentiated product, and
that buyers have perfect information about cost, price,
and quality of competing goods.
 These two key conditions ensure that the firm’s demand
curve is perfectly elastic (i.e., perfectly horizontal) so that
each firm can sell as much or as little output as it likes along
the horizontal price line: the “law of one price”.
 In the case of perfectly elastic demand, the firm’s marginal
revenue (MR) is simply the price it receives for the unit:
MR = P. Here the marginal revenue and price coincide.
 The firms supply schedule is related to its cost structure.
The firm faces a U-shaped average cost curve (AC) and an
increasing marginal cost curve (MC). The firm’s supply
curve is simply the portion of the MC curve lying above
average variable cost (Figure 4.1).
Cost and revenue per unit
P*
AC
Q*
Figure 4.1: A Competitive Firm’s Optimal Output (Short run)

Decision Rule: Optimal Level of Output
 The goal of a competitive firm is to maximize profit.
 A perfectly competitive firm maximizes profit by producing
an optimal level of output at it’s MC = P (Figure 4.1).
 The firm would sacrifice potential profit if it deviated from
this output, by producing either slightly more or less.
 In the long run, firms can freely enter or exit the market. In
light of this fact, the profit opportunity shown in Figure 4.1
is temporary. The competitive price will fall to the point
where all economic profits are eliminated.
 Long-run equilibrium is characterized by a “sublime” set
of equalities: P = MR = LMC = min LAC (Figure 4.2).
Figure 4.2: Long-run Equilibrium in a Competitive Market

The paradox of profit-maximizing competition
 In long-run equilibrium, we observe the paradox of profit-
maximizing competition: The simultaneous pursuit of
maximum profit by competitive firm’s results in zero
economic profits and minimum-cost of production for all.
 The typical firm produces at the point of minimum long-run
average cost (LAC) but earns only a normal rate of return
because P = LAC. A zero economic profit affords the firm a
normal rate of return on its capital investment.
Competitive Market (or Industry) Equilibrium
 The competitive market is in equilibrium when industry
demand exactly matches industry supply (Figure 4.3).
 The current market equilibrium occurs at E, where the
market price is P* per unit and the industry’s total quantity
of output is Q* units (Figure 4.3).
 At point E, all firms make zero economic profits; no firm
has an incentive to alter its output; and no firm has an
incentive to enter or exit the industry.
P’
P*
P’’
Q* Q’ Q”
Figure 4.3: Competitive price and output in the Long Run

The Effect of a Permanent Increase in Market Demand on
Competitive Market Equilibrium
 A permanent increase in market demand is shown as a
rightward shift of the demand curve (from DD to D’D’).
➢The first effect of this shift is to move the market
equilibrium from E to E’: the market price has risen
from P* to P’ and industry output has increased to Q’.
➢The new equilibrium is derived by equating demand
and short run supply. This is precisely the firm’s profit
maximizing response to the price (see Figure 4.1).
The Effect of a Permanent Increase in Market Demand …
 The shift in demand calls forth an immediate supply
response. Because the firms currently in the market are
enjoying excess profits, new firms will be attracted into
the industry. As a result, price will be bid down below and
will continue to be bid down as long as excess profits exist.
 The new long-run equilibrium result is at E*. Price is bid
down to P* per unit, its original level. At this price, total
market demand is Q” units. In turn, industry supply
increases to match this higher level of demand.
 In the long run, the increase in demand has called forth
increase in the number of firms as well.
Competitive market efficiency
 Competitive markets promotes social welfare: they
provide efficient amounts of goods and services at
minimum cost to the consumers who are most willing (and
able) to pay for them: market efficiency (Figure 4.4).
 Competitive market is efficient because it delivers the
maximum benefit to consumers and producers together.
 The total gain from competitive market transaction is the
sum of consumer surplus and producer surplus (profit).
 Consumer surplus is the difference between what the
consumer is willing to pay and what she/he actually pays.
Price
Figure 4.4: Consumer Surplus and Producer Surplus

Competitive market efficiency …
 A competitive market is efficient because
1) Production is efficient. The active firms in the market
are necessarily least-cost suppliers.
2) Consumption is efficient. All consumers who are most
willing (and able) to pay the market price (i.e., those
who reside on the highest portion of the demand curve)
will actually end up with the goods.
3) The level of output is efficient. Given the market
selection of minimum-cost producers and maximum-
value consumers, the optimal output is achieved at the
competitive intersection of supply and demand.
Example 4.1: A firm in a perfectly competitive market has a cost
structure described by the equation C = 25 - 4Q + Q2, where Q is
measured in thousands of units.
a) If 40 such firms serve the market,
i. what is the equation of the market supply curve?
ii. What is the equilibrium price in the long run?
b) Let industry demand be given by the equation QD = 320 - 20P.
i. Find the output level of the typical firm.
ii. Find total output in the long run.
iii. How many firms can the market support?
c) Suppose market demand increases to QD = 400 - 20P. Find the
equilibrium price in the short run (before new firms enter) and
check that the typical firm makes a positive economic profit.
d) In the long run (after entry) what is the equilibrium price? And
how many firms will serve the market?
4.2. Monopoly
Characteristics of Pure Monopoly
 A market structure that has only one seller: a single firm.
 The earnings of many are in the hands of one.
 The firm has complete control over industry output.
 There are two main issues to address in analyzing

monopoly. First, one must understand monopoly behavior
– how a profit-maximizing monopolist determines price and
output. Second, one must appreciate that a precondition for
monopoly is the presence of barriers to entry, factors that
prevent other firms from entering the market and competing
on an equal footing with the monopolist.
4.2. Monopoly … continued
Decisions of a Profit-Maximizing Monopolist Firm: Price
and Output
 Being the lone producer, the monopolist is free to raise
price without worrying about losing sales to a competitor
that might charge a lower price.
 However, this does not mean it can raise price indefinitely.
Its optimal price and output policy depends on market
demand. Because the monopolist is the industry, its demand
curve is given simply by the industry demand curve.
 As a profit maximizer, the monopolist maximizes its profit
by producing an output such that MR = MC (Figure 4.5).
The monopolist’s
total excess profit
Figure 4.5: A Monopolist’s Optimal Price and Output

Decisions of a Profit-Maximizing Monopolist Firm …
 The monopolist often makes positive excess profit.
 The monopolist’s total excess profit is the product of the
monopolist’s profit per unit, P – AC (Figure 4.5).
 The key to maximizing monopoly profit is to restrict
output to well below the competitive level and, in so
doing, to raise price. However, the actual size of the
monopolist’s total excess profit depends directly on the
position of industry demand versus its cost.
 For instance, if other goods or services are close substitutes
for the monopolist’s product, industry demand may be
relatively elastic and afford relatively little excess profit.
Measure of Monopoly Power
 A common measure of monopoly power is Lerner index, L:
L = (PM – MC)/ PM
 The Lerner index is just the monopolist’s optimal markup.
 According to the markup rule, (P - MC)/P =1/Ep, if the
monopolist is profit maximizing, the L should be equal to
the inverse of the industry’s price elasticity of demand.
 There are both advantages and disadvantages of using the
Lerner index as a measure of monopoly power. This index
indicates the degree to which the monopolist can elevate
price above marginal cost. However, it does not measure the
magnitude of monopoly profit.
The presence of monopoly represents
a major deviation from the efficiency
of perfect competition
The triangle MDE is referred

to as the deadweight loss
attributed to monopoly.
Figure 4.6: Perfect Competition versus Pure Monopoly

Preconditions for Monopoly: Barriers to Entry
 Sources of entry barriers include the following.
1) Economies of scale - the cost advantages that
monopolist obtain due to its scale of operation, with cost
per unit of output decreasing with increasing scale.
2) Capital requirement - When large sunk costs are
required, entry is highly risky.
3) Pure quality and cost advantage may be due to
superior technology, more efficient management,
economies of scope, or learning.
4) Product differentiation - Once an incumbent firm has
created a preference for a unique product or brand name
via advertising and marketing campaigns, it has erected
large barriers to new entrants.
Preconditions for Monopoly: Barriers to Entry …
5) Control of resources - A barrier to entry exists when an
incumbent firm controls crucial resources.
6) Patent, copyrights, and other legal barriers - A patent
grants the holder exclusive rights to make, use, or sell an
invention for 20 years.
7) Strategic barriers - the dominant firm may take strategic
actions explicitly aimed at erecting entry barriers.
▪ Securing legal protection via patent or copyright.
▪ Exercise limit pricing to keep price below monopoly levels to
discourage new entry.
▪ Engage in extensive advertising and brand proliferation to
raise the cost of entry for new competitors.
▪ Intentionally create excess productive capacity as a warning.
 Example 4.2: Firm S is the only producer of foam fire
retardant and insulation used in the construction of
commercial buildings. The inverse demand equation for the
product is given by P = 1,500 - 0.1Q where Q is the annual
sales quantity in tons and P is the price per ton. The firm’s
total cost function (in Birr) is C = 1,400,000 + 300Q + 0.05.
To maximize profit,
a) How much foam insulation should firm S plan to
produce and sell?
b) What price should it charge?
c) Compute the firm’s total profit.
4.3. Monopolistic Competition
Characteristics of Monopolistic Competition
 Monopolistic competition represents a mixture of perfect
competition and monopoly characteristics.
 The main feature of monopolistic competition is product
differentiation in most consumer markets: Firms compete
by selling products that differ slightly from one another.
 Firms sell goods with different attributes (claimed to be
superior to those of competitors). They also deliver varying
levels of support and service to customers. Advertising
and marketing, aimed at creating product or brand-name
allegiance, reinforce (real or perceived) product differences.
4.3. Monopolistic Competition … Continued
Characteristics of Monopolistic Competition …
 Product differentiation also means that competing firms
have some control over price. Because competing
products are close substitutes, demand is relatively elastic,
but not perfectly elastic as in perfect competition.
 In analyzing monopolistic competition, one often speaks of
product groups: collections of similar products produced
by competing firms. Within product groups there are
significant perceived differences among competitors.
 The determination of appropriate product groups always
should be made on the basis of substitutability and relative
price effects.
Characteristics of Monopolistic Competition …
 Monopolistic competition is characterized by three basic features.
1) Firms sell differentiated products. Although these products are
close substitutes, each firm has some control over its own price;
demand is not perfectly elastic.
2) The product group contains a large number of firms. This
number (be it 20 or 100) must be large enough so that each
individual firm’s actions have negligible effects on the market’s
average price and total output. In addition, firms act
independently; that is, there is no collusion.
3) There is free entry into the market.
 One observes that the last two conditions are elements drawn from
perfect competition. Nonetheless, by virtue of differentiated
products, the typical firm retains some degree of monopoly power.
Equilibrium of Monopolistic Competition
 Figure 4.7 shows a short-run equilibrium of a typical firm
under monopolistic competition.
 Because of product differentiation, the firm faces a slightly
downward-sloping demand curve (Figure 4.7 ).
 Given this demand curve, the firm maximizes profit by
setting its marginal revenue equal to its marginal cost.
 The resulting output and price are Q and P, respectively
(Figure 4.7). The firm makes a positive economic profit.
Figure 4.7: Short Run Equilibrium of Monopolistic Competition
Equilibrium of Monopolistic Competition …
 In the long run, the outcome in Figure 4.7 is not sustainable.
 Attracted by positive economic profits, new firms will enter
the market. Because it must share the market with a greater
number of competitors, the typical firm will find that its
demand curve will shift to the left (reduced demand).
 Figure 4.8 shows the firm’s new long-run demand curve
 The firm’s optimal output is QE, where MR = MC.
 However, he entry of new firms has reduced the firm’s
demand curve to the point where only a zero economic
profit is available. In a long-run equilibrium, thus, the free
entry (or exit) of firms ensures that all industry participants
earn zero economic profits (Figure 4.8).
Figure 4.8: Long Run Equilibrium of Monopolistic Competition
Perfect competition versus Monopolistic Competition
 The essential difference between perfect competition and
monopolistic competition centers on the individual firm’s
demand curve – either downward sloping (reflecting
differentiated products) or infinitely elastic (indicating
standardized products that are perfect substitutes).
 In both cases, the long-run equilibrium is marked by the
tangency of the demand line with the average cost curve.
 Under perfect competition, this occurs at the point of
minimum average cost. In contrast, the typical firm in
monopolistic competition (by virtue of its differentiated
product) charges a higher price above minimum average
cost and supplies a smaller output than its counterpart in a
competitive market.
 Example 4.3: Firm K is a member of a monopolistically competitive
market. Its total cost is C = 900 + 60Q1 + 9 Q12. The inverse demand
curve for the firm’s differentiated product is P = 660 – 16Q1.
a) Determine the firm’s profit-maximizing output, price, and profit.
b) Attracted by potential profits, new firms enter the market. A
typical firm’s demand curve (say, firm 1) is given by P = [1,224 -
16(Q2 + Q3 + . . . + Qn) - 16Q1], where n is the total number of
firms. The long-run equilibrium under monopolistic competition
is claimed to consist of 10 firms, each producing 6 units at a price
of Birr 264. Is this claim correct? (Hint: For the typical firm,
check the conditions MR = MC and P = AC.)
4.4. Oligopoly Competition
4.4.1. Characteristics of Oligopoly Market Structure
 Oligopoly occupies a middle ground between the perfectly
competitive and monopolistic extremes. It is a market
structure dominated by small number of firms.
 This “small number” is not precisely defined. It may be
as small as two (a duopoly) or as many as eight to ten.
 Strategic actions : Each firm’s profit is affected not only by
its own actions but also by actions of its rivals.
 The key to making optimal decisions in an oligopoly market
structure is anticipating the actions of one’s rivals.
 Firms might behave quantity or price competition.
4.4.2. Measures of Market Dominance by a Small
Number of Firms
a) Concentration ratio (CR).
▪ Concentration ratios can be computed from publicly
available market-share information.
▪ The four-firm concentration ratio is the percentage of
sales accounted for by the top four firms in a market or
industry. Eight-firm and twenty-firm concentration ratios
are defined analogously.
▪ The higher the concentration ratio, the greater is the
degree of market dominance by a small number of firms.
4.4.2. Measures of Market Dominance … continued
 Different market structures by degree of concentration:
▪ An effective monopoly is said to exist when the single-
firm concentration ratio is above 90 percent.
▪ A market may be viewed as effectively competitive when
CR4 is below 40 percent. If CR4 < 40 percent, the top
firms have individual market shares averaging less than
10 percent, and they are joined by many firms with still
smaller market shares.
▪ A loose oligopoly when 40 percent < CR4 < 60 percent
and a tight oligopoly when CR4 > 60 percent.
▪ Monopolistic competition falls in the loose-oligopoly range.
▪ The most serious limitation of concentration ratio lies in
the identification of the relevant market.
b) Herfindahl-Hirschman Index (HHI)
 HHI is an alternative measure of market dominance by a
small number of firms.
HHI = (S12 + S22 + ⋯ + Sn2)
 Where S1 denotes the market share of firm 1 and n denotes
the number of firms in the market. For instance, if a market
is supplied by five firms with market shares of 40, 30, 16,
10, and 4 percent, respectively, then
HHI = 402 + 302 + 162 + 102 + 42 = 2,872
 The HHI index ranges between 10,000 for a pure
monopolist (with 100 percent of the market) to zero for an
infinite number of small firms. If a market is shared equally
by n firms, HHI = 10,000/n. If the market has 5 identical
firms, HHI = 2,000; if it has 10 identical firms, HHI =1,000.
 The HHI has a number of noteworthy properties:
 The index counts the market shares of all firms, not
merely the top four or eight.
 The more unequal the market shares of a collection of
firms, the greater is the index because shares are
squared.
 Other things being equal, the more numerous the firms,
the lower is the index.
 Because of these properties, the HHI has advantages over
concentration ratios.
 However, because they are available more readily (and easier to
compute), concentration ratios are quoted more widely.
Market Concentration and Price
 Concentration is an important factor affecting pricing and
profitability within markets. Other things being equal,
increases in concentration can be expected to be
associated with increased prices and profits.
 Under pure competition, for example, low concentration
leads to minimum prices and zero profits.
 Under a pure monopoly, in contrast, a single dominant
firm earns maximum excess profit by optimally raising the
market price.
Market Concentration and Price …
 Given these polar results, positive relationship between an
industry’s degree of monopoly (measured by concentration)
and its prices has been hypothesized. This has also been
confirmed for a wide variety of products and markets.
 Price is viewed in the functional form
P = f (C, D, SC)
 where C denotes a measure of cost, D a measure of demand,
and SC seller concentration.
4.4.3. Quantity Competition
A Dominant Firm Model: Price Leadership
 The accepted model assumes that the dominant firm
establishes the price for the industry and the remaining
small suppliers sell all they want at this price. The small
firms have no influence on price and behave competitively;
that is, each produces a quantity at which its marginal cost
equals the market price. Figure 4.8 depicts the resulting
combined supply curve for these small firms.
 The demand curve for the price leader, labeled d, is found
by subtracting the supply curve of the small firms from the
total industry demand curve. In other words, it is the
horizontal distance between curves D and S (Figure 4.8).
Figure 4.8: Optimal Output for a Dominant Firm
4.4.3. Quantity Competition … Continued
A Dominant Firm Model: Price Leadership …
 Once the dominant firm anticipates its net demand curve, it
sets out to maximize its profits by establishing its quantity
where marginal revenue (derived from curve d) equals
marginal cost (curve MC). In Figure 4.8, the leader’s
optimal price is P*, its output is Q*, and the small firms’
combined output is QS.
 Thus, the dominant firm makes the first strategic move
in the market, with the remaining smaller firms responding
to its actions. The important strategic consideration for the
dominant firm is to anticipate the supply response of the
competitive fringe of firms. For instance, suppose the
dominant firm anticipates that any increase in price will
induce a significant increase in supply by the other firms
and, therefore, a sharp reduction in the dominant firm’s own
net demand. Under such circumstances, the dominant firm
does best to refrain from raising the market price.
 Example 4.4: Suppose that total market demand is given by
QD =248 - 2P and that the total supply curve of the 10 small
firms in the market is given by QS = 48 + 3P. The dominant
firm’s marginal cost is MC = 0.1Q. Then, the dominant firm
determines its optimal quantity and price as follows.
 The firm identifies its net demand curve as
Q = QD - QS = (248 - 2P) – (48 + 3P) = 200 – 5P
→ P = 40 - 0.2Q.
 Setting MR = MC →40 - 0.4Q = 0.1Q, or Q* = 80 units.
 In turn, P* = 40 - (0.2)(80) = Birr 24.
 Therefore, QS = 48 + (3) (24) = 120 units.
 Thus, each of the 10 small firms supplies 12 units.
Quantity Competition among Symmetric Firms
 Now we are considering an oligopoly consisting of a small
number of equally positioned competitors produce a
standardized, undifferentiated product.
 The going market price is determined by the total amount of
output produced and sold by the firms. That is, the total
quantity of output supplied by the firms determines the
prevailing market price according to an industry demand
curve Thus, all firms are locked into the same price.
 Via its quantity choice, an individual firm can affect total
output and therefore influence market price.
 Important model of quantity competition was first developed by
Augustine Cournot, a 19th century French economist.
Quantity Competition among Symmetric Firms …
Firm 2’s RF: q2(q1) Given quantity choices, price
q2
adjusts to the level that clears
the market P(q1* + q2*)
Cournot Equilibrium
q2* (q1*, q2*)
Firm 1’s RF: q1(q2)
q1* q1
Figure 4.10: Reaction functions and Cournot Equilibrium
54
 Example 4.5: A pair of firms (firm 1 and firm 2) competes
by selling quantities of identical goods q in a market. Each
firm’s average cost is constant at Birr 6 per unit. Market
demand is given by P = 30 - (Q1 + Q2), where q1 and q2
denote the firms’ respective outputs (in thousands of units).
Determine each firm’s profit-maximizing output.
 Solution: to solve the solution, we begin by observing the
effect on demand of the competitor’s output.
◦ Firm 1 faces the demand curve: P = 30 - Q1 - Q2
◦ Firm 1’s revenue function: R1= PQ1 = (30 - Q1 - Q2)Q1
◦ Marginal revenue, in turn, is: 30 -2Q1 – Q2
◦ Setting marginal revenue equal to the Birr 6 marginal cost,
we find reaction function of firm 1:
𝟑𝟎 − 𝐐𝟐 − 𝟐𝐐𝟏 = 𝟔 → 𝐐𝟏 = 𝟏𝟐 − 𝟎. 𝟓𝐐𝟐
◦ An increase in Q2 reduces firm 1’s (net) demand, marginal

revenue, and optimal output.
◦ Similar procedure produces firm 2’s reaction function:
𝑸𝟐 = 𝟏𝟐 − 𝟎.𝟓𝑸𝟏
◦ Solving the two reaction functions simultaneously, we
solve Cournot equilibrium. In equilibrium, each firm
makes a profit-maximizing decision, anticipating profit-
maximizing decisions by all competitors.
𝐐𝟏 = 𝟏𝟐 − 𝟎.𝟓 𝟏𝟐 − 𝟎.𝟓𝑸𝟏 → 𝐐𝟏 = 𝟏𝟐 − 𝟔 + 𝟎.𝟐𝟓𝑸𝟏 → 𝟎.𝟕𝟓𝑸𝟏 = 𝟔 → 𝑸𝟏 = 𝟖
𝐐𝟐 = 𝟏𝟐 − 𝟎.𝟓 𝟏𝟐 − 𝟎.𝟓𝑸𝟐 → 𝐐𝟐 = 𝟏𝟐 − 𝟔 + 𝟎.𝟐𝟓𝑸𝟐 → 𝟎.𝟕𝟓𝑸𝟐 = 𝟔 → 𝑸𝟐 = 𝟖

◦ These are the unique equilibrium quantities. Since the
firms face the same demand and have the same costs, they
produce the same optimal outputs.
◦ These outputs imply the market price,
P = 30 - Q1 - Q2 = 30 – 8 – 8 = Birr14
◦ Each firm’s profit is
Firm 1: (30 - Q1 - Q2)Q1 - 6Q1 = Birr 64,000
Firm 2: (30 - Q1 - Q2)Q2 - 6Q2 = Birr 64,000
◦ Total profit of the industry is Birr 128,000.
◦ The analysis can be applied to any number of firms; it is

not limited to the duopoly case.
Oligopoly, Perfect Competition and Pure Monopoly
 The oligopoly equilibrium lies between the pure-monopoly
and purely competitive outcomes.
 In the example above, for example, the purely competitive
outcome occurs at a quantity sufficiently large that price is
driven down to average cost AC = Birr 6, so that industry
profit is zero and total quantity is QC=24 thousand units.
 In contrast, a monopolist (either a single firm or the two
firms acting as a cartel) would limit total output (Q) to
maximize industry profit:
Π = (30 – Q)Q – 6Q
Oligopoly, Perfect Competition and Pure Monopoly …
 Setting marginal revenue equal to marginal cost implies
30 - 2Q = 6 → QM=12 thousand units
PM=18 thousand.
Total industry profit is Birr 144,000.
 In sum, the oligopoly equilibrium has a lower price, a larger
total output, and a lower total profit than the pure-monopoly
outcome; and a higher price, a smaller total output, and a
higher total profit than the perfect competition outcome.
4.4.4. Price Competition
 The case of price competition originally was suggested by
Joseph Bertrand, a nineteenth-century French economist.
 Suppose duopolists produce an undifferentiated good at an
identical (and constant) marginal cost, say Birr 6 per unit.
 Each firm seeks to determine a price that maximizes its own
profit while anticipating the price set by its rival.
 Each can charge whatever price it wishes, but consumers
are very smart and always purchase solely from the firm
giving the lower price: the lower-price firm gains the entire
market, and the higher-price firm sells nothing.
 The payoff (profit) function takes a radically different form.
4.4.4. Price Competition … Continued
 Letting Q(P) represent the market demand function and c
the marginal cost, this leads to a payoff to firm 1 of:
 What are the firms’ equilibrium prices?

 The unique equilibrium is for each firm to set a price equal
to marginal cost. In equilibrium, P = AC = MC so that both
firms earn zero economic profit.
 With the whole market, firms compete the price down to
the perfectly competitive, zero-profit level.
 This may appear to be a surprising outcome.
4.4.5. Other Dimensions of Oligopoly Competition
Advertising
A Single Firm’s Optimal Advertising
 One way to picture the firm’s decision problem is to write
its demand function as Q(P, A).
 Here the demand function, Q, shows that the quantity of
sales depends on price, P, and advertising expenditure, A.
 The firm’s total profit in terms of P and A can be written as
Π = P * Q(P, A) - C[Q(P, A)] – A
 We see that determining the level of advertising involves a
basic trade-off: Raising A increases sales and profits (the net
value of the 1st two terms) but is itself costly (the 3rd term).
4.4.5. Other Dimensions of Oligopoly Competition …
A Single Firm’s Optimal Advertising …
 As always, the optimal level of advertising is found where
marginal profit with respect to A is zero.
 Taking the derivative and setting this equal to zero, we find
 Example 4.6: Let the demand for a good be given by
Q=10,000P-5A0.5 and MC = Birr 0.80. Find the firm’s
optimal price, output, and level of advertising.
 Solution:
 Noting that EP =-5, we can solve for price using the markup
rule:
 Note that with the constant elasticity demand function,
optimal price does not depend on the level of advertising
expenditure. With P = 1 and MC = 0.8, the firm’s
contribution is Birr 0.20 per unit.
 Thus, net profit function is
 Finally, substituting A = Birr 1,000,000 into the demand

equation yields Q = 10,000,000.
Advertising as a Competitive Strategy within Oligopoly
Roles of advertising
1) Production differentiation. One role of advertising is to
convince consumers that its product is different and better
than competing goods. The ideal result of such advertising
is to create a large segment of loyal consumers—
customers who will not defect to a rival product, even if
the competitor offers a lower price or enhanced features.
2) Informational Advertising. A second major role of
advertising is to provide consumers better information
about competing goods. The effect of purely informational
advertising is to make consumers more aware of and
sensitive to salient differences among competing products.
Summary
 Whatever the market environment, the firm maximizes
profit by establishing a level of output such that marginal
revenue equals marginal cost.
1) In perfect competition, firms face infinitely elastic demand: MR =
P. So, the firm follows the optimal output rule P = MC. In long-run
equilibrium, the firm’s output is marked by the equalities P = MR =
MC = Min AC , and the firm earns zero profit.
2) In pure monopoly, a single firm supplies the market and has no
direct competitors. Prohibitive entry barriers prevent rival firms
from entering the market and competing evenhandedly with the
incumbent monopolist. To maximize profit, thus, the monopolist
firm restricts output (relative to the competitive outcome) and raises
price above the competitive level. It sets MR = MC, where MR is
determined by the industry demand curve. The magnitude of
monopoly profit depends on demand (the size and elasticity of
market demand) and on the monopolist’s average cost.
Summary …
3) In monopolistic competition, large number of small firms compete
in the market with no barriers to entry by new suppliers. In this
sense, it would occupy the same cell as perfect competition.
However, monopolistic competition is marked by product
differentiation and because each firm faces a slightly downward-
sloping demand curve, price exceeds minimum average cost.
However, the firm’s long-run equilibrium is described by the
conditions MR = MC and P = AC.
4) Oligopoly occupies a middle ground between perfect competition
and monopolistic competition. It is a market dominated by a small
number of firms. Each firm’s profit is affected not only by its own
actions but also by actions of its rivals. The key to making optimal
decisions in an oligopoly market structure is anticipating the actions
of one’s rivals. Firms might behave quantity or price competition.

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 Learning objectives:

◦ To understand the meaning of market structure

Figure 4.1: A Competitive Firm’s Optimal Output (Short run)

Figure 4.2: Long-run Equilibrium in a Competitive Market

Figure 4.3: Competitive price and output in the Long Run

Figure 4.4: Consumer Surplus and Producer Surplus

 There are two main issues to address in analyzing

Figure 4.5: A Monopolist’s Optimal Price and Output

The triangle MDE is referred

Figure 4.6: Perfect Competition versus Pure Monopoly

Firm 1’s RF: q1(q2)

◦ An increase in Q2 reduces firm 1’s (net) demand, marginal

𝐐𝟏 = 𝟏𝟐 − 𝟎.𝟓 𝟏𝟐 − 𝟎.𝟓𝑸𝟏 → 𝐐𝟏 = 𝟏𝟐 − 𝟔 + 𝟎.𝟐𝟓𝑸𝟏 → 𝟎.𝟕𝟓𝑸𝟏 = 𝟔 → 𝑸𝟏 = 𝟖

𝐐𝟐 = 𝟏𝟐 − 𝟎.𝟓 𝟏𝟐 − 𝟎.𝟓𝑸𝟐 → 𝐐𝟐 = 𝟏𝟐 − 𝟔 + 𝟎.𝟐𝟓𝑸𝟐 → 𝟎.𝟕𝟓𝑸𝟐 = 𝟔 → 𝑸𝟐 = 𝟖

◦ The analysis can be applied to any number of firms; it is

 What are the firms’ equilibrium prices?

 Finally, substituting A = Birr 1,000,000 into the demand

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